Download Debt financing, soft budget constraints, and government

Economics of Transition
Volume 15(3) 2007, 461–481
Debt financing, soft budget
constraints, and government
ownership
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Evidence from China1
Lihui Tian* and Saul Estrin**
*Guanghua School of Management, Peking University, Beijing, China.
E-mail: [email protected]
**CEPR and London School of Economics, London, UK. E-mail: [email protected]
Abstract
Debt financing is expected to improve the quality of corporate governance, but we
find, using a large sample of public listed companies (PLCs) from China, that an
increase in bank loans increases the size of managerial perks and free cash flows
and decreases corporate efficiency. We find that bank lending facilitates managerial
exploitation of corporate wealth in government-controlled firms, but constrains
managerial agency costs in firms controlled by private owners. We argue that the
failure of corporate governance may derive from the shared government ownership
of lenders and borrowers, which nurtures soft budget constraints.
JEL classifications: G32, G34, P34.
Keywords: Bank lending, corporate governance, government ownership, soft
budget constraints.
1
Comments and suggestions of the editor, an anonymous referee, Simon Commander, Julian Franks, Colin
Mayer, Henri Servaes, Jan Svejnar and participants in seminars at INSEAD, Lancaster University, London
Business School, and University of Michigan are gratefully acknowledged, though any errors or omissions
remain the responsibility of the authors. We also thank Hui Gong, Yun Xia and Houqi Zhang for providing
us with the dataset. Financial support from the National Science Foundation of China (Grant Number
70373001) and the British Academy (visiting fellowship) is also acknowledged.
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development.
Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main St, Malden, MA 02148, USA
Tian and Estrin
462
1. Introduction
It is recognized that debt financing operates as a device to discipline corporate
managers in developed market economies. For example, Jensen and Meckling
(1976) and Dewatripont and Tirole (1994) argue that debt keeps a tight rein on
managerial agency costs. This is a view accepted by practitioners: for instance,
‘. . . leverage is a financial discipline’ (Jonathan Meggs of JP Morgan quoted in
Financial Times, 14 June 2001). These arguments may not generalize to different
institutional settings: for example, China, in which retained state share holdings in
privatized companies is extensive. In this paper, we examine empirically the role
of debt in corporate governance in China’s public listed companies (PLCs).
In the Western literature, the governance role of debt comes from the threat of
bankruptcy, the reduction of free cash flows, and due diligence monitoring by
creditors. A high financial leverage is associated with a greater probability of financial
distress that causes managerial replacements. Aghion and Bolton (1992) model the
shift of control to debt holders when profits are low. Gilson (1990) argues that when
firms are in financial distress, creditors take over the dominant role in disciplining
the managers, replacing incumbent managers that were assigned by the shareholders.2
Debt can also have an incentive effect on shareholders’ monitoring efforts because
the shift of control to creditors drives out the private benefits of the controlling
shareholder. Based on a sample of British firms, Franks Mayer and Renneboog
(2002) find that the turnover frequency of board-members is higher with a higher
financial leverage.3
Grossman and Hart (1982) and Jensen (1986) argue that debt carves out free
cash flows and reduces managerial agency costs. Under the separation of ownership
and control, the managers are reluctant to distribute cash flows to shareholders and
are prone to over-investment. Over-expansion of corporate operations (‘empirebuilding’) suits the interests of managers at the cost of shareholders. With the legal
requirement to repay interest and loans, debt can force out cash flows. Moreover,
debt holders can impose rules and restrictions on management through loan indenture.
McConnell and Servaes (1995) find that leverage is positively correlated with firm
value when growth opportunities are scarce.
Furthermore, the theory of financial intermediation argues that banks have
incentives to collect information and monitor firms to ensure the returns to the
depositors (see, for example, Diamond, 1984). Information asymmetry between
2
Managers are punished for exploitation of corporate wealth through a reputation effect in the managerial
labour market.
3
Harris and Raviv (1988) and Stulz (1988) argue that voting rights of outsiders are reduced, and of insiders
increased, with an increase in leverage. Friend and Lang (1988) and Berger, Ofek and Yermack (1997)
provide empirical evidence that financial leverage is negatively correlated to managerial entrenchment in
developed economies. However, the average voting rights of the management teams in China’s PLCs were
as small as 0.005 percent of the total shares so the Stulz leverage impact will probably not be influential.
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Debt Financing and Government Ownership in China
463
corporate managers and investors can be reduced by the specialized knowledge of
bankers. Since bank loans are usually quite short term, during their renewal bankers
can investigate corporate quality and evaluate investment risk (see, for example,
Shleifer and Vishny, 1997). If managerial agency costs are excessive or credit risks
are high, banks tend to reject renewal and this signals the quality of management
and may trigger a disciplinary action from equity holders (see, for example, Harris
and Raviv, 1990).
China is transforming into a market economy and corporate governance is
taken as a paramount issue (see, for example, Bai et al., 2004). Since 1994, Chinese
PLCs have been modelled on an Anglo-American governance structure though
government ownership is still prevalent in both PLCs and banks (see, for example,
Tian and Estrin, 2006). According to China’s Securities Regulatory Commission, the
government owns on average more than one third of all PLC shares. Indeed, the
government has a majority holding in around one quarter of Chinese PLCs, and
a large stake (more than 30 percent) in around one half of firms. Moreover, bank
loans are a significant source of financing in Chinese PLCs, representing 22 percent
of total assets but the Chinese government is the owner of most commercial banks
and the government extensively intervened in banking operations, particularly
before 1999. In this paper, we test whether debt financing disciplines PLC managers
in China, in a situation where the government retains substantial shareholdings in
firms, and also in banks.
Using a panel dataset we have constructed, and showed that an increase in
financial leverage increases the size of managerial perquisites and free cash flows
in Chinese PLCs, but there is no significant relationship between debt levels and
board-member turnover. At first sight, our findings indicate that in China, debt
does not play a governance role; rather, debt financing facilitates managerial agency
costs. However, the story is more subtle. The facilitator role of debt on managerial
agency costs obtains in companies with a large government shareholder but not in
those with primarily private shareholders. This suggests that the failure of governance
functions of debt financing in Chinese PLCs may result from government ownership
being shared by creditors and debtors; loans from state owned banks expand the
resources under the control of the managers in majority state owned PLCs. Kornai
(1998) argues that soft budget constraints come with government ownership. By
linking the literature of corporate finance and transition economics, our study
contributes to understanding the governance impact of soft budget constraints.4
In the following section, we set the scene by illustrating the institutional backgrounds of China’s firms and banks. We describe our dataset and discuss the proxies
for agency costs and leverage in the third section, and report our empirical findings
in the fourth, before drawing conclusions in the fifth.
4
La Porta, Lopez-de-Silanes and Shleifer (2002) find government ownership of banks to be prevalent in
emerging markets while La Porta, Lopez-de-Silanes and Shleifer (1999) report that government ownership
of firms’ remains widespread, especially in developing economies.
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Tian and Estrin
464
2. China’s commercial banks and modern firms
Though the financial system remains bank-dominated, the Chinese stock market
has been growing very fast, providing a reasonable panel of data.5 Thus Chinese
PLCs, which represent a substantial share of the industrial economy, provide a good
laboratory in which to understand the influence of debt financing on managerial
behaviour.
2.1 Banking sector and bad loans
Enterprise debt is mainly financed by state-controlled banks. The government fully
owns the Industrial and Commercial Bank of China, Agricultural Bank of China,
China Construction Bank and Bank of China, each of which functioned as a department
of the Ministry of Finance during the planning era. According to the China Banking
Regulation Commission, these four banks still provide more than 80 percent of
all loans to Chinese firms. Most other banks are also under the control of the
government.
The 1995 Commercial Banking Law created commercial banks as independent
legal entities required to pursue profits. However, Lardy (1998) argues that the
legal reform in China has so far done little to improve the allocation and use of
bank capital. Given that the state was until very recently the sole owner, the four
largest banks usually followed the strategic direction of the government, and have
therefore been reluctant to allow the liquidation of the loss-making firms, because
of political concerns about unemployment. Consequently, the government as
owner may request that the banks refinance these loss makers and, for their own
career concerns, bankers may respond positively, even if they are also supposed to
generate profits.
Such conflicts of interest probably explain the accumulation of non-performing
loans (NPLs), estimated to be 25.4 percent of total loans by the former governor of
China’s central bank in 2001 (Dai, 2002). In 2006, Ernst & Young estimated NPLs
as over 900 billion US dollars, more than in any other country, although the current
official statistics show NPL as 133 billion.6 As NPLs are larger than net assets, some
banks are technically insolvent. These bad loans are not a legacy of the planned
economy, but have been accumulated during the reform period.
2.2 China’s stock market and public listed firms
The Chinese stock market has been growing very rapidly. Between 1992 and 2003
market capitalization increased at an average rate of 63.3 percent per year. At the
5
6
Total loans reached US$1.1 trillion and the ratio of loans to GDP exceeds 100 percent (Merrill Lynch, 2000).
This report was withdrawn after criticism from the Chinese government.
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Debt Financing and Government Ownership in China
465
end of 2003, the total market capitalization was 36.4 percent of China’s GDP. The
number of listed companies grew 43.4 percent annually, from 53 PLCs in 1992 to
851 PLCs in 1998 and to 1,287 PLCs in 2003. On the equity side, authority is based
on the rule of one share, one vote, so control rights depend on the shareholding size
and government retained ownership remains widespread though it is declining. In
1998, 41 percent of PLCs had a controlling (more than 30 percent) government
shareholder, but 32 percent had a controlling non-government one. The government
asset management companies and other agents of the government hold the shares
and they report to a special branch of the government – the Bureau of State Asset
Administration.
Turning to debt finance, there is no substantial corporate bond market in China.
Debt financing mainly comes from bank loans, except for temporary financing
from enterprise arrears or trade credits. Banks are not allowed to own shares of
PLCs.7
Panel A in Table 1 reports that the public listed firms are not heavily indebted.
The total liabilities are 42.9 percent of total assets, and the bank loans are 21.6 percent
of total assets. Given that the PLCs are usually large; their loans mainly come from
state-owned banks. In a balanced panel comprising the PLCs listed continuously
from 1992 (excluding all subsequent newly listed firms), financial leverage is
increasing over time. Panel B shows that the financial structure of these Chinese
firms is similar to that of the firms in Western economies.
Corporate governance structures in China’s PLCs, such as boards of directors,
are also conventional. However, though there is a trial code of Bankruptcy Law,
enforcement remains rare; very few large firms have been liquidated and until
recently no PLCs had gone into bankruptcy.8
2.3 Data sample
There are three main electronic databases for the historical data about Chinese
PLCs. Internationally, the leading vendor of Chinese data is the Taiwan Economic
Journal (TEJ), but the TEJ database has a number of missing values. Our accountancy
data before IPO and the information about directors come from this source. More
than 80 percent of Chinese investment bankers and security analysts rely on the
data provided by the Genius database. We use their accountancy data post-IPO as
well as their information about ownership. The industrial classification uses the
data from Securities Times, a leading Chinese newspaper of security markets. The
7
This rule came into effect in 1995, but it did not require a bank to sell out its shares in a firm purchased
before 1995.
8
The Enterprises Bankruptcy Law was legislated in 1986, only as a trial version. In 2001, the Huarong Asset
Management Company and other two creditors requested the Hubei Supreme Court to liquidate the Monkey King PLC. It is expected to be the first bankruptcy case of a public listed company.
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Tian and Estrin
466
Table 1. Financial leverages
1994
1995
1996
1997
1998
Total
Panel A: Leverage ratios in Chinese PLCs from 1994 to 1998
Liability to assets
All firms
mean
median
Firms listed in the same year 1992
mean
median
Debt to assets
All firms
mean
median
Firms listed in the same year 1992
mean
median
Debt to capital
All firms
mean
median
Firms listed in the same year 1992
mean
median
Observations
287
0.413
0.412
39
0.437
0.445
311
0.461
0.458
39
0.477
0.489
517
0.445
0.455
39
0.482
0.494
719
0.417
0.415
39
0.495
0.497
826
0.422
0.416
39
0.546
0.503
287
0.205
0.193
39
0.211
0.233
311
0.225
0.212
39
0.239
0.235
517
0.224
0.216
39
0.252
0.243
719
0.212
0.201
39
0.268
0.261
826
0.215
0.206
39
0.287
0.265
287
0.457
0.471
39
0.610
0.641
287
311
0.481
0.499
39
0.615
0.633
311
517
0.475
0.498
39
0.634
0.630
517
719
0.454
0.475
39
0.649
0.651
719
826
0.453
0.467
39
0.675
0.652
826
0.429
0.424
0.487
0.484
0.216
0.206
0.251
0.243
0.461
0.479
0.636
0.640
2,660
Panel B: International comparison
China
United States
United Kingdom
Germany
Japan
South Korea
India
Turkey
No. of firms
Time period
Liability
to assets
Debt to
assets
Debt to
capital
287–826
2580
608
191
514
49
99
45
1994 –1998
1991
1991
1991
1991
1985 –1991
1980 –1990
1983 –1990
0.43
0.58
0.56
0.76
0.75
0.30
0.67
0.59
0.22
0.27
0.24
0.16
0.42
0.46
0.37
0.34
0.39
0.63
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Debt Financing and Government Ownership in China
467
Table 1. (cont) Financial leverages
Panel B: International comparison
No. of firms
Brazil
Mexico
49
99
Time period
Liability
to assets
1985 –1991
1984 –1990
0.30
0.34
Debt to
assets
Debt to
capital
Note: The table reports the means, standard deviations, and medians of the proxies of capital structures for
our sample of companies listed on either the Shanghai Securities Exchange or the Shenzhen Stock Exchange.
The leverage ratios are based on the accounting reports. Panel A reports the leverage ratios of two samples:
total firms and the firms listed in the year 1992 excluding the noise brought by newly-listed firms each year.
Panel B reports the aggregated numbers compared with other countries. The figures for the United States,
United Kingdom, Japan, and Germany are from Rajan and Zingales (1995). The figures for South Korea,
India, Turkey, Brazil and Mexico are from Booth et al. (2001).
share price data come from Datastream. With regard to accountancy and ownership
data, the validity of the datasets was crosschecked, and initially missing points
were filled, using the annual reports from the Shenzhen Stock Exchange.
Two restrictions have been imposed on our sample. We excluded fund management
companies, as their operations are markedly different from industrial firms. We
also excluded the firms that do not issue shares for domestic investors; otherwise,
we would have had to use the share prices from the markets of foreign investors,
and such market values are not comparable. After these restrictions, the sample
includes 287 companies in 1994, 311 in 1995, 517 in 1996, 719 in 1997 and 826 in
1998. The 1994 Company Law created a modern corporate governance structure for
Chinese PLCs, and in the same year, the China Securities Regulatory Commission
introduced a series of six rules called the Contents and Forms of the Information
Release by PLCs, which formatted the annual reports. Our data sample therefore
starts from 1994 and ends in 1998; new measures were implemented in banks
and a new company law was introduced in 1999. The dataset has 2660 firm–year
observations.
3. Agency costs and financial leverage in Chinese PLCs
In this section, we outline our indicators of managerial agency costs and present
their distributions under different levels of financial leverages and ownership
structures.
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Tian and Estrin
468
Table 2. Managerial agency costs, financial leverage and ownership types
Leverage
0%–10%
10%–30%
30%–100%
All firms
Mean
Median
Mean
Median
Mean
Median
0.078
0.051
0.085
0.052
0.082
0.051
0.090
0.073
0.080
0.073
0.086
0.073
0.111
0.078
0.105
0.061
0.109
0.074
0.094
0.071
0.087
0.064
0.091
0.069
Panel 2: Investment ratio
Government
Mean
Median
Commercial
Mean
Median
All firms
Mean
Median
0.300
0.199
0.409
0.234
0.357
0.199
0.370
0.270
0.360
0.218
0.366
0.261
0.449
0.290
0.382
0.209
0.427
0.272
0.378
0.263
0.377
0.217
0.378
0.254
Panel 3: Board turnovers
Government
Mean
Median
Commercial
Mean
Median
All firms
Mean
Median
0.515
0.490
0.449
0.364
0.491
0.378
0.469
0.472
0.448
0.387
0.460
0.435
0.476
0.439
0.503
0.435
0.486
0.438
0.480
0.455
0.466
0.385
0.474
0.433
Panel 1: Administration cost
Government
Commercial
All firms
Note: The table presents means and medians of managerial agency costs using the dimensions of ownership
types and debt clusters. The ‘government’ cluster is made up of firms under the control of a government;
the ‘commerce’ cluster is the firms under the control of a non-government shareholder.
3.1 Financial leverage
As there is no substantial domestic corporate bond market and trade credits do not
contribute greatly to corporate governance, our main measure of financial leverage
in Chinese PLCs is the ratio of bank loans to total assets. This ratio indicates the
liability of the firm and the probability of financial distress, and approximates the
influence of bankers in corporate management. In Table 2, we group the firms into
three clusters: firms whose financial leverage is below 10 percent; firms with leverage
between 10 percent and 30 percent; and firms with leverage above 30 percent;
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Debt Financing and Government Ownership in China
469
23 percent of firms are in the first category, 51 percent in the second, and 26 percent
in the third.
3.2 Ownership clusters
In Table 2, we also separate the firms into two sub-samples by controlling shareholders –
government and commercial. Non-government (or commercial) shareholders include
family investors, another industrial company, investment funds and foreign investors.9
According to the China Security Regulation Commission, the relative controlling
threshold is 30 percent and we use this in the tables. We have experimented with
other cut-off points including 50 percent and the main empirical findings remain
unchanged. There is clearly the possibility of endogeneity between managerial
exploitation and ownership structures, for example, if the government retained
shares in less efficient companies. This issue has been explored thoroughly in a
companion paper (Tian and Estrin, 2006) which established that retained government
shareholding was not significantly associated with prior enterprise performance, a
finding echoed in Bai et al. (2004) and Wei, Xie and Zhang (2005). The result is
also consistent with the Chinese institutional context. The Chinese government
argued that its shares in PLCs were not being sold for revenue purposes, but
to restructure enterprises (see Measures on the Shareholding Experiment, State
Council, 15 May 1992).10 Meanwhile, ownership structures within listed companies
do not vary to any significant extent over our sample period. Nonetheless, recognizing
the potential causality issue, we report the distributions of managerial exploitation
proxies in different ownership clusters, and have tested our hypotheses using
instrumental regressions controlling for size and other factors (see Tian and Estrin,
2006).
3.3 Managerial perks
The literature highlights three dimensions of managerial exploitation that can
affect operational efficiency and corporate value: perquisites, empire-building and
entrenchment. Managerial perks represent disguised income for management
teams. In fact, such perks were the main income for Chinese managers, as the
average annual salary of the general managers was only $12,000 (see Kato and
9
Before 1999, these commercial shareholders were not allowed to hold a significant ownership stake in
China’s major commercial banks, except for the Minsheng Bank whose loans to PLCs are, however, marginal.
10
The proceeds from IPOs as well as seasoned equity offerings are retained in the ‘privatized’ firms rather
than transferred to the government. Enterprise restructuring rather than revenue is stipulated as the objective of the block transfer of state shares. Transfers of state shares, including both grant transfers and
negotiated transfers, are usually directed towards injecting new capital into the company and updating its
technology. Indeed, in some cases the government has actually given away their shares to strategic investors.
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Tian and Estrin
470
Long, 2006); for example, it has been a usual practice for a firm to pay the dining,
communication, transportation and entertainment bills for a senior manager’s
family.
Most perquisites for managers are not explicitly reported, but inflate administration
costs. Administration cost in the Annual Reports of PLCs, according to the Chinese
Security Regulation Commission, records the expenditures on organizing and
managing corporate operation, including the expenses of the management team,
such as corporate cars, travelling expenses, entertainment expenses and other service
bills. This is therefore the best indicator of managerial perks among the data publicly
available. We normalize the administration costs by sales, which controls for both
size and operation effects.
Panel 1 in Table 2 presents the distribution of perks by ownership and leverage
clusters. The average ratio of administration cost to total sales is 9.1 percent. The
firms under the control of a government shareholder spend 9.4 percent for every
unit of sales, and those with a controlling commercial shareholder spend 8.7 percent.
These differences are significant with the Student’s t test for means and Mann–
Whitney U test for medians. There is an increasing pattern of administration costs
with leverage in government-controlled firms, but not in firms with a controlling
commercial shareholder.
3.4 Over-investment
Empire-building is a problem of over-investment (see, for example, Titman, Wei
and Xie, 2004). In China’s GAAP items, capital expenditure is the sum of short-term
investment, long-term investment and construction in place. We use capital
expenditure normalized by sales to indicate the magnitude of investment. Other
things being equal, if the capital expenditure ratio is higher, managers are probably
more likely to be building empires, but the proxy is imprecise. Because of this, we
also used the cash retention ratios and found similar patterns.
Panel 2 of Table 2 indicates that the investment ratio increases with an increased
debt ratio; the investment ratio rises from 35.7 percent in the lowest leverage category
to 42.7 percent in the highest. This comes mainly from the government-controlled
firms where the comparable ratios are 30 percent rising to 44.9 percent. In contrast,
the medians of the firms with a controlling commercial shareholder present a
decreasing pattern, perhaps because highly leveraged private firms need to reduce
investment to pay back loans.
3.5 Managerial entrenchment
Board member turnover is an indicator of managerial entrenchment and is calculated
as the number of exits from the board over the total number of directors (see, for
example, Franks, Mayer and Renneboog, 2002). The data for Chinese PLCs are presented
in Panel 3 of Table 2. Turnover in these firms is quite high, averaging 47.4 percent
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Debt Financing and Government Ownership in China
471
per year. There is a slight increase of board turnover with leverage in private firms,
and a decrease with government owned ones.
4. Impact of debt financing on managerial quality
In this section, we report the empirical findings of our regression analysis. The
Western literature suggests that in developed market economies, debt financing
should improve corporate governance, and we will address this empirically in the
rather different Chinese institutional context by exploring the relationship in Chinese
PLCs between the three measures of managerial agency costs, outlined above, and
the leverage ratio, in the context of a standard agency cost equation. Given the
differences identified in the previous section in managerial agency costs at different
debt ratios between government and non-government (commercially) controlled
firms, we also explore the relationship for two subsets of the sample – government
and commercial controlled firms, respectively. As before, the cut-off point for ‘control’
in this work is 30 percent, though the main results are not sensitive to alternatives
in a range from 25 percent to 40 percent. Using the full sample, a positive relation
is found in Chinese PLCs between debt levels and two of the three measures of
managerial agency costs – managerial perks and empire building. The results on
managerial entrenchment are more mixed. When the dataset is broken into subsamples according to controlling owner, it is found that the group of firms with a
controlling government interest drives the results. We conclude with a summary
regression based on Ang, Cole and Lin (2000), which confirms our findings using
the agency ratio to approximate agency costs as a whole in the firm.
The model to be estimated is:
Managerial Agency Costs = C + α × Debt + B × Firm Characters + ε
(1)
where managerial agency costs are proxied by perks (Table 3), empire-building
(Table 4) and entrenchment (Table 5). Debt is measured by financial leverage, Firm
Characters are a vector of control variables discussed below and ε is the disturbance
term.
Following Berger and Ofek (1995), we control for the industry-specific shocks
by normalizing dependent variables on their medians for the same industry.11 We
also control for the time-specific shocks by normalizing dependent variables on the
five-year medians of the same firm, since the institutions keep changing in China.
11
There are two kinds of industrial classifications for Chinese PLCs used before 1997. One is the five-industry
code: manufacturing, trade, utility, real estate and conglomerates. It is used by most studies on Chinese
PLCs (see, for example, Xu and Wang, 1999), but the industry effects cannot be well captured by this oversimplified industry classification. The other is the two digit standard 21 industry industrial classification,
used in this paper.
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Tian and Estrin
472
Table 3. Administration cost and debt
Debt
OLS
DPD
CIV
2.403***
(0.226)
3.688***
(1.357)
2.584***
(0.936)
−0.222***
(0.059)
0.904***
(0.200)
2.156***
(0.253)
0.461***
(0.123)
−0.491***
(0.084)
0.432**
(0.221)
−6.448**
(3.227)
4.599***
(1.238)
2,214
58.17
0.000
0.227
−4.866*
(3.557)
0.112***
(0.024)
994
76.32
0.000
0.219
−0.308***
(0.044)
0.691***
(0.138)
0.002**
(0.001)
−0.821
(1.295)
3.967***
(0.441)
1,003
75.23
0.000
0.223
−0.175***
(0.021)
0.280**
(0.132)
0.001**
(0.001)
0.742
(1.089)
3.379***
(0.438)
684
46.46
0.000
0.220
Lagged debt
Size
Tangible
Age
Herfindahl
Constant
Observations
F test/χ2 test
Significance
OLS R2/MLP log
Government
Commercial
−0.082
(0.387)
−0.082*
(0.033)
0.525
(0.329)
−0.002
(0.003)
2.915**
(0.867)
1.542***
(0.044)
264
4.72
0.000
0.094
Notes: The table reports the regression results of administration cost ratios on debt. The dependent variable,
the ratio of administration costs is measured by the administration expense normalized by total sales,
adjusted by industries and years. The control variables are introduced in the appendix. The Hadi method
is followed to remove the outliers. Column 1 reports OLS regressions with robust standard errors. Column
2 reports Arellano–Bond GMM regressions (DPD). Based on Booth et al. (2001), column 3 instruments the
financial leverages on tax rate, risk, tangible, size, ROA and market-to-book ratio. If adding managerial
agency cost as one more instrument of financial leverages, the results remain the same. Columns 3–5 report
the robust two stage regressions with clustering by years (CIV). With the CIV methods, Column 4 examines
the sub-sample that a government shareholder is in control of the firms, Column 5 examines the sub-sample
that an entrepreneur is in control of the firms. The standard deviations are reported in parentheses.
*** indicates being highly significant with p-value smaller than 0.01, ** indicates being significant with
p-value smaller than 0.05 and * indicates being marginally significant with p-value smaller than 0.10.
Company size, tangibility, age, ownership and profitability can all induce spurious
correlations between proxies of managerial agency costs and financial leverages.
Large firms have scale economies and better access to bank credits (see, for example,
Chhibber and Majumdar, 1999) and size also affects governance. The asset structure
or the asset tangibility influences corporate growth and valuation (see, for example,
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Debt Financing and Government Ownership in China
473
Table 4. Investment ratio and debt
Debt
OLS
DPD
CIV
1.875**
(0.426)
2.377***
(0.562)
−0.501
(0.135)
−0.298*
(0.114)
−1.432***
(0.421)
2.783***
(0.348)
4.370**
(1.930)
−3.066
(3.395)
−0.128**
(0.037)
−0.958***
(0.169)
0.002*
(0.001)
−3.582
(1.317)
3.208**
(0.799)
1,123
19.23
0.000
0.098
0.217
(0.517)
−0.076
(0.080)
−0.001**
(0.000)
2.363
(1.776)
0.852***
(0.261)
688
8.30
0.000
0.125
−5.693*
(3.310)
0.017
(0.095)
−0.002**
(0.001)
−3.456
(2.247)
0.984**
(0.402)
251
2.89
0.010
0.051
Lagged debt
Size
Tangible
−0.093
(0.114)
−4.180***
(0.387)
Age
Herfindahl
Constant
Observations
F test/χ2 test
Significance
OLS R2/MLP log
−1.800
(6.254)
3.334
(2.416)
2,176
8.94
0.000
0.030
−2.897
(3.561)
3.329***
(0.244)
978
237.13
0.000
0.051
Government
Commercial
Notes: The table reports the regression results of capital expenditure ratio on debt. The investment ratio is
measured by capital expenditure normalized by sales, adjusted by industries and years. The control
variables are introduced in the appendix. Columns are as in Table 3. The standard deviations are reported
in parentheses.
*** indicates being highly significant with p-value smaller than 0.01, ** indicates being significant with
p-value smaller than 0.05 and * indicates being marginally significant with p-value smaller than 0.10.
Vilasuso and Minkler, 2001), as well as managerial agency costs. For example,
mortgage borrowing depends on the tangibility of assets. In addition, the tangibility
ratio also helps to identify the growth potential of a company.
A firm with a long history can establish its reputation in the debt market and
so firm age influences debt ratios. On the other hand, managerial agency costs are
also expected to vary with firm age. Corporate governance literature argues that a
concentrated shareholding structure improves corporate governance and therefore
reduces managerial agency costs (see, for example, Shleifer and Vishny, 1997). Creditors
decide their lending policies with reference to the shareholding structures. We use
a Herfindahl index to measure shareholding concentration; it calculates the weight
of the ten largest shareholders’ holding stakes.
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Tian and Estrin
474
Table 5. Board member turnover and debt
OLS
Debt
−1.182
(1.123)
Lagged debt
Lagged ROA
Size
Tangible
Age
Herfindahl
Constant
Observations
F test/χ2 test
Significance
OLS R2/MLP log
−0.299**
(0.054)
0.013
(0.009)
−0.038***
(0.004)
−0.0004
(0.0004)
2.040***
(0.207)
0.093
(0.274)
1,590
7.42
0.000
0.025
DPD
−1.251
(1.267)
−0.064
(0.057)
0.087
(0.186)
0.179**
(0.077)
−0.034**
(0.019)
3.434**
(1.981)
0.267***
(0.021)
601
6.06
0.000
0.052
Government
Commercial
−2.695*
(1.258)
CIV
−1.098
(1.183)
0.048
(0.153)
−0.701*
(0.392)
−0.101
(0.123)
−0.007
(0.392)
−0.002***
(0.001)
1.936*
(1.072)
0.255
(0.472)
978
10.91
0.000
0.041
0.217
(0.517)
−0.039***
(0.013)
−0.076
−0.080
−0.001**
(0.000)
2.363***
−0.776
0.852***
−0.261
507
8.28
0.000
0.031
−5.693*
(3.310)
−0.049**
(0.013)
0.017
(0.095)
−0.002**
(0.001)
3.456***
(1.247)
0.984**
(0.402)
204
0.69
0.657
0.026
Notes: The table reports the regression results of board member turnover frequency on debt. The dependent
variable, the ratio of board member turnover is measured by the annual number of resigning directors in
the board over the total number of directors. The control variables are introduced in the appendix. Columns
are as in Table 3. The standard deviations are reported in parentheses.
*** indicates being highly significant with p-value smaller than 0.01, ** indicates being significant with
p-value smaller than 0.05 and * indicates being marginally significant with p-value smaller than 0.10.
We report the results from three alternative estimation methods: ordinary least
square estimation (OLS), Arellano–Bond dynamic panel data method (DPD) and
instrumental variable regressions (CIV). Most results with respect to leverage are
robust to estimation method. Our OLS estimations use the robust standard errors,
which produces consistent standard errors even if the data are weighted or the
residuals are not independently distributed. Managerial agency costs may adjust
to both current and previous debt ratios, so we also report a version of the equation
with a lagged debt ratio which in our panel dataset requires the use of dynamic
panel data methods. The inclusion of the first lag of the independent variables is
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Debt Financing and Government Ownership in China
475
justified by the Sargan test in all three equations. Finally, financial leverage may be
endogenous, which leads us to use instrumental variable methods (CIV). Booth
et al. (2001) suggest that the level of debt financing can vary with tax rates, risk,
tangible, size, return to total assets (ROA) and market-to-book ratio in emerging
markets. The firm may raise more bank loans if managerial exploitation in the
previous year is more serious. We therefore instrument financial leverage on these
variables and the proxies of managerial agency costs lagged by one year. Once
again, Sargan tests confirm the validity of the instruments.
4.1 Administration cost and debt
We report the regressions using administrative cost as the dependent variable in
Table 3. OLS methods use all the data, but we lose information with DPD because
the panel is unbalanced and with CIV because lagged values are used as an instrument.
Since age is correlated with debt, it is omitted in the OLS regression. We also use
the log form of total assets instead of sales in this regression to address collinearity
with the ratio of administration cost to sales. The findings with respect to the control
variables are largely similar across estimation methods, and have the expected
signs and significance, apart from the Herfindahl which is not significant in the
CIV regression suggesting endogenity between this variable and administration
costs. Thus, larger firms have a lower administration ratio; firms with a higher
tangibility ratio have a higher administration cost ratio; and older firms have
higher administrative costs.
Our main concern is with the impact of leverage on agency costs. Table 3 shows
that the administration cost ratio always rises when the financial leverage increases.
In the OLS regressions, 1 percent higher financial leverage brings about 2.4 percent
higher administration costs. In the DPD regressions, it increases the ratio of administration costs by 2.2 percent and in CIV by 3.7 percent.
The final two columns in Table 3 uses sub-samples by controlling ownership to
explore whether this result is associated with government ownership, as is suggested
by the descriptive statistics. The Government and Commercial columns are estimated
by instrumental variable methods, but as we have seen already for the full dataset,
the main results are not sensitive to estimation method. In the government subsample, we continue to find a significant positive relation between debt and
administration cost, with a coefficient of around 2.6. However, in the commercial
sub-sample, the relationship between the size of bank loans and administration
costs is insignificant, and the sign of the coefficient is negative.
4.2 Capital expenditure and debt
In Table 4 we report the regressions using capital expenditure as a proxy for
‘empire building’ and find a positive relation between the ratios of capital expenditure
and financial leverages. The fit of the full sample regressions in the first three
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Tian and Estrin
476
columns is rather worse than for Table 3, and the control variables provide less of
an explanation. The tangible ratio has a negative impact on the investment ratio in
all regressions and size has a negative significant impact at the 5 percent level in
the better fitting CIV regressions. Interestingly, ownership concentration has no
significant effect on the investment ratio in our sample.
The results concerning the impact of leverage on this proxy for managerial
agency costs are, however, consistent across the three estimation methods, and
once again are found to be positive. Debt is expected to reduce free cash flows and
control the ‘empire building’ in American firms (see, for example, Jensen, 1986): in
China, bank lending facilitates the expansion of corporate size so a 1 percent
increase in financial leverage increases the ratio of capital expenditure over total
sales between 1.9 percent and 2.8 percent.12
Turning for interpretation to the sub-samples, we find the positive significant
effect of debt on investment is larger in government-controlled firms. If the leverage
ratio increases by 1 percent, the ratio of capital expenditure to sales increases by
4 percent. In contrast, in firms controlled by commercial shareholders, the firm
actually retains less free cash flows and reduces its investment ratio as the leverage
ratio increases, though this coefficient is not statistically significant.
4.3 Board member turnover and debt
Table 5 investigates whether debt has an impact on managerial entrenchment. The
regressions on the full dataset provide quite low levels of fit, though they are
statistically significant at the 99 percent level, perhaps because there is such high
variance in the dependent variable. The control variables are less frequently significant
and the pattern varies with estimation method. Concentrated shareholding structure
significantly increases the frequency of board member turnover and managerial
entrenchment is also lower in larger firms in the DPD regressions. Managerial
entrenchment is, however, greater in older firms according to CIV methods.
There are also poor results with respect to debt; the coefficient is negative using
all three estimation methods, but only significant in CIV, and even then only at the
10 percent level. The coefficient on debt is insignificant in both of the controlling
ownership sub-samples. We further decomposed our sampled firms into going
concerns and loss makers and found that the coefficient of bank loans remains
insignificant.13 We conclude that there is no conclusive evidence that debt significantly
affects managerial entrenchment, even in the firms in financial distress where the
shift of corporate control from shareholders to creditors is expected (see, for example,
Aghion and Bolton, 1992). In the absence of credible bankruptcies in China, bankers
do not play a big role in managerial replacements.
12
We also find a positive relation between cash retention and bank loans. The table is available upon
request.
13
Tables are available upon request.
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Debt Financing and Government Ownership in China
477
Table 6. Expense ratio and debt
Debt
OLS
DPD
CIV
0.825**
(0.374)
1.102***
(0.034)
0.588**
(0.323)
0.036*
(0.022)
0.038
(0.027)
0.050
(0.045)
Lagged
Size
Tangible
Age
Herfindahl
Constant
Observations
F test/χ2 test
Significance
OLS R2/MLP log
0.004
(0.005)
−0.070**
(0.030)
0.000
(0.000)
−0.047
(0.239)
−0.052
(0.100)
2,286
17.74
0.000
0.095
0.009
(0.006)
−0.049*
(0.028)
0.000
(0.000)
−0.110
(0.303)
−0.207*
(0.115)
1,021
10.87
0.000
0.110**
−0.115
(0.738)
0.014***
(0.004)
1,356
21.23
0.000
0.121
Government
0.104***
(0.036)
0.002
(0.005)
−0.062*
(0.033)
0.000
(0.000)
−0.280
(0.281)
0.064
(0.106)
711
16.23
0.000
0.108
Commercial
−0.751
(0.871)
0.022**
(0.009)
−0.025
(0.059)
0.001**
(0.000)
−1.949**
(0.800)
−0.291*
(0.174)
269
12.77
0.000
0.091
Notes: The table reports regression results of expense ratios on debt. Following Ang et al. (2000), this table
reports the results taking the corporate efficiency ratio as a dependent variable that is measured as operating
expense scaled by annual sales. The control variables are introduced in the appendix. Columns are as in
Table 3. The standard deviations are reported in parentheses.
*** indicates being highly significant with p-value smaller than 0.01, ** indicates being significant with
p-value smaller than 0.05 and * indicates being marginally significant with p-value smaller than 0.10.
4.4 Efficiency ratio and debt
There is no perfect proxy of managerial agency costs, so for robustness we follow
Ang et al. (2000) and use a further summary proxy, the expense ratio, for agency
costs. This is operating expense scaled by annual sales and it provides both an
auxiliary measure of managerial agency costs and a measure of corporate efficiency.
The results of estimating the same specification as in our previous experiments
using the expense ratio as dependent variable are reported in Table 6.
Despite the good fit, almost no control variables are significant in the full sample
regressions in the first three columns; managerial agency costs are not affected by size,
age, ownership or asset structure using most estimation procedures (though tangibility
is significant at the 5 percent level in the OLS regression). However, we do identify
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Tian and Estrin
478
a significant relationship between the expense ratio and debt ratio with the positive
coefficients, though in contrast with the results for the United States the coefficient
is positive; Ang et al. (2000) find the relationship to be negative but insignificant.
Thus, in Chinese PLCs, corporate efficiency is lower when the firm is highly leveraged.
When we turn to sub-samples by controlling ownership, the findings are consistent
with those in Tables 3 and 4; the expense ratio is higher in more leveraged firms
when the controlling interest is in the hands of the government. The results for the
commercially controlled firms, however, are the same as in the United States, with
a negative but insignificant coefficient on the debt ratio (Ang et al., 2000).
5. Conclusion
Using information about the companies listed on China’s stock market, we find
that financial leverage is positively associated with a number of managerial perquisites,
over-investment and corporate expenses in the Chinese context. Furthermore, this
positive relationship obtains in firms in which the government has the controlling
interest but not in privately controlled ones. We provide evidence that debt financing
does not provide effective corporate governance for PLCs in the Chinese context,
probably because of widespread government ownership of firms and banks.
In China, in firms controlled by the state, the government is both creditor and debtor.
In this situation, creditors may hesitate to pursue their financial interests to the benefit
of borrowing firms. The government as owner has multiple objectives such as
financial returns, social welfare and consolidation of political powers. For example,
the Chinese government has required its banks to provide ‘policy loans’ to support
these state-owned enterprises which make losses. When political interests mingle
with financial interests, the disciplinary function of debt may not operate well.
Government ownership of both banks and firms is also associated with soft
budget constraints, which can narrowly be defined as the expected re-negotiability
of debts in government-owned firms (see, for example, Kornai, 1980, 1998).14 The
government may explicitly or implicitly put pressure on creditors to refinance loss
makers for political benefits. Firms in financial distress expect refinancing instead
of bankruptcy and the threat of shift of control under financial distress is not
credible. But without this de jure threat, managers in de facto control of the borrowing
firms will not be concerned with the dissatisfaction of the creditors. Under soft
budget constraints, debt will not reduce managerial agency costs but instead expand
the resources managed by firm managers and facilitate managerial exploitation
14
Dewatripont and Maskin (1995) show that when creditors have limited information on the future return
of an investment and cannot commit to terminating ex post unprofitable projects, there is a soft budget
constraint problem. The sunk costs of initial financing provide creditors with the incentive to continue their
finance, even when the firm cannot pay back some interest and loans. This hold-up problem is universal.
This is a strong form of soft budget constraint, different from Kornai (1998).
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Debt Financing and Government Ownership in China
479
(see, for example, Shleifer and Vishny, 1994). Moral hazard also exists for the
Chinese bankers. La Porta, Lopez-de-Silanes and Shleifer (2002) argue that banks
under the control of the government are politicized. Chinese bankers may perceive
themselves as the financial agents of the government and follow the orders of the
government bureaucrats to help the government-controlled firms at the cost of
their own profitability, without fear of bankruptcy.
Our paper thus indicates the facilitator role of debt in managerial agency costs
under joint government ownership in China. Roland, Kornai and Maskin (2003)
point out the consequence of soft budget constraints in the collapse of the banking
sector of East Asian economies in the 1990s. It is therefore important to bring the
facilitator role of bank loans into the spotlight.
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Journal compilation © 2007 The European Bank for Reconstruction and Development
Variable
Description
Panel 1: Extent of leverage and adjusted leverages
Liability to assets
Book value of total non-equity liability to book value of total assets.
Debt to capital
Book value of total financial debt to the sum of book value of debt plus book value of equity.
In this paper, we use the abbreviation of debt for this ratio.
Debt to asset
Book value of total financial debts to total assets.
Panel 2: Proxies of managerial agency cost
Administration cost
Administration cost to sale ratio. It is computed as the logarithm of the accounting item of
administration expense over sales.
Board member turnover
Board turnover ratio. It is computed as the number of new directors over the number of the
incumbent directors.
Investment ratio
Investment ratio is computed as the sum of the accounting items of long-term investment,
short-term investment and construction-in-progress over total sales.
Expense ratio
Operation cost to sale ratio. A general proxy of agency costs.
Panel 3: Other variables
Size
Tangible
Age
Herfindahl
Debt Financing and Government Ownership in China
© 2007 The Authors
Journal compilation © 2007 The European Bank for Reconstruction and Development
Appendix
Firm size is approximated by the logarithm of total assets or sales.
Asset specificity. It is computed as fixed assets over total assets.
Firm age. The year when the firm was restructured or founded subtracted from the current
year.
Herfindahl index. This proxy of the concentration of the shareholding stakes is computed as
the sum of the squared shareholding fractions of the largest ten shareholders.
481