Outside Directors and Firm Performance: Evidence from Chinese Manufacturing Firms

Outside Directors and Firm Performance: Evidence

from Chinese Manufacturing Firms

Wang Jian (s1546376) University of Groningen Faculty of Economics and Business

Tel: (0031) 0614708098

Email: J.Wang.3@student.rug.nl

Outside Directors and Firm Performance: Evidence

from Chinese Manufacturing Firms

ABSTRACT

This paper investigates the effects of outside directors on Chinese publicly listed manufacturing firms’ performance. Using pooled data from 465 Chinese firms listed in Shanghai Stock Exchange, my results indicate that agency theory can not explain the effects of outside directors on Chinese firms’ performance and that passively increasing the proportion of outside directors can not help Chinese firms to solve the agency problem. However, by introducing outside directors who can bring resources the firm need, firms can improve their performance.

TABLE OF CONTENTS

. INTRODUCTION ... 4

. THE DEVELOPMENT OF OUTSIDE DIRECTOR MECHANISM

IN CHINA... 6







. LITERATURE REVIEW ………..8







. RESEARCH METHODOLOGY ... 13

. RESULTS... 18







. DISCUSSION ... 20







.

INTRODUCTION

Whether outside directors have an impact on firm performance is a widely discussed topic regarding boards (Hermalin and Weisbach, 2003). Millstein (1993) argues that inside directors may be unable or unwilling to challenge the management because they are likely to be influenced by managers when they make decisions. Agency theory argues that outside directors, because of their assumed independence from the firm, are in a better position to monitor managerial affairs and performance (Jensen and Meckling, 1976; Weisbach, 1988). Resource dependence theory proposes that outside directors bring resources which can suffice the resource demands of firms (Pfeffer, 1972). Both of these theories support the view that outside directors have an impact on firm performance. However, empirical studies on this topic show mixed and inconclusive results (Hermalin and Weisbach, 2003).

Despite the inconclusive results in developed countries, the China Securities Regulatory Commission (CSRC) formulated the “Guidelines for Introducing Outside directors to the Board of Directors in Listed Companies” in August 2001, to further improve the governance structure of listed companies and standardize their operation. All listed companies were required to act in accordance with the Guideline. It stipulated that all listed firms should have hired at least two outside directors by June 30, 2002, and the proportion of outside directors should have been no less than one third by June 30, 2003 (CSRC, 2001).

may provide a more accurate result for testing outside directors’ impact on firm performance. The objective of this paper is to test the agency theory and resource dependence theory in the context of China and answer the above question.

This paper contributes to existing literature by testing the outside directors’ impact on firm performance in an emerging and institutional transition economy. Although there is a large body of existing studies about this topic, most of the research is based on developed countries, especially U.S. This paper provides not simply a replication, but an extension in a different institutional context. It focuses on the largest emerging economy, which has attracted much attention in academia1_{. China’s particular institutional environment might make agency theory}

and resource dependence theory more pronounced. The concentration of ownership makes Chinese firms meet more serious agency problems (Zhang, 2000). It seems that outside directors’ effects to solve the agency problems will be very significant in such a serious agency problem-existing context. In addition, GuanXi (network) is an institutional characteristic in China which is a key factor influencing business, not only because of the Chinese cultural inclination to rely on relationships to get things done, but also due to the institutional imperative to activate network ties during institutional transitions (Peng, 2003). Firms could obtain benefits and facilitations (for instance, purchasing material at a relatively lower price, market-entry, etc.) from personal networks of outside directors. This particular institutional characteristic may make outside directors’ resource dependence function more pronounced in China (Young et al. 2001).

The remainder of the paper is organized as follows. Section two provides a description of outside director mechanisms in China. Section three reviews literature which is related to the effects of outside directors on firm performance and proposes the hypotheses. Section four describes the data and empirical methodology. Section five presents the empirical results, and section six provides a discussion and concludes the study.

1 _{As Peng (2004) points out: “We need to know ‘what is going on there’ if the field aspires to become globally}

. THE DEVELOPMENT OF OUTSIDE DIRECTOR MECHANISM

IN CHINA

Definition of outside director

According to the definition from the China Securities Regulatory Commission, the term “outside director” refers to “a director who holds no position (neither currently nor formerly) in the company other than the position of director, and who maintains no relationship at all to the company and its controlling shareholder that might prevent them from making objective judgment independently.” (CRSC, 2001)

The evolution of outside director mechanism in China

The term “outside director” is not a new in the Chinese corporate governance system. But the formal stipulation about this internal governance mechanism in China hasn’t been promulgated since August of 2001. The first Chinese firm to introduce outside directors on the board was Tsingtao Brewery Co. Ltd. in 1993 Tsingtao Brewery Co. Ltd. issued H-shares2 _{in Hong Kong}

Stock Exchange (HSE). In accordance to the stipulation of listed requirements of HSE, Tsingtao Brewery Co. Ltd. introduced two outside directors into their board. In December, 1997 CSRC formulated “the guide of public listed firms in China” which points out that firms can introduce outside directors according to their need. In March 29th, 1999 in order to further promote the strict compliance of relevant domestic and overseas laws and regulations on the part of the Companies and the fulfillment of consistent obligations to be undertaken by the Companies to investors, and establish a favorable image of the Companies in the international capital markets, the State Economic and Trade administration, P.R.C. and CSRC issued “the opinion for Chinese

2 _{H-share refers to the share issued by firm whose parent company is in mainland China but list on Hong Kong Stock}

firms listed abroad” which required Chinese firms listed abroad to introduce an outside directors mechanism when they listed abroad. This stated that there should be at least two outside directors on the board and that outside directors should comprise of more than 1/2 of board. In 2000 the State Economic and Trade administration, P.R.C. required large Chinese corporations to adopt a outside directors mechanism gradually. In the same year, the Office of the State Council for the People’s Republic of China issued “The basic norm about the establishment of modern firm system and strengthen the management for large and medium state owned firms”, and formally proposed that firms introduce outside directors who have no share and position3 _{in firms. In}

August, 2001 to further improve the governance structure of listed companies and standardize their operation, CSRC formulated the “Guidelines for Introducing Outside directors to the Board of Directors in Listed Companies”. It stipulated that all Chinese publicly listed firms should hire at least two outside directors by June 30th, 2002, and the proportion of outside directors should be no less than one third by June 30th, 2003.In 2003 According to the statistical data by the CSRC, by June, 2003, there were 1250 Chinese firms listed in the SSE and SZE and 1244 firms had introduced outside directors. The total number of outside directors has now reached to 3839. Most firms have complied with the stipulation and satisfy the basic requirements by the CSRC.

Duplicating the stylized Anglo-American corporate governance model, the aim of introducing outside directors on the board is to enhance board independence and improve corporate governance quality (Lu, 2002). However, whether this mechanism is empirically effective in China is still not clear. In the next section, I will review previous studies related to outside directors’ impact on firm performance and propose the hypotheses.







. LITERATURE REVIEW

There are various internal and external corporate governance mechanisms for helping firms to ameliorate the classic agency problem (Denis and McConnell, 2003). One of them is the board of directors. Boards usually function as hiring, firing, compensating and monitoring management, so as to align the interests between principle (shareholder) and agent (manager) and to maximize shareholder value. However, boards seem not to be so effective because the inside directors usually have various ties with the firm and are likely to be influenced by manager4_{. In this}

circumstance, introducing more outside directors, who are presumed in an independent position when monitoring managerial activities, onto the board is regarded as a means of improving firms’ performance. To enhance corporate governance, several countries and stock exchanges implement regulations and requirements related to the number and fraction of outside directors (see table 1).

Agency theory argues that due to the separation between ownership and control, managers may engage in some self-interest action. Because outside directors are more independent from manager’s influence, they stand for shareholder’s interests and can better help the firm to reduce agency costs and improve firm performance (Jensen and Meckling, 1976; Weisbach, 1988). In an empirical study, Mehran (1995) and Klein (1998) report an insignificant relation between accounting performance measures and the proportion of outside directors on the board. Bhagat and Black (2000) introduce more and various measurements including both accounting and market based measurements (Tobin’s Q, ROA, Market adjusted stock price returns, Ratio of sales to assets) to examine the outside directors’ effects on large American firms’ long term performance. Their results find that when have firms suffered low profitability, they intend to

4 _{Corporation scandals such as Enron fraudulent financial statement, Tyco, Global Crossing, WorldCom and}

increase the amount of outside directors, but greater board independence doesn’t improve firm performance. Various studies outside U.S. also find no relation between the fraction of outside directors and firm performance. Such results can be found in Peng, Buck and Filatotchev (2003), Judge, Naoumova and Koutzevol (2003), Yoshikawa and Phan (2003), Ghosh (2003) and Miwa and Ramseer (2005) to name a few. Agrawal and Knoeber (1996) even find a negative relationship between the fraction of outside directors and Tobin's Q in their study of nearly 400 large American firms. This puzzling result is not clearly explained by the authors. They surmise that one possible reason is that boards are expanded for political reasons, and those additional outside directors such as politicians or environmental activists reduce firm performance due to underlying political constraints.

“monitor” the behavior of a firm, the board needs to provide similar pressure to that which would otherwise have been generated in the market. In this situation, outside directors can generate such monitoring pressure because they are less influenced by managers. Their study indicates that board independence enhances firm performance of companies facing less competitive product markets. To check the outside directors’ effects on firm performance in post-Asian financial crisis, Choi, Park and Yoo (2005) examine the relationship between number of outside directors and performance of Korean non-financial listed firms. They argue that in the case of unexpected external stimulus, it is more important to try and introduce outside directors onto the boards because they can monitor managers better and solve the agency problems effectively. Using annual observations of 1834 firms between 1999 and 2002, they find that the effect of outside directors on firm performance is significantly positive. This strand of research affirms that outside directors might be effective for firms facing agency problems.

environment lacking in effective supervision5_{. This will reduce shareholder interest. To protect}

firms and shareholders’ legal rights and interests, Chinese firms are required to establish supervisory boards which play the role of supervising the boards’ actions and decisions (CRSC, 2002). The responsibilities of supervisory board include supervising the corporate finance and the legitimacy of directors, managers and other senior management personnel’s performance of duties. However, the supervisory effect by the supervisory board is insignificant. Li et al. (2002) find the supervisory boards of Chinese firms are mainly composed of internal supervisors with few employee representatives and that the board of supervisors cannot directly appoint and authorize the board of directors. Li (2007) also argues that effective supervision in China is almost impossible and says that “soft supervision” often arises because of the asymmetry in rights and responsibilities. Although CSRC also promulgates a variety of regulations to solve agency problems and improve corporate governance in China, agency problems are still significant in Chinese firms. As a result of these circumstances, introducing an outside directors’ mechanism was regarded by Chinese authorities as a good means to improve the quality of information disclosure of firms, to ensure the operation transparency, to enhance the firm stability and to reduce agency costs (He, 2003). I expect, where such serious agency problems exist, a larger fraction of outside directors will improve firm performance.

Hypothesis1: a larger fraction of outside directors will be have a positive effect on firm performance in China

Resource dependence theory predicts that the more resource-rich outside directors on the board to satisfy firm’s resources need, the better the firm performance. Pfeffer (1972) argues that outside directors having close working relationships with other members of financial community can act as an important purchaser of short-term debt instrument. Therefore, firms with a greater need for access to capital markets are expected to have a greater percentage of outside directors. Fama and

5 _{Zhang (1998) points out that the property rights are not very clear in Chinese SOEs. In the eye of the law, all Chinese}

Jensen (1983) argue that outside directors can add firm value as providers of relevant complementary knowledge. Several pieces of empirical literature support this view. For instance, Agrawal and Knoeber (1998) investigate the board composition of 260 large U.S. manufacturing firms. They find that politically useful outside directors are usually hired in firms where politics matter more because those directors act to enlist government favors or to forestall government constraints. Lee, Rosenstein and Wyatt (1999) examine whether appointing outside financial directors on the board of a public corporation is associated with abnormal positive returns. Using panel data from 1981-1985, they find that smaller firms which have limited access to financial markets and less financial expertise could benefit substantially from the appointment of outside financial directors. They suggest that outside financial directors can provide specific types of knowledge to the board, including intimate and timely knowledge of conditions in financial markets and the availability of financing.

(such as industry entrance permission6_{) they need, therefore benefiting the firm’s performance.}

Hypothesis 2: the participation of current or the former government officials on the board as outside directors will significantly enhance firm performance.







. RESEARCH METHODOLOGY

To test the hypotheses, I use the data from manufacturing firms which are publicly listed in Shanghai Stock Exchange (SSE). In May, 2007, there are 832 publicly listed firms in SSE. I selected 465 manufacturing firms from 2003-2006 according to the sector classification by the Shanghai Stock Exchange. The data comes from firms’ annual reports (2003, 2004, 2005 and 2006) which are presented in the SSE website7_{. Excluding firms whose data are not fully}

available and firms whose ROA terms are abnormal, the final sample is composed of 1660 manufacturing (392 in 2003, 425 in 2004, 433 in 2005 and 410 in 2006). According to the requirements by CSRC, the annual report of Chinese firm should provide comprehensive, accurate and reliable information about Chinese firm’s operation (Bai et al., 2003). So all variables in this study, including the Return on assets, the number of outside directors, the number of total directors, the occupation background of outside directors, the number of employees and firm establishment time, are taken from their annual reports (2003, 2004, 2005 and 2006).

Estimation methods

I adopt multiple regression analysis in this paper to investigate the relationship between outside directors and firm performance.

6 _{In China, some industries are control by the government, and these industries are usually those high profit industries}

such as energy industry.

The linear regression equation is as follows,

ROA it = 0 + 1POD it + 2BA it + 3NTS it + 4BS it + 5FA it + 6Log (FS) it + eit

Where ROA denotes the Return on assets and 0 is the constant. POD is the fraction of outside

directors. BA is the occupation background of outside directors. The value of this term is decided by the number of outside directors who are current or former government officials. NTS is the non-traded share of the firm. BS, FA and FS stands for board size, firm age and firm size respectively.

Measures

Dependent variable

The dependent variable in this study is firm performance. Tobin’s Q has often been used for measuring firm performance in past studies (e.g., Hermalin and Weisbach, 1991; Bhagat and Black, 2000; Choi, Park and Yoo, 2005). However, this measurement is expected to not be suitable for measuring performance of Chinese firms for two reasons. The first reason is that there are a lot of Chinese firms’ whose publicly-listed shares have limited tradeability. For the majority of SOEs, the proportion of listed shares is only about one third (Bai et al., 2003). Therefore, using a market-based measurement may not truly reflect the performance of Chinese firms. Secondly, the capital market is undeveloped and volatile in China (Tian and Lau, 2001; Peng, 2004). The turnover ratios of the Chinese stock exchanges are 700-1000 percent vs. 67 percent in the U.S. (Xu and Wang, 1999). So in this study I adopt another widely used accounting-based measure: Return on Assets (ROA) in accordance with previous studies on the performance of Chinese firms (e.g., Wang, 1998; Qi, Wu, Zhang, 2000; Tian and Lau, 2001) to measure performance.

Independent variables

There are two independent variables used in this paper.

directors to the total number of directors. It is used to check whether a higher proportion of outside director is significant in explaining firm performance.

The occupation background of outside directors. This term is introduced into the study to

investigate whether the occupational background of outside directors in China moderates their effect on firms’ performance. It is measured by the number of outside directors who are current or were former officials. I expect the occupational background of current or former government officials will make the outside directors more beneficial for firm performance.

Control variables

Several control variables are used in this study to enhance the accuracy of my finding.

Non-traded share. La Porta, Lopez-de-Silanes and Shleifer (1998) investigate the ownership

have its own characteristics which are different from those of private firms. This is because the aims of the state controlled firms are not only firm performance but also some state macro policies such as employment (Boycko, Maxim, Shleifer, and Vishny, 1996). So in this study I introduce the non-traded share variable as a control variable to examine whether ownership is a key factor to influence Chinese firm performance.

Board size. Herold (1979) finds that the search process in decision making usually becomes too

complex for large boards, therefore, increasing the coordination problems. Lipton and Lorsch (1992) claim that large boards could be less effective than small boards because large boards will face more agency problems, such as free-riding. When the board becomes too big, the board tends to be more symbolic and more easily controlled by the CEO. Many other pieces of empirical research also show negative relationships between board size and firm performance (Yermack, 1996; Eisenberg, Sundgren and Wells, 1998). In this paper, I include it as a control variable. Following previous research such as that by Hossain, Prevost and Rao (2001); Panasian, Prevost and Bhabra (2003) and Tian and Lau (2001), the value of this term is measured by the number of directors.

Firm age. Firm age has also frequently been used as a control variable in previous studies (e.g.

Tian and Lau, 2001; Peng, 2004; Choi, Park and Yoo, 2005). Ang et al. (2000) argue that older firms, due to the effects of the learning curve, will be more efficient than younger firms. So I take it as a control variable and expect firm age to have a positive effect on firm performance. It is measured as the number of years since the listed firm was founded. The founding date is identified as the firm’s registration date.

Firm size. From a microeconomic view, in many industries an increase in the scale of the firm

affect firm performance (e.g., Dalton, Daily, Ellstrand and Johnson, 1998; Rhoades, Rechner and Sundaramurthy, 2001; Judge, Naoumovab and Koutzevolc, 2003). So, in this study, I introduce this variable. I measure firm size as the number of employees currently working for firm at the end of the year and took natural logarithm of the original measures.

Endogeneity

. RESULTS

Table 4 presents the descriptive statistics for all the pooled variables (2003-2006). The descriptive statistics shows that the average ROA of Chinese listed firms in my sample is 5.85 percent. The mean value for the proportion of outside directors of Chinese firms is 34 percent. This proportion is lower than those reported for the US and most European countries by Li (1994), who pointed out that countries with single board structures tended to have outsider-dominated boards. A surprise finding is that there are 30 firms in the sample that still have not satisfied the CRSC regulation (that outside directors must make up at least one third of the board) by 2006. No reason can be given as to why these firms had not met the CSRC requirements and whether they will accept any punishment or not by CRSC is not yet known. There are only 64 firms (14.75 percent) in my sample having no outside director who are currently working in the government or who have past work experience in the government. The highest number of such outside directors on a board is 5. From the data on non-traded share, we can see that even though Chinese authorities have begun to reduce the state-control on the operation of firms8_{, the reform step is}

still a gradual process. A large proportion of Chinese listed firms are still controlled by a controlling shareholder (most of them are state held). The average fraction of non-traded share is 58.9 percent. The average board size of 9.68 directors for Chinese firms is smaller than 12.25 reported for U.S. firms by Yermack (1996). The average firm age and number of employees is 9.5 and 3267.5 respectively.

8 _{In June 13}th_{, 2001, the State Council of China promulgated “The stipulation about reducing the state share to raise}







. DISCUSSION

The aim of this study is to empirically test whether outside directors have an impact on Chinese firm performance. The result support the first hypothesis that the corporate governance mechanism of outside directors, which is widespread used in many countries, has no significant effect on solving the agency problems in Chinese firms. The Chinese authority (CRSC) has tried to adopt the American-style monitoring mechanism to enhance the corporate governance of Chinese firms. However, the effect is very weak. It seems that Chinese firms only passively accepted of the regulation for listing. Compared with developed countries, Chinese firms have more serious agency problems as they are experiencing an institutional transition period. Outside directors are presumed to play a better role in supervising management and protecting shareholders’ interests. However, Li (2003) investigates the nomination of outside directors in Chinese SOEs. He finds in this type of firm, the selection and nomination of outside directors is mainly done by the controlling shareholder (usually the state)9_{. Due to this reason, managers are}

likely to select outside directors who are less of a challenge to their management. This will reduce the independence of these outside directors. In addition, insider control is a very serious problem in Chinese firms (Chen, 2004). Insider control might eliminate the independence of outside directors when they process their work and weaken their supervisory authority. Therefore, there is no effective mechanism ensuring independence of outside directors which would enable them fulfill the goal of better supervision on firm performance, making this internal corporate

governance mechanism irrelevant in Chinese context.

Although agency theory can not be applied to China, resource dependence theory can explain the outside directors’ effects on Chinese firm performance. I find that outside directors who are current or former officials have significant effects on firm performance. This illustrates that such outside directors help firms to improve their performance by bringing in the resources firms need. Due to the particular social environment, resource-access is a very important factor for firms doing business in China. Because of their official work experience, such outside directors accumulate good relationship capital with the central or local governments, so bringing in resources which can help firms get facilitation such as industry-entry permission and other daily operational facilitation when doing business.

The implication of this study is that, to effectively exert the supervisory role of outside directors, Chinese authorities should not only introduce the method, but also improve the institutional environment in which the firms operate, so enhancing the independence of outside directors and ensuring that outside directors have a more independent status to supervise managerial activities. However, improving the institutional environment is a gradual and complex process. In this circumstance, Chinese authority could use other or a combination of mechanisms to improve corporate governance of Chinese firms. On the other hand, the results of this paper suggest that outside directors who have official work experience do contribute to increasing firm performance, which suggests that when firms introduce outside directors, they should also consider whether these directors can bring resources the firm needs.







. LIMITATIONS AND FUTURE RESEARCH

One limitation in this paper is the data. I only use data depending on Chinese publicly listed firms’ annual report because it is regarded as a reliable resource of accounting and governance information. However, the data from my study is all from publicly listed firms which are mostly large and state-controlled. There are also many non-listed firms who have different ownership structures. Because their data are not available, the research for them can not be preceded. If they were to be included, the study would be more accurate because they possess special characteristics such as better management and more agency conflicts (Tan and Peng, 2003). So, for future research, I suggest a study which collects more accurate data by using surveys and interviews combined with the firms’ annual reports.

introduce outside directors becomes questionable. To answer this question, requires taking up interviews with the related officials of CRSC.







. CONCLUSION

bringing resources the firm need. Chinese firms should not only increase the proportion of outside directors on their boards, but consider what resources they can get from outside directors.

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