The G-factor: What Drives CEO Pay in China?

Research reveals that geography impacts executive pay for listed firms in China, and that nonlocal CEOs tend to extract pay premium.

Photo by Alexander Mils on Unsplash

CEOs are often hailed as the driving force behind a business. Companies tend to offer attractive compensation packages to attract top CEO talent from around the world for the belief that the unique skillsets and personal attributes of individual CEOs can bring profits and value to a company. While the mass public casts relentless focus on how much CEOs are paid, less attention has been given to the real question — how they are paid. Is executive pay tied to corporate performance, firm valuation, or long-term investment in communities or innovations achieved under a CEO’s leadership?

This performance-driven compensation seems to be a rational arrangement for CEOs, regardless of their origin. Indeed, previous studies proved so in the US. Yet, such topics remain largely unexplored in China whose economy is gaining momentum on a global centre stage. A new research study by Prof. Zili Zhuang, Associate Professor of School of Accountancy at The Chinese University of Hong Kong (CUHK) Business School sheds light on whether geographic factors of CEOs affect their compensation in the context of China.

His working paper entitled “Visiting monks: Are nonlocal CEOs paid more?” aims to investigate whether nonlocal CEOs of firms in China are paid more than their local peers, and whether their pay premiums are commensurate with their ability. The study was carried out in collaboration with Prof. Lian Guo, Prof. Diefeng Peng, Prof. Yulei Rao from School of Business at Central South University.

“China features weak institutions and investor protection with its collectivist values, rich geographic variations and various hometown effects that make it a perfect place for this study.” says Prof Zhuang.

The Locality of CEOs Matters

The study incorporates data on thousands of firms and CEOs in China spanning 10 years. The base sample consists of information on CEO-related information, such as CEO age, tenure, and overseas experience, as well as firm characteristics and financial data for 7,613 CEOs in 21,821 firms listed on the Shanghai Stock Exchange and the Shenzhen Stock Exchange from 2005 to 2016. Researchers pored through these to first examine whether geography matters in CEO compensation. The study finds that nonlocal CEOs, meaning those who were born in a different province than the firm’s headquarter, receive cash compensation that is roughly 7.9% higher than that of their local peers in China. It suggests that geography plays a role in CEO compensation and nonlocal CEOs are likely to demand a pay premium as compensation for being away from their hometowns and possess higher managerial skills as they were drawn from a larger national pool.

Estimating CEO Pay for Performance

To fully understand whether this nonlocal CEO has superior ability than local candidates, the researchers also examined the effect of CEO locality on firms’ operating performance and values, which are measured by industry-adjusted return on assets and Tobin’s Q respectively.

Our analysis leads us to conclusions that are at odds with the prevailing wisdom on CEO compensation. It finds that firms run by nonlocal CEOs have worse operating performance and lower firm value than those run by local CEOs.

If the higher compensation of nonlocal CEO is an efficient outcome of the rational market mechanism, that means the executive pay premium is commensurate with ability, and for superior talent and that could be reflected in the performance or firm value. In contrast, it is likely that rent extraction drives nonlocal CEO pay premium, meaning the CEO has substantial influence over the compensation.

“Because nonlocal CEOs have less emotional hurdles as they don’t possess hometown identity or place attachment to where firm is located, they are more likely to engage in rent extraction. Besides, the belief that nonlocals possess superior traits and the lacking information about nonlocal CEI’s ability that gives nonlocal CEOs convenient pretext for higher pay,” he says.

Pay Premium is Real

Researchers take approaches to mitigate the concerns brought by factors that could have biased the result and testified nonlocal CEOs pay premiums are particularly prominent in firms with lower institutional ownership, in state-owned enterprises (SOEs), and in provinces that lacks the supply of local CEO talent.

Over half of sample companies hire nonlocal CEOs, meaning the proportion is high in China, in either the least developed regions like Tibet, or the most developed regions such as Beijing that attracts top talent from around the world. The nonlocal CEO pay premium varies with regional marketisation levels that implies CEO rent extraction is widespread in China.

In addition, the negative effects of nonlocal CEOs on operating performances and firm value do not exhibit cross-sectional variations with respect to institutional ownership, SOEs, local CEO talent supply, and regional marketization. Firms with nonlocal CEOs have lower pay-performance sensitivity and higher managerial perks. All these serve as corroborating evidence on rent extraction view of nonlocal CEO pay premium in China. In other words, the compensation of top executives in China is not independent of performance but other factors such as geography.

Implications to Business

Compensation policy is one of the most important factors in a company’s success. Not only does it shape how top executives behave but it also helps determine what kinds of executives one attracts.

While there had been studies suggesting on geography as a nonmonetary factor in CEO compensation in the US, this study sheds new light on the importance of institutions in understanding the role of geography in the context of China.

“Whether geography is the efficient contracting factor shaped by market forces or grounds for rent extraction depends on institutional environments.,’ said Prof. Zhuang. Companies should consider the potential risks and benefits of hiring nonlocal CEOs.

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