Developing China's Capital Market

Experiences and Challenges

D. Cumming, A. Guariglia, W. Hou, E. Lee, D. Cumming, A. Guariglia, W. Hou, E. Lee

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137341570
• Topic: Business
• Subtopic: Financial Services
• Index: Business

China is an increasingly influential emerging economy that is currently attracting the attention of academics, practitioners, and policy makers. This book is a collection of cutting edge research findings on issues relating to the experiences and challenges of China's capital market development.

1

Introduction to the Experiences and Challenges in the Development of the Chinese Capital Market

Douglas Cumming, Alessandra Guariglia, Wenxuan Hou, and Edward Lee

Following the recent financial crisis and ongoing decline experienced by developed economies, the weight of global economic growth is shifting increasingly toward emerging economies. China is widely recognized as playing a leading role in spearheading this shift of economic power. Indeed, China, an increasingly influential emerging economy, is currently attracting worldwide attention from academics, business practitioners, policy makers, and also from the more mainstream media. According to the analyses of IHS Global Insight, which is the world’s leading provider of economic research and intelligence, in 2010 China overtook the United States to become the largest manufacturing nation.¹ Based on the forecast of Pricewaterhouse Coopers (2011), China has the potential to surpass the United States, and become the world’s largest economy by 2020.² China’s growth has lifted millions of people out of poverty and has been hailed as one of the most important economic achievements in modern times. After three decades of transitioning from a centrally planned to a market-oriented economy, and as China’s rise in prominence becomes ever more visible on the global stage, the importance of China’s capital markets in this development process will only intensify.

The efficient allocation of financial resources is the primary objective of the capital market and a key determinant of economic growth in market-oriented economies. A well functioning capital market is crucial to promote investor confidence and facilitate capital acquisitions in order to convert growth opportunities into GDP. The knock on effects that spread from the banking sector difficulties into a global recession following the financial crisis of 2007–2008 demonstrates how capital markets can influence the well-being of the wider economy. As a result, the development of the capital market in China is set to play a crucial role in the country’s ascension toward becoming one of the largest economies in the world. Since its inception in the early 1990s, the Chinese stock market has experienced unprecedented development. By the early 2000s, China’s stock market was already the largest in the developing world, and, as of late 2010, the Shanghai Stock Exchange became the world’s fifth largest in terms of market capitalization.³ Given China’s economic achievements so far, the development of its capital market is expected to have useful policy implications to other emerging economies. However, given China’s economic ambition for the future, the challenges of its capital market development need to be identified to enable proper remedies to be formulated.

This book seeks to highlight some of the experiences and challenges pertaining to the development of China’s capital market. As a result of its socio-political and culture background, the Chinese capital market is associated with many unique institutional factors that are distinct from those of the developed countries in the Western Hemisphere. Therefore, China offers a unique research setting that provides new insight to enrich academic literature in business, finance, and accounting. This book brings together a collection of cutting-edge empirical research findings contributed by researchers worldwide with expertise in Chinese capital market development. Among our contributors are Michael Firth, who is a world leading authority on China’s financial market, as well as Martin Conyon, who is an internationally renowned expert in corporate governance. We group the topics into three themes ordered as follows: (I) asset valuation, (II) provision of capital, and (III) corporate governance. The two studies on asset valuation examine the impact of the information environment on the market value of Chinese listed firms (Chapter 2), and the effect of financial controls on the Chinese real estate market (Chapter 3). The three studies that deal with the provision of capital document the development of venture capitalism (Chapter 4), the growth of institutional investors (Chapter 5), and the impact of foreign bank entry (Chapter 6) in China. The corporate governance theme includes two studies: one explores executive remuneration issues (Chapter 7), and the second examines the association between independent director characteristics and firm performance (Chapter 8).

Chapter 2 by Michael Firth, Man Jin, and Yuanyuan Zhang, “Information Asymmetry and the Diversification Discount: Evidence from Listed Firms in China,” examines the effect of corporate diversification and information asymmetry on the stock valuation of Chinese listed firms. The objective of this study is to analyze whether corporate diversification reduces the value of firms directly, or whether it does so indirectly through increased information asymmetry. The underlying research question of this study is important for China’s fast growing economy. Diversification is an important but often controversial corporate strategy. If the firm value reduction associated with corporate diversification is not attributed to this strategy per se but due to the decline of transparency it invokes, then managers could alleviate the valuation effect of diversification through better corporate disclosure. In this study, the authors apply the probability of informed trading (PIN) as a measure of the degree of information asymmetry revealed through the trading process in the stock market. Over a sample period of 2003 to 2008, they reach the following conclusions. First, diversified firms have higher information asymmetry. Second, diversified firms have lower firm value. Third, after controlling for information asymmetry, the diversification strategy does not reduce firm value. In other words, managers that pursue a diversification strategy may not necessarily reduce shareholder wealth as long as they are able to enhance transparency. The policy implication of this evidence is that regulators of the Chinese capital market should try to strengthen corporate disclosure and reduce the adverse impact of information asymmetry induced by corporate diversification.

Chapter 3 by Xiuping Hua and Chris Adcock, “Asset Pricing under Financial Repression: Evidence from the Chinese Real Estate Boom during 1999 to 2010,” examines whether financial policies such as tight control of interest rates, credit allocation, bank reserve requirements, and capital account influence the valuation of real estate at both national and big-city levels. The research question examined in this study is interesting for two reasons. First, the rapidly rising real estate prices represent a serious concern in China among both investors and authorities. Second, strict financial controls are common policies in developing economies and may have contributed to the growth of China’s economy in its earlier stage. If an association is established between the real estate asset bubbles and the financial control policies, this would imply a need to promote policy reforms or to devise necessary solutions. The main findings of this study are as follows. First, the degree of financial control is positively associated with average housing prices. Second, this effect reduces the ability of direct interventions on the real estate market, such as transaction tax and minimum down payment ratio adjustments to control asset price rises. The main policy implication of this finding is that addressing China’s existing real estate asset pricing bubble may require further reforms in the financial system beyond existing interventions in the real estate markets.

Chapter 4 by Shen Xiao and Xiangyi Zhou, “Venture capital investments in China: Reputation, Syndication, and Valuation,” examines the multiple dimensions of venture capital (VC) development in China. These include the impact of VC firms’ reputations on their investment, the comparison between syndicated VC investment and single VC firm investment, and the impact of capital inflows into VC funds on the valuation of these funds’ new investments. These issues are important because, like in many Western developed economies, VCs have contributed to entrepreneurship, innovation, and economic growth in China. The main findings of this study are as follows. First, more reputable VC firms are associated with more successful investment exits and firms backed by more reputable VCs have higher asset productivity. Second, syndicated VC investments are associated with higher probability of successful exits. Third, when the VC fund inflows increase, the valuation of funds’ new investment rises, and this supports the “money chasing deals” hypothesis. The overall policy implication of this study is that the expertise of VC firms matters and that authorities should continue to promote venture capitalism to further China’s economic development.

Chapter 5 by Liming Wang, Ningyue Liu, and Shuo Wang, “Growth and Challenges in the Development in Institutional Investors in China,” provides comprehensive discussion of the growth and expansion of institutional investors in China over the period 2003 to 2009. In emerging economies like China, the development of institutional investors is viewed as favorable because of the expertise such investors can bring to the capital market. The study also compares the preferences of local versus foreign institutional investors operating in the Chinese capital market. The main finding is that, unlike evidence from developed markets, foreign fund holdings in China are more influenced by firms’ governance characteristics than financial indicators. One possible interpretation of this finding is that emerging countries have relatively less developed investor protection than Western developed economies, and this makes foreign investors more concerned about managerial expropriation. The main policy implication of this finding is that authorities should encourage further enhancement of corporate governance in order to widen the range of Chinese firms that will appeal to foreign investors. The study goes on to compare the development of China’s institutional investors against other emerging countries. The authors conclude that, while the growth of institutional investors is common across many emerging economies, this development varies largely in structure and level of investment due to country-specific background such as regulations and market practices.

Chapter 6 by Yizhe Dong, Alessandra Guariglia, and Wenxuan Hou, “Impact of Foreign Bank Entry on the Performance of Chinese Banks,” examines how competition from foreign banks affects Chinese local banks’ profitability, efficiency, and level of risk. The banking sector plays an important role in the Chinese capital market for two reasons. First, due to limited bond market development, banks provide the primary source of debt capital. Second, due to limited investment options, bank deposits remain one of the most important investment channels for the average Chinese citizen. Based on a sample of 51 Chinese banks over the period 2002 to 2010, the study finds that increasing foreign banking presence enhanced the profitability and efficiency of the Chinese banking sector. However, there is no evidence of any effect on the non-interest activities and risk levels of the local banking market. The main implication of this study is that foreign bank entry is positively facilitating the development of the banking sector in China. The authors go on to suggest that policy makers should continue to reform the banking sector to facilitate foreign bank entry by reducing barriers, and could even encourage domestic banks to strengthen their expertise by forming partnership with foreign counterparts.

Chapter 7 by Martin Conyon and Lerong He, “Chinese Executive Compensation: Where Do We Stand?”, examines the determinants of executive compensation in China. Since the financial crisis, managerial remuneration has been a topical and widely debated corporate governance issue in Western developed economies. As China evolves toward a market-oriented economy, the effect of executive compensation will become an increasingly visible issue as it affects both firm performance and investor confidence. This study first provides a thorough review on the institutional background and literature around the topic of executive compensation practices in China. It then explores empirically the characteristics of firms that issue incentives linked compensation such as stock options. The main finding is that equity incentives are more likely to be issued to executives of firms that are larger, better performing, and less risky. Firms that are privately controlled, have less ownership concentration, and have a compensation committee are also more likely to offer equity incentives to executives. The study then compares executive pay in China against other countries. It suggest that both the level of executive pay and the use of equity compensation are lower in China than in Western developed economies. The main policy implication of this study is that there could be room for further development or increase in the use of incentive-linked executive compensation in order to better align the interest of principal and agents.

Chapter 8 by Hanzhang Jiao, Yizhe Dong, Wenxuan Hou, and Edward Lee, “Independent Directors and Corporate Performance in China”, explores the association between independent director characteristics and firm performance. The board of directors represents the interest of shareholders and serves as the primary internal governance mechanism to monitor managers against self-serving activities and expropriating investors. The experience and background of independent directors could also provide firms with external resources and expertise. This study first explores existing literature on the efficacy of independent directors in Western developed economies and suggests there are mixed results. It then classifies independent directors into seven groups, that is, academics, politicians, legal professionals, financial professionals, overseas returnees, and others. Academics and accountants make up the largest proportion of independent directors, which indicates that Chinese firms value the expertise of individuals who are highly educated or have a professional accountancy background. One of the main findings is that firms with academics or accountants serving on the board of directors are associated with higher corporate productivity. A policy implication which follows is that future reforms in China should not only regulate the number of independent directors but could also set guidelines to their characteristics.

In general, the eight chapters in this book consistently suggest that in order to appreciate the experiences and challenges of the development of the capital market in China, it is necessary to consider its unique institutional background, which arises from its transition from centrally planned to market-oriented economy. We encourage future research on Chinese capital markets to take into account institutional factors such as regulations, reforms, regional differences, ownership structure, and even business culture. By exploiting research settings that are different to those characterizing Western developed economies, such studies have the potential to make contributions to the academic literature in business, finance, and accounting. Another potential avenue that offers a wealth of opportunities is to conduct comparative research across the capital market of the Greater China region (that is, mainland China, Hong Kong, and Taiwan) or across the BRICs (Brazil, Russia, India, and China). Finally, we would like to express our gratitude to our contributors for their excellent input to this book.

Notes

   1.  http://www.londonstockexchange.com/news/specials/global-manufactoring/china-asia/china-manufacturing/china-manufacturing.htm

   2.  http://www.pwc.com/en_GX/gx/world-2050/pdf/world-in-2050-jan-2011.pdf

   3.  www.world-exchanges.org/statistics/ytd-monthly

2

Information Asymmetry and the Diversification Discount: Evidence from Listed Firms in China

Michael Firth, Man Jin, and Yuanyuan Zhang

2.1 Introduction

Some firms adopt a strategy of business diversification, with the aim of increasing profitability through gre...

Table of contents

• Cover
• Title
• 1 Introduction to the Experiences and Challenges in the Development of the Chinese Capital Market
• 2 Information Asymmetry and the Diversification Discount: Evidence from Listed Firms in China
• 3 Asset Pricing under Financial Repression: Evidence from the Chinese Real Estate Boom during 1999–2010
• 4 Venture Capital Investments in China: Reputation, Syndication, and Valuation
• 5 Growth and Challenges in the Development of Institutional Investors in China
• 6 Impact of Foreign Bank Entry on the Performance of Chinese Banks
• 7 Chinese Executive Compensation: Where Do We Stand?
• 8 Independent Directors and Corporate Performance in China
• Index