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This paper studies how the evolution of market forces affects executive compensation in China's listed state-owned enterprises (SOEs) from 2000–2007. Along with the progress of market reforms we find that the level of executive compensation increases gradually and the relation between compensation and performance becomes more sensitive. However, the effect of market forces on executive compensation in SOEs is limited by CEOs' political connections. Our findings suggest that introducing exogenous market forces alone may not be sufficient to ensure the effectiveness of governance structure in a transition economy.

Recent studies focus on the evolution of corporate governance in emerging markets and how multiple forces affect the corporate governance structure (Claessens and Fan, 2002, Djankov and Murrell, 2002 and Kole and Lehn, 1999). The extant literature implies that market forces resulting from regulatory change might be pivotal exogenous factors promoting spontaneous and vigorous modification to the governance structure in developed markets.1 However, the evidence is mixed as to the extent to which market forces can reshape corporate governance in emerging economies under transitional reforms. Some studies, though quite limited, document that market-oriented forces do indeed improve corporate governance in emerging economies (see, e.g., Groves et al., 1995, Mar and Young, 2001 and Pinto et al., 1993). Other evidence casts doubts on the effectiveness of market forces in emerging economies in which state ownership still dominates the market, the capital market is undeveloped, and investor protection is poor (see, e.g., Gu et al., 2010, Kato and Long, 2006, Kornai and Weibull, 1983 and Shleifer and Vishny, 1994). As prior studies only focus on the endogenous determinants of corporate governance such as ownership structure, board characteristics, and managerial power after the adoption of market policies (Bebchuk and Fried, 2003, Firth et al., 2006, Kato and Long, 2006, Mehran, 1995, Riahi-Belkaoui, 1992, Sun et al., 2002 and Wang and Stammerjohan, 2007), some controversy remains. Our study attempts to provide evidence by examining the exogenous impact of market forces on the evolution of executive compensation in China's state-owned enterprises (SOEs) under progressive market reforms. We focus on executive compensation in China's SOEs for the following reasons. First, executive incentives are an important market-based governance mechanism to alleviate agency costs (Bebchuk and Fried, 2003 and Jensen and Murphy, 1990). In particular, monetary rewards play an increasingly prominent role as explicit incentives in Chinese firms since the implementation of market-wide reforms (Kato and Long, 2006 and Shirley and Xu, 2001). By examining the evolution of executive compensation in the progress of market development, we can measure the impact of market forces on the corporate governance structure. Second, China's market-oriented reforms provide a natural setting to observe the dynamic in governance structure when subject to multiple external forces. Although market-oriented reforms have been in motion for some time, China's economy is still dominated by state ownership and is under intense government intervention. Thus, China's setting allows us to observe the effect of non-market forces intertwining with market forces in the adoption of corporate governance during the transition period. Using data on listed SOEs in China from 2000 to 2007, we investigate the effects of market forces on the level of executive compensation and the pay-performance sensitivity. In terms of a market index developed by Fan and Wang (2009) to measure market forces introduced by the progress of market reforms, we find that the progress of market reforms is positively associated with the level of executive compensation. We also find that executive compensation is more sensitive to market-based performance in regions with stronger market forces. We further examine whether non-market forces such as government intervention and political connections hamper the effects of market forces on executive compensation. We only observe the effects of market forces on pay-performance sensitivity in the subgroup of CEOs without political connections. Thus, our findings support that market forces indeed play a positive role in shaping corporate governance, but its role is constrained by the continued presence of government forces in the business. To ensure the validity of our results, we use the first difference model to control for unobserved firm heterogeneity. We also conduct several robustness tests: (1) we use two different proxies for market forces (foreign direct investment and foreign imports and exports); (2) we use alternative performance measures; and (3) we conduct the tests on a cleaner sample. We find that the main findings remain. This paper contributes to the corporate governance literature in several ways. First, prior studies provide limited knowledge on the dynamic evolution of corporate governance, especially in the context of a transition economy with multiple exogenous factors (Claessens and Fan, 2002, Djankov and Murrell, 2002 and Kole and Lehn, 1999). One of the possible reasons is that it is difficult to identify and proxy various forces. Prior studies investigate executive compensation under a specific policy background and examine changes in the incentive mechanism after the government has deregulated a specific sector (Bryan et al., 2005, Crawford et al., 1995, Hubbard and Palia, 1995 and Kole and Lehn, 1999). Our study investigates this question in the context of the progress of market-oriented reforms in China and the disparity of market forces across different regions of China. Second, we contribute to the executive compensation literature on the role of performance measures in an emerging market (e.g., Conyon and He, 2011, Firth et al., 2006, Kato and Long, 2006 and Xiao and Wang, 2011). A large number of studies examine performance measures such as accounting-based performance and market-based performance in incentive contracts in terms of earnings properties as well as manager incentives and behavior ( Bushman and Smith, 2001, Camara, 2001, Murphy, 1999, Natarajan, 1996 and Zhang et al., 2005). We extend previous research by finding that the significance of the performance measures may be determined by the stage of market development. It also provides empirical evidence on tournament theory which argues that it rises the level of executive compensation since it serves as a sufficiently large prize for promotion tournament. Our findings have policy implications for improving corporate governance in China's emerging markets. While policy makers attempt to introduce market forces into SOEs by adopting policies such as performance contracts or overseas listings (e.g., Shirley & Xu, 1998), the effect of those policies might be mitigated by factors such as state ownership, access to politically-connected resources, and bureaucratic hierarchy. Hence, introducing an exogenous market force alone is insufficient to create a circumstance that fosters efficient corporate governance. The remainder of this paper is organized as follows. In the next section, we develop the hypotheses. Section 3 presents the research design. The results are presented and discussed in Section 4. We conduct several robustness tests in Section 5 and conclude the paper in Section 6.

This paper provides evidence for understanding the evolution of the governance structure in an emerging economy by examining the effects of market forces on SOE executive compensation. Using a sample of China's listed SOEs from 2000 to 2007, we find that the market forces introduced by market-oriented reforms increase the average amount of SOE executive compensation, and, more importantly, the sensitivities of SOE executive compensation to firm performance. In addition, executive compensation contracts rely more on market-based performance than accounting-based performance as market forces are introduced. Further, we examine the constraints on market forces in a transition environment. We find that CEO's political connections and the governmental hierarchy of the ultimate controller may limit the function of market forces. This is consistent with the expectation that SOEs are subject to multiple forces amid China's economic reforms. In other words, market-oriented reforms have no substantial influence on pay-performance sensitivities under the intervention of non-market forces. The results have both theoretical and policy implications during the economic transition. Based on the results of our study, we provide new evidence to show that market forces enable the adoption of corporate governance and choices of performance measures may be determined by market development. In addition, our findings suggest that it is insufficient to only introduce market forces by way of market reforms to cultivate an efficient corporate governance structure.