The effects of ownership, firm performance and corporate governance on CEO remuneration in Chinese listed firms.

The effects of ownership, firm performance and corporate

governance on CEO remuneration in Chinese listed firms.

Thesis

Master of Science in Business Administration

University of Groningen Faculty of Economics and Business

Author: Laurens J. Speelman Student number: 1613553 Supervisor: dr. Peter P. M. Smid 2nd Supervisor: dr. Jochen O. Mierau

Abstract

Since Deng Xiaoping has opened up the Chinese economy in 1978, China has slowly

implemented various economical reforms. However, the state is still very much present in its economy. This thesis investigates the effects of state ownership, performance and corporate governance on the way Chief Executive Officers (CEO) of Chinese listed firms are

remunerated. We find that state ownership has a negative influence on remuneration,

especially in centrally owned state firms. We furthermore find that previous’ year accounting based performance have positive effect on CEO remuneration.

JEL classification G32, J33

Keywords

1. Introduction

This study will focus on the Chief Executive Officer (CEO) remuneration of Chinese publicly listed firms. A key feature of Chinese firms is the large influence of the state. Since Chinese firms are often for a large part owned by the state or large block holders (Conyon & He, 2011), such shareholders have a much larger incentive to monitor the firm board. Being state owned has its drawbacks: Chen et al. (2011) find that political power (CEO/Party secretary duality) is positively weakly related to the CEO remuneration. Firth et al. (2006) find that in state owned firms and firms with concentrated ownership the executive pay and CEO incentives are lower. Since the pay of CEOs of Chinese listed firms may not be based on firm performance, management may not be properly incentivised to maximize firm value. Furthermore, because state controlled firms might pursue other objectives than the smaller private investors, a conflict of interest may arise (Firth et al. 2012).

China has realised impressive growth the last 25 years, slowly giving rise to free market policies. Chinese firms are increasingly adopting Anglo-Saxon corporate governance models (Conyon & He, 2011). New laws and practices are adopted that are based on capitalist countries (Firth et al. 2006). In such an increasingly capitalistic system, board incentive becomes more important. The Chinese main regulator, the China Securities Regulatory Commission (CSRC) is based on its Hong Kong and U.S. counterpart, respectively the SFC (Securities and Futures Commission) and the Securities and Exchange Commission (SEC). In contrast to ex-Soviet Union countries’ sudden market liberalization, the Chinese state prefers slow reform. So firms that are required to have two-tier boards and various committees are slowly becoming more common. Boards are furthermore required to have outside directors, and recently the switch to enforcing independent directors has been made as well (Chen et al, 2006; Conyon & He, 2011).

Before the Chinese economic reforms, CEO remuneration was based on the position on the political ladder. In the early days of the Chinese reform, accounting numbers were used in order to reward executives. Nowadays remuneration incentives are given to executives in order to boost firm value, but the use of stock options is still very limited. This still shows a lack of linkage between the interest of shareholders and the management.

incentive schemes motivate executives enough, especially compared to their western counterparts. The main question is thus: How does performance affect the CEO remuneration of Chinese firms? We answer this question by looking what type of performance drives CEO remuneration: stock or accounting performance? Furthermore we look into pay-performance sensitivities. How does this pay-performance link differ with state ownership? There is also a difference between local state owned and central state owned enterprises. We therefore question if the relationship between CEO remuneration and performance is affected by differences in central and local state ownership. Recent data will be used from 2005-2011. We will make use of a panel data regression for these years. In total four separate regressions will be run. Two regressions using the return on assets as a measure for performance and two regressions using the total stock return. Furthermore, we will first test if state ownership has any effect on remuneration and the performance-pay link. After that we question if differences in central and local state ownership have an effect on remuneration and the performance-pay link.

This paper will contribute towards existing literature by providing insight in the link between state ownership and CEO compensation. It furthermore provides insight in the way CEOs are remunerated in unique state-ownership cases such as in China. Since the state actively mingles in the firms it controls, executive remuneration policies may prove to be inefficient. We will see if the economic reforms that China strives for are indeed successful and see if they have optimized remuneration structures to give the proper incentives for management to boost performance.

One major difference this paper has with previous literature is the availability of new CEO data. Before 2005, mostly the sum of remuneration of the top three executives was available. Authors dealt with this problem by simply dividing the remuneration of the top three executives by three. This study uses data from 2005-2011, where individual pay reports were enforced by The Code of Corporate Governance for Listed Firms in China, issued by the CSRC.

2. Principal-Agent problem

Management and ownership is often dispersed in corporations. Since there is information asymmetry between management and shareholders, there is opportunity for management to serve its own interests. Thus their conflict of interest, combined with the inability to costlessly write perfect contracts and/or monitor management, ultimately reduces firm value (Dennis & McConnell, 2003). This is called the Principal-Agent problem.

Since the Chinese state acts on behalf of the people, it itself is also subject to the Agency theory. A state representative is assumed to work on behalf of the people, but is also tempted to serve its own interest first. So not only is there an agency problem present between the management of the firm and the state that owns it, but also between the state and ultimately the people it is supposed to serve. Thus both the companies’ management and the companies’ owner (state) are subject to the agency theory (Xu, 2004). The many links between the firm holders (the people) and the firm’s management make it very hard to give the proper incentives to the firm’s management. Without proper incentives, the management may not maximize firm value. Even though the Chinese government states that their ultimate goal is preserving and increasing the value of state properties, it is hard to value assets without a well-functioning market. There is little incentive for government officials to actually increase company value, since they would reap none of the benefits.

There are various ways to deal with the principal-agent problem, such as: granting management a slice of the profit; the use of shares, options or any other form of profit based cash bonus. This aligns incentives of management with the shareholders to maximize share value. Furthermore, close monitoring restricts the freedom management has to pursue its own interest. Lastly laws and regulations are in place in order to retain management from misbehaving.

3. Chinese economic reform

(SOEs) were converted to stock companies and policies were implanted that gave managers rights to a share of the profits or losses (Siquiera et al. 2009). It was thought that by providing such incentives managers would in turn reward employees with profit enhancing schemes. Managers however, never provided the employees with such schemes. The bonuses turned out to be nothing more than a wage supplement being untied to employee’s performance.

The government tried to establish property rights of the various SOEs betters. Trying to push on the reforms, the Chinese government made a concession regarding SOEs. Ownership was split into three types: state shares, legal person shares and common domestic A-shares (Qiang, 2003). Only a small fraction of those A-shares were tradable on the stock exchange, and the state kept the controlling stake. In 1997, the Communist party of China (CPC) decided to accelerate the reforms and pushed for a “grasping the big and enlivening the small” approach. Large enterprise groups were created using mergers in core industries and those enterprise groups were subsequently listed on the stock exchange to promote ownership diversification (Qiang, 2003). In 2001, China became a member of the World Trade Organisation and thereby agreed to reform not only its trade policy, but also its regulations on government subsidised state-owned sector (Bajona & Chu, 2010).

From 1998-2003 enterprise reforms were enforced and small and medium sized SOEs were privatized or sold off their assets. Large SOEs remained in place, and still faced incentive problems. Privatizing whole or parts of companies led to a growing of the creation of a stock market in a country that traditionally was bank-dominated. But despite these efforts, most companies still remained government controlled, directly or indirectly. So even though many of the old state owned companies have transferred into modern PLCs, they still had their old flaws (Qiang, 2003). Because of the emerging stock markets, local government used this as an opportunity to finance itself by selling off some of the loss-making SOEs. This was also due to the fact that local governments were increasingly operating under hard-budget constraints.

The managerial job market in China is still underdeveloped, many of the board members and managers of SOEs have close ties with their civil counterparts. These civil counterparts exert their influence on compensation and turnover. As a result, the compensation and turnover of managers and board members may not be based on performance, but rather their place on the political ladder.

4. SASAC

On the 16th national congress of the communist party of China, plans for a “new state asset management system in which authority, duty and responsibilities are united, and in which management of assets, personnel and affairs are unified” were presented (Naughton, 2003, p2). Trying to eliminate the SOE property rights dilemma created by poorly defined property rights, the State Assets Supervision and Administration Commission (SASAC) was founded in 2003. Instead of privatizing all state-owned companies, the Chinese government tried to optimize state-ownership efficiency. Seeing the former Soviet Union as an example that sudden government withdrawal halts economic development, the Chinese government also aimed at a slower transition (Naughton, 2003). By acting as the state representative, the SASAC was supposed to increase SOE efficiency. It was thought that separating the government’s investor function from its governing function could increase efficiency. Since the SASAC also had claims on profits of the SOEs, they rewarded executive managers with performance-based salaries. The SASAC furthermore has greater insight in the companies it controls than its predecessors.

From 1998 on, ownership was dispersed among the various government ministries and agencies. This led in turn to weak monitoring. With little monitoring, the managers enjoyed great freedom in running their companies. Friends and family were given contracts that favoured both parties and managerial buyouts became common (Naughton, 2003). Centralizing these ownership rights were a means to increase oversight over management.

5. Executive remuneration polices in China.

Remuneration policies based on the principal-agent model dictate that executives receive packages that discourage moral hazard behaviour and motivate CEOs to increase firm value (Conyon & He, 2011). Boards are entrusted with aligning the CEO’s interest with the shareholders. Boards do this by setting incentives based on economic factors, the magnitude of agency problems and monitoring difficulties (Conyon & He, 2011). Exactly how this should be set up is not dictated by the principal-agent model, and thus remains to be at the judgement of the board.

Before the reforms in 1978, the remuneration managers of SOEs received were based on a structured pay scale system. There were no profit sharing schemes for the managers, and thus no incentives to maximize shareholders value. In the early stages of the economic reform, the pay of a manager was around three times that of an unskilled worker (Firth et al, 2006). When the economic reforms gave rise to performance incentive schemes, this was mostly based on accounting numbers. Although some listed firms disclosed their remuneration information, the Chinese Securities and Regulation Committee (CSRC) did not require this before 2001. In 2001, the CSRC enforced listed firms to disclose the sum of the total remuneration of the three highest-paid executives and three highest-paid board members. From 2005 onwards, the CSRC demanded listed firms to report individual total compensation, including bonus, stipends and other benefits (Conyon & He, 2011). The CSRC furthermore allowed for equity incentives for management and board members.

firms that were cross-listed at Hong Kong and the United States, they found that only 4% of the firms grant their executives stock options. This is in a way in line with the short-term view of most Chinese CEOs. CEOs in China have a high turnover that would make long term incentives render useless.

6. Literature review

Comparing executive pay in China to the U.S., Conyon & He (2011) find that executive pay and CEO incentives are lower in Chinese firms that are state controlled or firms that have concentrated ownership structures. Even though Conyon & He (2011) find that drivers of Chinese executive remunerations look a lot like their U.S. counterparts, the pay is still 17 times lower in China then in the U.S. Conyon & He (2011) their findings are in line with Firth et al. (2006) who argue that in China the pay-performance sensitivity for CEOs are low, and they question the effectiveness of firms’ incentive system. Cao et al. (2011) investigated the relation between the ownership structure and the executive compensation for Chinese listed firms. They found that cash flow rights in the possession of the ultimate controlling shareholders have a positive effect on the pay-performance sensitivity of CEOs, even when this ownership is indirect. Firth et al. (2012) find similar results, suggesting that SOEs and block holders impose profit and wealth maximizing objectives on firms. This would align the CEO’s pay with firm profitability. In SOEs the executive remuneration is based on accounting performances, and not on market based firm performance (Cao et al, 2011l; Firth et al. 2012; Firth et al. 2007). This is in line with the non-tradability of the shares owned by SOEs. Privately controlled firms however have their CEO pay linked to market performance (Cao et al, 2011).

Using data on Chinese listed firms from 2000-2010, Conyon & He (2012) note that the usual Chinese CEO compensation is based on a set salary and some cash bonus. They argue that it seems that CEO remuneration is based on labour input. They do find a relationship between remuneration and accounting standards, and a somewhat limited relation between remuneration and stock performance. Conyon & He (2012) furthermore document that state ownership has fallen since 2000, the concentration of share ownership has dropped and that there was a slight increase in foreign ownership. Pay has increased and CEO share ownership has increased as well. The use of stock options is still very low, and is estimated to be between 1-3%. They also find that state ownership has a negative effect on CEO remuneration. Lastly they find autocorrelation effects, suggesting that CEO’s pay is also based on previous years.

the monitoring duties of the boards fall into the hands of the independent directors (Chen & Al-Najjar, 2012).

Boardroom governance is also important in Chinese firms. More independent directors on the board give rise to a higher pay-for-performance link (Conyon & He, 2011). Private firms with independent directors are more likely to fire CEOs that perform poor. Having independent directors also result in less fraud (Chen et al, 2006). Furthermore, a high level of non-executives results in a stronger pay-performance link between CEO pay and operating (accounting) profits (Firth et al, 2007). The same relationship is found for independent directors. It thus seems that non-executives and independent directors are able to align interest between management and the shareholders. Li et al. (2007) finds evidence that supervisory board size has a negative effect on CEO remuneration, although weakly. Li et al. (2007) argues that this is due to a Chinese supervisory board consisting of shareholders’ and workers’ representatives, and the latter often opposing high CEO pay. Lastly, director board size seems to have a constraining effect on CEO remuneration (Firth et al, 2007).

Investigating Japanese CEO pay and the link with performance, Kato & Kubo (2004) found that the return on assets (ROA) was a significant driver of CEO remuneration, elasticity between remuneration and ROA was between 1.3 and 1.4. Although only 51 firms were used, and of those 18 were listed, CEO pay was less linked to stock performance. Lastly Kato & Kubo (2004) argue that CEO bonuses are more linked to performance than the base salary, bonuses thus are not an additional base salary in disguise.

Fernandes et al. (2012) looks if CEO pay is higher in the U.S. than CEO pay in 13 other countries. They find that the U.S. pay premium has declined to a non-significant difference since 2003. They furthermore find that CEO pay is higher in firms with equity-based compensation. U.S. equity-based remuneration policies are internationally exported to non-U.S. firms that have exposure to product, capital and managerial labour markets.

Looking at executive incentives in the United Kingdom (UK), it appears that long-term incentive plans are becoming more popular (Zakaria, 2012). Earnings per share and Total shareholders return are the main performance measure on which executive remuneration schemes are based. As there aren’t proper guidelines in executive remuneration policies, firms appear to mimic each other.

Table 1. Summary of literature on CEO pay

Authors Country Data

Years

Relationship with CEO pay

Remarkable results

Kato & Kubo (2004)

Japan

1986-1995

Firm performance Remuneration sensitive to accounting performance. Firth et al. (2006) China

1998-2000

Firm performance and ownership

State agency has non-performance related pay Firth et al. (2007) China

1998-2000

Corporate

governance, firm performance and ownership.

ROA main driver. Board size

constrains pay Kato & Long

(2006) China 1998-2002 Corporate governance, firm performance and ownership

Sales has strong link with pay. Link pay and shareholder value too. Buck et al. (2008) China

2000-2003

Firm performance with board size control variables Two way performance-reward link. Pay-performance elasticities same as Western world Conyon & He (2012) China 2000-2010 Corporate governance, firm performance and ownership.

Pay both related with accounting and stock performance, although accounting performance more robust. Conyon & He (2011) China 2001-2005 Corporate governance, firm performance and ownership

Executive pay and incentive lower in SOE. Independent directors strengthen pay-performance link Zakaria (2012) UK 2002-2003 Performance and benchmarks

Equity based bonus. Other firms mimic CEO pay.

Cao et al (2011) China 2002-2007

Firm performance, cash flow rights and ownership

Cash flow right main driver pay-performance relationship. Fernanades et al. (2012) US vs. 13 other countries 2003-2008 US pay versus other countries. Equity pay

premium, CEO pay risk

7. Hypotheses

In order to see whether remuneration is affected by accounting performance or by stock based performance a we will focus on the Return on Assets (ROA) and Total Shareholders return (RET). Since previous literature (Firth et al. 2007 and Conyon & He, 2011) suggests that accounting performance drives CEO pay rather than share stock performance, we expect that ROA is a CEO pay driver. Historically, State-owned firms were always valued on accounting number basis, since there was no market to value it. In order to align the state’s and managers interests, executive remuneration was based on these accounting numbers. To see if this is still the case, the ROA and RET will be used to see its effect on performance (Firth et al, 2007).

Thus the following hypothesis (1) will be tested:

H0: There is no relation between CEO pay and either return on assets or shareholders return. H1a: CEO pay is positively related with return on assets.

H1b: CEO pay is positively related with total shareholders return.

Pay is expected to be less related with performance in state owned companies, both centrally and locally owned (This would be due to SOEs executives’ pay being based on their status on the social ladder, and not on performance.

Hereby, the following hypothesis will be tested (2):

H0: CEO pay is equally related with firm performance both in state- and non-state-controlled firms.

H1: CEO pay is stronger related with firm performance in non-state controlled firms than state controlled firms

It is also expected that centrally owned state firms have higher pay-for-performance links than their local counterparts (Firth et al., 2006). Centrally owned state firms enjoy greater and more consistent oversight, and are thus expected to have a stronger pay-performance link (Firth et al., 2006). This would be especially the case for SASAC controlled firms. Therefore we will test the hypothesis (3)

H1: Centrally owned state firms have a higher pay-for-performance link than locally controlled firms.

Board size also appears to constrain CEO remuneration (Firth et al. 2007). Larger boards might be able to pay more attention and generate more discussion on CEO pay and thus may improve corporate governance. Thus we test the following hypothesis (4):

H0: Board size has no effect on CEO remuneration.

H1: Board size has a negative effect on CEO remuneration

Independency also plays a role in remunerating the CEO (Firth et al. 2007). The Code of Corporate Governance furthermore requires Chinese firms to list independent directors. It is expected that about one-third of the board is comprised of independent directors (Conyon & He, 2011). Independency is seen as a way to increase corporate governance quality and thus better align management’s with shareholders’ interest. It reduces CEO power over the board and thereby limits the CEO’s power over its own remuneration. We therefore argue that independency decreases the CEO pay. The following hypothesis (5) is tested:

H0: Independency has no effect on the CEO pay.

H1: Independency has a negative effect on the CEO’s pay.

Furthermore we investigate the relationship between supervisory board and CEO incentive. Li et al. (2007) finds some evidence of a negative relationship between supervisory board size and CEO remuneration. Since the supervisory board exists out of shareholders’ and workers’ representatives, they may have a constraining effect on CEO remuneration. Larger supervisory boards may put more effort in constraining CEO remuneration. We thus hypothesize (6):

H0: Supervisory board size has no effect on CEO remuneration

H1a: Supervisory board size has a negative effect on CEO remuneration.

8. Methodology

the factors that determine the CEO’s pay, we first use two multifactor regressions, one return on asset based (ROA) and total shareholders return (RET) based:

(1)

(2)

The represents the height of the remuneration left unexplained by other variables. The term Remuneration is the natural log of the remuneration of the president, general managers, the chairman or a combination of them both, whomever is paid most. This proxy of CEO remuneration is in line with previous literature, whom either choose the highest paid executive as the CEO (Firth et al. 2006 & Firt et al. 2007) or they choose to use the sum of the three highest paid executives (Conyon & He, 2011). As Conyon & He (2011), we use the natural logarithm of total sales as a proxy for Size. ROA is the return on assets; a ratio of the attributable profits for the last 12 months to total assets (fixed and current) for the same period, expressed as a percentage. RET is the end year total return to shareholders, including cash dividends, stock dividends and rights offerings, expressed as a percentage. SOE is a dummy variable that is one (1) when the state is the ultimate controlling shareholder and zero otherwise. Ind is the fraction of independent directors on the board. Board is the board size. Foreign is a dummy variable that is one (1) if a foreign company is the controlling shareholder and zero (0) otherwise. Supervisory is the size of the supervisory board. Mkt/Book is the end year market-to-book ratio, where market is the market capitalisation and book value is the tangible book value. Debt/Equity is the total end year book value of debt (Short and long term) divided by the end year total equity book value (Common plus preferred stock). Sector is a dummy one (1) when the firm is in the IT sector and zero (0) for the cyclical consumer products sector.

Furthermore to test the effects of central control and local control, we distinguished between centrally controlled SOEs and locally controlled SOEs. is the error term. Once again, one

(3) (4)

Where Central is a dummy one (1) when a firm is controlled by the central government and zero (0) otherwise and Local is a dummy one (1) when enterprise a firm is controlled by the local government and zero (0) otherwise.

In order to see if lagged performance has influence on CEO remuneration, we will redo all four regressions with one-year lagged ROA and RET instead of current year ROA and RET.

Ultimate Controlling Shareholder

According to the Clause 41 of the Guidelines for the Articles of Association of Listed companies, which was released by the CSRC on December 16 1997, the controlling shareholder in the article refers to the shareholder meeting one of the following conditions;

1. The person can select over half of the directors independently or by acting in concert with others.

2. The person can exercise or control more than 30 per cent of voting rights independently or by acting in concert with others

3. The person holds over 30 per cent of shares independently or by acting in concert with others

4. The person can actually control the company independently or by acting in concert with others.

State ownership

Early literature on this subject separates state owned enterprises in two different categories depending on their share classification: State shares and shares owned by legal entities. As Firth et al. (2006) argue, this division is too simplistic. Many of the legal entities shares are ultimately owned by the state. However, compared to the state shares enterprises, legal entities do hold some autonomy over their actions.

In contrast with previous literature, we choose to separate state ownership solely on its ownership by the or local government. Centrally owned state enterprises are mostly owned by the SASAC, although some are owned by the ministry of finance or education. Locally controlled state enterprises are directly under control of the local government, or via a local state asset management bureau (Xu, 2004).

The way centrally controlled versus locally controlled state enterprises are monitored differs as well (Xu, 2004). Central controlled state enterprises are subject to monitoring by various departments of the central government such as the Ministry of Finance, the National Development and Reform Commission and the National Audit Office. All this supervision of the central government leads to strict monitoring.

There is a wide range of different local governments and supervision levels vary accordingly. Although China’s laws and regulations have gone through reforms, there is still much work to be done. A suboptimal judicial system, law enforcement and corrupt government officials are giving room for firms to disobey laws and regulations (Xu, 2004). Although both centrally and locally controlled state firms are expected to obey laws and regulations, Xu (2004) argues that it is harder to enforce laws and regulations the further away a firm is from the central power (the central government). Therefore, it is generally assumed that locally owned state enterprises enjoy greater freedom in their actions.

Control variables

Sales, Market/Book, Debt/Equity, Foreign and Sector are used as control variables. These variables were chosen based on previous literature (Firth et al. 2006, 2007; Conyon & He, 2011). Previous literature dictates us that sales is large driver of CEO remuneration. Larger companies are expected to have more funds than choose for the best possible management, and thus leads to an increase in management remuneration in order to attract the best possible management. In addition, in state organisations the position on the social ladder may also determine salary. Therefore, management of larger companies are expected to be higher on the social ladder than the management of smaller companies, and hence attain a higher salary.

Market to Book ratio is expected to have a positive influence on CEO remuneration (Conyon & He, 2011). If Market to book is high, the firm has a high growth potential and in turn will reward the CEO better. It furthermore shows that shareholders place their trust in the current CEO and his or her capabilities. Shareholders would thereby go to greater lengths to retain the CEO in its position and thus remunerate the CEO higher.

Debt/Equity represents the firm risk. We expect it to be positively associated with CEO remuneration. A higher debt/equity ratio increases monitoring by debt holders (Firth et al, 2007). John & John (1993) furthermore argue that shareholders can use CEO remuneration as a pre-commitment device to decrease the cost of agency cost of debt.

Foreign ownership is a dummy one when a Chinese firm is controlled by a foreign entity and zero otherwise. Since we expect foreign ownership to impose international remuneration practices on a firm, we believe this may be beneficial for the CEO’s pay.

9. Hypothesis testing

Hypothesis one (1), whether CEO pay is related to either ROA or RET, will be tested by using the variables and in regressions one (1) and two (2). If the coefficient of a variable is significant, we can conclude that it is a driver in a Chinese CEO pay. Expected is that ROA is the main driver of the two. Since economic reforms have internationalized CEO pay, we expect RET drive CEO pay somewhat as well.

Hypothesis two (2), whether SOEs provide fewer incentives to CEOs than non-SOEs, will be answered by the terms and in regressions one (1) and two (2) as well as the SOE, ROA and RET terms themselves. By looking at the interaction term, we can determine if there is a difference between performance-based incentives between SOEs and non-SOEs. If either term is negative, it shows that SOEs provide fewer incentives than non-SOEs to their CEOs.

Hypothesis three (3), differences in incentive schemes between central SOEs, local SOEs and non-SOEs, will be tested using the variables in regressions three (3) and four (4) using the variables , , and in combination with the stand alone SOE, ROA and ROE terms. Since most central SOEs enjoy greater oversight and since their owners often have direct cash flow rights, we expect them to provide more performance-based incentives than their local counterparts. We thus expect central SOEs to positive and statistically larger sign than local SOEs.

Hypothesis four (4), whether larger boards constrain CEO pay, is tested using the term in regressions one (1), two (2), three (3) and four (4). Since we expect larger boards to constrain CEO pay, we expect these terms to be significantly negative.

Lastly we test hypothesis six (6), the effect of supervisory board size on CEO remuneration. Using the term in regressions one (1), two (2), three (3) and four (4), we expect board size to have a negative effect on CEO remuneration. This negative effect would be explained by a larger amount of workers’ representatives on larger supervisory boards that in turn would lead to a constraining effect on CEO remuneration.

10. Data

Data about the book value, return on equity, return on assets and market value are taken off Reuters’ Eikon. Data about the ultimate controlling shareholder, director independency, board size and supervisory board size, monthly stock returns and forms of dividends are taken from the GTA database and Hong Kong Top Data Company; both are Chinese corporations specialized in Chinese stock information. The two sectors used are the software and IT services, and non-cyclical consumer goods. In total this led to 867 firm-year observations over the years 2005-2011.

Graph 1: CEO remuneration per year

Graph 1 shows us the average yearly CEO remuneration. We can see that CEO remuneration has increased the past years. The average yearly CEO remuneration went from

0 100000 200000 300000 400000 500000 600000 700000 2005 2006 2007 2008 2009 2010 2011 Y ua n Year

Average Yearly CEO Remuneration

around 260,000 Chinese Yuan (±42,000 US dollars) in 2005 to around 580,000 Chinese Yuan in 2011, which translates to roughly 93,000 US dollars.

Table 2: Descriptive statistics of IT service sector. 211 firm year observations

Table 3: Descriptive statistics of non-cyclical consumer goods sector. 656 firm year observation

1 _Jarque-Bera 2 _Jarque-Bera

Remuneration Sales ROA RET SOE Central Local Independence Board Foreign Supervisory Mkt/Book Debt/Equity

Mean 575884 1387129754 6.27 32.56 0.36 0.27 0.09 0.36 8.86 0 3.69 6.22 0.68 Median 457400 729711772 6.05 2.36 0 0 0 0.33 9 0 3 4.65 0.57 Maximum 2560000 19409519891 25.09 462.90 1 1 1 0.50 15 0 8 52.12 5.13 Minimum 72000 78242475 -55.50 -77.99 0 0 0 0.27 5 0 2 0.42 0.02 Std. Dev. 456995 1987661862 7.37 93.12 0.48 0.45 0.29 0.04 1.94 0 1.18 6.28 0.64 Skewness 1.88 5.02 -2.76 1.69 0.56 1.04 2.77 1.65 0.73 1.52 4.11 3.65 Kurtosis 6.87 39.25 25.91 6.42 1.31 2.07 8.65 5.47 4.69 4.62 25.67 23.59 J-B1 Probability 0 0 0 0 0 0 0 0 0 0 0 0

Remuneration Sales ROA RET SOE Central Local Independence Board Foreign Supervisory Mkt/Book Debt/Equity

Remuneration Sales ROA RET SOE Central Local Independence Board Foreign Supervisory Mkt/Book Debt/Equity Mean 455311 2475810281 4.71 38.60 0.49 0.18 0.31 0.36 9.15 0.01 3.82 5.63 0.97 Median 350000 978049345 4.02 11.03 0 0 0 0.33 9 0 3 4.42 0.75 Maximum 4414300 47015157587 48.96 625.62 1 1 1 0.60 17 1 9 52.12 11.09 Minimum 10000 21393799 -62.05 -77.99 0 0 0 0.13 5 0 0 0.42 0.02 Std. Dev. 425864 4419554845 7.80 94.28 0.50 0.38 0.46 0.06 1.91 0.11 1.29 4.86 0.94 Skewness 3.13 4.34 -0.84 1.56 0.03 1.70 0.80 0.86 0.73 8.71 1.45 3.49 4.39 Kurtosis 20.85 28.38 15.58 6.55 1.00 3.88 1.64 6.73 4.83 76.83 5.06 24.48 35.78 J-B3 Probability 0 0 0 0 0 0 0 0 0 0 0 0 0

Table 4: Descriptive statistics of non-cyclical consumer goods sector and IT service sector combined. 867 firm year observations.

From table 5, we can see that ROE and ROA correlate little, which shows us that both performance proxies do behave differently. The interaction terms logically correlate all heavily with the variables of which they are built off, but they do not correlate heavily enough with other variables to omit any of them.

11. Results

We’ve checked for the presence of fixed effects using the redundant fixed effects test. We’ve found that there are both cross-sections as period effects present. We’ve furthermore employed the Hausman test for correlated random effects and found that the random effects model is not appropriate. We thus use the fixed model effects with both cross-section as period effects. 4 Added benefit of the fixed effects model is also that it captures the time effects of the recent global crisis.

In table 6 and 7 we see the results of the OLS and fixed effects models. Table 6 shows us eight regressions using ROA (Column 1-4) and RET (Column 5-8) as proxies for performance without having state ownership split up. Four of these eight use the ordinary least square models (OLS, Column 1, 2, 5& 6) and the other four use fixed effects models to capture firm and year specific characteristics (Column 3, 4, 7& 8). Table 7 shows us four more regressions that use ROA (Column 1-4) and RET (Column 5-8) as proxies for performance, but this time state ownership is split up in centrally and locally state owned enterprises. Once again, four regressions use the OLS model (Column 1, 2, 5& 6) and four make use of the fixed effects model (Column 3, 4, 7& 8).

Table 6 and 7 show us that our proxy for size, Sales, is a large driver of CEO remuneration in all models. This is in line with previous literature (Firth et al, 2007, Conyon & He, 2011). CEO’s of larger companies are remunerated higher for the larger amount of responsibilities they carry. ROA is non-significant in all models, revealing that CEO pay is not based on firm current accounting performance. If we look at table 8 and 9 though, we find that ROAt-1 does have a significant influence on current CEO remuneration. A 1% increase in last year ROA increases current year remuneration by 0.9%. When looking at the RET performance based models, we see that the RET has a negative coefficient and is significant in most models. The coefficient of RET is so small, that it hardly has an effect on CEO remuneration. A one per cent rise in RET would result in decrease of around 0.07% in CEO remuneration. Past stock performance plays no role in current CEO remuneration. Since stock performance plays no role in CEO remuneration, shareholders’ and CEO’s interests are thus not linked via stock performance. CEOs of Chinese CEOs are remunerated based on past year’s accounting based (ROAt-1) performance.

4 _{Results of the redundant fixed effects test and Hausman test for correlated random effects can be}

Table 6 shows us some evidence that in the ROA based fixed effects model CEOs of Chinese SOEs are remunerated less than their non-SOE counterparts. When we dig deeper, we see Table 7 showing the differences between local SOEs and central SOEs. There is a large difference in the way CEOs are remunerated between central SOEs and the way non-SOEs are remunerated. In the ROA based fixed effects model with local and central owned state ownership split up, CEOs of central SOEs make 27% less than non-SOE CEOs. This leads us to believe that due to increased supervision by the various central government organisations, CEOs are less able to exert their power over the way they are remunerated. Local SOEs do not pay their CEOs significantly less than non-SOEs. It is generally accepted that local SOEs experience more freedom since they are less monitored by their stakeholders (Xu, 2004). It thus appears that owned state enterprises are less monitored and their CEO pay is linked to their non-SOE peers.

Table 6 presents us with the interaction terms. Given a negative SOE coefficient and a ROA term that is zero, we can see from the ROA*SOE term that SOEs employ incentive pay schemes to their CEOs. So although SOEs pay their CEO’s less than non-SOEs, they do employ ROA based incentives. Table 7 once again goes into depth showing us the interaction terms of centrally and locally controlled enterprises. The ROA based interaction terms show that in combination with given ROA and SOE coefficients, both locally and centrally owned state enterprises employ incentive pay schemes.

that foreign ownership has little impact on the remuneration of CEOs in Chinese firms. CEOs in the I.T. sector are higher remunerated than their non-cyclical consumer goods counterparts. This may be due to the firm specific knowledge that increases CEO’s value to the firm.

OLS Fixed effects OLS Fixed effects 1 2 3 4 5 6 7 8 α 5.49*** 5.77*** 7.31*** 7.79*** α 5.44*** 5.44*** 7.40*** 7.38*** Sales 0.29*** 0.28*** 0.24*** 0.22*** Sales 0.30*** 0.30*** 0.24*** 0.24*** ROA 0.00 0.00 0.00 0.00 RET -0.00*** -0.00*** -0.00*** -0.00 SOE 0.00 -0.05 -0.20* -0.21** SOE 0.01 0.00 -0.18 -0.16 Ind 2.11*** 2.14*** 0.26 0.26 Ind 1.85*** 1.85*** 0.31 0.25 Board 0.04*** 0.04*** 0.00 -0.00 Board 0.04*** 0.04*** 0.01 0.01 Foreign 0.54*** 0.56*** 0.10 0.11 Foreign 0.44*** 0.43** 0.12 0.13 Supervisory -0.06*** -0.05*** 0.06* 0.05* Supervisory -0.06** -0.06*** 0.05 0.05 Mkt/Book 0.02 0.02 -0.00 -0.00 Mkt/Book 0.03*** 0.03*** -0.00 -0.00 Debt/Equity -0.07*** -0.05* 0.04 0.06** Debt/Equity -0.09*** -0.09*** 0.03 0.03 Sector 0.52*** 0.52 Sector 0.50*** 0.50*** SOE*ROA 0.01** 0.02*** SOE*RET 0.00 -0.00

Table 6: OLS regressions results of regressions:

Sales = Natural log of total sales. Performance = ROA (Return on assets) in regressions 1-4 and RET (Total shareholder return) in regressions 5-8. SOE = State controlling ownership dummy one (1) when a firm is state controlled and zero (0) otherwise. Ind = Fraction of independent directors. Board = Board of directors size. Foreign = Foreign controlling ownership dummy one (1) when firm a firm is foreign controlled and zero (0) otherwise. Supervisory =

Supervisory board size. Mkt/Book = End year market value divided by the end year book. Debt/Equity = Total debt to total equity ratio. Sector = Dummy one (1) when a firm is in the I.T. service sector and zero (0) when in the non-cyclical consumer goods sector.

OLS Fixed Effects OLS Fixed Effects 1 2 3 4 5 6 7 8 α 5.49*** 5.77*** 7.32*** 7.78*** α 5.44*** 5.45*** 7.41*** 7.35*** Sales 0.29*** 0.28*** 0.24*** 0.22*** Sales 0.30*** 0.30*** 0.24*** 0.25*** ROA 0.00 0.00 0.00 0.00 RET -0.00*** -0.00*** -0.00*** -0.00* Central -0.00 0.00 -0.31** -0.29** Central 0.01 0.04 -0.29** -0.27* Local 0.00 -0.07 -0.14 -0.17 Local 0.00 -0.01 -0.12 -0.11 Ind 2.11*** 2.21*** 0.27 0.27 Ind 1.85*** 1.84*** 0.31 0.23 Board 0.04*** 0.04*** 0.00 -0.00 Board 0.04*** 0.04*** 0.01 0.00 Foreign 0.54*** 0.56*** 0.12 0.12 Foreign 0.44** 0.43** 0.14 0.16 Supervisory -0.05*** -0.06*** 0.06* 0.05* Supervisory -0.06*** -0.06*** 0.05 0.05 Mkt/Book 0.02*** 0.02*** -0.00 -0.00 Mkt/Book 0.03*** 0.03*** -0.00 -0.00 Debt/Equity -0.07*** -0.05* 0.04 0.06** Debt/Equity -0.09*** -0.09*** 0.03 0.03 Sector 0.52*** 0.53*** Sector 0.50*** 0.49*** Central*ROA -0.00 0.01* Central*RET -0.00 -0.00* Local*ROA 0.02*** 0.02*** Local*RET 0.00 -0.00

Table 7: OLS regressions results of regressions

.

Sales = Natural log of Total sales. Performance = ROA (Return on assets) in regressions 1-4 and RET (Total shareholder return) in regressions 5-8. SOE = State controlling ownership dummy one (1) when a firm is state controlled and zero (0) otherwise. Ind = Fraction of independent directors. Board = Board of directors size. Foreign = Foreign controlling ownership dummy one (1) when firm a firm is foreign controlled and zero (0) otherwise. Supervisory =

Supervisory board size. Mkt/Book = End year market value divided by the end year book. Debt/Equity = Total debt to total equity ratio. Sector = Dummy one (1) when a firm is in the I.T. service sector and zero (0) when in the non-cyclical consumer goods sector.

12. Conclusion

This thesis examines ownership and corporate governance effects on the remuneration of Chief Executive Officers (CEOs) in Chinese listed firms. As China has implemented various economic reforms since 1978, we would like to see how they have worked out in practice. Since new data is opening up to the academic world, we can focus on the effectiveness of the economic reforms China has undergone. Data from 2005-2011 is used in this study. Since 2005, listed companies are forced to disclose the total remuneration of their CEOs. Compared to previous literature that used older data (Firth et al, 2007, Conyon & He, 2011) this thesis is thus able to obtain the exact individual remunerations of CEOs.

Since many companies in China are still government controlled, CEO remuneration may not be based on performance but rather on a CEO’s place on the political ladder. Furthermore, state owned companies may not necessarily pursue a profit objective but are forced to pursue state objectives. One way the Chinese government has tried to cope with these problems is by centralizing shares under one state entity that pursues a profit-maximizing objective, the State-owned Assets Supervision and Administration Commission (SASAC). Supervision is furthermore believed to be stricter in centrally owned state enterprises than locally state owned enterprises (Xu, 2004). Centrally owned state enterprises deal with more government entities that supervise them in contrast to locally owned state enterprises. Since there is still corruption and an imperfect legal system present in China, centrally owned state enterprises are also expected to obey the laws and regulation more than locally controlled state enterprises due to their proximity to the central power. Lastly it is expected that centrally state owned firms serve nationwide interests, and are therefore under higher supervision than locally owned state enterprises.

and stock performance. Its effect is so small that it is not expected to hold any real effect on CEO decision-making.

Since shareholders’ and management goals aren’t linked through stock based incentives for CEOs, we believe that this could contribute to the agency problem still being at large in China. There is thus still a lot of work to be done to further enforce and enhance the economic reforms in China.

Our results are somewhat in line with previous literature: Conyon & He (2012) and Firth et al. (2007) find a link between past years’ return on assets and CEO remuneration. Firth et al. (2006) however do find a link between current year accounting performance and CEO remuneration. Most of the literature also finds a negative effect of state ownership on remuneration.

A shortcoming of this study is the difficulty to really pinpoint the CEO. Since the title CEO is only used very sparingly in corporate China, we had to resort to different methods to determine who was in charge, such as who was remunerated the most. Another limitation of this study is that only 2 sectors are investigated in this study. Lastly, finding proper proxies for performance is difficult. Performance measurements may be altered by managers in order to make the numbers look good, a practice that especially state owned firms used to employ (Qiang, 2003).

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14. Appendix

Table 8: OLS regressions results of regressions:

Sales = Total sales. Performancet-1 = Previous end year performance, ROAt-1 (Previous year return on assets) in regressions 1-4 and RETt-1 (Previous year

total shareholder return) in regressions 5-6. SOE = State controlling ownership dummy one (1) when a firm is state controlled and zero (0) otherwise. Ind = Fraction of independent directors. Board = Board of directors size. Foreign = Foreign controlling ownership dummy one (1) when firm a firm is foreign controlled and zero (0) otherwise. Supervisory = Supervisory board size. Mkt/Book = End year market value divided by the end year book. Debt/Equity = Total debt to total equity ratio. Sector = Dummy one (1) when a firm is in the I.T. service sector and zero (0) when in the non-cyclical consumer goods sector. */**/*** Denotes significance at the 10%/5%/1% significance level respectively

Appendix 1 OLS Fixed OLS Fixed

Appendix 1 cont. OLS Fixed OLS Fixed 1 2 3 4 5 6 7 8 α 5.72*** 5.81*** 7.70*** 7.66*** α 5.45*** 5.44*** 7.04*** 6.95*** Sales 0.28*** 0.28*** 0.24*** 0.24*** Sales 0.30*** 0.30*** 0.27*** 0.28*** ROAt-1 0.01*** 0.01** 0.01*** 0.01** RETt-1 0.00 -0.00 0.00 -0.00 Central 0.04 0.07 -0.76*** -0.80*** Central 0.04 0.07 -0.71*** -0.70*** Local 0.05 -0.01 -0.43** -0.45** Local 0.04 0.00 -0.38** -0.41** Independency 2.06*** 2.15*** 0.15 0.09 Independency 1.97*** 1.97*** 0.16 0.14 Board 0.04** 0.03** 0.00 0.00 Board 0.04** 0.04** -0.00 -0.00 Foreign 0.55*** 0.56*** -0.10 -0.11 Foreign 0.51** 0.52** -0.11 -0.10 Supervisory -0.05*** -0.05** 0.05 0.05 Supervisory -0.06*** -0.06*** 0.07* 0.06* Mkt/Book 0.02*** 0.02*** -0.01 -0.01** Mkt/Book 0.02*** 0.02*** -0.01** -0.01** Debt/Equity -0.06** -0.05* 0.03 0.03 Debt/Equity -0.08** -0.08** 0.02 0.02 Sector 0.51*** 0.52*** 7.66 Sector 0.53*** 0.52*** Central*ROAt-1 -0.01 0.01 Central*RETt-1 -0.00 -0.00 Local*ROAt-1 0.01*** -0.00 Local*RETt-1 0.00 0.00*

Table 9: OLS regressions results of regressions:

.

Sales = Total sales. Performancet-1 = Previous end year performance, either ROAt-1 (Return on assets) in regressions 1-4 and RETt-1 (Previous year total