How do market forces affect executive compensation in Chinese state-owned enterprises?

•This paper studies how market forces affect pay-performance sensitivity.•We find that compensation increases gradually with the market forces in China's SOEs.•Pay-performance sensitivity is enhanced by market-oriented reforms.•But the external political forces hamper the effect of market forces on compensation.

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.