Comparative statics analysis

In this section, we examine the effectiveness of corporate governance through comparative statics analysis. Because expropriation ultimately reflects on stock return, the effectiveness of corporate governance on deterring expropriation can be detected by analyzing the influence of corporate governance on stock return. Since the investment return π represents the extent of external shock (Liu et al., 2009), we further investigate the moderating role of heterogeneous adverse shock. The impact of the controlling shareholder’s cash flow rights is also discussed.

To analyze the influence of corporate governance on stock return, we take the first order derivative of stock returnrwith respect to the control-ownership disparityλand corporate governance

κ

* ₍ 1) , init init r π δ π ρπ κρ λ ω λ ω   ∂ _{= ⋅ −}∂ ₌ −   ∂ _ ∂ _ (8) * _{( 1)} . init init r π δ π ρπ λρ κ ω κ ω   ∂ ∂ − = ⋅ −_{ }= ∂ _ ∂ _ (9)

The direction of the above derivative equations is ultimately determined by the derivative of expropriation (i.e., _∂δ*_{/∂λand∂δ}*_{/∂κ). When better corporate governance mechanism}

_κ

deters expropriation (i.e.,_∂δ*_{/∂ >κ 0), it increases stock return (i.e.,∂ ∂ <r/ κ 0). Similarly,}

when the control-ownership disparity λ stimulates expropriation (i.e., _∂δ*_{/∂ >λ 0 ), it}

decreases stock return (i.e.,∂ ∂ <r/ λ 0). Therefore, we can investigate the effectiveness of corporate governance based on stock return.

The direction of equation (8) and (9) is determined byρπ −1. Considering the

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and (9) are negative. It implies that the control-ownership disparityλis negatively associated with stock return during the adverse shock. In contrast, shareholder protecting corporate governance mechanism

κ

However, the above predictions do not necessarily hold during boom or normal state. When the economic situation is good, the investment returnπtends to be high, and the condition π <1/ρdoes not necessarily hold. In this situation, the controlling shareholder has less expropriation incentive, and it would choose to leave the resource inside the company to increase its equity value. Therefore, the control-ownership disparity and corporate governance are not expected to show significant influence on stock return during boom or normal state.

The recent global financial crisis caused severe adverse shock to Chinese economy. Summarizing the above discussions, we propose the following testable hypothesis:

H1. During the global financial crisis, the control-ownership disparity is negatively

associated with stock return, and the shareholder protecting corporate governance is positively associated with stock return. However, the above relation does not hold before or after the crisis.

As discussed above, the adverse shock plays a key role in stimulating expropriation and initiating the effectiveness of corporate governance. During an adverse macro shock, different firms could be exposed to different level of shock. In the following section, we further investigate how the effectiveness of corporate governance is moderated by the heterogeneous external shock. Since the investment returnπ reflects the extent of external shock, we investigate the moderating role of heterogeneous adverse shock by taking the second order

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partial derivative of equation (8) and (9) with respect to the investment returnπ, that is

2 ₁ * 2 * , init init r δ π δ λ π ω λ ω λ π ∂ _{= − ⋅}∂ _{− ⋅} ∂ ∂ ∂ ∂ ∂ ∂ (10) 2 ₁ * 2 * . init init r δ π δ κ π ω κ ω κ π ∂ ∂ ∂ = − ⋅ − ⋅ ∂ ∂ ∂ ∂ ∂ (11)

The above derivative equations can be described as the function of the controlling shareholder’s expropriation_δ*_{. Specially, equation (10) consists of two components: the first}

order derivative 1 ₍ *_{/ )}

init

ω− δ λ

− ⋅ ∂ ∂ and the second order derivative _{( / ) (} 2 *_{/ )}

init

π ω δ λ π

− ⋅ ∂ ∂ ∂ .

Since_∂δ*_{/∂ >λ 0, the first order derivative factor} 1 ₍ *_{/ )}

init

ω− δ λ

− ⋅ ∂ ∂ is negative. The second order derivative factor _{( / ) (} 2 *_{/ )}

init

π ω δ λ π

− ⋅ ∂ ∂ ∂ can be written as_{( / )} 2

init

π ω ⋅κρ , which is positive. Thus, the direction of equation (10) is determined by the relative magnitude of the first order derivative factor and the second order derivative factor. Similarly, the direction of equation (11) is also determined by the first order derivative factor and second order derivative factor of expropriation_δ*_.

The controlling shareholder’s cash flow rightsρ have significant influence on the direction of equation (10) and (11). When a controlling shareholder has higher cash flow rights, its end-of-period equity value_ρπω*_{is more sensitive to the external shock. Therefore,}

it has a higher incentive to expropriate resource from the company. Accordingly, the second order derivatives of expropriation, _∂2 *_{δ /∂ ∂λ πand∂}2 *_{δ /∂ ∂κ π , take lower values, and the}

equation (10) and (11) are more likely to be positive.37

The positive equation (10) and (11) imply that, the effectiveness of corporate

37 _{The second order derivative} 2 * /

δ λ π

∂ ∂ ∂ can be derived as_−κρ2_{, which is monotonically decreasing with respect to the}

controlling shareholder’s cash flow rightsρ. With the cash flow rightsρincreasing, the value of 2 * /

δ λ π

∂ ∂ ∂ decreases, and the second order derivative factor _{( / ) (} 2 *_{/ )}

init

π ω δ λ π

− ⋅ ∂ ∂ ∂ increases. Accordingly, equation (10) is more likely to be positive. Similarly, equation (11) is also more likely to be positive when the cash flow rightsρ_increase.

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governance enhances with the severity of adverse shock. When a firm is exposed to severer adverse shock, its controlling shareholder has a higher incentive to expropriate resource, and the shareholder protecting corporate governance mechanism is more likely to play a role in deterring expropriation. Since expropriation ultimately reflects on stock return, with a firm being exposed to severer adverse shock, the control-ownership disparity is more likely to be negatively associated with stock return, and corporate governance is more effective in improving firm performance.

To more clearly demonstrate the role of cash flow rights, we further derive equation (10) and (11) as follows: 2 ₍₂ 1) , init r ρπ κρ λ π ω ∂ ₌ − ∂ ∂ (12) 2 _{(2 1)} . init r ρπ λρ κ π ω ∂ ₌ − ∂ ∂ (13)

Suppose a controlling shareholder’s cash flow rightsρare greater than or equal to 50%, we have2ρ ≥1_{(or1/ 2}ρ ≤₁). Given that the investment project is profitable (i.e.,π >1), we can obtainπ > ≥1 1/ 2ρ, and hence2ρπ − >1 0and the equation (12) and (13) are positive. It is worth to note that, although in the above analyses we set the cash flow rights of 50% as the threshold, the exact threshold point could vary with model settings. In general, with the controlling shareholder having higher cash flow rights, the adverse shock is more likely to stimulate the effectiveness of corporate governance. Accordingly, the impact of heterogeneous adverse shock on the effectiveness of corporate governance is more pronounced.

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exposed to the credit crunch shock. Summarizing the above discussions, we propose the following hypothesis:

H2. With a firm being exposed to severer credit crunch shock, the control-ownership

disparity is more negatively associated with stock return, and the shareholder protecting corporate governance is more effective in improving stock return. Furthermore, the above relation is more pronounced when a controlling shareholder has higher cash flow rights.

3.3Sample and research design