False options

tauringhuang.

Sep 4th 2008 | HONG KONG
From The Economist print edition

A study of share options reveals a vast amount of untouched wealth


HOW executives are rewarded is one of the many mysteries of China’s increasingly powerful companies. Unravelling it is important, not least because it should help to explain corporate China’s transformation from a state-controlled to a consumer-driven creature.

Research on this question has been surprisingly sparse. A new study by Zhihong Chen and Yuyan Guan, of the City University of Hong Kong, and Bin Ke, of Pennsylvania State University, casts a rare beam of light. However, its main achievement is to reveal how little is understood about the incentive structure of Chinese business.

The authors examine “red chips”—companies operating in China but incorporated abroad and listed in Hong Kong. For many years this was the main way in which big Chinese companies interacted with the capital markets. The 83 mostly state-controlled companies covered by the study’s final year of data, 2005, account for more than half of the stockmarket value of all Chinese firms and more than one-third of the capitalisation of the Hong Kong Stock Exchange.

Senior executives’ cash pay was low by global standards: $180,000 a year on average. Almost every firm awarded stock options, worth an average of $140,000, giving bosses healthy top-ups as well as equity stakes—if those options were exercised. Remarkably, a lot never were. At more than half of the firms, no options were exercised within four years of vesting.

Share options are intended to address one of the great schisms in the structure of publicly owned companies: the divergent interests of managers and owners. In developed markets, especially America, share options have been used a lot—but it is not at all clear that they have worked as intended. Clever consultants, whose immediate incentive is to please managers rather than shareholders, have devised ingenious compensation schemes allowing bosses to reap handsome rewards even if they foul things up. Among the deposed chief executives of both Wall Street and Main Street there are plenty of examples.

In America researchers have been looking into why these schemes were so skewed. They have been aided by a wealth of data and a fair understanding of the underlying incentives. The merits of stock options elsewhere have received little attention. In China they would seem to be a good way of fostering the profit incentive, and there is evidence that they have been used since 1990. But the study questions the point of this. “If executives in general do not exercise stock options, how can the option scheme align executives with the interest in shareholders?” asks Mr Chen. “What forces make them throw away money on the table?”

There are many possible reasons. Cultural pressure may explain why bosses do not want visible income. Companies may meet the cost of cars, housing and school fees in other ways. And state-controlled companies’ bosses may be compensated in a different fashion. Executives’ tenure at red-chip companies is brief: only three years, against five at big Western firms. Managers who do a good job are often “promoted” from one company to another by the largest shareholder—the state. Their rewards are more opaque than salary and options, and could even be imperilled by overt signs of affluence. All Mr Chen and his colleagues can conclude is that there is ample room for further study.