Stoyan Tenev and Chunlin Zhang with Loup Brefort Corporate Governance and Enterprise Reform in CHINA BUILDING THE INSTITUTIONS OF MODERN MARKETS Corporate Governance and Enterprise Reform in China Building the Institutions of Modern Markets Stoyan Tenev and Chunlin Zhang with Loup Brefort “The authors of this book, with unparalleled depth of knowledge on China’s enduring experience in enterprise reform, provide an up-to-date analysis on the issue that is central to its transition to market. They demonstrate how corporatiza- tion and ownership diversification, which introduced new institutional forms with- out the dismantling of old ones, have further complicated the universally complex problem of corporate governance. They make a number of recommendations for China’s future reform that are economically sensible and politically feasible. I high- ly recommend this book to all who are interested in China’s corporate governance reform.” Yingyi Qian, Professor of Economics, U NIVERSITY OF C ALIFORNIA , B ERKELEY “Corporate Governance and Enterprise Reform in China is the most thorough and up- to-date analysis of the issues that China is grappling with as it enters the World Trade Organization. It sets forth an ambitious agenda of reforms that are required to complete the transition to a modern market economy.” Nicholas Lardy, Senior Fellow, B ROOKINGS I NSTITUTION “Corporate Governance and Enterprise Reform in China is an extraordinarily rich study of an extraordinarily complex and dynamic topic. At one level, the study offers an essential empirical snapshot of the latest stage of Chinese reform, the effort to build the regulatory and governance mechanisms of a developed industrialized economy. At an even more profound level, the study—in its analysis of China—challenges us to reflect more broadly upon what constitutes the requisite institutional foundations of any modern market system. Given its wide-ranging data and thoroughgoing analysis, this study is ‘must reading’ for academics and practitioners alike. Edward S. Steinfeld, Associate Professor of Political Science, M ASSACHUSETTS I NSTITUTE OF T ECHNOLOGY 2121 Pennsylvania Avenue, N.W. Washington, D.C. 20433 www.ifc.org ISBN 0-8213-5136-2 I NTERNATIONAL F INANCE C ORPORATION A Member of the World Bank Group Tenev/Zhang/Brefort Corporate Governance and Enterprise Reform in China Corporate Governance and Enterprise Reform in China frontmatter.p65 3/15/02, 3:59 PM1 frontmatter.p65 3/15/02, 3:59 PM2 Corporate Governance and Enterprise Reform in China Building the Institutions of Modern Markets World Bank and the International Finance Corporation washington, d.c. 2002 Stoyan Tenev and Chunlin Zhang with Loup Brefort frontmatter.p65 3/15/02, 3:59 PM3 Principal authors: Stoyan Tenev, Chunlin Zhang, and Loup Brefort. Copyright © 2002 The World Bank and the International Finance Corporation 2121 Pennsylvania Avenue, N.W. Washington, D.C. 20433 USA www.ifc.org All rights reserved Manufactured in the United States of America First printing, March 2002 ISBN 0-8213-5136-2 The findings, interpretations, and conclusions expressed in this study are entirely those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. IFC and the World Bank do not guaran- tee the accuracy of the data included in this publication and accept no responsibil- ity whatsoever for any consequence of their use. To order additional copies by mail, write to the World Bank, P.O. Box 960, Herndon, VA 20172-0960, USA; by phone, 1-800-645-7247 or 703-661-1580; by fax, 703-661-1501; by e-mail, www.books@worldbank.org. The material in this publication is copyrighted. Requests for permission to repro- duce portions of it should be sent to the Copyright Clearance Center, Inc., Suite 910, Rosewood Drive, Danvers, Massachusetts 09123, USA. Telephone: 978-750- 8400; fax 978-750-0569; Web address, www.publishers@copyright.com. Library of Congress Cataloging-in-Publication data have been applied for. frontmatter.p65 3/15/02, 3:59 PM4 Contents Foreword, Javed Hamid and Homi Kharas vii Acknowledgments ix Abbreviations and Acronyms x Executive Summary xi 1 Introduction 1 2 The Evolution of Governance Mechanisms in China’s State Sector 5 Corporate Governance in the Context of China’s Overall Approach to Reform 5 From Danwei to the Modern Enterprise System 10 Agency Costs of Local Government Ownership and Enterprise Autonomy 20 Current Approach 24 Conclusion 28 3 The Corporate Governance of Transformed Small and Medium Enterprises 29 Ownership Transformation and Emerging Governance Issues 29 Role of Employees 40 Role of Banks 55 Role of Private Equity Investors 70 Conclusion 74 v frontmatter.p65 3/15/02, 3:59 PM5 4 Ownership and Control of Listed Companies 75 Ownership Concentration and Types of Investors 76 Ownership and Corporate Governance Issues 80 Board of Directors 83 Board of Supervisors 99 Agency Problem of the Controlling Shareholder 101 Conclusion 103 5 Role of Stock Markets and Information Dislosure in the Corporate Governance of Listed Companies 105 Corporate Governance and Performance 105 Stock Market Role in Promoting Good Governance 110 Information Disclosure as a Tool of Corporate Governance 117 Conclusion 126 6 Building a Modern Governance System 127 Establishing Credible Penalties for Failure 127 Addressing the Agency Costs of Government Ownership 128 Strengthening Boards of Directors 135 Empowering Shareholders 142 Developing Capital Markets That Reward Good Corporate Governance 154 Improving Disclosure 156 Activating the Use of Various Corporate Governance Mechanisms 159 Conclusion 160 References 163 contents vi frontmatter.p65 3/15/02, 3:59 PM6 Foreword Corporate governance has been identified by the Chinese government as the core element of the “modern enterprise system.” The policy focus on corporate governance reflects the significant progress that China has made in building market institutions and the importance it attaches to changing corporate behavior. More than two decades of market-oriented reforms in China have created economic entities with a relatively high degree of autonomy. To date, however, ownership diversification and corporatization have had only a limited impact on corporate behavior. China’s commit- ment to improving corporate governance practices reflects the authori- ties’ growing concerns about the potential consequences of a high-level of nonperforming loans in the banking system, overcapacity in most of the industrial sector, and a highly volatile and speculative stock market. Externally, commitments under the World Trade Organiza- tion will expose Chinese companies to the opportunities and chal- lenges of globalization and add to the urgent need to tackle corporate governance issues in a comprehensive and systematic manner. In this context, Corporate Governance and Enterprise Reform in China explores the main corporate governance issues that China is encountering during the course of corporatization and ownership trans- formation of its enterprise sector. It makes a large number of recom- mendations concerning the policy and legal frameworks, procedures, and institutional capacity for improving corporate governance prac- tices in China. The study reflects the increasing emphasis that IFC and the World Bank place on improving corporate governance practices as part of the general effort to support the development of the market institu- tions needed for sustained growth and poverty reduction. In China, the World Bank’s work over the years in support of government re- forms in the financial sector, corporate restructuring, accounting, and legal and judicial practices has contributed directly to the development vii frontmatter.p65 3/15/02, 3:59 PM7 of the institutions of corporate governance. At the company level, IFC is playing an important role in bringing Chinese companies closer to international standards in corporate governance through technical assistance, institution building in the area of financial markets, and incentives embedded in financial instruments. Current World Bank Group work in corporate governance emphasizes governance of fi- nancial institutions; capacity building through training for regulators, company directors, business owners, and investors; and dissemina- tion of best practices through the Global Corporate Governance Fo- rum, studies, and workshops. We hope that this study will provide all those with an interest in the corporate governance practices of Chinese companies with new insights into their status and new ideas for ways to support and par- ticipate in their future improvement. Javed Hamid Homi Kharas Director Chief Economist East Asia and Pacific Department East Asia and Pacific International Finance Corporation World Bank corporate governance in china viii frontmatter.p65 3/15/02, 3:59 PM8 Acknowledgments The study is a joint product of the IFC East Asia and Pacific Depart- ment and the Private Sector Development Unit, East Asia and Pacific Region of the World Bank. Background notes were prepared by Jean- Francois Arvis, Cally Jordan, Zhong Jiyin (Integrity Consulting, Beijing), Klaus Lorch, Daochi Tong, Feng Tongqing (China Labor College), Jing Yiqing, (Deloitte & Touche, Beijing), Xu Xiaosong (China University of Politics and Law), and Junkuo Zhang (DRC). Arvind Gupta and Chau-Ching Shen made special contributions at various stages of the work. Harry Broadman, Cheryl Gray, and Rich- ard Newfarmer were peer reviewers. Extensive guidance and support were provided by Loup Brefort and Karin Finkelston. The Development Research Center (DRC) at the State Council supported and facilitated the study for its successful implementation. Chen Xiaohong, director general, and other DRC staff provided valu- able guidance and support throughout. A draft of the study was pre- sented and discussed at a workshop organized by the World Bank Group and DRC in May 2001 in Beijing. Additional presentations and com- ments were made by Wu Jinglian (DRC), Zhang Zuoyuan (CASS), Fang Liufang (China University of Politics and Law), Chen Xiaohong (DRC), Ding Ningning (DRC), Hu Ruyin (Shanghai Stock Exchange), Zhang Wenkui (DRC), Wang Dongjiang (SCORES), Chen Yanhai (SETC), Zhang Weiguo (CSRC), Li Xiaoxue (CSRC), Zhou Fangsheng (SETC), Chen Su (CASS), Liu Shijin (DRC), and Li Zhaoxi (DRC), who to- gether with the discussions at the workshop enriched the final study. The study also benefited from comments and insights from other World Bank and IFC staff, including Deepak Bhattasali, Olivier Fremond, Carmen Genovese, Sudarshan Gooptu, Mike Lubrano, Behdad Nowroozi, Djordjija Petkoski, Guy Pfeffermann, Peter Tay- lor, Jun Zhang, and Junkuo Zhang. Udayan Wagle and Mariko Higashi supported the field work through funding from IFC Trust Funds. Alice Faintich was the principal editor. Dana Lane organized the produc- tion of the book. Assistance was provided by Katie Shaw, Doris Chung, and Guo Zhenxuan. ix frontmatter.p65 3/15/02, 3:59 PM9 [...]... towns of Jinhua in Zhejiang province and Zhucheng in Shandong province; interviews with enterprise and government officials in Beijing, Chongqing, Chengdu in Sichuan province, Shunde in Guangdong province, and other localities; and findings from surveys and research conducted by Chinese academic and government institutions Localities were chosen based on considerations about political and economic importance,... domestic and international private institutional investors, should be considered China has the option of importing regulatory and corporate governance capacities in this area by opening its capital markets to foreign institutional investors and by promoting cooperation between foreign and domestic institutional investors in the form of joint ventures and technical assistance arrangements Strengthening Banks’... allowing institutional investors to xv frontmatter.p65 15 3/15/02, 3:59 PM corporate governance in china be named controlling parties in shareholder lawsuits against company management Also of importance is the regulators’ ability to supervise institutional investors and the corporate governance of domestic institutional investors In this context, privatization of existing institutional investors and, ... about corporate governance practices was thus obtained for 257 listed companies Regarding transformed small and medium enterprises, the information came from three sources in the following order of importance: 3 chap1.p65 3 3/15/02, 4:03 PM corporate governance in china in- depth interviews with government officials, workers, and managers and detailed case studies of 14 enterprises in the towns of Jinhua... institutional investors Based on international experience, three critical factors for active involvement of institutional investors in corporate governance are: (a) mitigation of conflicts of interests by restricting activities that may create excessive interdependence between companies and institutional investors; (b) making voting an integral part of institutional investors’ fiduciary duties; and (c) allowing... based on the following guiding principles: • Corporate governance scandals in emerging and developed markets indicate that there is no perfect corporate governance model An effective corporate governance system should above all be capable of identifying weaknesses before they develop into systemic problems, of learning from failures, and of taking prompt corrective actions Critical ingredients of such... promoting a drive for administrative and fiscal decentralization, and allowing bureaucrats to quit the bureaucracy and join businesses (Li 1998) Powerful incentives were added to promote local economic 5 chap2.p65 5 3/15/02, 4:03 PM corporate governance in china box 2.1 Corporate Form and Corporate Governance Modern, large-scale production involves inputs by multiple agents with divergent interests Specialization... they were being used, these institutional arrangements were evolving, gaining strength, and assuming new functions In the process, new constraints to the existing institutional structure were emerging Over time, the ideological landscape has become more hospitable to new, market-oriented concepts and initiatives In a similar vein, the current emphasis on corporate governance is another instance of... becoming functional In 9 chap2.p65 9 3/15/02, 4:03 PM corporate governance in china the process they are creating a demand for new laws, regulations, and other institutional arrangements These institutions are still weak and will remain imperfect in the presence of dominant state ownership and party control over managers; however, if they succeed they will prepare China for fundamental changes in these... of new and old institutions has been a distinctive feature of China s process of institutional transformation Introduced partially and gradually and surrounded by institutional relics, the new institutions were imperfect, but were generally a sensible response to existing problems Because China adopted new institutions in response to actual, narrowly defined problems, these institutions were being put . comprehensive and systematic manner. In this context, Corporate Governance and Enterprise Reform in China explores the main corporate governance issues that China. Tenev/Zhang/Brefort Corporate Governance and Enterprise Reform in China Corporate Governance and Enterprise Reform in China frontmatter.p65 3/15/02, 3:59 PM1