Corporate Governance and Tunneling Empirical Evidence From China

+ MODEL
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PACFIN-00436; No of Pages 15
Available online at www.sciencedirect.com
Pacific-Basin Finance Journal xx (2007) xxx – xxx

www.elsevier.com/locate/pacfin
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 China
b
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 prevent
operational tunneling; (2) belonging to a business group and issuing B or H share exacerbate asset appropriation.
Institutional ownership does not prevent the embezzlement of assets and is endogenous, as investors select
companies with good governance. Besides governance mechanisms, stock characteristics matter in that larger
firms exhibit less tunneling, whereas highly leveraged firms experience the opposite. We find a decline of
tunneling in 2001, which might be due to economic reforms.
© 2007 Elsevier B.V. All rights reserved.
JEL classification: G34; G38

Keywords: Corporate governance; China; Operational tunneling
1. Introduction
In China, a series of scandals related to the embezzlement of assets by principal shareholders have
been 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 of
companies 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 (Project
Number: 70532001, Chef Scientist: Weian Li) and the Project of the National Social Science Fund of China (Project
Number: 07CJY001).
⁎ Corresponding author. Tel.: +44 11732 83418.
E-mail addresses: drgaolei@126.com (L. Gao), gerhard.kling@uwe.ac.uk (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
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2 L. Gao, G. Kling / Pacific-Basin Finance Journal xx (2007) xxx–xxx
could hinder economic development (see Li et al., 2004), which raises the question: how to prevent
tunneling and protect the interests of small investors? To improve corporate governance, we need to
identify which corporate governance mechanisms 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 and
operational tunneling has not been studied. Besides corporate governance measures, we incorporate
firm characteristics (e.g. size, financial leverage, industry specific effects) and account for regional
development (e.g. coastal area, regional GDP growth). Our study refers to a panel data set of all listed
companies on the Shanghai and Shenzhen Stock Exchange from 1998 to 2002. Based on panel OLS
fixed-effects estimation and more elaborate techniques, namely censored-normal regressions, ordered
logit, and quantile regressions, we can assess the impact of governance, ownership structures, firm
characteristics, industry effects, and macroeconomic variables on the extent of tunneling. Moreover, we
address 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 of
Granger causality and panel vector autoregressions uncover the underlying causal relationships clearly.
In recent years, the exploitation of minority shareholders by large shareholders has attracted
scholars' widespread attention. Shleifer and Vishny (1986) detected that when large stockholders
control firms, the main problem is no longer the conflict of interests between management and
shareholders, but preventing principal shareholders from exploiting minority shareholders. Johnson
et 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 the
interests of small shareholders, but also seriously hinders stock markets' development (see Johnson
et al., 2000b; Wurgler, 2000; Bertrand et al., 2002). Johnson et al. (2000a) argued that unrestrained
tunneling was the main reason for the Asian financial crisis from 1997 to 1999. During financial
crises, many facts proved that emerging markets suffer from tunneling more severely than mature
markets. To enhance the development of emerging financial markets, one has to identify internal and
external governance mechanisms that prevent tunneling. Our paper tries to detect mechanisms and
provides policy recommendations to strengthen corporate governance not only in China—but also in
other emerging markets.
Our paper is organized as follows: the literature review highlights different forms of tunneling and
their relevance in China. Focusing on operational tunneling, we analyze interrelations between
corporate governance mechanisms and asset appropriation and derive hypotheses. The third part
describes our dataset followed by our model specification. Based on panel OLS, censored-normal
regressions, ordered logit, and quantile regressions, we present our findings and discuss policy
implications.
2. Literature review
2.1. Tunneling in China
Tunneling is also the focus of current Chinese corporate governance research, which provides
evidence that principal shareholders tunnel assets; however, these studies only describe the
problem without uncovering the underlying causes inherent with internal and external corporate
governance mechanisms. Li et al. (2004) collected evidence on tunneling of big shareholders
focusing 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 found
that concentrated ownership enhances asset appropriation by block-holding shareholders. In
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L. Gao, G. Kling / Pacific-Basin Finance Journal xx (2007) xxx–xxx 3
particular, companies controlled by the government or business groups experienced the most
severe form of tunneling. Jian and Wong (2003) reported that related lending transactions,
commonly referred to as financial tunneling, negatively correlates with firm value. This study
relied on data of 131 Chinese companies in materials industry. Besides their scope, these studies
suffer from inherent endogeneity issues, as the direction and causality of impact is not analyzed.
The literature distinguishes between financial and operational tunneling. In particular, financial
tunneling refers to freeze-outs and dilution—both are less relevant for China due to the overwhelming
influence 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 actual
market value of the company, which affects minority shareholders negatively. In China, an effective
delisting 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 and
acquisitions are important (see Gao and Kling, in press). However, uncompensated transactions are
mainly common when the state restructures state-owned enterprises (SOEs) and other related SOEs
are 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 is
less likely in China, as the state tries to keep control of publicly listed companies and issuing new
shares is not easily absorbed by the notoriously thin Chinese stock markets.
In contrast, operational tunneling through transfer pricing (see Johnson et al., 2000b) and other
unjustified transfers, i.e. related party transactions of intangibles (see Cheung et al., 2006) seem to
be more relevant in China (see Li et al., 2004; Tang et al., 2004). Accordingly, our paper focuses
on operational tunneling and tries to measure the extent of unjustified asset transfers based on
annual 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 (see
Shleifer and Vishny, 1997; Johnson et al., 2000b; Denis and McConnell, 2003). To solve the
problem that block-holding shareholders hurt the interests of small shareholders, one should
improve the following two kinds of corporate governance mechanisms (see Denis and
McConnell, 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 mechanisms
include market competition for corporate control, legal environment, protection of minority
shareholders, 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 not
been related to the company before becoming board members. Internal board members are familiar
with 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, the
easier 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 appropriation
by block-holding shareholders.
The size of the board of director matters, as Jensen and Murphy (1990) argued that reasonably
increasing 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 balance
the 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 prevent
asset 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 once
per year, while some firms hold as many as 37 meetings.2 Nevertheless, one could argue that
distressed 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 incentive
mechanism. This arrangement aligns the interests of managers and shareholders. As long as
managers are minority shareholders, who they usually are, it might also mitigate the danger of
tunneling.
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 also
determine 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, they
found 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 major
shareholders. 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 the
return for holding is relatively low.4
Hypothesis 5. Firms with a single block-holding shareholder exhibit more tunneling compared
to a structure with several principal shareholders.
When principal shareholders and listed firms can conduct related party transactions, tunneling is
more likely (see Khanna and Palepu, 2000a,b; Jian and Wong, 2003). Conducting transactions is
easier when the block-holding shareholder is organized as corporation in contrast to state agencies
and 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 hold
more than ten meetings in a year. Obviously, these firms are abnormal in terms of meetings. In our analysis, we accounted
for 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 big
shareholders to tunnel (see Khanna and Palepu, 2000a). There are strong incentives and multiple
measures to appropriate member companies' resources; therefore, tunneling in business groups is
more severe (see Jian and Wong, 2003).
Hypothesis 6. Firms with block-holding shareholders in the form of business groups suffer more
from tunneling.
Most Chinese publicly listed companies are transformed from SOEs. In the case of privatizations,
well-performing units of companies are separated and listed, while the remaining inferior part serves
as parent company. Consequently, when the parent company encounters difficulties, it commonly
uses the resources of the listed company to maintain its operations. Bai et al. (2004) argued that firms
controlled by the state are likely to suffer more from tunneling.
Hypothesis 7. Firms with the state as block-holding shareholder face more serious asset
appropriation.
Jarrell and Poulsen (1987), Shleifer and Vishny (1986), and McConnell and Servaes (1990) and
Brickley, Lease and Smith (1988) uncovered that institutional investors tend to oppose firm's
actions that destroy shareholder value. In contrast to findings for other countries, Tang, Luo, and
Wang (2004) found that Chinese listed companies whose second largest shareholder is
institutional investor badly suffer from tunneling.5 Yet Xiao and Wang (2004) showed that
Chinese institutional investors invest in firms with superior governance structures. Hence, one
can argue that institutional investors select companies with good corporate governance, which
indicates an alleged endogeneity bias (see section five).
Hypothesis 8. A high percentage of institutional investors enhances good corporate governance

practices; thus, companies suffer less severely from asset appropriation.
Annual reports are the most important financial information disclosed by listed firms, and
independent 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 corporate
governance.
Hypothesis 9. Audits without non-clean opinion signal good governance and hence tunneling
should be less severe.
Generally, larger audit firms and firms with international reputation offer superior audits and
more reliable audit opinions. According to signaling games, when listed firms hire audit firms that
charge high fees and offer high-quality audit opinions, they give the signal that the firm has sound
corporate governance structures. Obviously, hiring one of the top five audit firms might be
endogenously 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, private
funds 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 appropriation
becomes less severe.
The legal system is an effective external mechanism to protect minority shareholders. La Porta
et 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, the
protection of small shareholders is usually weak. In China, the stock market is segmented into A
and B-shares, and some companies can issue stocks listed on foreign exchanges (such as H-share
in Hong Kong, and ADR in the USA). These mature markets have strict regulations and
developed legal systems.
Hypothesis 11. Firms issuing B-share or H-share are subject to the legal system in more
developed markets. Therefore, the extent of tunneling should be low.
In the corporate governance evaluation system of Standard & Poor's, the country's market
development is an important indicator regarding country's grade. Due to regional disparities
concerning economic development in China, the eastern costal area has a higher level of market
development than other regions. This would imply that corporate governance is more advanced when
companies are located in leading economic regions. Besides using this simple regional division, we
incorporate 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 eastern
coastal region exhibit better corporate governance structures, which could prevent tunneling.
One important external mechanism is competition on the product market. If managers waste
resources, firms would ultimately lose in the product market. Fierce competition in the product
market could limit inefficient actions and reduce the risk of tunneling. In China, some industries
are protected, and firms operating in these industries face less competition; thus, these firms might
suffer 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 on
operational tunneling, company characteristics (sales and financial leverage), and corporate
governance mechanisms from 1998 to 2002 of all firms listed at Shanghai and Shenzhen stock
exchanges. Due to newly listed companies, the number of observations increases from 695 in 1998
to 1108 in 2002. To analyze the extent of tunneling, we determine the difference between accounts
receivable and payable that are based on related party transactions. When listed companies have
transactions with one of their block-holding shareholders, we regard these transactions as related
party transactions, which have to be disclosed in annual reports. In general, related party
transactions are the gateway for operational tunneling (see Johnson et al., 2000b). Albeit not all
related party transactions lead to asset appropriation, the risk of operational tunneling is much
higher in case of extensive transactions. Section five discusses the measurement problems and
related issues in detail.
6
We follow the definition of industries protected by the state in Chen et al. (2005).
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Table 1
Basic descriptive statistics
Years 1998 1999 2000 2001 2002 All
Tunneling 0.057 0.056 0.058 0.038 0.040 0.049
Cases of tunneling/observations 0.672 0.698 0.676 0.492 0.450 0.573
Single 0.603 0.599 0.578 0.567 0.560 0.578
Multi 0.111 0.128 0.139 0.139 0.148 0.135
Board size 9.757 9.634 9.481 9.450 9.922 9.650
Meetings 4.212 4.863 5.393 6.256 8.498 6.073
Outsider 0.003 0.005 0.011 0.061 0.237 0.075
Shares 0.001 0.001 0.001 0.001 0.003 0.001
Audit 0.853 0.826 0.852 0.886 0.904 0.868
Big five 0.030 0.031 0.036 0.057 0.090 0.052
HB shares 0.117 0.111 0.097 0.099 0.097 0.103
State 0.860 0.868 0.850 0.843 0.814 0.845
Group 0.796 0.813 0.821 0.814 0.799 0.809
Fund share 0.004 0.009 0.007 0.005 0.007 0.006
Protected 0.109 0.105 0.112 0.111 0.114 0.111
Ln(Sales) 8.595 8.641 8.687 8.718 8.759 8.689
Leverage 0.407 0.422 0.432 0.455 0.498 0.448
Observations 695 782 936 1038 1108 4559
Explanatory variables are constructed as follows and summarized in Table 1. To determine the
concentration of ownership, namely single or several major shareholders, we follow the definitions by
Zhao and Yang (2003). The percentage of stocks held by senior managers is based on stocks hold by all
board members and top management members. Percentage of stocks held by institutional investors
refers to stocks owned by public funds including open and closed-end funds. To obtain a proxy for the
prestige of audit firms, we use a dummy that takes value one if one of the leading five international
firms 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, we
focus on the four remaining international accounting firms. Determining the extent of state control is
difficult, as the state controls only 8.5% directly. However, due to ‘pyramid shareholding schemes’, the
state 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 groups
refer to management agencies of state assets, research institutions, institutions of higher education,
social groups, banks, insurance companies, and investment companies. We follow the definition of
industries protected by the state in Chen, Chen, and Wan (2005). This includes the petroleum and
chemical industry, energy and raw material production. To account for regional disparities regarding
market 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 eastern
coastal region, which might exhibit better governance structures and less tunneling. Besides this
straightforward geographical division, we use regional GDP to quantify market development.
To illustrate the extent of tunneling and obtain a relative measure, we divided the difference between
accounts receivable and payable by the total assets. About 5.68% of total assets were lost in related
party transactions in 1998 compared to 4.04% 4 years later; hence, tunneling is still a considerable
problem. Besides the decline in the extent of tunneling, the frequency of asset appropriation declined
from 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 drop
in asset appropriation in 2001 and 2002 is accompanied by an increase in the number of board
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Table 2
Definition and computation of variables
Name Definition and computation Type
Tunneling Proxy: difference of accounts payable and receivable divided by total assets. Accounts payable / Continuous
receivable refer to related party transactions, which are disclosed in annual reports
Single Dummy is equal to one, if one shareholder controls more than 50% of equity. If the ownership Dummy
is between 40% and 50% and higher that the sum of the shares held by the second to fifth
largest shareholder, we regard the largest shareholder still as single major shareholder
Multi Dummy is equal to one if largest shareholder holds between 10% and 50%, second largest at Dummy
least 10%, and the percentage of the largest is smaller than the summed percentage of the
second to the fifth largest shareholder
Board Number of board members Continuous
size
Meetings Number of board meetings per year Continuous
Outsider 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 Dummy
Big five Dummy that is equal to one if the five leading audit firms are in charge Dummy
HB Dummy that is equal to one if the firm issues B or H shares or other shares not traded on the Dummy
shares Shanghai and Shenzhen Stock Exchange
State Dummy that is equal to one if the state ultimately controls the company. Control is based on Dummy
the pyramid ownership structure
Group Dummy that is equal to one if block-holding shareholders are business groups Dummy
Fund Percentage of stocks held by institutional investors Continuous
share between [0,1]
Protected Dummy that is equal to one if the firm operates in a protected industry Dummy
Coast Dummy that is equal to one if the firm is located in the eastern coastal region Dummy
Ln(Sales) The natural log of firm's net sales is a proxy for firm size Continuous
Leverage To assess the capital structure, we divide long-term debts by total assets Continuous
meetings, the percentage of outsiders as board members, the percentage of stock held by managers
and 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 theoretical
hypotheses, we can focus on the following regression model.
Tunneling ¼ ai þ b1 Singleit þ b2 Multiit þ b3 Board Sizeit þ b4 Meetingsit

þb5 Outsiderit þ b6 Sharesit þ b7 Auditit þ b8 Big Fiveit
þb9 HB Shareit þ b10 Stateit þ b11 Groupit þ b12 Fund Shareit
þb13 Protectedit þ b14 Coastit þ b15 GDPit þ b16 Growthit
þb17 lnðSalesÞit þ b18 Leverageit þ eit
ð1Þ
Before carrying out any regressions, one should be aware of potential multicollinearity. Yet
correlation 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 the
constant term (fixed-effects model). To improve our measure of regional development, we used
the level of GDP per capita, and GDP growth rates for every province to measure the degree of
economic 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 variable
for coastal provinces is not significant. In addition, neither GDP per capita nor GDP growth of a
province has a significant influence on asset appropriation.
To obtain reference estimates of Eq. (1), we use a panel OLS estimation without considering
time 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 of
asset appropriation. Regional variables, namely the dummy for coastal provinces, relative GDP per
capita, and relative GDP growth do not possess any relevant impact on corporate governance. In all
specifications, firm size as measured by sales reduced asset appropriation, whereas a high financial
leverage enhanced it. Ownership structure matters in that a higher extent of concentration (single
major shareholder) increases tunneling. The more outsiders are represented in the board of
directors the lower the level of asset appropriation. Interestingly, controlling for firm specific
effects (see model 4) shows that institutional ownership and being in a protected industry are not
relevant drivers for asset appropriation as suggested by models 1–3.
However, there are two main shortcomings of our OLS estimates that should be clarified
before claiming that our results are robust: (1) our proxy for tunneling is censored, as only about
50% of all firms exhibit asset appropriation. To account for a truncated distribution of our
dependent variable, we use a censored-normal regression model (see Tobin, 1958). (2) Besides
observing many cases without tunneling, some observations are extreme values, for instance
some companies lost 48.04% of total assets in related party transactions.9 These extreme cases of
tunneling deviate strongly from the median of our measure, which reaches only 0.44%. To explain
severe 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 is
transformed into an ordinal variable with five or ten ranks. To analyze a ranked dependent
variable, we apply an ordered logit approach (see Zavoina and McElvey, 1975). Table 4 provides
the 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 of
tunneling in Table 5.10 The steps are as follows: (1) we determine the predicted values of
tunneling 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 shareholder
and several principal shareholders. Note that highly dispersed ownership structure is the reference group for our
discussion 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. To
derive 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.
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Table 3
Panel 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⁎⁎ 0.002
Multi − 0.007 −0.007 − 0.007 −0.016⁎⁎
Board size 0.000 0.000 − 0.000 −0.001
Meetings 0.000 0.001 0.001 0.001
Outsider − 0.059⁎⁎⁎ −0.059⁎⁎⁎ − 0.064⁎⁎⁎ −0.032⁎⁎
Shares − 0.053 −0.055 − 0.055 −0.094
Audit − 0.052⁎⁎⁎ −0.052⁎⁎⁎ − 0.051⁎⁎⁎ −0.014⁎⁎⁎
Big five − 0.011 −0.010 − 0.010 0.005
HB shares 0.017⁎⁎⁎ 0.017⁎⁎⁎ 0.017⁎⁎⁎ 0.026
State 0.007⁎ 0.007⁎ 0.007⁎ 0.014
Group 0.014⁎⁎⁎ 0.014⁎⁎⁎ 0.014⁎⁎⁎ 0.012⁎
Fund share − 0.363⁎⁎⁎ −0.365⁎⁎⁎ − 0.386⁎⁎⁎ −0.053
Protected 0.018⁎⁎⁎ 0.017⁎⁎⁎ 0.018⁎⁎⁎ −0.011
Coast 0.000 0.000 −0.007
GDP growth 0.000
GDP per capita 0.000
Ln(Sales) − 0.025⁎⁎⁎ −0.024⁎⁎⁎ − 0.024⁎⁎⁎ −0.044⁎⁎⁎
Leverage 0.051⁎⁎⁎ 0.051⁎⁎⁎ 0.051⁎⁎⁎ 0.046⁎⁎⁎
Year 1999 − 0.001
Year 2000 0.004
Year 2001 − 0.013⁎⁎
Year 2002 0.001
Constant 0.264⁎⁎⁎ 0.234⁎⁎⁎ 0.264⁎⁎⁎
Observations 4566 4566 4566 4566
Adjusted 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.
contribution of every explanatory variable to the predicted value of asset appropriation. Table 5
shows the partial contribution in percentage points. This method helps to identify not just
statistically but also ‘economically` significant external and internal governance mechanisms.12
In all models, audits without non-clean opinion have a negative and statistically significant impact
on tunneling; however, the economic impact is rather limited, as it reduces tunneling only by
2.83% to 14.69%. At a first glance, the most effective governance tool is the percentage of
institutional investors, which can reduce asset appropriation by at least 43.91% (lowest estimate).
Especially, for severe cases of embezzlement explained by the quantile regressions, institutional
ownership seems to prevent (reduction of 85.37% and 87.19%) belonging to the 90 and 95
percentile. In spite of the alleged impact of institutional ownership, endogeneity issues could
distort the picture discussed in the next section. Another key-element for improving corporate
governance is shares held by managers, which leads to a decline in predicted asset appropriation
by at least 45.21%. However, managers' ownership is less relevant for extreme cases, as the
partial contribution reaches only 6.62% to 6.85% in the quantile regressions. Company specific
factors, namely firm size (measured by log net sales) and financial leverage, are in all models
highly 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 on
tunneling is high.
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Table 4
Censored-normal regression, ordered logit, and quantile regressions
Years Censored Ordered logit Ordered logit Quantile regression Quantile regression
regression (10 percentile) (20 percentile) (95%) (90%)
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 −0.000
Meetings 0.002⁎⁎ 0.021⁎⁎ 0.022⁎⁎ 0.002 0.000
Outsider − 0.153⁎⁎⁎ − 1.855⁎⁎⁎ − 1.811⁎⁎⁎ −0.094 −0.049
Shares − 0.895⁎⁎ − 10.295⁎⁎ − 10.622⁎⁎ −0.098 −0.065
Audit − 0.066⁎⁎⁎ − 0.717⁎⁎⁎ − 0.640⁎⁎⁎ −0.178⁎⁎⁎ −0.139⁎⁎⁎
Big five − 0.027⁎⁎ − 0.357⁎⁎ − 0.366⁎⁎⁎ −0.044⁎ −0.029
HB shares 0.031⁎⁎⁎ 0.381⁎⁎⁎ 0.395⁎⁎⁎ 0.031 0.024⁎
State 0.011⁎ 0.146⁎ 0.127 0.006 −0.002
Group 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 −0.001
Ln(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 −0.014
Year 2000 0.004 − 0.075 − 0.079 0.001 −0.015
Year 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.
tend to suffer less from asset appropriation, whereas firms with high financial leverage exhibit
more tunneling. Besides the impact of governance mechanisms and firm characteristics, we
confirm a general decline of tunneling in 2001 indicated by significant dummy variables (see
Table 4). This might be due to economic reforms in 2001, for China has tried to sell state-owned
stocks 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 that
might arise. In particular, the number of board meetings and institutional ownership could be
endogenous. The number of board meetings might increase due to a high number of related party
transactions 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 high
importance of the board and hence a sound corporate governance. As both arguments are valid
from a theoretical point of view, we have to test the endogenous relationship between corporate
governance and board meetings to uncover the causal relationship. In addition, institutional
investors may choose to invest in firms with good corporate governance as shown by Xiao and
Wang (2004); therefore, the reduction of tunneling may be due to the good corporate governance
and not driven by institutional investors' engagement. Furthermore, there could be a self-selection
bias in the case of the variable ‘big five auditors’, for companies might hire these leading audit
firms because they believe they do not suffer from asset appropriation. To address this alleged
self-selection bias and endogeneity issues, we apply a two-stage least squares model.
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Table 5
Illustration of results for a representative firm
Years Censored Ordered logit Ordered logit Quantile regression Quantile regression POLS
regression (10 percentile) (20 percentile) (95%) (90%)
Single − 0.02 − 0.31 − 0.33 0.74 1.67 1.41
Multi − 1.35 − 1.67 − 1.73 − 2.35 −2.26 − 9.51
Board size − 0.01 0.01 − 0.01 − 0.14 −0.02 − 0.61
Meetings 0.09 0.09 0.10 0.10 0.00 0.49
Outsider − 8.22 − 8.15 − 8.00 − 6.32 −5.17 − 19.82
Shares − 48.04 − 45.21 − 46.91 − 6.62 −6.85 − 57.67
Audit − 3.56 − 3.15 − 2.83 − 11.99 −14.69 − 8.47
Big five − 1.43 − 1.57 − 1.62 − 2.98 −3.04 3.01
HB shares 1.65 1.67 1.75 2.10 2.53 15.71
State 0.61 0.64 0.56 0.40 −0.20 8.53
Group 1.32 1.34 1.25 3.79 3.74 6.69
Fund share −44.18 − 45.57 − 43.91 − 87.19 −85.37 − 30.74
Protected 1.26 1.22 1.16 3.48 4.18 − 6.75
Coast 0.03 − 0.22 − 0.26 0.18 −0.11 − 3.87
Ln(Sales) − 1.59 − 1.08 − 0.92 − 4.93 −4.85 − 26.81
Leverage 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 are
expressed in percentage points, which provide an indication for the economic relevance of the respective variable. All
models predict lower values of tunneling for the average firm; hence, negative values indicate a reduction of tunneling.
A two-stage least squares approach, however, requires finding appropriate instruments for the
three allegedly endogenous variables. Hence, we used all potential sets of instruments based on
our 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 the
variables 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 time
series observations to test for Granger causality. Henceforth, we use a panel vector autoregression
and estimated the model with system OLS. Table 6 shows the results and highlights that the extent
of asset appropriation is not Granger caused by the number of board meetings, institutional
ownership or choosing one of the “big five” audit firms. In contrast, sound corporate governance
with low levels of tunneling stimulates stock purchases from institutional investors.
Besides endogeneity problems, the measurement of asset appropriation is not straightforward, for
direct measures cannot be observed from public 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 annual
reports indicate related party transactions; hence, we focus on the accounts payable and receivable
due to transactions between the respective company and another company that is a principal
shareholder of the former. To obtain a relative measure that accounts for firm size, we divide the
difference between accounts receivable and accounts payable by total assets. This serves as a proxy
for asset appropriation, as related party transaction with a high imbalance between accounts payable
and receivable could indicate that the dependent company loses in these transactions.
As a matter of fact, this accounting measure exhibits some inherent disadvantages. First, the
measure is noisy in that asset appropriation cannot be directly observed, and related party
transactions are just one potential source of asset appropriation. Henceforth, it is difficult to
distinguish between normal related party transactions and transactions used for operational
tunneling. Second, the accruals may be a result of prior earning management and do not indicate
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Table 6
Granger causality tests
Null hypotheses F-test P-value
Board meetings, institutional ownership and the “big five” audit firms 0.81 0.488
do not Granger cause asset appropriation
Asset appropriation does not Granger causes the number of board meetings 0.88 0.348
Asset appropriation does not Granger causes choosing one of the “big five” audit firms 0.44 0.506
Asset appropriation does not Granger causes institutional stockholding 4.36 0.037
tunneling. Third, an increase in accounts receivable can also imply that the large shareholder is
embezzling assets from the listed company, for the listed company is facing a risk of failing to
collect accounts receivable in future.
Besides accounting measures, empirical measures based on financial and stock market
performance have been used (Bae et al., 2002; Cheung et al., 2006). However, the main problem
with these measures is that they require an efficient stock market with high liquidity so that stock
performance really reflects financial and operational aspects. The most crucial shortcoming is that
by testing the impact of tunneling on stock performance additional factors (e.g. firm specific
effects, institutional ownership) are usually not considered, which biases the results.
Accordingly, we suggest using an accounting based measure; however, we test for its
relevance on firm performance and valuation levels. Tobin's Q defined as the market value of firm
assets divided by the repurchase value of firm assets indicates whether a company's valuation
level is higher than the repurchase value of its assets. Putting this differently, a company with a
Tobin's Q exceeding one creates value by combining its resources, whereas a company with a
ratio below one should be acquired or liquidated. Accordingly, companies with a high Tobin's Q
seem 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, which
lowers value creation potential. If our proxy for asset appropriation is an adequate indicator for
asset appropriation, we should observe the following relationships: (1) companies with high
Tobin's Q should be a preferred target for asset appropriation; thus, the accounting proxy should
have 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 high
Tobin's Q causes more asset appropriation (p-value: 0.000), and asset appropriation reduces
Tobin's Q in the following year (p-value: 0.025). Consequently, our proxy for asset appropriation
exhibits the pattern one would expect.
6. Conclusion
Our study uncovered a high extent of operational tunneling in China, as about 4% of total
assets are embezzled. Yet the situation has improved because the extent of tunneling declined
from 1998 to 2002 from 5.68% to 4.04%, and only 45.04% of the firms suffer from asset
appropriation 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 and
external governance structures in China and reduce tunneling. Audits without non-clean opinion
signal 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 operational
tunneling. Granger causality tests reveal that institutional investors pick stocks of companies with
sound governance. Thus, the argument that institutional ownership should be stimulated to install
better 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 as
principal shareholders do not significantly affect asset appropriation; hence, tunneling seems not be
driven by the influence of the state as principal shareholder. Nevertheless, several block-holding
shareholders that compete for controlling a company make embezzlement less likely—albeit the
economic impact is relatively low. Accordingly, our results do not confirm the pessimistic view of
Chen et al. (2005) that the state as principal shareholder facilitates tunneling. We uncover that in the
year 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 the
state in publicly listed companies are recommended and will help to further improve corporate
governance principles in future.
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Corporate Governance and Tunneling Empirical Evidence From China

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Pacific-Basin Finance Journal xx (2007) xxx – xxx

Corporate governance and tunneling:

Received 3 January 2006; accepted 28 September 2007

JEL classification: G34; G38

2.1. Tunneling in China

2.2. Theoretical hypotheses

Hypothesis 8. A high percentage of institutional investors enhances good corporate governance

Tunneling ¼ ai þ b1 Singleit þ b2 Multiit þ b3 Board Sizeit þ b4 Meetingsit

5. Endogeneity issues and robustness checks

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