Institutional Causes of Corporate Finance and Governance in Asia

1. Institutional Causes of Corporate Finance and Governance in Asia Joseph P.H. Fan (http://ihome.cuhk.edu.hk/~b109671/index.html)Professor, School of Accountancy and Department of Finance Deputy Director, Center for Institutions and Governance (http://www.baf.cuhk.edu.hk/research/cig/) The Chinese University of Hong Kong Prepared for the 2005 AAA Meeting, San Francisco

2. Outline • Research framework • Asia’s institutional environments • How rent seeking affects corporate behaviors • Conclusions Institutions

3. A Top-down Framework Institutions

4. Asia’s Business Environments • Incomplete or weakly enforced laws and property rights • Government regulations / interventions in market activities • Corruption problems in a few economies • Crony capitalism: some governments allocate business privileges by connections rather than by the market rule • Relationship-based transactions, Confucianism, low trust society Institutions

5. Property Rights Protection in Asia(Source: Property Rights Index, Heritage Foundation, 2001) Institutions

6. Protection of Property Rights across China’s Different Regions High Low Middle Missing Institutions

7. Corruption in Asian Economies(Source: Transparency International: mean Corruption Perception Index 1992-2000) Institutions

8. Rent Seeking and Corporate Behaviors • The quality of public sector governance is of the first order importance in shaping the behavior of Asia’s corporate sector • However, it is often ignored in corporate sector debates in Asia and around the world • In the following we present our research progress on the roles of rent seeking in • Stock valuation • Corporate finance • Governance and professionalism • Corporate transparency • Organizational structure Institutions

9. I. Low Stock Valuation • Asian share investors are subject to expropriation by politicians and/or managers • Investors not able to fully enforce their property rights results in low valuation of shares Institutions

10. Price Protection by Minority Shareholders in AsiaClaessens, Djankov, Fan, Lang (2002) Institutions

11. Cumulative market-adjusted compound stock returns Chinese companies’ post-IPO stock return performance (CAR) distinguished by whether CEOs are politically connected (Fan and Wong, 2005) Institutions

12. Firm Behavior II: High Financial Leverage • Companies in Asia rely on debt much more than equity to finance their investment • Moreover, they rely on short-term debt, even when they engage in long-term investment • Banks, not capital markets, are the primary sources of funds for firms in Asia and other developing countries • Why are these? • Owners’ desire to maintain control • More fundamentally caused by institutional factors Institutions

13. Cross Country Pattern of Corporate leverage (Fan, Titman, Twite, 2004) Institutions

14. Cross Country Pattern of Corporate Debt Maturity (Fan, Titman, Twite, 2004) Institutions

15. Rent seeking and Corporate Finance • In a corrupted country, the government is a weak enforcer (or even a violator) of property rights, and debt (bank loans) provide better protection than equity • Politicians/bureaucrats channel funds to their favored firms through banks they control • We are investigating the effects of government officers corrpution on corporate finance in China (Fan, Rui, Zhao, in progress) Institutions

16. Corruption and Firm Leverage in China(Fan, Rui, Zhau, in progress) Institutions

17. Corruption and Long-term Debt Financing in China (Fan, Rui, Zhau, in progress) Institutions

18. Corruption and Corporate Debt Maturity in China (Fan, Rui, Zhau, in progress) Institutions

19. Firm Behavior III:Boards of directors are weak in governance: the case of China (Chen, Fan, Wong, 2004) Board size 9.22 (range 5 to 19) Manager directors 34% Largest shareholder 53% Minority shareholders 0% Politicians 32% Central govt 4% Local govt 19% Others 9% Institutions

20. Firm Behavior III:Low Director Professionalism in China (Chen, Fan, Wong, 2004) Directors from unaffiliated firms (outside experts) 18% Accountants, lawyers, finance experts 5% Academics 14% Woman directors 5% Age 47 Education Between Junior college and university Institutions

21. Corruption and board professionalismShougang Group in ChinaPercentage of Directors that Are Professionals – Corruption Case Institutions

22. Firm Behavior IV: Opaqueness • Why are Asian companies opaque? • Complex organizational and ownership structures • Covering up: difficulties of putting investors’ interests before family interest • Relationship-based business dealings, rent seeking, or even corruption • Prevent predation and expropriation (sometimes by governments) in weak property rights systems • If these institutional constraints cannot be relieved, it would be difficult to improve corporate transparency even with new accounting standards, laws, and regulations Institutions

23. Opacity Premium in AsiaSource: PricewaterhouseCoopers Institutions

24. Corruption in Asian Economies(Source: Transparency International: mean Corruption Perception Index 1992-2000) Institutions

25. Firm Behavior V:Complex Organizational Structures • Business group • A corporate organization where a number of firms are linked through stock-pyramids and cross-ownership • Groups are the dominant form of corporate organizations in Asia. About 70 percent of publicly traded companies in Asia are group affiliated (Claessens, Fan, Lang, 2005) • Diversification • Asian companies are known for extensive diversification of their businesses (Claessens, Fan, Lang, 2004) Institutions

26. Wang Qunbin Fan Wei Liang Xinjun GUO Guangchang 22% 10% 10% 58% Shanghai Guangxin Technology Development Co. Ltd. Shanghai Fusun High Technology Co. Ltd. 10％ 49％(2) 中国医药控股有限公司. 43.33％ (2) 95% ACCORD PHARM (000028) Shanghai Fusun BusinessInvestment Co. Ltd. 10％ 5% Shanghai Fusun High Technology (Group) Co. Ltd. 90％ 53.92％ Estate 30％ 20％ Iron&Steel 1.94％ 24.53％ 3.77％ 20％ 20％ Nanjing Iron &Steel United Co.,Ltd. Medicine 13.53％ Fusun Pharm (600196) FORTE (HK2337) Zhaojin Mining Co. Ltd. YYTM (600655) 21％ 70.95％ 25％(2) 90.3% 11.36％ NISC (600282) Commerce 8.81％％ Shanghai Fusun I.T. Development Co. Ltd. (Subsidiary) Shanghai Fusun Pharmaceutical Development Co. Ltd. 30％ SFGIC (600827) LRGF (600285) 15.04％(2) Tangshan Jianlong Steel Co. Ltd. 36.03％(1) 26.04％(1) 11.95%(2) Shanghai Friendship-Fusun (holding) Co. Ltd. Lianhua Supermarket (HK0980) TJPC (600488) JianMin Pharm (600976) Tianjin Pharmaceutical Holdings, Ltd. 67.12％ 48％(2) Figure 1: Organization Framework of Fusun Group Institutions

27. Number of business lines of listed companies in China (2003) Institutions

28. Chinese Corporate Pyramids(Fan, Wong, Zhang, 2005) Institutions

29. Why are diversification and group affiliation popular in Asia? • Creating internal factor markets to circumvent external markets subject to distortions and high transaction costs. • These factor markets include financial capital, labor, raw materials and product markets. • The distortions are caused by regulations, taxations, or weak legal protections. • Risk reduction through cross-subsidization • Agency problem • Diversification and group formation could be means for controlling owners to expropriate outside investors • Rent seeking can be more important than professionalism when competing in weak institutional environments Institutions

30. Conclusions • Asian companies’ behaviors are fundamentally shape by their institutional environments • Focusing only on firm level factors is not enough • Top-down approach that examines the interactions between firms and institutions will be fruitful • What should be the focus of corporate sector reforms? • No firm-level quick fix please • No more new laws and regulations cut-and-pasted from formula books • Focusing on institutional factors, such as fighting corruption, will more likely payoff Institutions