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Pacific-Basin Finance Journal xx (2007) xxx–xxxwww.else

Corporate governance and tunneling:Empirical evidence from China☆

Lei Gao a,1, Gerhard Kling b,⁎

a Nanjing University of Information Science & Technology, School of Finance, Nanjing Pukou 114, 210044, PR Chinab Bristol Business School, University of the West of England, Coldharbour Lane, Bristol BS16 1QY, UK

Received 3 January 2006; accepted 28 September 2007

Abstract

We analyze asset appropriation by principal shareholders in China and uncover the following relationships:(1) outsiders in the board of directors, audit without non-clean opinion, and dispersed ownership preventoperational tunneling; (2) belonging to a business group and issuing B orH share exacerbate asset appropriation.Institutional ownership does not prevent the embezzlement of assets and is endogenous, as investors selectcompanies with good governance. Besides governance mechanisms, stock characteristics matter in that largerfirms exhibit less tunneling, whereas highly leveraged firms experience the opposite. We find a decline oftunneling in 2001, which might be due to economic reforms.© 2007 Elsevier B.V. All rights reserved.

JEL classification: G34; G38Keywords: Corporate governance; China; Operational tunneling

1. Introduction

In China, a series of scandals related to the embezzlement of assets by principal shareholders havebeen brought to light recently. From the incident of ‘Qiongminyuan’ in 1997 to the scandal of the‘Sanjiu Group’ in 2005, plenty of anecdotal evidence demonstrates the extent with which resources ofcompanies have been abused by principal shareholders. This serious corporate governance problem

☆ This paper was financially supported by the Key Project of the National Natural Science Foundation of China (ProjectNumber: 70532001, Chef Scientist: Weian Li) and the Project of the National Social Science Fund of China (ProjectNumber: 07CJY001).⁎ Corresponding author. Tel.: +44 11732 83418.E-mail addresses: [email protected] (L. Gao), [email protected] (G. Kling).

1 Tel.: +86 754 2902383; fax: +86 754 2903442.

0927-538X/$ - see front matter © 2007 Elsevier B.V. All rights reserved.doi:10.1016/j.pacfin.2007.09.001

Please cite this article as: Gao, L., Kling, G., Corporate governance and tunneling: Empirical evidence from China,Pacific-Basin Finance Journal (2007), doi:10.1016/j.pacfin.2007.09.001

mailto:[email protected]

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http://dx.doi.org/10.1016/j.pacfin.2007.09.001


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could hinder economic development (see Li et al., 2004), which raises the question: how to preventtunneling and protect the interests of small investors? To improve corporate governance, we need toidentify which corporate governancemechanisms fail and hence facilitate asset appropriation in China.

Chinese scholars have already conducted valuable research on the extent of operational tunneling(see Li et al., 2004; Tang et al., 2004). Yet, the interrelation of corporate governance mechanisms andoperational tunneling has not been studied. Besides corporate governance measures, we incorporatefirm characteristics (e.g. size, financial leverage, industry specific effects) and account for regionaldevelopment (e.g. coastal area, regional GDP growth). Our study refers to a panel data set of all listedcompanies on the Shanghai and Shenzhen Stock Exchange from 1998 to 2002. Based on panel OLSfixed-effects estimation and more elaborate techniques, namely censored-normal regressions, orderedlogit, and quantile regressions, we can assess the impact of governance, ownership structures, firmcharacteristics, industry effects, andmacroeconomic variables on the extent of tunneling.Moreover,weaddress the inherent endogeneity issue, for corporate governance measures might affect firm behavior(e.g. tunneling)—but asset appropriation in turn influences governance structures. The concept ofGranger causality and panel vector autoregressions uncover the underlying causal relationships clearly.

In recent years, the exploitation of minority shareholders by large shareholders has attractedscholars' widespread attention. Shleifer and Vishny (1986) detected that when large stockholderscontrol firms, the main problem is no longer the conflict of interests between management andshareholders, but preventing principal shareholders from exploiting minority shareholders. Johnsonet al. (2000b) coined the term ‘tunneling’ to describe asset appropriation by large shareholders,which legally or illegally transfer assets and profits to themselves. Tunneling not only hurts theinterests of small shareholders, but also seriously hinders stock markets' development (see Johnsonet al., 2000b; Wurgler, 2000; Bertrand et al., 2002). Johnson et al. (2000a) argued that unrestrainedtunneling was the main reason for the Asian financial crisis from 1997 to 1999. During financialcrises, many facts proved that emerging markets suffer from tunneling more severely than maturemarkets. To enhance the development of emerging financial markets, one has to identify internal andexternal governance mechanisms that prevent tunneling. Our paper tries to detect mechanisms andprovides policy recommendations to strengthen corporate governance not only inChina—but also inother emerging markets.

Our paper is organized as follows: the literature review highlights different forms of tunneling andtheir relevance in China. Focusing on operational tunneling, we analyze interrelations betweencorporate governance mechanisms and asset appropriation and derive hypotheses. The third partdescribes our dataset followed by our model specification. Based on panel OLS, censored-normalregressions, ordered logit, and quantile regressions, we present our findings and discuss policyimplications.

2. Literature review

2.1. Tunneling in China

Tunneling is also the focus of current Chinese corporate governance research, which providesevidence that principal shareholders tunnel assets; however, these studies only describe theproblem without uncovering the underlying causes inherent with internal and external corporategovernance mechanisms. Li et al. (2004) collected evidence on tunneling of big shareholdersfocusing on the embezzlement of funds and asset transfers related to mergers and acquisition;thus, operational tunneling due to related party transactions has not been considered. They foundthat concentrated ownership enhances asset appropriation by block-holding shareholders. In



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particular, companies controlled by the government or business groups experienced the mostsevere form of tunneling. Jian and Wong (2003) reported that related lending transactions,commonly referred to as financial tunneling, negatively correlates with firm value. This studyrelied on data of 131 Chinese companies in materials industry. Besides their scope, these studiessuffer from inherent endogeneity issues, as the direction and causality of impact is not analyzed.

The literature distinguishes between financial and operational tunneling. In particular, financialtunneling refers to freeze-outs and dilution—both are less relevant for China due to the overwhelminginfluence of the state. Freeze-outs (see Gilson and Gordon, 2003; Bates et al., 2006; Subramanian,2004) describe a situation of delisting due to a tender offer that is relatively low compared to the actualmarket value of the company, which affects minority shareholders negatively. In China, an effectivedelisting mechanism does not exist and the state is usually a dominating shareholder. Hence, freeze-outs are not essential in China—but so-called uncompensated transactions in the case of mergers andacquisitions are important (see Gao and Kling, in press). However, uncompensated transactions aremainly common when the state restructures state-owned enterprises (SOEs) and other related SOEsare not fully compensated for acquisitions. Consequently, minority shareholders are less affected.Dilution (see Black and Kraakman, 1996), which describes a considerable increase in equity capital isless likely in China, as the state tries to keep control of publicly listed companies and issuing newshares is not easily absorbed by the notoriously thin Chinese stock markets.

In contrast, operational tunneling through transfer pricing (see Johnson et al., 2000b) and otherunjustified transfers, i.e. related party transactions of intangibles (see Cheung et al., 2006) seem tobe more relevant in China (see Li et al., 2004; Tang et al., 2004). Accordingly, our paper focuseson operational tunneling and tries to measure the extent of unjustified asset transfers based onannual reports of listed companies.

2.2. Theoretical hypotheses

The research focus of corporate governance has shifted from the problem between share-holders and management to that between major shareholders and minority shareholders (seeShleifer and Vishny, 1997; Johnson et al., 2000b; Denis and McConnell, 2003). To solve theproblem that block-holding shareholders hurt the interests of small shareholders, one shouldimprove the following two kinds of corporate governance mechanisms (see Denis andMcConnell, 2003): (1) internal mechanisms include the structure of the board of directors,incentive systems of senior management, ownership structure, type of block-holding share-holders, institutional investors' ownership, and corporate transparency. (2) External mechanismsinclude market competition for corporate control, legal environment, protection of minorityshareholders, market development, and competition on the product market.

To assess the structure of the board of directors, we use the percentage of outsiders, who have notbeen related to the company before becoming board members. Internal board members are familiarwith the firm's operations (see Yermack, 1996). This can enhance the efficiency and decision-making of the board of directors. However, the higher the percentage of internal board members, theeasier the firm can be controlled by the management, which leads to the first hypothesis.

Hypothesis 1. A high percentage of outsiders in the board of directors prevents asset appropriationby block-holding shareholders.

The size of the board of director matters, as Jensen and Murphy (1990) argued that reasonablyincreasing the number of board members could improve the board's efficiency because directors
come from more diverse backgrounds. Consequently, it is more difficult for the CEO or senior



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managers to manipulate the board. Thus, the board can better function to coordinate and balancethe interests of all parties and can resist tunneling. However, when the board is too big,communication would become difficult and the efficiency of the board decreases (see Yermack,1996).

Hypothesis 2. In a reasonable range, more board members help to reduce asset appropriation.

The frequency of board meetings indicates the importance of the board in firm's decision-making. Hence, more meetings would indicate a stronger position of the board and might preventasset appropriation. In China, from 1998 to 2002, on average boards hold 5.9 board meetings.There is considerable variation between companies and years. Some firms convene as few as onceper year, while some firms hold as many as 37 meetings.2 Nevertheless, one could argue thatdistressed companies suffering from tunneling hold more meetings due to their state of emergency;hence, section five has to address an inherent endogeneity issue.

Hypothesis 3. The number of board meetings indicates the importance in the decision process,which should reduce tunneling.

Holding stocks makes senior managers also owners of the firm and hence works as an incentivemechanism. This arrangement aligns the interests of managers and shareholders. As long asmanagers are minority shareholders, who they usually are, it might also mitigate the danger oftunneling.

Hypothesis 4. If managers own stocks, they act in the interest of minority shareholders.

Concentration of ownership could facilitate asset appropriation (see Gomes and Novaes, 2001),as major shareholders not only dominate shareholder gatherings and the board of directors, but alsodetermine firm's daily operation by appointing their ‘own candidate' as CEO. Shi and Shitu (2004)found that in 2001, block-holding shareholders selected 82.9% of all CEOs.3 Furthermore, theyfound that 52.4% of board directors or CEOs had positions at block-holding shareholders'companies. Due to this dependency, it seems to be likely that CEOs decide in the interest of majorshareholders. In firms with several major shareholders, major shareholders have to negotiate; thus,some decisions that damage small shareholders could possibly be avoided (see Zwiebel, 1995).Bloch and Hege (2001) argued that if there are several shareholders struggling for control, then thereturn for holding is relatively low.4

Hypothesis 5. Firms with a single block-holding shareholder exhibit more tunneling comparedto a structure with several principal shareholders.

When principal shareholders and listed firms can conduct related party transactions, tunneling ismore likely (see Khanna and Palepu, 2000a,b; Jian and Wong, 2003). Conducting transactions iseasier when the block-holding shareholder is organized as corporation in contrast to state agenciesand non-profit organizations. In particular, business groups, in which principal shareholders control

2 Yet abnormal conditions in the firm's operation might cause a higher number of meetings. About 8.78% firms holdmore than ten meetings in a year. Obviously, these firms are abnormal in terms of meetings. In our analysis, we accountedfor abnormally high number of meetings, but we did not find any significant impact on asset appropriation.3 Actually, the state directly or indirectly appoints 69% of all directors and CEOs based on figures for 2001; hence,

becoming a CEO is mainly politically determined (see Quiang, 2003).4 Highly dispersed ownership structure is rather rare in China—but it can serve as reference group.




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the member companies by a pyramid ownership structure, are very common in emerging markets.The internal capital and factor markets of business groups become the best venue for bigshareholders to tunnel (see Khanna and Palepu, 2000a). There are strong incentives and multiplemeasures to appropriate member companies' resources; therefore, tunneling in business groups ismore severe (see Jian and Wong, 2003).

Hypothesis 6. Firms with block-holding shareholders in the form of business groups suffer morefrom tunneling.

Most Chinese publicly listed companies are transformed fromSOEs. In the case of privatizations,well-performing units of companies are separated and listed, while the remaining inferior part servesas parent company. Consequently, when the parent company encounters difficulties, it commonlyuses the resources of the listed company tomaintain its operations. Bai et al. (2004) argued that firmscontrolled by the state are likely to suffer more from tunneling.

Hypothesis 7. Firms with the state as block-holding shareholder face more serious assetappropriation.

Jarrell and Poulsen (1987), Shleifer and Vishny (1986), andMcConnell and Servaes (1990) andBrickley, Lease and Smith (1988) uncovered that institutional investors tend to oppose firm'sactions that destroy shareholder value. In contrast to findings for other countries, Tang, Luo, andWang (2004) found that Chinese listed companies whose second largest shareholder isinstitutional investor badly suffer from tunneling.5 Yet Xiao and Wang (2004) showed thatChinese institutional investors invest in firms with superior governance structures. Hence, onecan argue that institutional investors select companies with good corporate governance, whichindicates an alleged endogeneity bias (see section five).

Hypothesis 8. A high percentage of institutional investors enhances good corporate governancepractices; thus, companies suffer less severely from asset appropriation.

Annual reports are the most important financial information disclosed by listed firms, andindependent audit directly affects the quality of financial information. Audit firms can issue a non-clean opinion, which is usually done when the company faces financial difficulties. Henceforth,audits without non-clean opinion indicate a stable financial situation and signal good corporategovernance.

Hypothesis 9. Audits without non-clean opinion signal good governance and hence tunnelingshould be less severe.

Generally, larger audit firms and firms with international reputation offer superior audits andmore reliable audit opinions. According to signaling games, when listed firms hire audit firms thatcharge high fees and offer high-quality audit opinions, they give the signal that the firm has soundcorporate governance structures. Obviously, hiring one of the top five audit firms might beendogenously determined and has to be analyzed in section five.

5 We think that the reason for this finding is that they included private funds as institutional investors; however, privatefunds in China cannot be regarded as institutional investors.




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Hypothesis 10. If the leading five international audit firms prove annual reports, asset appropriationbecomes less severe.

The legal system is an effective external mechanism to protect minority shareholders. La Portaet al. (1998) uncovered that in common law countries, the level of corporate governance is high,and interests of small shareholders are well protected. In contrast, in civil law countries, theprotection of small shareholders is usually weak. In China, the stock market is segmented into Aand B-shares, and some companies can issue stocks listed on foreign exchanges (such as H-sharein Hong Kong, and ADR in the USA). These mature markets have strict regulations anddeveloped legal systems.

Hypothesis 11. Firms issuing B-share or H-share are subject to the legal system in moredeveloped markets. Therefore, the extent of tunneling should be low.

In the corporate governance evaluation system of Standard & Poor's, the country's marketdevelopment is an important indicator regarding country's grade. Due to regional disparitiesconcerning economic development in China, the eastern costal area has a higher level of marketdevelopment than other regions. This would imply that corporate governance is more advancedwhencompanies are located in leading economic regions. Besides using this simple regional division, weincorporate GDP growth rates and GDP per capita for regions into our regression framework.

Hypothesis 12. Compared to firms in western and central China, firms located in the easterncoastal region exhibit better corporate governance structures, which could prevent tunneling.

One important external mechanism is competition on the product market. If managers wasteresources, firms would ultimately lose in the product market. Fierce competition in the productmarket could limit inefficient actions and reduce the risk of tunneling. In China, some industriesare protected, and firms operating in these industries face less competition; thus, these firms mightsuffer more from asset appropriation.6

Hypothesis 13. Firms operating in protected industries suffer more from tunneling.

3. Data

Our study uses data provided by the China Center for Economic Research (CCER) database onoperational tunneling, company characteristics (sales and financial leverage), and corporategovernance mechanisms from 1998 to 2002 of all firms listed at Shanghai and Shenzhen stockexchanges. Due to newly listed companies, the number of observations increases from 695 in 1998to 1108 in 2002. To analyze the extent of tunneling, we determine the difference between accountsreceivable and payable that are based on related party transactions. When listed companies havetransactions with one of their block-holding shareholders, we regard these transactions as relatedparty transactions, which have to be disclosed in annual reports. In general, related partytransactions are the gateway for operational tunneling (see Johnson et al., 2000b). Albeit not allrelated party transactions lead to asset appropriation, the risk of operational tunneling is muchhigher in case of extensive transactions. Section five discusses the measurement problems andrelated issues in detail.

6 We follow the definition of industries protected by the state in Chen et al. (2005).



Table 1Basic descriptive statistics

Years 1998 1999 2000 2001 2002 All

Tunneling 0.057 0.056 0.058 0.038 0.040 0.049Cases of tunneling/observations 0.672 0.698 0.676 0.492 0.450 0.573Single 0.603 0.599 0.578 0.567 0.560 0.578Multi 0.111 0.128 0.139 0.139 0.148 0.135Board size 9.757 9.634 9.481 9.450 9.922 9.650Meetings 4.212 4.863 5.393 6.256 8.498 6.073Outsider 0.003 0.005 0.011 0.061 0.237 0.075Shares 0.001 0.001 0.001 0.001 0.003 0.001Audit 0.853 0.826 0.852 0.886 0.904 0.868Big five 0.030 0.031 0.036 0.057 0.090 0.052HB shares 0.117 0.111 0.097 0.099 0.097 0.103State 0.860 0.868 0.850 0.843 0.814 0.845Group 0.796 0.813 0.821 0.814 0.799 0.809Fund share 0.004 0.009 0.007 0.005 0.007 0.006Protected 0.109 0.105 0.112 0.111 0.114 0.111Ln(Sales) 8.595 8.641 8.687 8.718 8.759 8.689Leverage 0.407 0.422 0.432 0.455 0.498 0.448Observations 695 782 936 1038 1108 4559


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Explanatory variables are constructed as follows and summarized in Table 1. To determine theconcentration of ownership, namely single or several major shareholders, we follow the definitions byZhao andYang (2003). The percentage of stocks held by seniormanagers is based on stocks hold by allboard members and top management members. Percentage of stocks held by institutional investorsrefers to stocks owned by public funds including open and closed-end funds. To obtain a proxy for theprestige of audit firms, we use a dummy that takes value one if one of the leading five internationalfirms are involved. The big five consists of Anderson, KPMG LLP, Ernst & Young, De-loitte &Touche, and PriceWaterCooper. In 2002, Anderson withdrew from the audit business; hereafter, wefocus on the four remaining international accounting firms. Determining the extent of state control isdifficult, as the state controls only 8.5%directly. However, due to ‘pyramid shareholding schemes’, thestate can ultimately control 84% of equity in 2001 (see Quiang, 2003). To identify the type of block-holding shareholders, we follow the definition of Tang et al. (2004) in that non-corporation groupsrefer to management agencies of state assets, research institutions, institutions of higher education,social groups, banks, insurance companies, and investment companies. We follow the definition ofindustries protected by the state in Chen, Chen, and Wan (2005). This includes the petroleum andchemical industry, energy and raw material production. To account for regional disparities regardingmarket development, we insert a regional dummy variable for the eastern coastal area. Beijing, Tianjin,Shanghai, Jiangsu, Zhejiang, Fujian, Shandong and Guangdong belong to the developed easterncoastal region, which might exhibit better governance structures and less tunneling. Besides thisstraightforward geographical division, we use regional GDP to quantify market development.

To illustrate the extent of tunneling and obtain a relativemeasure,we divided the difference betweenaccounts receivable and payable by the total assets. About 5.68% of total assets were lost in relatedparty transactions in 1998 compared to 4.04% 4 years later; hence, tunneling is still a considerableproblem. Besides the decline in the extent of tunneling, the frequency of asset appropriation declinedfrom 67.19% to 45.04%. In spite of this considerable improvement, tunneling is still quite common.

Table 2 summarizes descriptive statistics of the dependent and explanatory variables. The dropin asset appropriation in 2001 and 2002 is accompanied by an increase in the number of board



Table 2Definition and computation of variables

Name Definition and computation Type

Tunneling Proxy: difference of accounts payable and receivable divided by total assets. Accounts payable /receivable refer to related party transactions, which are disclosed in annual reports

Continuous

Single Dummy is equal to one, if one shareholder controls more than 50% of equity. If the ownershipis between 40% and 50% and higher that the sum of the shares held by the second to fifthlargest shareholder, we regard the largest shareholder still as single major shareholder

Dummy

Multi Dummy is equal to one if largest shareholder holds between 10% and 50%, second largest atleast 10%, and the percentage of the largest is smaller than the summed percentage of thesecond to the fifth largest shareholder

Dummy

Boardsize

Number of board members Continuous

Meetings Number of board meetings per year ContinuousOutsider Percentage of outsiders in the board of directors Continuous

between [0,1]Shares Percentage of stocks held by senior managers (board members and top management) Continuous

between [0,1]Audit Dummy variable that takes the value one if an audit without non-clean opinion is issued DummyBig five Dummy that is equal to one if the five leading audit firms are in charge DummyHB

sharesDummy that is equal to one if the firm issues B or H shares or other shares not traded on theShanghai and Shenzhen Stock Exchange

Dummy

State Dummy that is equal to one if the state ultimately controls the company. Control is based onthe pyramid ownership structure

Dummy

Group Dummy that is equal to one if block-holding shareholders are business groups DummyFund

sharePercentage of stocks held by institutional investors Continuous

between [0,1]Protected Dummy that is equal to one if the firm operates in a protected industry DummyCoast Dummy that is equal to one if the firm is located in the eastern coastal region DummyLn(Sales) The natural log of firm's net sales is a proxy for firm size ContinuousLeverage To assess the capital structure, we divide long-term debts by total assets Continuous


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meetings, the percentage of outsiders as board members, the percentage of stock held by managersand institutional investors, and annual reports checked by audit firms with international reputation.These changes in explanatory variables could be responsible for lower levels of tunneling.

4. Empirical analysis

We try to explain the extent of tunneling by panel data analyses. Based on our theoreticalhypotheses, we can focus on the following regression model.

Tunneling ¼ ai þ b1 � Singleit þ b2 �Multiit þ b3 � Board Sizeit þ b4 �Meetingsitþb5 � Outsiderit þ b6 � Sharesit þ b7 � Auditit þ b8 � Big Fiveitþb9 � HBShareit þ b10 � Stateit þ b11 � Groupit þ b12 � Fund Shareitþb13 � Protectedit þ b14 � Coastit þ b15 � GDPit þ b16 � Growthitþb17 � lnðSalesÞit þ b18 � Leverageit þ eit

ð1Þ

Before carrying out any regressions, one should be aware of potential multicollinearity. Yetcorrelation coefficients between explanatory variables are rather small; hence, multicollinearity




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does not affect our results.7 As we deal with panel data, we embed firm specific effects in theconstant term (fixed-effects model). To improve our measure of regional development, we usedthe level of GDP per capita, and GDP growth rates for every province to measure the degree ofeconomic development. To distinguish between highly developed and less developed provinces,we calculated the deviation of GDP per capita and GDP growth rate from the national trend.8

However, the results in Table 3 do not indicate that regional effects matter, as the dummy variablefor coastal provinces is not significant. In addition, neither GDP per capita nor GDP growth of aprovince has a significant influence on asset appropriation.

To obtain reference estimates of Eq. (1), we use a panel OLS estimation without consideringtime or firm specific effects (see models 1 and 2). Model 3 incorporates time effects using a fixed-effect approach, whereas model 4 accounts for firm specific effects based on a fixed-effects model.Audits without non-clean opinion have in all models a significantly negative effect on the extent ofasset appropriation. Regional variables, namely the dummy for coastal provinces, relative GDP percapita, and relative GDP growth do not possess any relevant impact on corporate governance. In allspecifications, firm size as measured by sales reduced asset appropriation, whereas a high financialleverage enhanced it. Ownership structure matters in that a higher extent of concentration (singlemajor shareholder) increases tunneling. The more outsiders are represented in the board ofdirectors the lower the level of asset appropriation. Interestingly, controlling for firm specificeffects (see model 4) shows that institutional ownership and being in a protected industry are notrelevant drivers for asset appropriation as suggested by models 1–3.

However, there are two main shortcomings of our OLS estimates that should be clarifiedbefore claiming that our results are robust: (1) our proxy for tunneling is censored, as only about50% of all firms exhibit asset appropriation. To account for a truncated distribution of ourdependent variable, we use a censored-normal regression model (see Tobin, 1958). (2) Besidesobserving many cases without tunneling, some observations are extreme values, for instancesome companies lost 48.04% of total assets in related party transactions.9 These extreme cases oftunneling deviate strongly from the median of our measure, which reaches only 0.44%. To explainsevere forms of asset appropriation, we apply quantile regressions for the 90 and 95 percentile(see Koenker and Hallock, 2001). (3) An alternative approach is constructing ranks for tunneling,which can be based on 10 or 20 percentiles. Hence, the continuous measure of tunneling istransformed into an ordinal variable with five or ten ranks. To analyze a ranked dependentvariable, we apply an ordered logit approach (see Zavoina and McElvey, 1975). Table 4 providesthe result of the censored-normal regression, quantile regressions, and ordered logit models.

As coefficients of the panel OLS and the more advanced methods are not easily comparable,we illustrate the average contribution of every corporate governance variable on the extent oftunneling in Table 5.10 The steps are as follows: (1) we determine the predicted values oftunneling based on the respective estimation technique.11 (2) Then, we compute the partial

7 The largest correlation coefficient of –0.4625 can be detected between the dummies for a single principal shareholderand several principal shareholders. Note that highly dispersed ownership structure is the reference group for ourdiscussion concerning concentration of ownership.8 This approach also avoid trend correlation and stationarity problems of GDP time series, as we compare regional

GDP figures with national levels in every year. As regional and national GDP time series exhibit a comovement,calculating a relative measure yields a stationary time series that indicates relative development of provinces.9 This value is based on the 99% percentile.

10 We use average values of explanatory variables to determine the effect on tunneling for a representative firm. Toderive the partial impact, we compute marginal effects (elasticity).11 Note that all models suggest a lower level of tunneling if a company reaches the mean of all explanatory variables.



Table 3Panel OLS with and without fixed-effects

Years Model (1) Model (2) Model (3) Model (4)

Panel OLS Panel OLS Year effects Firm effects

Single 0.008⁎⁎ 0.008⁎⁎ 0.007⁎⁎ 0.002Multi −0.007 −0.007 −0.007 −0.016⁎⁎Board size 0.000 0.000 −0.000 −0.001Meetings 0.000 0.001 0.001 0.001Outsider −0.059⁎⁎⁎ −0.059⁎⁎⁎ −0.064⁎⁎⁎ −0.032⁎⁎Shares −0.053 −0.055 −0.055 −0.094Audit −0.052⁎⁎⁎ −0.052⁎⁎⁎ −0.051⁎⁎⁎ −0.014⁎⁎⁎Big five −0.011 −0.010 −0.010 0.005HB shares 0.017⁎⁎⁎ 0.017⁎⁎⁎ 0.017⁎⁎⁎ 0.026State 0.007⁎ 0.007⁎ 0.007⁎ 0.014Group 0.014⁎⁎⁎ 0.014⁎⁎⁎ 0.014⁎⁎⁎ 0.012⁎

Fund share −0.363⁎⁎⁎ −0.365⁎⁎⁎ −0.386⁎⁎⁎ −0.053Protected 0.018⁎⁎⁎ 0.017⁎⁎⁎ 0.018⁎⁎⁎ −0.011Coast 0.000 0.000 −0.007GDP growth 0.000GDP per capita 0.000Ln(Sales) −0.025⁎⁎⁎ −0.024⁎⁎⁎ −0.024⁎⁎⁎ −0.044⁎⁎⁎Leverage 0.051⁎⁎⁎ 0.051⁎⁎⁎ 0.051⁎⁎⁎ 0.046⁎⁎⁎

Year 1999 −0.001Year 2000 0.004Year 2001 −0.013⁎⁎Year 2002 0.001Constant 0.264⁎⁎⁎ 0.234⁎⁎⁎ 0.264⁎⁎⁎

Observations 4566 4566 4566 4566Adjusted R2 0.11 0.11 0.11 0.60

⁎ Significance at the 0.10 level. ⁎⁎ Significance at the 0.05 level. ⁎⁎⁎ Significance at the 0.01 level.


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contribution of every explanatory variable to the predicted value of asset appropriation. Table 5shows the partial contribution in percentage points. This method helps to identify not juststatistically but also ‘economically` significant external and internal governance mechanisms.12

In all models, audits without non-clean opinion have a negative and statistically significant impacton tunneling; however, the economic impact is rather limited, as it reduces tunneling only by2.83% to 14.69%. At a first glance, the most effective governance tool is the percentage ofinstitutional investors, which can reduce asset appropriation by at least 43.91% (lowest estimate).Especially, for severe cases of embezzlement explained by the quantile regressions, institutionalownership seems to prevent (reduction of 85.37% and 87.19%) belonging to the 90 and 95percentile. In spite of the alleged impact of institutional ownership, endogeneity issues coulddistort the picture discussed in the next section. Another key-element for improving corporategovernance is shares held by managers, which leads to a decline in predicted asset appropriationby at least 45.21%. However, managers' ownership is less relevant for extreme cases, as thepartial contribution reaches only 6.62% to 6.85% in the quantile regressions. Company specificfactors, namely firm size (measured by log net sales) and financial leverage, are in all modelshighly significant—but the economic relevance is rather limited. In particular, larger companies

12 By ‘economically’ significant, we mean that the magnitude of impact of the respective explanatory variable ontunneling is high.



Table 4Censored-normal regression, ordered logit, and quantile regressions

Years Censoredregression

Ordered logit(10 percentile)


Quantile regression(95%)


Single −0.000 −0.070 −0.074 0.011 0.016⁎

Multi −0.025⁎⁎⁎ −0.379⁎⁎⁎ −0.391⁎⁎⁎ −0.035⁎ −0.021⁎Board size −0.000 0.003 −0.002 −0.002 −0.000Meetings 0.002⁎⁎ 0.021⁎⁎ 0.022⁎⁎ 0.002 0.000Outsider −0.153⁎⁎⁎ −1.855⁎⁎⁎ −1.811⁎⁎⁎ −0.094 −0.049Shares −0.895⁎⁎ −10.295⁎⁎ −10.622⁎⁎ −0.098 −0.065Audit −0.066⁎⁎⁎ −0.717⁎⁎⁎ −0.640⁎⁎⁎ −0.178⁎⁎⁎ −0.139⁎⁎⁎Big five −0.027⁎⁎ −0.357⁎⁎ −0.366⁎⁎⁎ −0.044⁎ −0.029HB shares 0.031⁎⁎⁎ 0.381⁎⁎⁎ 0.395⁎⁎⁎ 0.031 0.024⁎

State 0.011⁎ 0.146⁎ 0.127 0.006 −0.002Group 0.025⁎⁎⁎ 0.306⁎⁎⁎ 0.283⁎⁎⁎ 0.056⁎⁎⁎ 0.035⁎⁎⁎

Fund share −0.823⁎⁎⁎ −10.377⁎⁎⁎ −9.944⁎⁎⁎ −1.294⁎⁎⁎ −0.809⁎⁎Protected 0.024⁎⁎⁎ 0.278⁎⁎⁎ 0.263⁎⁎⁎ 0.052⁎⁎⁎ 0.040⁎⁎⁎

Coast 0.001 −0.049 −0.059 0.003 −0.001Ln(Sales) −0.030⁎⁎⁎ −0.247⁎⁎⁎ −0.208⁎⁎⁎ −0.073⁎⁎⁎ −0.046⁎⁎⁎Leverage 0.064⁎⁎⁎ 0.441⁎⁎⁎ 0.381⁎⁎⁎ 0.174⁎⁎⁎ 0.099⁎⁎⁎

Year 1999 0.003 −0.039 −0.017 0.019 −0.014Year 2000 0.004 −0.075 −0.079 0.001 −0.015Year 2001 −0.037⁎⁎⁎ −0.671⁎⁎⁎ −0.674⁎⁎⁎ −0.020 −0.052⁎⁎⁎Year 2002 −0.014 −0.446⁎⁎⁎ −0.450⁎⁎⁎ −0.009 −0.035⁎Constant 0.274⁎⁎⁎ 0.898⁎⁎⁎ 0.616⁎⁎⁎

Observations 4559 4559 4559 4559 4559

⁎ Significance at the 0.10 level. ⁎⁎ Significance at the 0.05 level. ⁎⁎⁎ Significance at the 0.01 level.


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tend to suffer less from asset appropriation, whereas firms with high financial leverage exhibitmore tunneling. Besides the impact of governance mechanisms and firm characteristics, weconfirm a general decline of tunneling in 2001 indicated by significant dummy variables (seeTable 4). This might be due to economic reforms in 2001, for China has tried to sell state-ownedstocks and to improve corporate governance (see Quiang, 2003).

5. Endogeneity issues and robustness checks

To check whether our results are robust, we have to address a potential endogeneity bias thatmight arise. In particular, the number of board meetings and institutional ownership could beendogenous. The number of board meetings might increase due to a high number of related partytransactions that need approval; hence, asset appropriation could cause more board meetings.Nevertheless, a high number of board meetings can be interpreted as a signal for a highimportance of the board and hence a sound corporate governance. As both arguments are validfrom a theoretical point of view, we have to test the endogenous relationship between corporategovernance and board meetings to uncover the causal relationship. In addition, institutionalinvestors may choose to invest in firms with good corporate governance as shown by Xiao andWang (2004); therefore, the reduction of tunneling may be due to the good corporate governanceand not driven by institutional investors' engagement. Furthermore, there could be a self-selectionbias in the case of the variable ‘big five auditors’, for companies might hire these leading auditfirms because they believe they do not suffer from asset appropriation. To address this allegedself-selection bias and endogeneity issues, we apply a two-stage least squares model.



Table 5Illustration of results for a representative firm

Years Censoredregression





POLS

Single −0.02 −0.31 −0.33 0.74 1.67 1.41Multi −1.35 −1.67 −1.73 −2.35 −2.26 −9.51Board size −0.01 0.01 −0.01 −0.14 −0.02 −0.61Meetings 0.09 0.09 0.10 0.10 0.00 0.49Outsider −8.22 −8.15 −8.00 −6.32 −5.17 −19.82Shares −48.04 −45.21 −46.91 −6.62 −6.85 −57.67Audit −3.56 −3.15 −2.83 −11.99 −14.69 −8.47Big five −1.43 −1.57 −1.62 −2.98 −3.04 3.01HB shares 1.65 1.67 1.75 2.10 2.53 15.71State 0.61 0.64 0.56 0.40 −0.20 8.53Group 1.32 1.34 1.25 3.79 3.74 6.69Fund share −44.18 −45.57 −43.91 −87.19 −85.37 −30.74Protected 1.26 1.22 1.16 3.48 4.18 −6.75Coast 0.03 −0.22 −0.26 0.18 −0.11 −3.87Ln(Sales) −1.59 −1.08 −0.92 −4.93 −4.85 −26.81Leverage 3.43 1.94 1.68 11.73 10.43 28.40

This table shows the contribution of one specific variable to the predicted level of tunneling. These contributions areexpressed in percentage points, which provide an indication for the economic relevance of the respective variable. Allmodels predict lower values of tunneling for the average firm; hence, negative values indicate a reduction of tunneling.


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A two-stage least squares approach, however, requires finding appropriate instruments for thethree allegedly endogenous variables. Hence, we used all potential sets of instruments based onour explanatory variables (see Eq. (1)). Regardless which specification is used, Wu-Hausman F-tests and Durbin-Wu-Hausman Chi-squared tests cannot reject the null hypothesis that thevariables board meetings, institutional ownership and ‘big five auditors’ are exogenous.

To avoid inherent specification problems of a two-stage least squares approach, we use our timeseries observations to test for Granger causality. Henceforth, we use a panel vector autoregressionand estimated the model with system OLS. Table 6 shows the results and highlights that the extentof asset appropriation is not Granger caused by the number of board meetings, institutionalownership or choosing one of the “big five” audit firms. In contrast, sound corporate governancewith low levels of tunneling stimulates stock purchases from institutional investors.

Besides endogeneity problems, themeasurement of asset appropriation is not straightforward, fordirectmeasures cannot be observed frompublic sources (e.g. annual reports). Based on Johnson et al.(2000b), we use related party transactions to quantify the extent of tunneling. The notes in annualreports indicate related party transactions; hence, we focus on the accounts payable and receivabledue to transactions between the respective company and another company that is a principalshareholder of the former. To obtain a relative measure that accounts for firm size, we divide thedifference between accounts receivable and accounts payable by total assets. This serves as a proxyfor asset appropriation, as related party transaction with a high imbalance between accounts payableand receivable could indicate that the dependent company loses in these transactions.

As a matter of fact, this accounting measure exhibits some inherent disadvantages. First, themeasure is noisy in that asset appropriation cannot be directly observed, and related partytransactions are just one potential source of asset appropriation. Henceforth, it is difficult todistinguish between normal related party transactions and transactions used for operationaltunneling. Second, the accruals may be a result of prior earning management and do not indicate



Table 6Granger causality tests

Null hypotheses F-test P-value

Board meetings, institutional ownership and the “big five” audit firmsdo not Granger cause asset appropriation

0.81 0.488

Asset appropriation does not Granger causes the number of board meetings 0.88 0.348Asset appropriation does not Granger causes choosing one of the “big five” audit firms 0.44 0.506Asset appropriation does not Granger causes institutional stockholding 4.36 0.037


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tunneling. Third, an increase in accounts receivable can also imply that the large shareholder isembezzling assets from the listed company, for the listed company is facing a risk of failing tocollect accounts receivable in future.

Besides accounting measures, empirical measures based on financial and stock marketperformance have been used (Bae et al., 2002; Cheung et al., 2006). However, the main problemwith these measures is that they require an efficient stock market with high liquidity so that stockperformance really reflects financial and operational aspects. The most crucial shortcoming is thatby testing the impact of tunneling on stock performance additional factors (e.g. firm specificeffects, institutional ownership) are usually not considered, which biases the results.

Accordingly, we suggest using an accounting based measure; however, we test for itsrelevance on firm performance and valuation levels. Tobin's Q defined as the market value of firmassets divided by the repurchase value of firm assets indicates whether a company's valuationlevel is higher than the repurchase value of its assets. Putting this differently, a company with aTobin's Q exceeding one creates value by combining its resources, whereas a company with aratio below one should be acquired or liquidated. Accordingly, companies with a high Tobin's Qseem to have desirable resources and could be an attractive prey for asset appropriation. In turn,asset appropriation should reduce Tobin's Q in future, as essential resources disappear, whichlowers value creation potential. If our proxy for asset appropriation is an adequate indicator forasset appropriation, we should observe the following relationships: (1) companies with highTobin's Q should be a preferred target for asset appropriation; thus, the accounting proxy shouldhave high values; (2) when highly valued assets disappear indicated by a high value of our proxy,companies should exhibit a lower Tobin's Q in future. Fixed-effects models show that a highTobin's Q causes more asset appropriation (p-value: 0.000), and asset appropriation reducesTobin's Q in the following year (p-value: 0.025). Consequently, our proxy for asset appropriationexhibits the pattern one would expect.

6. Conclusion

Our study uncovered a high extent of operational tunneling in China, as about 4% of totalassets are embezzled. Yet the situation has improved because the extent of tunneling declinedfrom 1998 to 2002 from 5.68% to 4.04%, and only 45.04% of the firms suffer from assetappropriation in 2002 compared to 67.19% in 1998. Our empirical analysis identified four key-mechanisms of corporate governance that could help to significantly improve internal andexternal governance structures in China and reduce tunneling. Audits without non-clean opinionsignal financial health and sound governance lowering the extent of asset appropriation by 2.83%to 14.69%. Consequently, minority shareholders should be alarmed when audit firms issue non-clean opinions, and auditors in turn have a crucial function in detecting irregularities. In addition,stock ownership of senior managers is a guarantee for preventing tunneling. Henceforth, enhancing




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stock ownership (i.e. by stock option plans) is our second policy recommendation. In contrast,institutional ownership alone does not foster internal governance mechanisms to reduce operationaltunneling. Granger causality tests reveal that institutional investors pick stocks of companies withsound governance. Thus, the argument that institutional ownership should be stimulated to installbetter governance mechanisms cannot be confirmed. Nevertheless, we disagree with Tang et al.(2004), who found that institutional ownership enhances tunneling.Noteworthy, the state or SOEs asprincipal shareholders do not significantly affect asset appropriation; hence, tunneling seems not bedriven by the influence of the state as principal shareholder. Nevertheless, several block-holdingshareholders that compete for controlling a company make embezzlement less likely—albeit theeconomic impact is relatively low. Accordingly, our results do not confirm the pessimistic view ofChen et al. (2005) that the state as principal shareholder facilitates tunneling. We uncover that in theyear 2001, in which economic reforms occurred (see Quiang, 2003), tunneling declined. Hence,economic reforms like the attempt to improve corporate governance and to limit the influence of thestate in publicly listed companies are recommended and will help to further improve corporategovernance principles in future.

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