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Business Group Affiliation, Firm Governance,

and Firm Performance: Evidence from Chinaand India

Deeksha A. Singh* and Ajai S. Gaur

ABSTRACT

Manuscript Type: EmpiricalResearch Question/Issue: This study seeks to understand how business group affiliation, within firm governance anexternal governance environment affect firm performance in emerging economies. We examine two aspects of within firgovernance ownership concentration and board independence.Research Findings/Insights: Using archival data on the top 500 Indian and Chinese firms from multiple data sources fo2007, we found that group affiliated firms performed worse than unaffiliated firms, and the negative relationship wastronger in the case of Indian firms than for Chinese firms. We also found that ownership concentration had a positive effeon firm performance, while board independence had a negative effect on firm performance. Further, we found that grouaffiliation firm performance relationship in a given country context was moderated by ownership concentration.Theoretical/Academic Implications: This study utilizes an integration of agency theory with an institutional perspectivproviding a more comprehensive framework to analyze the CG problems, particularly in the emerging economy firmEmpirically, our findings support, as well as contradict, some of the conventional wisdom, and suggest useful avenues fofuture research.Practitioner/Policy Implications: This study shows that reforms in general and CG reforms in particular are effective i

emerging economies, which is an encouraging sign for policy makers. However, our research also suggests that it may btime for India and China to stop the encouragement for the empire building through group formation in the corporatworld. For practioners, our findings suggest that firms need to balance the need for oversight with the need for advice, whiselecting independent directors.

Keywords: Corporate Governance, Ownership Concentration, Board Independence, China, India

INTRODUCTION

W

ith an increasing integration of world economies andthe growth of large organizations, corporate gover-

nance (CG) has emerged as an important issue for scholarsas well as managers all over the world. Using agency theoryas the dominant theoretical paradigm, the extant literaturehas mainly focused on the efficacy of various governancemechanisms that protect the shareholders from self servingmanagers (Rajagopalan & Zhang, 2008). Much of thisresearch is situated in the context of developed economies,where the external governance environment and institutionsto support the internal firm governance are stable and welldeveloped (Judge, Douglas, & Kutan, 2008).

While a focus on within firm governance mechanisms hadvanced our understanding of the links between govenance standards and firm performance, there is an increaing realization that the efficacy of within firm governancmay be dependent on the quality of external governance aninstitutions (Judge et al., 2008). This issue is particularimportant for emerging economies, which often lack thinstitutions needed to support efficient within firm govenance (Peng, 2003). It is well documented that many emering economies, such as India and China, do not have wedeveloped external control mechanisms, such as a markfor corporate control, merger, and acquisition laws, and efficient law enforcement (Khanna & Palepu, 2000a; Peng, 2003This not only makes it more difficult to govern the organzations, but also makes standard CG practices less legitima(Judge et al., 2008).

*Address for correspondence: Department of Business Policy, National University ofSingapore, Singapore, 117592. Tel: 1-757-401-5963; E-mail: [email protected]

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mailto:[email protected]:[email protected]

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The lack of external institutional support raises severaltheoretical and empirical questions that have not beenexamined in the extant literature. For example, the theo-retical focus of much of the extant literature has beenon agency theory, which focuses on the governanceproblems due to a conflict of interest between ownersand agents. While principal-agent conflict is common fordeveloped economies, emerging economies face a different

type of agency problem, where majority shareholders,who are often owners, exploit the interests of minorityshareholders (Claessens, Djankov, & Lang, 2000; Dharwad-kar, George, & Brandes, 2000). Such a conflict ofinterest between different groups of owners, known asprincipal-principal conflict arises due to the lack ofshareholder protection and enforcement mechanism(Dharwadkar et al., 2000). This necessitates that theagency centric view of corporate governance be suitablymodified to incorporate the arguments from an institu-tional perspective.

The unique context of emerging economies also raisesimportant empirical questions, as the governance arrange-ments found in these countries are quite different fromthose found in developed countries. For example, firmsoften arrange themselves in the form of business groupsthrough pyramidal ownership structures in countries thatlack the institutions needed for efficient market basedexchanges (Almedia & Wolfenzon, 2006; Khanna, 2000; LaPorta, Lopez-De-Silanes, Shleifer, & Vishny, 2000). Suchgovernance arrangements may make traditional gover-nance mechanisms, such as the presence of independentdirectors in the board redundant. The independent direc-tors may come from sister firms of a group, and thereforemay not be effective, and their role may be limited to sat-isfying the statutory requirements. While affiliation to a business group itself may have a positive or negative

impact on firm performance, depending on the level ofinstitutional development in a country, within firmgovernance is likely to moderate the effect of groupaffiliation.

In this paper, we address the above-mentioned issues byusing an integration of the agency theory with the institu-tional perspective. Specifically, we investigate the relation-ship between group affiliation, within firm governance andfirm performance, and how these relationships are contin-gent on the country contexts. We investigate two aspects ofwithin-firm governance presence of independent direc-tors in the board and the ownership concentration. Further,we investigate how the within-firm governance moderatesthe effect of group affiliation in a given country context forfirm performance. In doing so, this paper contributes to thecorporate governance literature by providing a more holis-tic theoretical framework, and empirical findings in thecontext of two important emerging economies India andChina.

The rest of the paper is arranged as following. In the nextsection, we provide a background on the CG standards inIndia and China. We build on this discussion to develop ourtheoretical arguments. This is followed by a presentation ofour sample, methodology, and results. Finally, we discussour results, and provide avenues for future research in thisarea.

THEORY AND HYPOTHESES

Background: Corporate Governance in Indiaand China

Good corporate governance practices are essential for thdevelopment of a market based economy and consequentla prosperous society. In a historical analysis of the growt

of different world economies, North and Thomas (197attributed the rise of Western economies to a better govenance environment and to more developed institutions thsupport market based exchange. An advanced external goernance environment helps in the development of souncorporate governance practices in firms (Judge et al., 2008Emerging economies such as India and China have laggein this aspect in comparison to their developed economcounterparts. In a ranking of 25 emerging markets, conducted by the Credit Lyonnais Securities Asia (Gill, 2001India was ranked 6th while China was ranked 19th. Anothreport by Asian Corporate Governance Association (Gill Allen, 2007) puts China towards the bottom among 1Asian markets. While India is third place in this rankinthe report says that the CG standards in these countries arstill quite low as compared to their developed economcounterparts.

Since the overall institutional environment has a definibearing on the CG standards in a country, we need to undestand CG practices in view of the broader institutional chaacteristics. Tables 1 and 2 present the general economreforms and CG specific reforms carried out in China anIndia respectively (Gaur, 2007). In the case of China, theconomic reforms started in 1978 at a very modest level (LPark, & Li, 2004). However, it was not until 1993 that the firimportant steps were taken to improve the CG standardChina passed the Company Law in 1993, which becam

effective in 1994. This was further modified in 1999. ThCompany Law provided the guidelines concerning thrights, responsibilities, and liabilities of different groupsuch as shareholders, board of directors, and managerFurther, in 1998, China enacted the Securities Law, to regulate the stock markets. The Securities Law stipulated striprohibition of unfair practices such as market manipulatioand insider trading.

Even with these laws, China faced several corporate scandals, the biggest being a RMB 745 million fraud in a listecompany named Ying Guang Xia in 2001. This prompted thChina Securities Regulatory Commission (CSRC) to issueCode of Corporate Governance for Listed Companies. Thcode specifies several requirements for listed companiesuch as presence of independent directors in the boardadherence to strict information disclosure norms, and equstatus to minority shareholders. The objective of thereforms has been to establish CG standards similar to the Usystem. However, as is revealed in several CG rankingChina has a long way to go before its CG standards can comclose to those of Western economies.

Unlike China, India has been a slow starter in reforminitiating the first steps only in 1991, when it was forced to dso due to a severe balance of payment crisis. However, eve before the economic reforms started in India, India hadflourishing stock market, and large private participation

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business activities. There were also explicit rules governingfirm behavior, even though many of the rules may have beeninadequate (RBI, 2001). As a result, Indian firms had a betterexposure to CG standards than their counterparts in manyother emerging economies (Rajagopalan & Zhang, 2008). Theneed to strengthen the CG standards was felt after themarkets witnessed scandals soon after the liberalization poli-cies were initiated in 1991. This led to the constitution ofSecurities and Exchange Board of India (SEBI), which hassince then become an independent regulator of capital

markets. SEBI instituted four committees over the yearheaded by prominent industrialists, to suggest CG reformfor Indian firms. These committees have given recommendtions on issues such as the composition of the board odirectors, audit committee, shareholder rights, and boarprocedures. While following the American model of CGSEBI has made sure that the reforms take into account thcontingencies of the local environment. Several scholasuggest that the CG standards in India are as good as in manother developed countries, even though the enforceme

TABLE 1Institutional Reforms in China

General economic reforms

Time line Key reforms

Stage 1 (19781983) Initiated during the third plenum of the 11th

Chinese Communist Party Congress held inDecember 1978 Ideological shift from abolition of markets to accepting markets as secondary with planning

being the primary tool of economic well being. Specific steps included: Agricultural reform by the introduction of household responsibility system, which madehouse holds residual claimant on the agricultural produce Gradual opening up of the economy beginning with Guangdong and Fujian provinces, an

establishment of special economic zones, which were allowed to become market economiedominated by private ownership

Partial fiscal decentralization, which encouraged some fiscal responsibility at the provincelevel

Reforms in SOEsStage 2 (19841993) Market liberalization through a dual track approach. SOEs could sell excess produce at mark

price after fulfilling the planned quota Introduction of contract responsibility system for SOE reform Financial reforms through bank decentralization Further opening up of the economy through coastal open cities, and development zones Entry of private and collective firms

Stage 3 (1994onwards)

Objective was to transform China to a socialist market economic structure and build arule-based system

Unification of exchange rates and convertibility on current account Restructuring of tax and fiscal system Reorganization of the central bank Downsizing of government bureaucracy Privatization and restructuring of SOEs

Constitutional amendment to allow for private ownership

Corporate governance specific reforms


1994 Introduction of Chinas Company Law1998 Introduction of Chinas Securities Law to regulate capital markets and trading activities1999 The Company Law was amended2002 Code of Corporate Governance for listed companies released

Source: Gaur (2007).

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mechanism may be relatively weaker (Rajagopalan & Zhang,2008; Varma, 1997).

The impact reforms have had on the business environmenthave become quite visible as reflected in the business envi-

ronment ratings given by the World Competitiveness Yeabook (19972006). Table 3 presents ratings on some generreform parameters for China, India, and the US for th10-year time period from 1997 to 2006. We included the U

TABLE 2Institutional Reforms in India

General economic reforms


1991 Fiscal crisis Foreign exchange sufficient to support just two weeks of imports Pressure from IMF to start liberalization as a pre-condition to loans Realization on part of policy makers of the importance of liberalization Government initiated a limited liberalization initiative

Reserve Bank of India (RBI) devalued the Indian rupee by 20 per cent Delicensing

Number of industries reserved for public sector reduced from 17 to 8 Licensing system abolished except in 15 critical industries Eliminated the requirement of governments approval for expansion of large firms Foreign firms allowed to hold majority ownership in JVs Automatic approval for foreign investment up to 51 per cent in 35 industries 100 per cent ownership shares and full repatriation of profits in many industries for investmen

by NRIs

1992 Foreign institutional investors (FIIs) given permission to invest in all securities traded on theprimary and secondary markets with certain restrictions

Restrictions on the use of foreign loans abolished Foreign portfolio investors allowed to invest in listed companies

1994 Indian rupee made fully convertible on current account1996 100 per cent debt FIIs permitted, FIIs could buy corporate bonds, but not government bonds1997 The maximum ownership limit of 24 per cent for all FIIs in a firm raised to 30.1998 Further reforms in investment policies

Upper limit of ownership by one FII in one firm raised form 5 per cent to 10 per cent FIIs allowed to operate in forward markets on a limited basis FIIs allowed to trade equity derivatives

1999 Requirement of having at least 50 investors for FIIs eased to 20 investors

2000 onwards Further liberalization in the investment regime Maximum ownership limit by FIIs made 49 per cent and further raised to sectoral specific caps

Corporate governance specific reforms


1992 Securities and Exchange Board of India (SEBI) act passed by the parliament SEBI instituted as an independent regulator Over the years, SEBI instituted four committees (in 1996, 1998, 2000, and 2002) for CG reforms

1994 Government efforts to reform Bombay Stock Exchange (BSE), the major stock exchange in Indiamet with stiff resistance. Government instituted a new stock exchange, National Stock Exchange(NSE), as a competitor to BSE, establishing better practices and more standard corporategovernance (BSE was an association of Brokers). Over time, this resulted in reforms in the BSE aswell

2003 SEBI made as a single window approver for FIIs (earlier they had to seek approval from the federbank also)

Source: Gaur (2007).



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to provide a general sense of relative understanding ofChina and India. As can be seen from the table, both Indiaand China have steadily improved their standings on keyparameters, such as reducing bureaucratic hindrances, anti-trust regulation (in the case of India), etc. While the businessenvironment is still far from being close to what we observein the Western economies, it is better than what it was in theearly 1990s.

An important feature of both Indian and Chinese econo-mies has been a large presence of business groups in eco-nomic activities. We argue that business groups are not onlyan organizational form, but also a governance mechanismwith positive as well as negative consequences. In the nextsection, we elaborate on the performance consequences ofgroup affiliation, along with two other firm level governancemechanisms ownership concentration and board indepen-dence. Our hypotheses linking group affiliation with firmperformance primarily rely on the institutional perspective,

while those linking firm governance with firm performancprimarily rely on agency theory.

Group Affiliation and Firm Performance

Business groups are an important feature of many emergineconomies. Khanna and Rivkin (2001:47) define a busine

group as a set of firms which, though legally independenare bound together by a constellation of formal and informties and are accustomed to taking coordinated action.

Scholars have put forth several theoretical perspectivexplaining the prevalence of business groups. These includa resource based view of business groups (Guilln, 2000business groups as a response to market failure (Caves, 198Leff, 1976, 1978), institutional voids (Chang & Choi, 198Khanna & Palepu, 1997, 2000a, 2000b; Leff, 1978) and policdistortions (Ghemawat & Khanna, 1998); and businegroups as maximizers of control through pyramidal owneship structures (La Porta, Lopez-de-Silanes, & Shleife1999).

The dominant logic in explaining the presence of businegroups in China and India is an institutional perspectivThe institutional perspective suggests that business groupin China and India have thrived due to two main factorspolicy inducements, and institutional voids. In the case China, groups emerged as a consequence of governmenpolicy of ownership reforms of state owned enterpris(SOEs). In 1987, the Chinese government started providinincentives for SOEs to form business groups. The StaAdministration of Industry and Commerce (SAIC) definbusiness groups as those in which the core company hascapital of at least 50 million Yuan, with at least five affiliatecompanies, whose combined capital should be greater tha100 million Yuan. The Chinese government selected some

the state owned business groups as national trial groupwhose job was to absorb the non-performing SOEs. Ovtime, business groups in China have come to be associatewith prestige, even though there are several costs associatein managing a business group. Recognizing the reputatioassociated with being a business group, many entrepreneualso formed their own business groups in China. At presenbusiness groups in China contribute about 60 per cent of thindustrial output (Yiu, Bruton, & Lu, 2005).

In the case of India, the presence of business groups coulbe attributed to policy distortion as well as institutionvoids (Kedia, Mukherjee, & Lahiri, 2007). After independence from the colonial rule in 1947, the Indian governmenindirectly forced firms to form business groups by imposinsevere regulatory and bureaucratic hindrance to thegrowth. Some of the policy instruments that governmeused to control economic activities include the IndustriPolicy Resolution (1956), Monopolies Inquiry Commissio(1965), Monopolies and Restrictive Trade Practices (MRT1969), Industrial Licensing Policy Inquiry Committee (1969and Foreign Exchange Regulation Act (1973) (see Majumda2004, for details). Together, these policies created an excesively restricted environment for private businesses. Firmhad to seek a host of regulatory clearances before they coulstart a new operation or even increase production capacitIn addition to several restrictions, there was a conspicuou

TABLE 3Key Reform Indicators

Reform indicators Year China India US

Government adaptspolicies to new

economic realities

1997 5.31 4.23 5.462000 5.03 4.51 6.58

2003 5.17 3.91 5.312004 5.17 3.91 5.312005 4.81 5.04 4.902006 5.41 5.19 5.34

Bureaucracy does nothinder economicdevelopment

1997 1.80 2.65 4.632000 1.60 2.49 4.662003 2.88 2.16 4.332004 2.88 2.16 4.332005 1.94 2.69 3.372006 2.82 2.79 4.39

Anti-trust regulation 1997 4.00 5.00 7.002000 4.82 4.67 6.252003 4.99 4.21 6.61

2004 6.81 5.91 5.922005 5.19 4.86 5.542006 5.47 4.58 6.41

Intellectual propertyprotection

1997 5.32 4.27 7.442000 7.67 4.23 8.762003 5.02 4.22 8.412004 5.02 4.22 8.412005 4.23 4.75 8.002006 5.51 5.21 7.96

Judiciary systemefficiency

1997 5.70 6.05 6.062000 3.71 5.17 7.422003 5.12 5.09 6.41

2004 5.12 5.09 6.412005 4.40 5.38 7.002006 5.45 6.07 6.87

Source: World Competitiveness Yearbook (19972006).



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absence of institutions needed for efficient functioning ofproduct, labor, and capital markets.

With explicit restrictions in the total capacity and size, andbecause of a lack of external institutions needed to supportentrepreneurial acts, the only way firms could grow was bydiversifying into areas wherever opportunities were avail-able. By arranging firms in the form of a business group,entrepreneurs could make use of internal markets for

capital, products, and labor. These things were not availableto stand alone firms due to the lack of quality institutionsthat could support efficient capital, product and labormarkets.

According to the institutional perspective, business groupaffiliation provides several benefits for emerging economyfirms. Business groups help firms circumvent the problemsthat arise due to inadequate institutional support as groupsfill the institutional voids (Chang & Choi, 1988; Khanna &Palepu, 1997, 2000a, 2000b). Group affiliation also providesan easier access to capital, raw materials, and markets forend products of at least some member firms. The overall sizeof the group allows for economies of scope in terms ofumbrella branding of the affiliated companies, research anddevelopment in the case of related businesses, and develop-ing internal human resources that could be used across dif-ferent affiliated firms. Finally, in the case of countries such asChina and India, groups generally enjoy a good reputation,and are able to derive benefits through their connectionswith the government, which are not easily available to standalone firms. Because of these benefits, groups often indulgein a high level of unrelated diversification, and control theaffiliated firms through a complex, often family or statedominated, ownership structure.

The complexity of the ownership arrangement in a busi-ness group poses unique governance challenges, and conse-quently costs of being affiliated to a business group (Gaur &

Kumar, 2009). For example, group affiliated firms experi-ence principal-principal agency problems that arise due toconflict of interest between the controlling family sharehold-ers and minority shareholders. Such conflict may result inmisallocation of resources across the group. The misalloca-tion of resources could also be to maintain internal equityacross the affiliated firms. Groups may also indulge in tun-neling resources from one firm to the other (Bertrand,Mehta, & Mullainathan, 2002; La Porta et al., 1999). Tunnel-ing can take many forms such as intra-firm transactions atnon-market rates, leasing of assets, and providing loans atnon-market rates. In the extreme case, the group owner maydecide to systematically transfer the assets of one of thefirms, which may not fit into the future scheme of things forthe group, to other group affiliated firms, and declare thefirm as bankrupt in due course, or sell it off to potentialbuyers. At the same time, a group may have to absorb thelosses of non-performing firms of the group. While suchsubsidization helps the unprofitable ventures in sustainingtheir operations, it negatively affects the performance of theprofitable ones.

The analysis of sources of benefits and costs of groupaffiliation suggests that benefits primarily arise due to thecontext specific properties, and largely depend on the extentof inefficiencies in the external governance environment. Asthe context changes and institutions develop to support

market-based exchanges, the benefits are likely to decreasIn recent years, there has been a substantial improvement the governance standards, and labor, capital, and produmarkets in India and China (Gaur, 2007), which has resultein partial filling of the institutional voids, and thereby reduing the potential benefits of group affiliation.

For example, in India, bank deposit rates fell from a higof 13 per cent in 1991 to 5.25 per cent in 2004, while th

lending rates fell from a high of 19 per cent in 1991 to 10.2per cent in 2004. Foreign investment inflows during thsame period increased from a miniscule base of US $13million in 1992 to US $16,050 million in 2004. The transactiocosts for transactions in Indian stock exchanges reducefrom more than 4.75 per cent of the total transaction amounin 1994, to .60 per cent in 1999, which is close to the globbest of .45 per cent. There have been several such improvments with respect to the labor and product markets in Ind(see Gaur, 2007 for details). While, China has been somewhlagging behind India on the reform indices, it has also coma long way from a non-functional stock market in 1990 to thworlds fifth largest stock exchange (Shanghai StocExchange) with a US $3.2 trillion market capitalization 2007.

Clearly, the institutional voids hypothesis (Khanna Palepu, 2000a) would suggest that as the institutional voiddisappear, the benefits group affiliated firms derive frosuch voids would also disappear. Consistent with thseveral studies done in contexts with different levels of instutional development, and across different time periodhave shown that the benefits of group affiliation decrease athe institutions develop (Gaur & Delios, 2006; HoskissoJohnson, Tihanyi, & White, 2005).

Costs associated with group affiliation on the other hanarise due to the internal governance challenges and agencproblems associated with managing a business group (Gau

& Kumar, 2009). Several of these costs, such as those arisindue to the complexity in managing a diversified busineportfolio may actually magnify as the environment changeand the competition from independent, focused firms anforeign firms increases. Given the changes in the institutional environment in India and China, we expect that grouaffiliation will no longer be beneficial for firm performancin these economies. Accordingly, we hypothesize:

Hypothesis 1a (H1a). Affiliation to a business group will negatively associated with firm performance in China anIndia.

As discussed before, the institutional environment China and India has some subtle differences. For examplthere is more active, direct as well as indirect participatioby the government in the case of China compared to IndiTable 3 shows that China lags behind India on parametesuch as bureaucratic hindrances, anti-trust regulations, anthe efficiency of the judicial system. As the business envronment in India is more conducive for private sector activties than it is in China, group affiliated firms in India enjofewer benefits than their counterparts in China.

As we elaborated upon earlier, business groups in Chinstarted as a tool for government intervention to reform SOEand make them world class competitors (Keister, 2000). key ingredient of reforms in China has been corporatizatio



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rather than privatization of state-owned enterprises (SOEs)(Keister, 2000; Li & Wong, 2003). The objective was toprovide support to the SOEs so that they can stand on theirown and compete against foreign and other private players.Several scholars have argued that the Chinese governmentpolicies are targeted at not allowing the private sector to playa major role in the economy (Qian, 1996; Xu & Wang, 1999).At the same time, the Chinese government encouraged for-

mation of business groups for SOEs to fill the ownershipvoids created by the sudden withdrawal of direct supervi-sion and control by the government (Li, 1997). In this sense, business groups in China essentially act as the owners ofChinese SOEs, although the ultimate control resides with thegovernment. Chinese government has, from time to time,provided active support to business groups, and many ofthese organizations have indeed emerged as world classcompetitors.

The situation in India had been quite different, wheregovernments active participation in economic activitiesactually discouraged the formation of large organizations.The only way for Indian businesses to benefit from gov-ernment intervention was to somehow manipulate thegovernment intervention to their advantage. While suchinterventions benefited some firms, they were harmful forothers. In recent years, however, government interventionin economic activities is limited to providing support insti-tutions for market-based exchanges. As a consequence,groups role as filling institutional voids has drasticallyreduced (Kedia et al., 2007). Moreover, the opportunities to benefit from the governments intervention have beenreduced, and competition from independent and foreignfirms has increased significantly (Gaur, 2007). As a net effect,we expect that group affiliation will have a greater negativeimpact on the Indian firms than on the Chinese firms.

Hypothesis 1b (H1b). Affiliation to a business group will havea greater negative impact on the performance of the Indianfirms than that of the Chinese firms.

Firm Governance and Firm Performance

Ownership Concentration. Research on ownership con-centration and firm performance has a rich heritage (Morck,Shleifer, & Vishny, 1988; Shleifer & Vishny, 1997), with schol-ars investigating the effect of ownership concentration onperformance of firms from both developed as well as emerg-ing markets. Much of this literature has been developedbased on agency theory and the Anglo-American model ofCG (Varma, 1997). Even though increasing globalization isforcing the CG practices to converge towards the Anglo-American model, the unique conditions in emerging econo-mies demand investigations that take into account the effectof the local contingencies.

Based on the Anglo-American model of CG, scholars haveargued that a greater ownership in the hands of a fewowners helps in disciplining the erring managers, evenwhen there may not be enough legal protection (Shleifer &Vishny, 1997). A greater ownership provides the neededincentive to actively engage in monitoring the actions of themanagers, collect necessary information, and take actionswhen needed to protect self-interest. A greater ownership

also provides enough voting rights to oust the managemenor even to take an outright control of the firm (Shleifer Vishny, 1986). In a survey of corporate governance practicearound the world, Shleifer and Vishny (1997) found thownership concentration benefited firms in several ways countries such as Germany, Japan, and the US. Howevethey also found that ownership concentration does nautomatically provide controlling rights to owners and ma

agers in countries such as Russia, and the effectivness concentration as a governance mechanism depends on thextent of legal protection for the voting rights of thshareholders.

In the case of emerging economies such as India anChina, a higher ownership concentration may substitute fothe absence of strong external governance (Dharwadkar al., 2000). In the case of India, dominant owners often alswork as managers, eliminating the principal-agencproblem altogether (Carney, 2005; Schulze, Lubatkin, Din& Buchholtz, 2001). In the case of China, the state ofteworks as dominant owner. Liu and Sun (2005) examined thownership structure of the Chinese listed firms and founthat 84 per cent of the firms had the state as the ultimaowner. A high ownership concentration in such cases mabe beneficial due to several reasons. First, a high ownershconcentration minimizes the traditional agency problemrelated to managerial entrenchment (Walsh & Seward, 1990Second, a high ownership concentration helps in more efficient and faster decision making, which is very important remain competitive in the fast changing environment emerging economies (Carney, 2005). Finally, high ownershconcentration means that owners will be actively involvedmaking sure that their investments are successful (Gau2007). In the case of emerging economies, such as China anIndia, owners often bring a lot of political and social capitaSuch political and social capital helps emerging mark

firms secure easier access to raw materials and financing, awell as government contracts.

While providing several benefits, a high ownership concentration, especially in the hands of a family or state alscauses a few problems. Owners with a high ownership concentration may exploit the minority shareholders, anpursue actions that are not always in the best interest of thfirm (Bertrand et al., 2002). A dominant owner may alsexploit the minority owners using pyramidal ownershstructures or complex interlocking ownership arrangemen(Almedia & Wolfenzon, 2006). In the case of state ownefirms, a high ownership concentration increases the istances of perquisite consumption by the salaried managerPerquisite consumption relates to employees attempts tenhance their non-salary income and other on-job consumtions, such as wasteful expenditure on travel (Gedajlovic Shapiro, 1998). Dharwadkar et al. (2000) attribute theagency problems to weak external governance mechanismprevailing in emerging economies.

The above discussion suggests that a greater ownershiconcentration in the case of Indian and Chinese firms ha both positive and negative consequences. The positieffects arise as greater ownership concentration alleviatethe traditional agency problems such as expropriatiohazards (Schulze et al., 2001). The negative effects arise duto weak external governance environment (Dharwadk



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et al., 2000), and the associated principal-principal agencyproblems.

However, as discussed before, there have been substantialimprovements in the governance environment in both Chinaand India in recent years. For example, both India and Chinahave developed a corporate governance code for listed firms,in line with the Sarbanes-Oxley Act of the US. There havealso been efforts to protect the rights of the minority share-

holders. In the case of China, if the controlling shareholderowns more than a 30 per cent stake, the firm must adapt acumulative voting mechanism to give appropriate consider-ation to the voting rights of minority shareholders (Rajago-palan & Zhang, 2008). In addition, at least one-third of theshareholders must be independent and firms must fully dis-close the related party transactions. Similar to China, Indiancorporate governance code is also targeted at securing theminority rights and ensuring that the controlling stakehold-ers are not making undue advantage of their position forpersonal gains.

As a result of these corporate governance specific reforms,the negative effects of high ownership concentration arelikely to get reduced. Consequently, we expect the positiveeffects of ownership concentration to outweigh the negativeeffects. Accordingly, we hypothesize:

Hypothesis 2a (H2a). Ownership concentration will be posi-tively associated with firm performance in China and India.

Even with many similarities in the institutional environ-ment in India and China, we expect that the costs and ben-efits associated with a high ownership concentration willdiffer for Indian and Chinese firms. In the case of India,there has been a very active participation of retail and insti-tutional investors in recent years. This can be gauged by thefact that the Bombay Stock Index, which is the index of themain stock exchange in India, has increased more than 1,600

per cent from 1,000 in 1992 to close to 16,000 in 2007. This hasbeen accompanied by improvements in investor protectionand corporate governance laws, making it difficult for amajority owner to expropriate the firm value at the expenseof minority owners. The improvement in the external gov-ernance environment means that the negative effects of own-ership concentration are minimized, while the effectivenessof ownership concentration as a governance mechanismincreases.

As compared to India, the corporate governance laws andgovernance standards are not very strong in China in spite ofthe progress made in recent years (Rajagopalan & Zhang,2008). The stock market in China is relatively new, and firms

are still learning effective strategies for operating in a freemarket economy. With poorly functioning stock markets,ownership concentration as a governance mechanism is notas effective as it is in India. In fact, owners and/or managersin these firms are known to take actions that not only harmthemselves, but also others around them in their pursuit ofnon-rationale goals (Jensen, 1998). As a result, we expect thatownership concentration is likely to be more beneficial forthe Indian firms than for the Chinese firms.

Hypothesis 2b (H2b). Ownership concentration will have agreater positive impact on the performance of the Indian firmsthan that of the Chinese firms.

Board Independence. Board independence as a Cmechanism gained in prominence after the 2002 SarbaneOxley Act mandated the presence of independent directoon the boards of listed US companies. Following this othcountries also mandated the use of independent directors othe boards, to strengthen the monitoring role of the boardScholars arguing in favor of board independence rely on thagency theory view point, which suggests that boar

members, who are free from the influence of firm managment, may be better able to monitor the actions of the management (Cadbury, 1992). Scholars arguing against boarindependence rely on the stewardship theory, which sugests that having more insiders on the boards providesunified leadership and helps make more prudent decision(Davis, Schoorman, & Donaldson, 1997; Finkelstein DAveni, 1994).

The empirical evidence on the relationship between boarindependence and firm performance is mixed, with scholareporting a negative (Boyd, 1995), positive (Rechner Dalton, 1991), as well as no relationship (Daily & Dalto1997; Dalton, Daily, Johnson, & Ellstrand, 1999) between thtwo constructs. In a meta-analysis of 54 studies, Dalton et a(1999) found no systematic relationship between board composition and firm performance. We argue that wheth board independence is beneficial or not depends on tfunction a board serves in a given context. Boards have twprimary roles an oversight role and an advisory role. In thoversight role, board members are expected to mitigate thagency problems and protect the interests of the shareholders. In the advisory role, board members are expected tguide the firm in its vision and mission development as weas in strategy formulation.

Board independence is important if a boards primafunction is to oversee the firm management and alleviate thtraditional agency problems. However, an independe

board is likely to be less effective in an advisory role. Indpendent members are less aware of the internal functioninof the firm, its resources and capabilities, and the complexties associated with the functioning of the firm (Davis et a1997). A greater number of independent members alincrease the chances of a conflict within the board, and delathe decision making on key issues. As a result, independemembers, though good from the point of view of oversighmay not be good from the point of view of an advisory rol

We argue that in emerging economies such as India anChina, the advisory role is likely to be more important thathe oversight role due to several reasons. First, as arguebefore, the traditional agency problems related to the conflict between owners and managers are less of a concern emerging economies due to the unification of ownershiand control (Dharwadkar et al., 2000). As the potential oconflict between owners and managers reduces, so dothe importance of boards oversight role. Second, owneand/or managers in emerging economy firms often vieboard independence as a mere statutory requirement anattempt to fulfill it by appointing people who consider therole as ceremonial. The principle of board independence thus followed only in letters and not in spirit. This probleis accentuated because of weak external governance, whicallows firms to get away with loose adherence to rules anregulations about board independence. For exampl



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business group affiliated firms are known to employ peoplefrom other affiliated companies in their boards. Third, evenwhen the oversight role may be important, it is not easy foremerging economy firms to get the services of qualifiedindependent directors because of the limited availability ofsuch directors (Knowledge@Wharton, 2007).

At the same time the advisory role is quite important foremerging economy firms as the firm management often

lacks the requisite expertise needed for running the firm(Khanna & Palepu, 1999). With limited oversight needed,board members also consider advising as their main role. Asa net result, we expect that in general, it may be more ben-eficial for emerging economy firms to have less independentdirectors in the boards. Accordingly, we hypothesize:

Hypothesis 3a (H3a). Board independence will be negativelyassociated with firm performance in China and India.

We also expect country specific differences in differentroles of a board. In the case of India, the unification of own-ership and control is more common due to the prevalence offamily managed firms and privately owned business groups(Gaur, 2007). As a result, boards may have only a limitedoversight role, and the advisory role may be their mainfunction. With an advisory role taking precedence over anoversight role, independent boards are likely to be harmfulfor Indian firms. On the other hand, in the case of China, anoversight role becomes more important due to the activeparticipation of the state in business activities, and less trans-parent internal functioning of firms. The problem of perqui-site consumption is particularly important for state ownedfirms and business groups as employees often indulge incorruption. Furthermore, the complex ownership arrange-ments in Chinese firms (Delios, Wu, & Zhou, 2006) necessi-tate that the board keeps an eye on the functioning of themanagement. As a result, board independence may still have

some value in the case of Chinese firms. Accordingly, wehypothesize:

Hypothesis 3b (H3b). Board independence will have a greaternegative impact on the performance of the Indian firms thanthat of the Chinese firms.

The Contingent Value of Firm Governance

As elaborated before, we expected that affiliation with abusiness group will have a negative effect on firm perfor-mance. Further, we expected this negative effect to be stron-ger for the Indian firms than for the Chinese firms. In thissection we discuss how two aspects of firm governance ownership concentration and board independence affectthe group affiliation, firm performance relationship in Indiaand China. In doing so, we rely on an integration of agencytheory with an institutional perspective to suggest that thecosts and benefits of group affiliation are contingent on thetype of within-firm governance.

A higher ownership concentration minimizes the agencyproblems and enables the decision makers to make quickdecisions. Given that the negative effects of group affiliationprimarily arise due to the governance challenges, and thecomplexities of managing a disparate set of businesses, cohe-sive actions by the affiliated firms may be important to reach

a desired goal (Khanna & Palepu, 2000a). Such decisiomaking is easier if the ownership is in the hands of a fewwhose interests are aligned with the interests of the firmBusiness group affiliated firms in the case of India represensuch a case as the fortunes of owners or families are directlinked with the performance of the firm. Carney (2005) sugests that ownership concentration in family owned busness groups is a very effective governance mechanism fo

emerging economy firms.The scenario is different in the case of China as busine

groups in China are mostly state owned. A higher state owership in business groups is not likely to have the same effeas a higher family or individual ownership (as is found the case of Indian business groups). This is because unlikindividual owners, the state does not always pursue profimaximization strategies. The state has many other objetives, such as societal welfare, equitable developmensurvival etc., which may take precedence over promaximization (Menshikov, 1994). As a result a higher ownership concentration in the case of Chinese business groupmay not be able to mitigate the negative consequences group affiliation. Accordingly, we propose the followinthree-way interaction hypothesis:

Hypothesis 4a (H4a). The negative effect of group affiliation ofirm performance for the Indian firms will be reduced if therea greater ownership concentration.

Unlike ownership concentration, board independence, a governance mechanism has a negative effect on emergineconomy firms. In the case of Indian business groups, thnegative effect may get amplified due to three reasons. Firsfor an effective functioning of affiliated firms, an in-depunderstanding of group-wide resources and capabilities needed, which independent members may not posses

Second, affiliated firms need to be very cohesive with eacother, taking coordinated actions. Independent membemay hinder such functioning of affiliated firms as they manot be able to appreciate the value of coordinated action(Davis et al., 1997). Finally, the importance of an advisorrole over an oversight role requires that the board membedo not unnecessarily interfere with the functioning of thgroup, and the board acts to assist the firm managemenrather than contain it. More insiders in the board are likelybe helpful in this respect.

In contrast to firms affiliated with the Indian businegroups, board independence in the case of firms affiliatewith the Chinese business groups may be beneficial. Chinebusiness groups have evolved due to forced agglomeratioof businesses by the state. Even in the case of privately anforeign owned business groups, the group formation habeen due to active encouragement by the Chinese goverment. As a result, these affiliated firms in China do noalways have to take coordinated actions. In fact scholars havsuggested the group formation by private firms in Chinmay be only to conform to the mimetic pressures, than duto any economic rationale. As a consequence, the advisorrole is further reduced for firms affiliated with Chinese busness groups. At the same time, the oversight role is accentuated to make sure that the managers in the affiliated firms dnot indulge in self-serving actions. Accordingly, we propos



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Hypothesis 4b (H4b). The negative effect of group affiliation onfirm performance for the Indian firms will be increased if thereare more independent members in the board.

Being three-way interaction hypotheses, the previous twohypotheses include our arguments for China. We will elabo-rate on this when we discuss our results.

METHODS AND VARIABLES

Sample

We focused our study on China and India. We obtained a listof firms listed in the major stock exchanges in China andIndia from the 2008 edition of the OSIRIS database. TheOSIRIS database has a comprehensive coverage of morethan 55,000 firms in over 190 countries. It has a total of 1,701Chinese listed firms and 2,957 Indian listed firms. Weselected top 500 firms from both India and China, based onmarket capitalization at the end of 2007. We had to dropsome firms for which we could not gather information onkey independent variables. This resulted in a final sample

size of 813 firms, 400 of which were Indian, while 413 wereChinese.

Variables

Dependent Variable. We chose return on assets (ROA) asthe dependent variables. ROA is one of the accounting basedmeasures of performance, commonly used to measure firmperformance. We also used return on equity (ROE) andreturn on sales (ROS) as alternate performance indicators,but found the results to be qualitatively similar. We obtainedthe data on ROA, ROE, and ROS from the OSIRIS database.

Explanatory Variables. Business group affiliation, own-ership concentration, and board independence were the keyexplanatory variables. We measured group affiliation by anindicator variable, which took a value of one, if the firmbelonged to a business group, and zero otherwise. This isconsistent with the conceptualization of group affiliation inthe extant literature (Khanna & Rivkin, 2001). We obtainedinformation on the group affiliation variable from thePROWESS database, which has been used extensively inresearch (e.g., Chacar & Vissa, 2005; Khanna & Palepu,2000a). We measured ownership concentration by the per-centage of ownership held by the largest shareholder. Weobtained this information from the OSIRIS database for the

Chinese firms and from the PROWESS database for theIndian firms. The ownership concentration variable wasskewed, so we performed a logarithmic transformation onthis variable. We measured board independence by taking anatural logarithm of the number of independent directors inthe board. The OSIRIS database provides information on theboard of directors, along with details such as if they areindependent or not.

Control Variables. We controlled for firm age, firm size,level of diversification, board size, and country membership.While firm age and firm size are standard controls in any

study investigating the performance differential betweefirms, we included diversification as a control to accounfor the performance differential that can be attributed diversification.

We measured age as the number of years since foundtion to 2007. Firm size was the natural logarithm of thmarket capitalization at the end of 2007. We measured thlevel of diversification by the number of subsidiaries

which the focal firm has some ownership. A better wawould have been to find a Herfindhal like measure diversification, which we could not due to data limitationHowever, for a control variable, the number of affiliates isreasonable approximation. We measured board size btaking the natural logarithm of the total members in board. Finally, country membership was an indicator vaable, which took a value of one for Indian firms, and zerfor the Chinese firms.

Modeling Procedure

We performed hierarchical moderated regression analysis

investigate the performance consequences of group affilition and within firm governance variables. Since ouhypotheses require testing for two-way and three-way inteactions, we developed the models in a hierarchical manneintroducing one interaction at a time. Such modelling procedure minimizes the problem of multicollinearity arisindue to correlations between the main effect variables antheir interaction terms (Wooldridge, 1999). In the models which we tested for three-way interactions, we entered athe lower order interactions. We interpret the coefficient main effects from the models in which interaction terms anot introduced.

RESULTSTable 4 provides the descriptive statistics and correlationWith 49 per cent Indian firms, the sample is evenly distributed between Indian and Chinese firms. Sixty-six per ceof the firms in the sample are business group affiliateAverage age of the firms in the sample is 26 years. Thaverage ownership concentration is 50 per cent, with thlowest and highest values being 7 per cent and 98 per cenrespectively. The average size of the board is 8.37, with firmreporting as low as just two member boards and as high a25 member boards. Board independence does not seem to bvery common, with the average being only .31. Some firmdo not have any independent members in their boardwhile the maximum a firm has is seven. None of the corrlations are high enough to warrant any problem of multicolinearity due to the main effect variables. The highest valuof shared variance is only 42 per cent.

Table 5 presents the results of regression analysis wireturn on assets (ROA) as the dependent variable. Modelhas all the main effect variables along with the control varables. We introduced the interactions of group affiliatioownership concentration, and board independence with thcountry indicator variable in Models 2, 3, and 4. In Model we introduced these interactions together. Models 6 andhave the three-way interactions, along with all the possib



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lower order interactions. We conducted F-tests on the sig-nificance of the inclusion of each additional variable. Asshown in Table 5, change in R-squared is significant oninclusion of additional terms in Models 2, 5, and 6, confirm-ing that the significance of the additional interaction term isnot spurious.

H1a suggested that firms affiliated with business groupswill perform worse than the unaffiliated firms. The coeffi-cient of group affiliation variable is negative and significant(Model 1: b= -1.94, p < .01), giving support to H1a. H1bsuggested that the negative effect of group affiliation will bestronger for Indian firms that for Chinese firms. A signifi-cantly negative coefficient (Model 2: b= -2.94, p < .05) on the

interaction of group affiliation with the country indicatorvariables provides support for H1b. H2a suggested thatownership concentration will have a positive effect on firmperformance. The coefficient of ownership concentrationvariable is positive and significant (Model 1: b= 1.33,p < .10), giving support to H2a. H2b suggested that owner-ship concentration will have a greater positive impact forIndian firms than for Chinese firms. This hypothesis is notsupported as the coefficient on the interaction term in Model3 is insignificant. H3a suggested that board independencewill have a negative effect on firm performance. The coeffi-cient of the board independence variable is negative andsignificant (Model 1: b= -1.32, p < .05). H3a is supported.H3b suggested that board independence will have a greaternegative impact for Indian firms than for Chinese firms. Thishypothesis is marginally supported as the coefficient on theinteraction term in Model 4 is only marginally significant(Model 4: b= -1.78, p < .10, one tailed). When we introduceall the two-way interaction terms together in Model 5, thecoefficients and their significance remain qualitatively thesame.

Next, we look at the three way interaction hypotheses.H4a proposed a three-way interaction between country indi-cator variable, group affiliation, and ownership concentra-tion, suggesting that the negative effect of group affiliationfor Indian firms will be reduced if these firms have a higher

ownership concentration. The coefficient on the three-wainteraction term in Model 6 is positive and significa(Model 6: b= 6.68, p < .05). Similar to H4a, H4b suggestethat the negative effect of group affiliation for Indian firmwill be amplified if there are more independent members ithe board of these firms. This hypothesis is not supported the coefficient of the three-way interaction term in Model 7not significant.

Robustness Tests

We tested the sensitivity of our relationships to alternaoperationalizations of our key variables and on differesubsamples, and found qualitatively similar results. We usereturn on equity (ROE) and return on sales (ROS) as altenate performance measures. In addition, we measureboard independence by the ratio of independent to totdirectors. In all these cases, our estimation produced quatatively similar results.

Further, we created two subsamples one belonging manufacturing firms and the other belonging to servisector firms. While all the hypothesized main effects and thtwo-way interaction effects were similar in sign and signicance to the results obtained in the full sample, the three wainteraction effects were not significant in the service sectsubsample. This could be because of the small sample sizethe service sector sub-sample.

DISCUSSION AND CONCLUSION

We examined the performance consequences of businegroup affiliation and within firm governance in India anChina, which have a similar and yet distinct external govenance environment. We looked at two aspects of within firgovernance ownership concentration and board independence. We discussed the reform process and evolution of Cpractices in India and China in recent years. Building othis, we developed our hypotheses utilizing an integratioof agency theory with the institutional perspective.

TABLE 4Descriptive Statistics and Correlations

Variables Mean S.D. 1 2 3 4 5 6 7 8

1. Return on Assets 6.64 8.61 2. Age 26.03 24.57 .18

3. Sizea

1.06 .40-

.02-

.26 4. Diversification 7.77 13.63 -.17 -.33 .48 5. Board size 8.37 4.66 .21 .42 -.23 -.42 6. Board Independence .31 1.08 -.01 .10 .00 -.12 .47 7. Ownership

Concentration48.58 18.04 .11 .06 .04 -.22 .09 .03

8. Group Affiliation .66 .47 -.17 -.09 .14 .23 -.14 .01 -.04 9. Country (1 = India) .49 .50 .31 .58 -.50 -.65 .65 .16 .12 -.23

aMillion US$.N = 813; Correlation >.10 and

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TABLE5

RegressionAnalys

is(DependentVariable:ReturnonAssets)

Variables

Model1

Model2

Model3

Model4

Model5

Model6

Model7

Beta

S.E.

Beta

S.E.

Beta

S.E.

Beta

S.E.

Beta

S.E.

Beta

S.E.

Beta

S.E.

Age

.00

.01

.00

.01

.00

.01

.00

.01

.00

.01

.01

.01

.00

.01

Sizea

1.0

9***

.25

1.1

0***

.25

1.0

9***

.25

1.1

2***

.25

1.1

3***

.25

1.2

0***

.26

1.1

3***

.26

Diversificationa

.26

.32

.32

.32

.26

.32

.29

.32

.35

.32

.33

.32

.33

.32

BoardSizea

.66

.85

.67

.85

.65

.85

-.1

3

1.0

2

-.1

3

1.0

2

.03

1

.02

-.1

1

1.0

2

India

6.4

6***

1.0

5

8.5

0***

1.3

6

8.1

5

6.0

6

7.4

6***

1.2

6

12.0

3*

6.2

1

26.1

4**

9

.95

11.1

9

6.4

6

GroupAffiliation(GA)

-

1.9

4**

.62

-.2

8

.94

-1.9

7**

.62

-1.9

4**

.62

-.3

3

.94

6.1

3

7

.93

-3.5

2

6.2

1

OwnershipConc.(OC)a

1.3

3

.73

1.2

1

.74

1.4

7

.89

1.1

9

.70

1.1

9

.90

2.5

2

1

.90

.53

1.6

0

BoardIndependence(BI)a

-

1.3

2*

.58

-1.3

0*

.58

-1.3

4*

.58

.04

1.1

2

.01

1.1

2

-.0

9

1

.43

-.2

6

1.9

7

GA

India

-2.9

4*

1.2

5

-2.9

3*

1.2

5

-28.6

5*

12

.9

-2.8

1**

1.4

1

OC

India

-.4

4

1.5

5

-.6

6

1.5

5

-4.3

7

2

.58

-.4

7

1.6

4

BI

India

-1.7

8

1.2

5

-1.7

4

1.2

5

-1.4

9

1

.28

-1.0

6

2.2

0

GA

OC

-1.7

3

2

.12

.84

1.6

6

GA

BI

-.0

7

1

.11

.34

2.0

5

GA

India

OC

6.6

8**

3

.36

GA

India

BI

-1.0

0

2.4

5

RSquared

.141

.146

.141

.143

.149

.153

.149

ChangeinRSquared

.006**

.000

.002

.008***

.004**

.000

aLogarithmictransformationperformed.

p

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