CEO Compensation and Corporate Governance in China

• Author: Martin J. Conyon,Lerong He
• Published date: 01 November 2012
• Date: 01 November 2012
• DOI: http://doi.org/10.1111/j.1467-8683.2012.00935.x

CEO Compensation and Corporate Governance

in China

Martin J. Conyon and Lerong He*

ABSTRACT

Manuscript Type: Empirical

Research Questions: This study investigates the determination of Chinese CEO pay. We focus on three related questions:

(1) Is Chinese CEO pay related to f‌irm performance? (2) Are CEO pay dynamics important? (3) Does corporate governance

affect CEO pay and equity incentives in China?

Research Findings: Using data on CEO compensation in China’s public traded f‌irms from 2000 to 2010, we document

signif‌icant changes in CEO pay, ownership and board structure. We document that CEO pay is positively correlated to

both accounting and stock market performance, although the link to accounting performance is more robust. We f‌ind that

CEO pay dynamics are important as pay in the current year is signif‌icantly positively correlated to CEO pay the previous

year. We also f‌ind that CEO equity ownership and equity grants are inf‌luenced by board and ownership structure.

Theoretical/Academic Implications: This study supplements the standard agency theory approach to executive compen-

sation with insights gained from the dynamics of wage setting theory developed in the labor economics f‌ield.It predicts that

incomplete information and learning lead to adjustment costs and non-instantaneous changes in CEO pay.

Practitioner/Policy Implications: This study offers insights to policy makers interested in enhancing the design of executive

compensation and internal corporate governance within transition economies.

Keywords: Corporate Governance, CEO Pay, China, Wage Dynamics

INTRODUCTION

This study investigates the determination of Chinese

CEO pay. Given China’s tremendous economic growth

and development of capital markets, scholars have begun

to devote signif‌icant attention to the systematic examina-

tion of Chinese executive compensation and corporate gov-

ernance in recent years (e.g., Allen, Qian, & Qian, 2005;

Chen, Liu, & Li, 2010; Conyon & He, 2011; Firth, Fung, &

Rui, 2006, 2007; Kato & Long, 2006; Peng, 2003; Shen & Lin,

2009; Xu, Zeng, & Zhang, 2011). A few key themes emerge

from this literature. Are Chinese executives paid in the

same way as Western executives, given China’s limited

experience with stock markets and governance reform? Are

the drivers of executive pay, such as f‌irm performance,

ownership, and board structure, as important in China as in

the West? These questions are located in the broader ques-

tion of whether executive pay will globalize along Ameri-

can lines (Cheff‌ins, 2003). There are few concrete answers

to these questions as yet, particularly compared to the volu-

minous literature on executive compensation in the

Western setting (see reviews by Devers, Cannella, Reilly,

& Yoder, 2007; Murphy, 1999).

This study addresses three related research questions

using a comprehensive executive compensation database

on public f‌irms from 2000 to 2010. First, is CEO pay in

China linked to f‌irm performance? Specif‌ically, we estimate

the association between CEO pay and accounting and

market-based measures of performance. Critically, we also

demonstrate the diffusion of equity incentives such as stock

options and restricted stock in China since the enactment of

new legal rules in 2005. By addressing the role of equity

incentives, we form a better picture of the role of compen-

sation contracts in motivating the efforts of Chinese CEOs.

Second, does corporate governance affect CEO pay? We

document structural changes of the corporate governance

system of Chinese f‌irms and investigate the inf‌luence of

f‌irm ownership and the boards of directors on CEO pay

and equity incentives, under the context of corporate gov-

ernance reforms in the 2000s. Finally, and most importantly,

are CEO pay dynamics important in China’s public f‌irms?

Prior studies have assumed that CEO pay is in equilibrium

*Address for correspondence: Lerong He, School of Business Administration and

Economics, College at Brockport,State University of New York, Brockport, NY 14420,

USA. Tel: 585-3955781; E-mail: lhe@brockport.edu.

575

Corporate Governance: An International Review, 2012, 20(6): 575–592

© 2012 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2012.00935.x

and have therefore only estimated static pay models devel-

oped using agency theory. We relax this restriction and

supplement the traditional agency theory approach to

executive compensation with insights gained from the

wage dynamic theory developed in the labor economic

f‌ield. We view the CEO compensation decision as a

dynamic process where incomplete information and learn-

ing are as important as incentive alignment. We demon-

strate that CEO pay is highly persistent which is consistent

with the presence of adjustment costs and learning in the

board pay-setting process.

Our study adds to the Chinese executive compensation

literature in the following ways. First, we f‌ind that CEO pay

is positively and signif‌icantly linked to f‌irm performance,

using data on public f‌irms from 2000 to 2010. There is a

positive association between CEO pay and return on assets

(an accounting-based performance measure) but the link

between payand stock returns (a market-based performance

measure) is less well determined. We f‌ind that CEOs are

increasingly holding equity in their f‌irms, an important

avenue for aligning owner and manager interests. Moreover,

we f‌ind that the average value of CEO shareholdings is sig-

nif‌icantly higher than the average value of current CEO pay,

suggesting that equity ownership is an important source of

CEO incentives. We also f‌ind that some f‌irms have begun to

grant stock options and restricted stock to their CEOs since

2005. However, the take-up is not very dramatic with only

about 2 or 3 percent of f‌irms doing so. Here, we believe,

there is much more scope for aligning owners’ and manage-

ment’s interests.

Second, our study shows that CEO pay is highly persis-

tent. Dynamic panel data estimates suggest that the current

level of CEO pay is signif‌icantly and positively correlated to

last period’s pay level. CEO pay is not always in equilibrium

as assumed in prior China studies. Instead, boards and com-

pensation committees set pay dynamically and adjust it

towards an equilibrium target level, presumably set by

market expectations.Adjustment cost in Chinese CEO pay is

an important discovery. Our estimates thus takeinto account

the endogenous nature of f‌irm performance and corporate

governance factors. We show that incomplete information

and learning are as important as incentive alignment in CEO

pay determination.

Third, our study demonstrates the importance of corpo-

rate governance; namely, the effects of ownership and

internal corporate governance factors in affecting CEO

compensation contracting. We document substantial

changes in the internal corporate governance and ownership

structure of Chinese f‌irms in our sample years. We f‌ind

broad support that board and shareholder monitoring sub-

stitute for the need of equity incentives. We also f‌ind that

economic variables, such as f‌irm performance and f‌irm size,

and CEOs’ human capital, are more important factors

shaping the level of CEO pay than ownership and corporate

governance variables. In particular, the effect of corporate

governance on CEO pay level is considerately weaker after

controlling for unobserved f‌irm heterogeneity and pay per-

sistence. Overall, our results show that the effectiveness of

internal corporate governance mechanisms is limited, par-

ticularly after considering the impact of wage dynamics in

the pay-setting process.

RESEARCH HYPOTHESES

CEO Pay and Performance

The standard approach to executive compensation is the

principal agent model (Holmstrom, 1979; Jensen & Meck-

ling, 1976; Mirrlees, 1976). Agency theory predicts that CEO

pay should be linked to performance in order to solve moral

hazard problems associated with the asymmetric informa-

tion between owners and managers. Shareholders can only

imperfectly observe the actions of agents, or do so at very

high cost. As a result, they design compensation contracts

that motivate the CEO to take the right actions of his or her

own volition. Therefore, rewarding executives based on f‌irm

performance becomes a central issue in the design of execu-

tive compensation contracts.

The extant literature on Chinese executive compensation

typically documents a positive relationship between execu-

tive pay and f‌irm performance, while signif‌icance and mag-

nitude of the link vary with performance measures and

study periods. Early pay studies relied on survey data from

state-owned enterprises (SOEs) rather than publicly traded

f‌irms. They showed some evidence that CEO pay was

related to accounting performance measures or CEO pro-

ductivity (Bai & Xu, 2005; Groves, Hong, McMillan, &

Naughton, 1995; Mengistae & Xu, 2004). The later studies on

executive payusing public f‌irm data have yielded additional

evidence on the pay-for-performance link. Kato and Long

(2006) show that changes in executive pay are related to f‌irm

performance measured by stock returns. Firth et al. (2006,

2007), Li, Moshirian, Nguyen, and Tan (2007), and Wangand

Xiao (2011) all f‌ind that Chinese CEO cash pay is related to

f‌irm accounting performance, while an insignif‌icant rela-

tionship is identif‌ied for stock returns. More recently, Buck,

Liu, and Skovoroda (2008) and Conyon and He (2011)

suggest that both accounting performance and stock market

performance inf‌luence executive compensation contracts.

All these studies share a similar approach to measuring

executive compensation. Specif‌ically, researchers measure

executive compensation as the average of the three highest-

paid directors, instead of using individual data on the CEO

(with the only exception of Chen,Ezzamel, & Cai, 2011). This

is due to a much weaker disclosure system in China in the

earlier years, although the situation is improving over time

as market reforms deepen. Specif‌ically, the China Securities

Regulatory Commission (CSRC) regulates the disclosure of

executive compensation information in publicly traded

f‌irms. Early regulation (pre-2001) did not require public

f‌irms to disclose information about executive pay in their

annual reports. Some f‌irms did on a voluntary basis.

Between 2001 and 2005, the CSRC required all public f‌irms

to report the aggregated sum of total compensation for the

three highest-paid executives and board members. The

extant Chinese executive pay studies typically use aggre-

gated compensation data from these periods (Conyon &

He, 2011; Ding, Wu, Li, & Jia, 2010; Firth et al., 2006, 2007;

Firth, Leung, & Rui, 2010; Kato & Long, 2006; Li et al., 2007).

Only from 2005 was separate compensation disclosure

required for individual executives. Our study thus takes

advantage of this more informative pay disclosure rule to

focus on the CEO directly. As such, our strategy permits us

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