Are Political Connections a Blessing or a Curse? Evidence from CEO Turnover in China

• Author: Jiaxing You,Guqian Du
• Published date: 01 March 2012
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00902.x
• Date: 01 March 2012

Are Political Connections a Blessing or a Curse?

Evidence from CEO Turnover in China

Jiaxing You* and Guqian Du

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paperinvestigates the issue of forced CEO turnover in China and summarizes the economic

consequences of political connections within the framework of corporate governance.

Research Findings/Insights: Using a large sample of listed f‌irms in China from 2005 to 2008, we f‌ind that politically

connected CEOs are less likely to be f‌ired and that the sensitivity of forced turnover to f‌irm performance is weaker for

connected CEOs than for their non-connected peers. This suggests that CEOs in a transition economy tend to use their

political resources for their own good. We also f‌ind a signif‌icantly positive relationship between the political connections of

retained CEOs and future f‌irm performance only when f‌irm prof‌itability is below the industry median. These f‌indings

suggest that the value of political connections is contingent on a f‌irm’s operating performance, and that the benef‌its of

political connections may outweigh their costs when f‌irms do not meet their prof‌itability targets.

Theoretical/Academic Implications: This study is the f‌irst to examine how the political ties of CEOs relate to their forced

turnover. It integrates agency theory with resource dependence theory and contributes to the ongoing debate on the role of

political connections in emerging markets. It also takes a step toward reconciling the mixed evidence for the effects of

political connections on f‌irm performance by demonstrating a sharp difference between f‌irms under different operating

statuses.

Practitioner/Policy Implications: This study offers insights to policy makers who are interested in improving corporate

governance in transitional economies such as China, where CEOs have close connections with the government. It also

provides a deep perspective for the boards in politically connected f‌irms, allowing them to deal with the relationship

between top management and the government in a healthy way.

Keywords: Corporate Governance, Business-Government Relations, CEO Succession Policy, Emerging Market

Economy

INTRODUCTION

There is a large body of literature on the impact of politi-

cal connections on f‌irm performance and market value.

According to the resource dependence theory developed by

Pfeiffer and Salancik (1978), political connections can help

f‌irms to obtain key resources, cope with various external

uncertainties, and thereby increase f‌irm value. Consistent

with this view, Hillman (2005) f‌inds that f‌irms in heavily

regulated industries have more former politicians on their

boards than those in less-regulatedindustries, and thus have

better accounting performance. However, the agency theory

proposed by Jensen and Meckling (1976) argues that con-

nected CEOs may utilize political resources for their own

interests rather than the interests of shareholders. Thisraises

the further question of whether a CEO’s political connec-

tions are related to the principal-agent conf‌lict and thus the

quality of corporate governance, which has received little

attention in the recent academic literature.

In this paper, we try to f‌ill this gap by investigating the

inf‌luence of political connections on forced CEO turnover,

a key determinant of corporate governance. Shleifer and

Vishny (1989) argue that CEOs can retain their positions by

making manager-specif‌ic investments to stop outside inves-

tors from replacing them. According to this argument, politi-

cal connections can be regarded as a type of manager-

specif‌ic investment and thus lower the risk of forced

turnover faced by connected CEOs. In particular, when a

CEO’s leadership is threatened by poor performance, the

possibility of being replaced severely affects his or her per-

sonal reputation, career prospects, future wealth and so on

*Address for correspondence: Jiaxing You,School of Management, Xiamen University,

Xiamen, Fujian 361005, China. E-mail: hymnyou@sina.com

179

Corporate Governance: An International Review, 2012, 20(2): 179–194

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00902.x

(Morck, Yeung, & Yu, 2000; Stulz, 1988). In this situation, the

political networks established by a CEO may become a per-

sonal umbrella and reduce the possibility of being dismissed

due to poor performance. Furthermore, as CEOs’ political

connections help f‌irms to gain better access to key resources

controlled by the government, f‌irm performance is less

important when assessing the ability of politicallyconnected

CEOs, which would weaken turnover-performance sensitiv-

ity. Based on this supposition, we hypothesize that politi-

cally connected CEOs are less likely to be f‌ired and that the

relationship between forced turnover and poor performance

is weaker for politically connected CEOs than for their non-

connected peers.

Although political connections may affect normal selec-

tion mechanisms and interfere with the board’s ability to

discipline poorly performing managers, well-connected

CEOs provide their f‌irms with competitive advantages by

keeping them in close touch with the government (Claes-

sens, Feijen, & Laeven, 2008). When f‌irm prof‌itability is

negative or below the industry median, politically connected

CEOs face great pressure to meet their performance targets,

which may prompt them to initiate their political connec-

tions. This suggests that the value of political connections

may depend on f‌irm operating performance. Hence, another

fundamental question arises: what is the effect of retained

CEOs’ political connections on future f‌irm performance?

Are these effects signif‌icantly different between f‌irms with

different operating statuses?

In our study, we take China as an ideal setting in which to

explore these issues for the following reasons. First, political

connections are commonplace in China and have great inf‌lu-

ence on f‌irm behavior. As a transition economy, China has a

weak legal system to protect the rights of private investors

(Allen, Qian, & Qian, 2005). In these circumstances, political

connections become an important substitute for formal insti-

tutional structures (Li, Meng, Wang, & Zhou, 2008), and

listed f‌irms tend to appoint candidates who possess rich

political connections (Fan, Wong, & Zhang, 2007; Xu &

Zhou, 2008). In this respect, China provides a natural labo-

ratory to study the nexus between business and politics and

helps us develop a deeper understanding of the various

economic consequences of political ties. Second, during

China’s process of economic liberalization, the political

system has been highly decentralized, with various levels of

the government having autonomous policymaking powers

within their jurisdictions. The case of China therefore offers

useful variation in the type of political connections that can

be exploited to identify the relationships of interest.

Following a detailed analysis of the curriculum vitae of

CEOs, we identify two categories (political experience and

political identity) and construct a composite index to

measure both the existence and the closeness of these con-

nections. We f‌ind that politically connected CEOs are less

likely to be f‌ired and that the relationship between forced

turnover and poor performance is weaker for these CEOs

than for their non-connected counterparts. The results

remain robust to a series of control variables and to various

specif‌ications of f‌irm performance and political connections.

Overall, these f‌indings show that political connections may

weaken the board’s monitoring strength and undermine the

quality of corporate governance.

We also investigate the effect of political connections of

retained CEOs on future f‌irm performance. After controlling

for other factors affecting f‌irm performance, we f‌ind that the

accounting-based performance of f‌irms with connected

CEOs is better than that of those without. However, this

positive effect is more pronounced in underperforming

f‌irms. Specif‌ically, we f‌ind a signif‌icantly positive relation-

ship between future f‌irm performance and political connec-

tions only when current f‌irm prof‌itability is below the

industry median. These results indicate that the value of

political connections is contingent on actual f‌irm perfor-

mance and is stronger when f‌irms fail to meet their perfor-

mance targets.

Our f‌indings contribute to the literature in several ways.

First, we provide evidence to the ongoing debate on the

exact role of political connections in transitional economies.

According to Faccio (2006), connected f‌irms are more preva-

lent in countries with weak legal systems and high levels of

corruption. Li et al. (2008) also argue that political connec-

tions add additional value by bridging over the imperfect

institutional structures of these countries. However, politi-

cal connections are not a CEO’s birthright, but rather a

return on investment. When faced with the risk of being

replaced, connected CEOs may use their political ties to

reduce the risk of replacement.To the best of our knowledge,

this study is the f‌irst to examine how CEOs’ political ties

relate to their forced turnover. Our evidence strongly sug-

gests that political ties have an adverse effect on forced CEO

turnover by reducing turnover-performancesensitivity. This

expands our understanding of the role of political connec-

tions in the framework of corporate governance. Second, we

provide additional evidence from China and take a further

step toward reconciling the mixed evidence on the effects of

political connections on f‌irm performance. In previous

studies, political ties have been documented to have both

positive effects (e.g., Goldman, Rocholl, & So, 2009; Li et al.,

2008) and negative effects (e.g., Faccio, 2010; Fan et al., 2007).

Our analysis reveals that these effects are subject to a f‌irm’s

f‌inancial performance by demonstrating a sharp difference

between f‌irms with different operating statuses.

The remainder of the paper is organized as follows. The

next section discusses the related research and develops our

hypotheses. We go on to describe the research context and

design, and then report and analyze the empirical results. A

f‌inal section provides conclusions.

RELATED RESEARCH AND HYPOTHESIS

DEVELOPMENT

In transition economies, the government controls a wide

range of f‌inancial and regulatory resources either through

its power of planning or through its full control over

state-owned enterprises (McMillan, 1997; Nee, 1992). The

economy also lacks a sound legal system for property rights

protection and contract enforcement (Johnson, McMillan, &

Woodruff, 2002; McMillan & Woodruff, 1999). It is common-

place that f‌irms in these economies make extensive use of

political resources, not only to avoid multiform government

extortions such as arbitrary fees and charges, but also to gain

access to key resources offered by politicians. Such benef‌its

180 CORPORATE GOVERNANCE

Volume 20 Number 2 March 2012 © 2011 Blackwell Publishing Ltd