Corporate Governance and Firm Performance

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Corporate Governance and Firm Performance: Evidence from Chinese Listed Firms

Miao Wenhao^1*, Junainah Jaidi¹, Rosle Mohidin¹

1 Faculty of Business, Economics and Accountancy, Universiti Malaysia Sabah, KK, Malaysia

*Corresponding Author: [email protected]

Accepted: 20 August 2020 | Published: 31 August 2020

________________________________________________________________________________________

Abstract: The purpose of this paper is to investigate the relationship between corporate governance and firm performance. In order to examine the relationship, this paper employed panel data regression techniques using stock data to represent the aggregate composition of the Shanghai Stock Exchange 180 Index (SSE 180 index) based on Chinese capital market from 2010 to 2019. The empirical results showed that corporate governance could influence the firm performance. More specifically, both board size and CEO duality are positively and significantly related to firm performance measured by ROA. While board independence has not yet had a significant and positive impact on firm performance. There is no significant relationship between state ownership and firm performance. CEO compensation can indeed improve firm performance. Debt has a significant negative correlation with firm performance. Therefore, the viewpoint that good corporate governance can lead to better firm performance is not true of every country because of the different culture in the different country.

Keywords: Corporate Governance, Firm performance, China, Panel data regression

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1. Introduction

The global market in the 21st century has been undergoing complex and profound changes in tandem with the acceleration of world economic globalization. This may result in instability and uncertainty in the business environment in this new century (Taouab, 2019). In relation to that, complex and changeable market environment has forced enterprises to face challenges and even cruel market competition. Under this situation, enterprises have opportunities to occupy a larger market, yet will be eliminated by the market forces because of failure to compete. Hence, continuous performance is a key driver of a firm especially in coping with a growing number of challenges arising from unforeseen event in dynamic business landscape.

As a matter of fact, the rapid growth in capital market in Asia, especially China, has brought the importance of the corporate governance (CG) practices in portraying firm’s future performance.

Corporate governance is considered an important element in firm performance. It firstly became a hot topic in academic discussions during the Asian financial crisis in 1997 as well as some landmark events, such as the well-known corporate scandals of Enron and WorldCom in Europe and many others (li, xu, Niu, and Qiu, 2012). According to Al-Matari,

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Al-Swidi, and Fadzil (2014), good corporate governance could prevent possible financial crisis, attract investment for firms to maximize the company’s capital as well as strengthen the pillars of the company, which will lead to the improvement of the firm’s performance.

Furthermore, a strong corporate governance will not only improve firm performance, but also promote the capital market operation and long-term sustainable development of both capital markets and enterprises (Sabbaghi, 2016).

Mirza (2013) believed that corporate governance plays a vital role in improving firm performance, but most of the research about their relationship have only collected the data from developed countries. Given the significant institutional difference between developed and emerging countries, there is still a wide gap specially in the case of growing economies like China. China is known as the World’s largest transition economy (moving away from planned economy to a market-oriented one) in Asia, which has become a leading economy in the Asia economy. Mutlu, Van Essen, Peng, Saleh, and Duran (2018) highlighted that Chines Capital Market is considered a good platform for a dynamic institution-based conception of CG research in relation to a firm’s performance.

As far as the capital market is concerned, China's capital market possess a high degree of ownership concentration, weak institutional environment (poor investor protection and rampant insider self-dealing) as well as quite weak law enforcement (Y. Liu, Miletkov, Wei, and Yang, 2015). As such, there are many problems like unnecessary government intervention in business decisions, poor corporate governance, and the lack of incentives provided for senior executives, which have an adverse effect on firm performance. Due to the low efficiency of Chinese capital market and unique environment compared to developed economies. Therefore, this paper will try to investigate the contribution of corporate governance dimensions on firm performance based on Chinese Listed Firms.

2. Literature Review

The term “corporate governance” has no global standard definition but could be described in many ways. Corporate governance was defined by Shleifer and Vishny (1997) as a mechanism, which can guide the actions of managers to ensure that financiers’ financial investments can be repaid in the future. Nowadays, corporate governance seems to be an important indicator of a firm’s performance, which not only protects the interests of shareholders, but also plays a vital role in the survival and sustainable development of a firm (Srivastava, Das, and Pattanayak, 2018). However, the term corporate governance has been used frequently since mid-1980s when the economies and politics in the Organization for Economic Co-operation & Development (OECD) countries changed dramatically. According to the OECD (2004), corporate governance involves a series of relationships among the company's management, board of directors, shareholders and other stakeholders, and provides a structure through which the company can identify the firm’s objectives, work out ways to achieve them, and predict future performance.

The literature review in terms of the effect of corporate governance on firm performance in China is inconclusive (Mutlu et al., 2018). Some findings showed that good governance mechanisms do have a beneficial impact on firm performance (Sami, Wang, and Zhou, 2011). While other scholars have a different opinion. A study done by Chen, Li, and Shapiro

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(2011) examined whether adopting the corporate governance principles stipulated by the OECD could help solve some of the major corporate governance problems in emerging economies (expropriation by controlling shareholders) using a panel of over 1,100 Chinese listed firms. They found that the negative impact of expropriation by controlling shareholders on firm performance cannot be mitigated by the good corporate governance provided by OECD countries. Most good governance practices are primarily aimed at resolving conflicts between shareholders and management and not between controlling and minority shareholders.

Likewise, Dian (2014) furthermore argued that the so-called good governance practices originating from the west (such as the independent director system) are often divorced from the actual situation in the host country (OECD countries). He proposed that the so-called good governance practice is the result of the "construction" of various complex social forces and interest groups in specific social, political, and cultural institutions.

Due to those issues highlighted in previous studies, it is worthwhile to investigate the contribution of corporate governance dimensions on firm performance. Jiang and Kim (2015) summarized several attributes that represent corporate governance in China. They are:

ownership structure; board structures; CEO compensation; debt ratios and dividend payouts.

In addition to that, Nuhu and Ahmad (2017) hold that corporate governance mechanisms like board structure, ownership structure, and CEO compensation are key drivers to effectively control the management of the firm and produce desired results. Therefore, this paper identifies four important dimensions of corporate governance that can influence firm performance, which are board characteristics, state ownership, CEO compensation and capital structure.

Other studies on the relationship between corporate governance and firm performance are as follows: some studies investigated the impact of overall corporate governance on the firm performance (V. Z. Chen et al., 2011; Hu, Tam, and Tan, 2010; Leung and Cheng, 2013;

Sabbaghi, 2016; Sami et al., 2011; Shao, 2019). Some of studies focused on one specific dimension of corporate governance, such as board characteristics (Merendino and Melville, 2019; Rodriguez-Fernandez, Fernandez-Alonso, and Rodriguez-Rodriguez, 2014); ownership structure (Yu, 2013); capital structure (Ahmed Sheikh and Wang, 2013; Margaritis and Psillaki, 2010); CEO compensation (Elsayed and Elbardan, 2018; Jiang and Zhang, 2018).

However, attempts to determine the effectiveness of governance mechanisms based on these factors produce mixed findings.

In China, research on the relationship between board size and firm performance, (C. H. Chen and Al-Najjar, 2012; Li, Lu, Mittoo, and Zhang, 2015) showed a positive relationship between them, while Liu et al. (2015) showed that board size is negatively related to ﬁrm performance. Although there are mixed results, most research findings tend to find a negative relationship between larger board size and firm performance based on Chinese listed companies (Liu and Fong, 2010). In view of the immature development of CG in China, the structure of Chinses board of directors is largely a product of regulations, rather than based on the characteristics of each firm (Jiang and Kim, 2015).

Empirical studies have showed that in Chinese ﬁrms, independent directors are often

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regarded as a bridge between managers and stakeholders, which can reduce agency problems (Kao, Hodgkinson, and Jaafar, 2019). However, Liu et al. (2015) noted that Chinese independent director system only satisfied the requirements of regulation. In terms of the role of supervision, it is not only perfunctory, but also inefficient. Controlling shareholders usually keep their listed companies with a minimum number of independent directors according to the regulation requirement (Jiang and Kim, 2015).

In the Chinese context (Chen et al., 2011) , it is argued that CEO duality is often considered an obstacle to effective CG by Chinese policy makers and researchers. However, in China, if the chairman and CEO are separate, the chairman can supervise the CEO, but the role of supervising is limited and may also lead to power disputes.

Most of studies often showed that state ownership is considered as a factor hindering the improvement of firm performance based on the Western perspective. However, based on empirical evidence from Chinese listed firms, Yu (2013) found that because of the benefits of government support and political relations based on the Chinese environment, a higher level of state ownership is better than a dispersed ownership structure and there is an optimal level of state ownership for improving firm performance.

Empirical studies of the relationship between CEO compensation and firm performance has generally shown mixed results (Elsayed and Elbardan, 2018). However, previous literature on CEO compensation using Chinese data shows that CEO compensation is positively correlated with firm performance on the whole (Jiang and Zhang, 2018).

The empirical research on the influence of capital structure on enterprise performance is paid less attention to in developing countries than in developed countries (Ahmed Sheikh and Wang, 2013). In China, there is a strong positive correlation between debt and corporate performance, which is the consensus of Chinese academic circles. They attribute the positive relationship to minority shareholders' dislike of new equity financing, as the minority shareholders worry that their financing will be deprived of by controlling shareholders.

Hence, this positive relationship is not surprising in China. (Jiang and Kim, 2015).

3. Research Methodology

Data and Sample

In this paper, all financial data are collected and gathered from China Stock Market &

Accounting Research Database (CSMAR) and annual reports (for missing data). To examine the relationship between corporate governance and firm performance, this paper employed panel data regression techniques using stock data to represent the aggregate composition of the Shanghai Stock Exchange 180 Index (SSE 180 index) based on Chinese capital market.

As the core index of the SSE Index, it is an index formed by sample stocks selected through scientific and objective selection methods.

However, since we required our sample firms to have data available for all identified provisions, the sample will exclude companies in the finance industry, as financial, insurance and real estate firms have different regulatory compliance requirements and asset holding requirements, which will effectively change their performance characteristics (Burinwattana,

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2018). In addition to that, in order not to have missing data in our estimates and to have the same sample size in all models, companies with unavailable information, indeterminable data or incomplete financial data (e.g. the observations listed after 1/1/2010) will be deleted.

Therefore, this study will retrieve the firm-year data (Kao et al., 2019) from 2010-2019 and the final total number of observations are 86 firms, therefore the firm-year observations are 860.

Model Design

Given that our data set is balanced panel data of different numbers of firms (86 firms) over a 10-year period from 2010-2019, this study applied panel data (panel data correspond to data with large numbers of cross-sections (86 firms), with variables held in single series (2010- 2019) in stacked form) regression techniques to test the relationship between corporate governance dimensions and firm performance. In order to test our hypotheses, the random effect model is employed. The econometric model is specified as follows:

= + + + + + + + +Year dummy + Industry dummy+ +

(i =1,…N; t=1,…T)

Where:

represents ROA to measure firm performance for firm i at time t. In this paper, ROA is defined as the ratio of consolidated net earnings to average assets.

Board Size (BS) is measured as the total number of directors on the board. Board Independence (BI) is calculated as the ratio of the number of independent directors divided by the total number of directors on the board. CEO duality (CD) is a dummy variable, which equals 1 if the CEO is also the chairman of the board of directors, and 0 otherwise (Kao et al., 2019).

State ownership (SO) is calculated as the ratio number of state-owned shares divided by total number of shares. represents the natural log of the total compensation of TOP3 executives, excluding allowance received by executives. represents the capital structure. In this paper, capital structure is the ratio of debt and equity financing, which is obtained by dividing total debt by total asset.

represents the firm size, which is the control variable that will be controlled to ensure the robustness of the conclusion. In addition, this paper will follow the work done by (Kao et al., 2019), including industry dummy variables to control for industrial effects as well as year dummy variables in the model to capture the regulation effect, which may affect the outcome variable.

4. Empirical Analysis

Descriptive statistics and correlation

Table1 shows the main descriptive statistics of the research variables used in this study for the full sample. Firm performance (ROA) ranges from the minimum of -11.96350 to the

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maximum of 47.7017 with an average value of 6.988960, indicating that there are big differences among these sample firms and some firms have poor performance. In term of the board characteristics, three variables were shown in the table. Firstly, the average number of members serving on the board (Board Size) is 9.55, ranging from 9 to 17, which is in line with China's legal requirements on board size of listed firms. Listed firms in China are required to have boards ranging from 5 to 19. In addition, the percentage of independent directors (Board Independence) has a mean of 38.85% and a median of 36.36%, which meets China's rules on board composition of listed firms (as of 2003 one-third of the members of the board must be independent). While still a few sample firms do not have enough independent directors on their boards (the minimum is 12.5%). Last but not the least, about 12.44% of the sample firm CEOs and chairman are the same person, indicating that the prevalence of CEO duality is less severe in China (Jiang and Kim, 2015).

The mean value of the proportion of state-owned shares (SO) is 0.0545, the minimum value is 0.000, and the maximum value is 0.7682, which indicates that the difference between the minimum value and the maximum value is large, and the proportion of state-owned shares in most enterprises is not high. The average value of executive compensation (CC) is 14.8625, the minimum value is 11.8241, and the maximum value is 17.7457. In addition, the mean of debt is 0.5127, indicating that the average DEBT ratio is 51.27%. The mean value of enterprise size (FS) is 24.3930, the minimum value is 19.7325 and the maximum value is 28.6364, indicating that there is a certain gap in the size of different firms.

Table 2 provides the correlation matrix (with Probability) among all key variables in the regression analysis. The maximum correlation coefficients between all independent variables is 0.6090, implying that there is no multicollinearity problem. According to the study of Shao (2019), a correlation of absolute value 0.7 or higher may indicate a multicollinearity problem, which serves as a preliminary test for multicollinearity. Therefore, the regression models used to test the hypotheses are relatively free from multicollinearity problems.

Table 1: The main descriptive statistics of main variables

Variables Mean Median Maximum Minimum Std. Dev.

ROA (%) 6.988960 5.676250 47.70170 -11.96350 6.126738

BS 9.548837 9.000000 17.000000 5.000000 1.907936

BI 0.388503 0.363636 0.800000 0.125000 0.078162

CD 0.126744 0.000000 1.000000 0.000000 0.330251

SO 0.054486 0.000000 0.768198 0.000000 0.140589

㏑CC 14.86254 14.79305 17.74573 11.82408 0.766422

DEBT 0.512741 0.516892 0.885872 6.17E-05 0.184164

㏑FS 24.39303 24.33377 28.63642 19.73252 1.689056

Observations 860

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Table 2 : The correlation matrix with probability of main variables in the regression analysis CORRELATION

(PROBABILITY)

1 ROA 2 BS 3 BI 4 CD 5 SO 6 CC 7 DEBT 8 FS

1 ROA 1.000000

2 BS 0.010728

(0.7534)

1.000000

3 BI -0.147808

***

(0.0000)

-0.369941

***

(0.0000)

1.000000

4 CD 0.098180

***

(0.0040)

-0.115890

***

(0.0007)

0.007211 (0.8328)

1.000000

5 SO -0.023147

(0.4978)

0.094908

***

(0.0053)

0.057043 * (0.0946)

-0.081987

**

(0.0162)

1.000000

6 CC 0.185812

***

(0.0000)

0.056916 * (0.0953)

-0.026309 (0.4410)

0.100659

***

(0.0031)

-0.161615

***

(0.0000)

1.000000

7 DEBT -0.609021

***

(- 17.41767)

0.033704 (0.3235)

0.211614

***

(0.0000)

-0.051474 (0.1315)

0.040022 (0.2410)

0.003137 (0.9268)

1.000000

8 FS -0.248335

***

(0.0000)

0.119966

***

(0.0004)

0.235390

***

(0.0000)

-0.142176

***

(0.0000)

0.047086 (0.1677)

0.243358

***

(0.0000)

0.442456

***

(0.0000)

1.000000

Note: ***, **, * Represent The Significant At The 0.01 Level, 0.05 Level, 0.1 Level Respectively.

Regression Results

After the Hausman-test, the results (p=1.0000) show that the Random-effect model is more suitable for our data set. More importantly, in order to avoid endogeneity problems in the model, Instrumental Variables (IV regression) are adopted for regression analysis. In this paper, the lagged value of each explanatory variable is used as the instrumental variable. In order to test whether these instrument variables are appropriate for the model, we conducted the test for over-identifying restrictions. The result of Sargan-Hansen statistic value strongly accepted the null hypothesis that all instrumental variables are exogenous. In other words, all the selected instrumental variables are valid and are not related to error term. The results confirmed that the model in our study was valid. The specific results are shown in the Table 3.

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Table 3: The results of firm performance on corporate governance (with probability) Dependent Variable: ROA Random Effect Model 2SLS Random Effect IV

regression

BS 0.276422**

(0.014)

0.2949981*

(0.079)

BI -1.698960

(0.542)

-5.203881 (0.280)

CD 0.970869*

(0.065)

2.608021**

(0.020)

SO 0.188995

(0.866)

0.5959706 (0.762)

CC 1.653724***

(0.000)

1.075966**

(0.021)

Debt -20.68952***

(0.000)

-20.91366***

(0.000)

FS 0.941404***

(0.000)

1.114387***

(0.000)

_cons -27.73770***

(0.000)

-22.47244***

(0.001)

Industry Yes Yes

Year Yes Yes

Part2 Model test and the basic parameters related to the model.

N 860 860

Hausman-test p=1.000

R-squared 0.304 0.632

Adjusted R-squared 0.284 0.474

F-statistic 15.231 ***

Prob(F-statistic) 0.000

Wald 228.71 ***

Prob > 0.0000

Sargan-Hansen statistic 10.152

p-value 0.1801

Note: ***, **, * represent the significant at the 0.01 level, 0.05 level, 0.1 level respectively.

According to the Table 3, the regression coefficient of board size (BS) is 0.2761, indicating that board size significantly promotes firm performance at the level of 5% significance. That is, for every unit increase in board size, firm performance significantly increases by 0.2761%.

The regression coefficient (-1.5286) of the proportion of independent directors (BI) did not pass the significance test, indicating that BI has a certain inhibitory effect on firm performance, but it is not significant. The regression coefficient of CEO duality (CD) is 0.9549, which is significant at 10%. In other words, compared with enterprises that CEO and chairman are the different person, enterprises with CEO duality have significantly better performance. The regression coefficient (0.1686) of the proportion of state-owned shares (SO) also did not pass the significance test, indicating that state ownership had a certain promoting effect on firm performance, but it was not significant. The regression coefficient of CEO compensation (CC) is 1.5944, which is significant at 1% level. That indicated that CEO compensation can significantly improve firm performance. The coefficient of debt is negative and significant at 1 per cent level for ROA, which means that firm performance decreases with the increase of debt ratio. In other words, firm performance decreases by 20.8902% for every increase of 1 unit of debt ratio. The regression coefficient of enterprise size (FS) was 1.0275, which passed the 1% significance level test, indicating that the bigger firm is, the better its performance will be. For every unit increase in firm size, the firm

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performance will increase 1.0275%.

Robustness test

In order to test the robustness of regression results, the return on equity (ROE) is used to replace the ROA mentioned above as the explained variable to measure firm performance for the robustness test. It is consistent with the regression results and the conclusion that the model is robust. The results are as follows:

Table 4: The Robustness test result of firm performance on corporate governance (with probability) Dependent Variable: ROE

BS 0.563086**

(0.019)

BI -4.906443

(0.410)

CD 2.503770**

(0.027)

SO 2.714467

(0.264)

CC 3.671253***

(0.000)

Debt -15.59492***

(0.000)

FS 1.826868***

(0.000)

_cons -71.75336***

(0.000)

Industry Yes

Year Yes

N 860

R-squared 0.174

Adjusted R-squared 0.150

F-statistic 7.312

Prob(F-statistic) 0.000

Note: ***, **, * represent the significant at the 0.01 level, 0.05 level, 0.1 level respectively.

5. Discussion and Conclusion

This paper investigated the relationship between corporate governance and firm performance using stock data to represent the aggregate composition of SSE 180 index based on Chinese capital market. The findings of this paper can be concluded as follows.

At first, in terms of board characteristics, the results showed that board size is positively and significantly related to firm performance measured by ROA, implying that the larger board size, the better the firm performance will be. This indicated that although some people believe that the increase in board size will affect the operational efficiency of the board of directors and lead to communication and coordination problems, a larger board size may also lead to stronger decision-making and a wider range of views and external connections, thus promoting the improvement of firm performance. Particularly, board independence has not yet had a significant and good impact on firm performance. One of the reasons may be because the main role of Chinese independent directors is different from that of the United States and Western Europe. In Western countries, independent directors have been usually

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relied on to effectively regulate the agency cost between internal managers and external shareholders. But in China, large shareholders or controlling shareholders may plunder wealth from small shareholders. In addition, CEO duality is positively and significantly related to firm performance, which suggested that although the separation of CEO and chairperson was view as a good corporate governance practice by OECD (2004), it may not be applicable to Chinese listed firms. Therefore, the viewpoint that good corporate governance can lead to good results is not true of every country because of the different culture in the different country.

The state, if it is the largest shareholder, can provide support in terms of financing and provide resources under the unique environment in which it has a concentrated ownership structure, reliance on the banking system, poor investment protection and weak law enforcement, thus could improve the firm performance. However, the results showed that there is no significant relationship between state ownership and firm performance. One of the reasons that might lead to insignificant results is because the proportion of state-owned shares in most enterprises is not high.

The agency theory on the importance of aligning CEO compensation with firm performance emphasized that the action of agents should be in the best interests of the principals to obtain high incentives. The results also showed that CEO compensation can indeed improve firm performance, but the system of CEO compensation in China still can be improved. In China, the CEO compensation structure is single and cash compensation is still dominant, which indicates that the CEO compensation incentive mechanism in China is not perfect and lacks effective executive restraint mechanism. Therefore, China should establish a perfect professional manager market and implement effective incentive and restraint mechanism of executive compensation for the long-term development of enterprises. If the executives can maximize the interests of enterprises while pursuing their own interests, so as to give full play to the positive role of CEO compensation on firm performance.

Last but not the least, it is found that debt has a significant negative correlation with firm performance. This is in contrast with the assumption of agency theory as commonly received and accepted in China other developed countries. According to agency theory, debt acted as a punishment mechanism that can discipline or motivate managers to put in more efforts for maximum benefits of shareholders. Thus, it is often regarded as an effective governance mechanism, which may improve firm performance. However, the result showed the opposite way. We have reason to believe that although debt financing is generally adopted by Chinese companies, considering that the market mechanism in China is not mature, debt plays a limited role in constraining corporate management. On the contrary, debt seems to become a tool for controlling shareholders to erode creditors and minority shareholders, thus failing to improve firm performance.

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