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ernance. In addition,
private companies, e.g., Standard & Poor, California Public Employees’ Retirement Pension
System (CaLPERS), CLSA, and McKinsey, are also calling for sweeping reforms of
governance practice in emerging economies.
Corporate governance is paramount in China. The Chinese government opened stock
exchanges in the early 1990s to raise capital and improve the operating performance of
state-owned enterprises (SOEs). In less than twelve years, China’s stock markets have
grown to become the eighth largest in the world with a market capitalization of over $500
billion. Chinese companies, especially SOEs, have benefited substantially from the rapid
growth in issuance and the general public’s enthusiasm on equitymarket.Meanwhile, stock
market regulations have been evolving to address the tradeoff between growth and control
in which a liberal approach fosters fast growth while a controlled approach leads to slower
growth. Even though issuance approval, pricing, and placement systems have been liberalized
significantly, they are still controlled tightly compared to other Asian markets.
Nonetheless, poor governance practices are rampant among the Chinese listed companies.
In 2001, the largest shareholder ofMeierya, which had been a profitable company, colluded
with other related parties and embezzled $44.6million or 41% of the listed company’s total
equity. In the same year, the largest shareholder of Sanjiu Pharmacy extracted $301.9 million
or 96%of this listed company’s total equity.2 Although Chinese companies, especially
SOEs, obtain considerable capital from the public through either the banking system or the
1 Recent research by McKinsey finds that articles featuring the term corporate governance in major international
economics and finance newspapers or magazines, e.g., the Financial Times, the Asian Wall Street Journal,
and the Far-East Economic Review, have increased ten-fold from the pre-crisis period in 1996 to 1997 to the
period from 2000 to 2001 (McKinsey & Company, 2002). In the academic literature, the crisis has spawned a
voluminous body of research on governance related issues, especially in emerging markets.
2 Liu and Lu (2002) find that most listed companies manage their earnings in response to a variety of regulatory
loopholes. However, the incentives are stronger for firms with poorer governance practice.
C.-E. Bai et al. / Journal of Comparative Economics 32 (2004) 599–616 601
capitalmarket, they remain extremely inefficient. For example, recent official statistics suggest
that about one-third of all SOEs are loss-makers, another third either break even or are
plagued with implicit losses, while the remaining one-third are marginally profitable. Ineffective
governance is widely believed to be the root cause of this lackluster performance
so that improving corporate governance should be a crucial objective of China’s further
economic reform.
To improve corporate governance, the government must strengthen laws that protect
shareholder interests and increase enforcement of such laws and regulations. Equally important,
firms must also act to improve the situation. Corporate governance must provide
the appropriate market incentives. For a firm’s corporate governance practice to have a positive
effect on its market value, two conditions must be satisfied. First, good governance
must increase the r