An investigation of the information content of the financial policies of chinas listed companies

AN INVESTIGATION OF THE INFORMATION
CONTENT OF THE FINANCIAL POLICIES OF
CHINA’S LISTED COMPANIES




LI NING
(MA, Nankai University)




A THESIS SUBMITTED
FOR THE DEGREE OF DOCTOR OF PHILOSOPHY
DEPARTMENT OF ECONOMICS
NATIONAL UNIVERSITY OF SINGAPORE
2004

i


ACKNOWLEDGEMENTS

Being in the Ph.D. program in Economics and writing this thesis have been a very
special experience in my life. I am very grateful to my supervisor, Associate Professor
Lu Ding, who has not only provided valuable opinions and advices on my research
but also shown extraordinary kindness and patience throughout this period. Special
thanks have to be given to Dr John Sequeira who provided many useful comments
and suggestions on the revisions of this thesis.

The ceaseless love, encouragement, and support that I received from my family,
especially my parents and my husband, are the sources of my spirit, without which, it
is unimaginable for me to finish this thesis finally. I also wish to say thank you to
people who helped me and to my friends who shared the pains and happiness with me.
I will bear all of these in my mind forever.



i
Table of Contents

Page

Acknowledgments
i
Table of content
ii
Summary
iv
List of Tables
vi
Content of Thesis


Chapter 1 Introduction
1
1.1 Background 1
1.2 Objectives 4
1.3 Methodology 9

Chapter 2 Institutional Feature of China’s Stock Market
11
2.1 Features of China’s Stock Market 11
2.1.1 A Unique Feature of China’s Stock Market 11
2.1.2 Comparison with the Insider-based Model 14
2.1.3 Comparison with the Outsider-based Model 18
2.2 Problems of China’s Stock Market 22
2.3 Solution to the Problems 33

Chapter 3 Literature Review
39
3.1 Cash Dividends 39
3.1.1 Introduction 39
3.1.2 Information Content of Cash Dividends 43
3.2 Stock Distributions 47
3.2.1 Introduction 47
3.2.2 Accounting Treatment of Stock Dividends in China 50
3.2.3 Information Content of Stock Dividends 53
3.3 Rights Issues 55
3.3.1 Introduction 55
3.3.2 Information Content of Rights Issues 58
3.3.3 Institutions of Rights Issues in China 65

Chapter 4 Methodology
68
4.1 Data 68
4.2 Hypotheses 71
4.2.1 Cash Dividends 71
4.2.2 Stock Distributions 79

4.2.3 Rights Issues 85
4.3 Event Study 91
4.4 Regression Models 96
4.4.1 Cash Dividends 96
4.4.2 Stock Distributions 99
4.4.3 Rights Issues 102


Chapter 5 Findings and Results
104

ii
5.1 Cash Dividends 104
5.1.1 Event Studies 104
5.1.2 Regression Analysis 108
5.2 Stock Distributions 113
5.2.1 Event Studies 113
5.2.2 Regression Analysis 116
5.3 Rights Issues 120
5.3.1 Event Studies 120

5.3.2 Regression Analysis 122

5.4 Summary 126


Chapter 6 Conclusions
129

Tables

137
Bibliography
178
Appendix
The OLS Model of Event Study 190


iii
Summary
The thesis attempts to find out the reasons that caused the deteriorating share price
performance and the unusual financial behavior of China’ listed companies. By
comparing the institutions of China’s stock market with those of the stylized markets
in matured capitalist economies, it reveals that the chief problem of China’s stock
market is its failure to protect the interests of public minority shareholders and this is
caused by the share structure of the stock market where most shares are state-owned
or state-controlled which are non-tradable. The possible solution to the problems of
weak corporate governance without changing the share structure is to connect the
firm’s performance with shareholders’ wealth by enforcing regular cash dividend
payment.
Based on data collected for financial events of China’s listed companies over
1994-2003, the thesis investigated the information content of cash dividends, stock
dividends, transferred capital stocks, and rights issues using event study and
regression analysis under the framework of information signaling. The empirical
results did not support the main hypotheses implied by the information signaling
theory, suggesting that these hypotheses may not be applicable to China’s case due to
the institutional differences, which are discussed in light of our test results. A series of
regulatory policies associating the cash dividend distributions with the equity issues
were released since 2000. The empirical findings indicate that the new policies,

iv

associating the equity issues with cash dividends, have impacts on the managerial
behavior to a certain extent. These findings have brought optimism to the effect of the
cash-dividend-enforcement policy on improving corporate governance.
This study has implications for the relationship between corporate governance and
corporate finance. On one hand, the thesis provides evidence about the influence of
corporate governance on corporate finance by investigating the information content of
various financial policies in a stock market with unique institutions. On the other hand,
it provides evidence about the how corporate finance can affect corporate governance
by examining the impact of the cash-dividend-enforcement policy on the managerial
behavior of listed companies.



v
List of Tables


Page
Table 1-1
Number of Listed Companies (1993-2004)
137
Table 1-2
Features of All A-share Firms (1993-2004)
137
Table 1-3 China’s Stock Market in the National Economy (1992-2004) 138
Table 2-1 Share Structure of All Listed Firms (1992-2004) 139
Table 2-2 Ownership Structure of Listed Companies (1993-2001) 139
Table 2-3 Ownership concentration in terms of a single shareholder 140
Table 2-4 Overall Performance of Listed Companies (1992-2001) 140
Table 2-5 Losing Firms in China’s Stock Market (1995-2003) 140

Table 2-6 Changes of Capital Structure of Listed Companies (1992-
2002)
141
Table 2-7 A summary of A-share Firms Issuing New Shares (1994-
2003
142
Table 2-8 A summary of A-share Firms Paying Dividends (1994-2003) 142
Table 2-9 Turnover Rates of China’s Stock Market and Major World
Markets
143
Table 2-10 Number of A-share Investors (1990-2001) 144
Table 4-1-1 Sample Description of Cash Dividend Events (1994-2003) 145
Table 4-1-2 Sample Description of Pure Cash Dividend Events (1994-
2003)
145
Table 4-1-3 Expected Results of Regression Models of Cash Dividends 146
Table 4-2-1 Sample Description of Stock Dividend Events (1994-2003) 147
Table 4-2-2 Sample Description of Pure Stock Dividend Events (1994-
2003)
147
Table 4-2-3 Expected Results of Regression Models of Stock
Distributions
148
Table 4-3-1 Sample Description of Transfer Capital Stocks Events
(1994-2003)
149
Table 4-3-2 Sample Description of Pure Transferred capital stocks
Events (1994-2003)
149
Table 4-4-1 Sample Description of Pure Rights Issues Events (1994-

2003)
150
Table 4-4-2 Expected Results of Regression Models of Rights Issues 151
Table 5-1-1 Announcement Effect of Cash Dividends Events (1994-
2003)
152
Table 5-1-2 Announcement Effect of Cash Dividends Changes (1994-
2003)
153

vi
Table 5-1-3 Announcement Effect of Cash Dividends Initiations and
Resumptions (1994-2003)
154
Table 5-1-4 Announcement Effect of cash dividends by Year 155
Table 5-1-5 Announcement Effect of cash dividends by Period 156
Table 5-1-6 Statistical Description of Explanatory Variables in
Regression Models of Cash Dividends
157
Table 5-1-7 Cross-sectional Regressions of Cumulative Abnormal Return
of Cash Dividends
158
Table 5-1-8 Cross-sectional Regressions of Percentage Change in Cash
Dividend Distribution Size
159
Table 5-1-9 Cross-sectional Regressions of Cash Dividend Distribution
Size
160
Table 5-2-1 Announcement Effect of Stock Dividends (1994-2003) 161
Table 5-2-2 Announcement Effect of Stock Dividends by Year 162

Table 5-2-3 Announcement of Stock Dividends by Period 163
Table 5-2-4 Statistical Description of Explanatory Variables in
Regression Models of Stock Distributions
164
Table 5-2-5 Cross-sectional Regressions of Cumulative Abnormal Return
of Stock Dividends
165
Table 5-2-6 Cross-sectional Regressions of Distribution Size of Stock
Dividends
166
Table 5-3-1 Announcement Effect of Transferred Capital Stocks (1994-
2003)
167
Table 5-3-2 Announcement Effect of Transferred capital stocks by Year 168
Table 5-3-3 Announcement Effect of Transferred Capital Stocks by
Period
169
Table 5-3-4 Statistical Description of Explanatory Variables in
Regression Models of Transferred Capital Stocks
170
Table 5-3-5 Cross-sectional Regressions of Cumulative Abnormal Return
of Transferred Capital Stocks
171
Table 5-3-6 Cross-sectional Regressions of Distribution Size of
Transferred Capital Stocks
172
Table 5-4-1 Announcement Effect of Rights Issues (1994-2003) 173
Table 5-4-2 Announcement Effect of Rights Issues by Year 174
Table 5-4-3 Announcement Effect of Rights Issues by Period 175
Table 5-4-4 Statistical Description of Explanatory Variables in

Regression Models of Rights Issues
176
Table 5-4-5 Cross-sectional Regressions of Cumulative Abnormal Return
of Rights Issues
177

vii
CHAPTER 1
INTRODUCTION
1.1 Background
The rapid development of stock market is one of the major achievements that China
has made in the past two decades. Two national securities exchanges Shanghai
Securities Exchange (SHSE) and Shenzhen Securities Exchange (SZSE) were
established in Shanghai and Shenzhen at the end of 1990 and 1991 respectively. At
the beginning, there were only a few companies publicly listed and little amount of
transactions in these two national exchanges, but China’s stock market grew rapidly.
The number of listed companies increased from 183 in 1993 to 1377 in 2004 (see
Table 1-1). The listed firms raised a large amount of funds from the equity market, the
total market capitalization increased from 331.8 billion Yuan in 1993 to 3630.9 billion
Yuan in 2004 and the total tradable market capitalization increased from 68.3 billion
in 1993 to 1099.8 billion in 2004 (see Table 1-2). As a result, the stock market has
played a very important role in China’s economy. According to Table 1-3, the market
capitalization as a percentage of GDP has been increasing until it reached the peak in
2000 which is 53.79 percent, after that, it began to decrease and reached 27.14 percent
in 2004.
The stock market was established due to practical needs of improving state-owned
enterprises. Although the enterprise reform, which began in mid 1980s, had made
many trials to replace the old management system administered by bureaucrats with
more effective management system, including the Director Responsibility System,
and the Contract System, the efficiency of State Owned Enterprises (SOEs) was not

1
greatly improved. The SOE sector which employed over 70% of the urban workforce
still occupied a predominant status in the economy, but the overall performance of
SOEs was unsatisfactory because over one thirds of SOEs were in chronic financial
distress and being supported by the state budget grants and government-directed bank
credits. It was getting worse because the state treasury and the state-owned banks
themselves were facing financial difficulties, the former of which had a constantly
decreasing income since the taxation reform, and the latter of which had already been
implicated by the huge amount of bad debts. How to solve the financing problems and
to improve the efficiency of SOE became urgent issues of Chinese government at the
early 1990s.
The development of stock market was regarded as a remedy for the above issues and
was thus greatly supported by the Chinese government. Undoubtedly, by directing the
huge amount of personal savings and even the foreign funds to the investment needs,
stock market can solve the financing problem faced by many enterprises including
both state-owned enterprises and many non-SOEs, and to relieve the burden of state
budget and state-owned banking sector as well. Moreover, it was believed that stock
market can function as a governance system that would help establish a truly
competitive corporate sector in China as argued by some economists. Firstly,
companies going public have to be transformed to shareholding companies. In this
process, the company’s ownership would become clearer based on the shareholdings
that the ownership was not clear was considered as a key factor leading to the
inefficiency of SOEs; secondly, by issuing shares to the public, the ownership of
shares will be diversified. It helps improve the performance of SOEs and the public
shareholders can directly or indirectly participate in the corporate management
through the stock market.

2
There are two characteristics in the building of the Chinese stock market. One is that

the Chinese stock market was patterned after the US stock market in many
legislations of the stock market
1
. The reason that the China’s stock market emulated
the US stock market is because the latter is regarded as one of the most active and
efficient markets for corporate control which helps the US maintain a leading role in
the world economy. The other characteristic is that most of the listed companies are
SOEs or dominated by state-owned shares. The government hoped that a shareholding
system together with an active stock market can help develop an effective
management system of SOEs to restructure their inefficient management system.
Under the direct control of the government, the construction of stock market has
become a program of reforming the SOEs.
After more than one decade’s development, it is still uncertain whether the reform on
the stock market is successful. It is no doubt that China’s stock market absorbed a
great amount of public funds and began to exert an important influence on the China’s
economy. There were also concerns about over-speculation making the share prices
greatly volatile and the stock market highly risky. However, the concern of this thesis
is whether the US-like stock market established in China has worked well in
improving the corporate efficiency. The following phenomena, which were observed
in China’s stock market, intrigued my research interests.
In contrast to what was expected, the overall performance of the listed companies has
been deteriorating although the trend was reversed in recent two years. Indicated in
the Table 1-4, the average return on equity decreases from 14.28 percent in 1992 to as
low as 5.35 percent in 2001. The average earnings per share decreased from 0.35


1
Tam, On Kit (1999)

3

Yuan in 1992 to 0.13 Yuan in 2001. Since 1994, more and more listed companies
became money-losers. The proportion of firms losing money increased from 5.1
percent in 1995 to 12.51 percent in 2003 (see Table 1-5).
It was also observed that the financial behavior of China’s listed companies differed
in significant ways from that of their counterparts in mature economies such as the US.
For example, China’s listed companies paid little and irregular cash dividends; the
seasoned equity offerings were very popular in China, and the rights issue which was
rare in the US stock market has been the only form of seasoned stock issues before
1999. Furthermore, investors’ reactions towards these financial decisions were also
different from their US counterparts. China’s investors prefer stock dividends and
transferred capital stocks to cash dividends whereas investors in the US prefer cash
dividends; while in the US the market reaction towards rights issues is generally
negative, China’s stock market reacts favorably to rights issues.
The above facts show that, despite the similarities in many institutions, the operations
of China’s stock market and the US stock market are different. It also suggests that
the objective of creating an effective system for corporate control and improving the
Hence, exploring the reasons behind the differences between China’s stock market
and the US stock market becomes the motivation of this thesis.
1.2 Objectives
The unique financial behavior of China’s listed companies has also drawn the
attention of many researchers. It can be seen from the existing studies that at least
some of the results are not consistent with those of the US stock market. The
limitations of these studies are that they studied the market response to the news of a

4
financial decision either without reasonable explanations or, even if there are any,
they are not empirically supported. Therefore, the questions about why there was such
an announcement effect towards a specific financial decision and why the firm took
this financial policy remain inconclusive. In addition to study the market reaction to
certain business financial decisions, this thesis attempts to examine the managerial

incentives of financial policies by testing a number of hypotheses derived from the
information signaling theory or other theories.
Miller and Modigliani (1961) are the first ones to propose signaling-based
explanations for the positive stock price response to dividend increases. They
suggested that managers may announce such dividend changes in an effort to move
market expectations closer to those of the management about future earnings
prospects. From this information proposition an information signaling model was
eventually derived and many researchers
2
have contributed to the signaling theory by
providing a rigorous logical structure. They developed models of financial policy
under the assumption of asymmetric information showing that the financial decision
was relevant to the shareholders’ wealth.
The theoretical construct of the information signaling approach were developed by
Spence (1974), and were expanded into the areas of financial and dividend signaling
by Ross (1977), Leland and Pyle (1977) and Bhattacharya (1979). Spence (1974)
observes that buyers may use an imperfect proxy to predict product quality ex ante
market transactions. Because there is a negative correlation between the marginal cost
of improving the proxy and the actual product’s quality, the level of the proxy is a
signal to potential buyers. Ross (1977) applied this signaling mechanism in


2
Bhattacharya, (1979); John and Williams, (1985); Miller and Rock, (1985); Myers and Majluf, (1984);
Leland and Pyle, (1977); Brennan and Kraus, (1987); and Ambarish, John & Williams, (1987)

5
investigating the effect of financial leverage. The change in the financial structure can
alter the market’s perception of a risk without actually altering the actual risk. An
implication is that in a cross-section sample, the value of firms will rise as the

leverage increases because the increasing leverage raises the market’s perception of
value. Leland and Pyle (1977) also investigate the signaling implications of financial
structure in a world of information asymmetries. They show that the willingness of
insiders to invest in their own projects is a signal of the project’s quality. They found
that the value of the firm increases with the shares of the firm held by insiders.
The main idea of information signaling theory is that, due to information asymmetry,
financial instruments can be used by the management to convey inside information to
outside investors. This theory is applied to explain the changes in share prices on the
announcement of certain financial policy, a phenomenon well-documented in the
literature. For the management to convey any inside information about the firm’s
prospect to the outside shareholders through certain policy, two assumptions must be
met according to the information signaling theory that (i) the share price is changed
with the shareholders’ assessment about the firm’s value; and (ii) the falling share
price tends to oblige managers to maximize the shareholders’ wealth.
It is not certain whether these assumptions hold in China, because the manager-
shareholder relationship in China’s listed companies is complicated. The public
minority shareholders are the weakest group among all the parties, as they do not
receive enough protection from the regulatory framework. Although they hold almost
all the tradable shares, they have hardly any control over the company. Things are
more complicated in the state-owned enterprises, which account for a large proportion
of the listed companies. In these companies, the controlling shareholders are not

6
shareholders in a conventional sense. Such a shareholder-manager relationship
certainly will affect the corporate finance. Those agents of state-owned shares with
controlling power may pursue the interests of their own instead of the interests of the
company and other shareholders. By colluding with the major shareholders, they may
also pursue their common interests at the cost of minor shareholders.
Therefore, the objectives of this thesis are as follows. It is hypothesized that the
financial behavior and the overall performance of China’s listed companies are the

outcome of the institutional arrangements, which shape the relationship between
shareholders and managers, and thus shape the behavior of shareholders and managers.
A financial decision is not only a decision made by the managers, but is also a
reflection of the relationship between shareholders and managers. Therefore, the first
objective is to find out what are the differences in the institutional settings between
China and other countries, especially the US.
It is also expected that the conventional information signaling theory may not be able
to explain some empirical tests for China’s case because, in addition to the
information asymmetry, there also exists more complicated agency relationship in
China’s listed companies. The second objective is to verify whether the behavior of
the shareholders and management in China’s listed companies are consistent with the
predictions of conventional information signaling theory. The investigation of the
information content of the financial policies is conducted through the following steps.
Firstly, the market reaction of the announcement of a particular financial decision will
be examined. If the financial decision does contain some information not known to
the shareholders, the announcement of this decision will change the shareholders’
expectation about the firm’s performance and reevaluate the firm’s shares. Therefore,

7
the announcement effect of a particular policy on share price can verify (1) whether
there is any information conveyed by this policy; and (2) if any, whether it is good
news or bad news from the shareholders’ viewpoint.
Secondly, the thesis attempts to find out whether the market behavior in China is
consistent with the information signaling theory. According to the information
signaling theory, the shareholders can perceive whether a certain action is value-
added from the announcement, and the management has to avoid those actions which
may be perceived by the shareholders as value-reduced. Therefore, the information
signaling to some extent helps reduce the cost of asymmetric information. However,
provided in China the shareholders are lack of corporate control power, the
management is likely to take actions not in the interests of shareholders.

The last objective is to explore whether the cash-dividend-enforcement policy has
some impacts on the financial polices. It is noteworthy that the policy makers of
China gradually realized that the insufficient legal protection provided for the public
minority shareholders and the weak corporate governance are the dysfunctions of the
stock market. A series of regulatory polices about the corporate governance were
enacted by the China Securities and Regulatory Commission (CSRC), such as the
“Directives on the Reinforcement of the Supervision for Listed Companies” in June
2000, the “Directives on the Establishment of the Institution of Independent Board of
Directors” in August 2000, the “Code of the Corporate Governance for Listed
Companies” in January 2002, and the ‘Seven Measures to Promote the Corporate
Governance’ in January 2003. Among these regulatory policies, some policies are
relevant to the corporate finance. For example, the release of “Supplementary Notice
on the Rights Issues of Listed Companies” in March 2000, the Directive on the

8
Management of New Share Issues of Listed Companies” in February 2001 and “The
regulations of Reinforcement of the Social Public Shareholders’ Rights Protection” in
year 2004. It is supposed that these policies would have some impacts on the financial
policies of the listed companies. Therefore, the third objective of this thesis is to
confirm whether the new policies have impacts on the corporate finance.
1.3 Methodology
Event study and regression analysis are the primary tools adopted in this thesis to
achieve the above three objectives. This thesis conducts event study to examine the
market reaction towards the announcement of specific financial decisions made by the
listed companies. Regression models are then used to investigate the possible factors
that cause the announcement effect of a specific event and the managerial incentives.
There are some features of the empirical tests of this thesis in comparison to those in
the literature of the information content theory. Firstly, the aim of the thesis is to find
out the nature of the information that can be used to interpret the market reactions and
the managerial incentives, no matter whether it is suggested by the information

signaling theory or any other theories.
Secondly, the thesis concerns whether the market reaction towards and the managerial
incentives of a specific policy are consistent. The empirical studies of information
content in the literature usually omit the examination of the managerial incentives and
make conjectures on whether the event signals good or bad news for the firm’s
prospect based on the market reaction only. These studies assume that the
shareholders concern about the firm’s value and actively involve in monitoring the
corporate management. When a financial policy reflects the management’s confidence

9
in the future, the shareholders will revise their expectation upward and cause the share
prices to increase; when a financial policy signals the management’s pessimism about
the future, the shareholders will revise their expectations down and cause the share
prices to decrease. The institutional features of China’s stock market, however,
suggest that the public shareholders’ wealth in China may not be linked to the firms’
value due to insufficient legal protection. Therefore the investor’s reaction may be
different from that suggested by the information signaling theory. Even if the
investors do care about the firm’s value, it may still be problematic whether they are
able to correctly interpret the information conveyed by a certain corporate decision
especially in an emerging market with ever-changing institutions, incomplete
information disclosure, and immature listed companies. Therefore, both the market
reaction and the managerial incentives are to be examined for any type of events.
The remainder of the thesis is organized as follows. Chapter 2 examines the
institutional settings of China’s stock market, the problems of China’s stock market,
and the possible solution. Chapter 3 reviews all the relevant literature about the
market reaction towards and the managerial incentives of the announcement of cash
dividends, stock distributions and rights issues of listed companies over 1994 to 2003.
Chapter 4 presents the data used and methodologies applied. The results and findings
are presented in Chapter 5 and Chapter 6 is about the conclusions.

10
CHAPTER 2
INSTITUTIONAL FEATURES OF CHINA’S STOCK MARKET
Institutional features and the problems related to China’s stock market are two
subjects discussed in this chapter, which comprises three sections. Section 2.1
analyzes the institutional arrangements in China in comparison to two stylized
markets, the insider-based market and the outsider-based market; Section 2.2
discusses the problems of China’s stock market; with possible solutions to these
problems discussed in Section 2.3.
2.1 Features of China’s Stock Market
2.1.1 A Unique Feature of China’s Stock Market
In China, the shares are classified as A-shares the ownership of which is confined to
only local citizens, and B-shares were allowed to be held initially by foreigners only,
and now are open to domestic citizen, but are traded in foreign currency. A-shares and
B-shares are shares of companies registered in China and listed in China’s stock
exchanges. H-shares are shares of companies registered in China but listed in stock
exchanges of Hong Kong. A company can issue A-shares and B-shares together and
can be listed in a domestic stock exchange and a foreign stock exchange
simultaneously.
The classification of shares above-mentioned is not unique as it is a common practice
to classify shares as domestic shares and foreign shares. The uniqueness is that the
shares of a company are classified according to the ownership property of the
shareholders, and are categorized as State-owned Shares, Legal person’s shares, Staff

11
Shares and Public shares. Before the reform and opening, there are only two types of
enterprises, state-owned enterprises which dominated the economy and collective-
owned enterprises. In the transformation from state-owned enterprises to shareholding
companies, the state assets were converted to state-owned shares, the assets belong to
the state-owned enterprises were converted to Legal person’s shares, and shares

issued to employees were converted to Staff Shares. Once the transformed
shareholding company is listed in either stock exchange, the shares issued to other
enterprises belong to the Legal person’s shares; and shares issued to the public are
called public shares.
The aim of such classification is to separate tradable shares with non-tradable shares.
State-owned shares, Legal person’s shares, Staff Shares are not allowed to be traded
in the stock market, only public A-shares and B-shares are traded in the stock
exchanges. The policy-makers are afraid that the state might lose the control rights on
the state-owned shareholding companies with the reduction in the proportion of the
state ownership when it can be freely transferred. While prohibiting the state-owned
shares and Legal person’s shares to be transferred in the stock market, the dominant
status of state’s ownership can remain. Since most of the legal person’s shares are
also the assets owned by the state-owned enterprises, legal person’s shares are treated
as state-owned shares and not allowed to be traded in the stock market. As a result,
most of the shares are non-tradable and most of the companies are controlled by the
state or legal persons. The unique share structure of the listed company has substantial
impact on China’s stock market.
The ownership of non-tradable shares can be transferred outside the stock exchanges.
The ownership is generally transferred through agreements signed by both parties

12
concerned. The ownership transfer of state-shares and state-owned legal person’s
shares has to be conducted within state-owned enterprises or organizations, and
approved by the state assets management organizations. The transfer is helpful to
some extent to mobilize the capital, but a large proportion of the transfer of state-
owned enterprises were proposed and organized by the government or state-
authorized organizations rather than a free market transaction organized by firms.
This government behavior greatly reduced the effects that ownership transfer would
have in mobilizing the funds and improving the management efficiency.
Table 2-1 gives a general picture of share structure in China’s stock market through

years 1992 to 2004. The figures are the numbers of each type of shares as percentage
of total shares. It shows that on average the state-owned share accounts for 41.31
percent of the total shares, while the legal person’s share accounts for 23.04 percent,
and the public A-share accounts for 23.30 percent. During 1992-2004, there has been
a decrease in the proportion of legal person’s shares from 26.60 percent to 16.40
percent, but the proportion of state-owned shares increased from 42.10 percent to
46.78 percent, and the proportion of public A-shares increased from 15.90 percent to
27.87 percent. But the number of total non-tradable shares remains almost a double of
that of total tradable shares as the percentage of the non-tradable shares to the total
shares is 66.02 percent and the percentage of tradable shares to the total shares is only
34.03 percent.
The ownership structure is further described by Table 2-2. On average, in about 49%
of the companies, the state-owned share accounts for the largest proportion; in about
32 percent of firms, the legal person’s share accounts for the largest proportion, public
A-share dominates in only about 19 percent of the firms. Therefore, in about 86.7

13
percent of the firms, non-tradable shares dominate the ownership structure. As
mentioned before, part of the legal person’s shares is also state-owned. Although the
proportion of the state-owned legal person’s shares in the total Legal person’s shares
is not known, one thing can be sure is that the state control is more than what is
reflected in the proportion of state-owned shares where the proportion of state-owned
Legal person’s shares is not included.
Based on Table 2-1 and Table 2-2, the following conclusions can be drawn upon the
share structure of China’s stock market: a) on average most of the shares (66.02%) in
the stock market are not tradable in the stock exchanges. A vast majority of the listed
firms (86.70%) whose ownership is dominated by non-tradable shares; b) state-owned
shares, which on average account for 41.31 percent of the total shares, dominate the
scene in the stock market. The state ownership has the absolute control rights in about
48.89 percent of the total firms; c) Public shareholders holding tradable shares are the

weakest shareholders because on average they hold about only 23.30 percent of the
total shares, and the A-share ownership dominates in only about 19.90 percent of the
total firms; d) The status of legal person’s shares is in between the state-owned shares
and public tradable shares.
2.1.2 Comparison with the Insider-based Model
The insider-based model is also called bank-based corporate governance model
because this model puts emphasis on the role of the banks in the corporate governance.
Germany is often cited as an example of a country in which the relationship between
bank and industry is not burdened at all by regulatory constraints. The institutional
structure of the German financial system centers on the principle of universal banking.
Universal banks can hold as many of equities as they like in any non-financial firm. In

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Japan, financial institutions are subject to few regulations regarding the holding of
corporate stock or the use of the stock they own for corporate control. Japanese
commercial banks are not prohibited from owning corporate stock, although they are
subject to anti-monopoly regulations.
Interlock shareholding is another feature of Germany-Japan model. The large shares
of a company are often held by other companies – a cross-holding of shares – or by
holding companies for families. In smaller German companies, the family exerts
control through majority ownership, in which the owner controls 51% of a company,
which in turn controls 51 percent of its subsidiaries and so on (Franks and Mayer,
2001). In Japan, many companies are organized around a major bank and form a
network group called “keiretsu.” There are long standing business relationships
between the group companies. The banks and other financial institutions own shares
in most of the group companies and those companies may in turn hold the bank’s
shares or each other’ shares. The power in Keiretsu is split among the main bank, the
largest companies, and the group as a whole.
In this model, banks end up holding equity as well as debt of the firms they invest in,
or alternatively vote the equity of other investors (OECD 1995). The power of the

banks’ control on the companies is very significant because banks vote significant
blocks of shares, sit on boards of directors, play a dominant role in lending, and
operate in a legal environment favorable to creditors. As a consequence, the share
ownership is concentrated on the small portion of the inside shareholders. In Germany,
large commercial banks through proxy voting arrangements often control over a
quarter of the votes in major companies, and also have smaller but significant cash
flow stakes as direct shareholders or creditors (Frank and Mayer 1994, OECD 1995).

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In Japan, though ownership is not nearly as concentrated as in Germany, large cross-
holdings as well as shareholdings by major banks are very common (Prowse 1992,
Berglof and Perotti 1994, OECD 1995).
Germany firms own a two-tier board structure comprised of a supervisory board and
an executive board. The employees of a firm have a right to participate directly in the
governance of the company through representation in the company’s supervisory
board with half of the board membership. The supervisory board supervises the
activities, and can scrutinize and veto the management’s investment plans, appoints or
removes members of the executive board. Members of the executive board cannot sit
on the supervisory board. Board members are required to represent the interest of the
company, not of the group they represent.
The advantage of Germany-Japan model is that, the banks and other large
shareholders can, with the majority shares they hold of a company, take their
advantageous position in the board of directors and shareholders’ meeting, and exert
their influence directly on the corporate control through the internal governance
system. That is the reason that the model is also called insider-based market. However,
the disadvantage of such an insider-controlled governance system is that, the interests
of the numerous minority shareholders was neglected and might be impaired by the
majority shareholders. That is also the reason that an active stock market is absent
under this model.
China’s ownership structure is more like the Japan-German model with share

ownership highly concentrated in a few insiders. In a study of 530 listed companies in
1996, He (1998) gives evidence about the ownership concentration in terms of an
individual shareholder. One of his results is presented in the Table 2-3 which

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classifies the companies into groups by the percentage of shares owned by the largest
shareholder. It shows that in 38.3 percent of the 530 companies, the largest
shareholder holds more than 50 percent of the total shares of a firm which means he
has the absolute rights on the firm. In about three quarters of the sample companies,
an individual shareholder holds more than 30 percent of the total shares of a firm. The
degree of ownership concentration is comparable to that of the Germany and Japan.
Although the ownership structure is highly concentrated, the governance system of
the China’s public companies was not similar to that of the Germany-Japan model
which is bank-centered. Banks in China cannot control the firms by acting as active
large shareholders because they are not allowed to invest in equity markets.
According to the Article 133 of the “Securities Law of China”, capital of banks is
prohibited from entering into securities exchanges. Even if the bank can be a large
creditor, the banks’ role on the management of the firm is limited. In principle, banks
can impose financial discipline on firm primarily by requiring them to make regular
payments on loans. Banks also have rights to access to fairly detailed information on
the financial condition of a borrowing firm, and exert corporate management. But
most of the listed companies are former state-owned enterprises; their short-term
external financing relies on the loans from the state-owned banks. State-owned banks
are not likely to play an effective role in the management when they have only limited
rights to choose between carrying a bad loan on their books and force bankruptcy and
closure of the state-owned firms.
China’s listed companies have a similar supervisory board as in Germany, which is
comprised of employees and representatives of shareholders. It is supposed to
supervise the illegal behavior or misconduct of directors and managers that would

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