The Financing of Private Enterprise in China

Introduction
Chinese enterprises → relied primarily on self-financing → to Thrive → firms need increased access to → external loan and equity financing
China’s economy has undergone a fundamental change over the pas decade → from complete reliance on state-owned and collective enterprises to → mixed economy → where private enterprises play a strong role
1999 → private sector accounted only 1% of bank lending
Only 1% of private company are listed on the Capital market
Private sectors may not be able to sustain its current rate growth unless it can increase its access to financing
Financing Patterns
International Finance Corporation (IFC) → private sector arm of World Bank Group → revealed if company has 80% lack of access to finance → will be a serious problem
Chinese relied heavily on self-financing for both → start-up and expansion
More than 90% initial capital → came from → principal owners, family, start-up teams
For post-start-up investment → firms depend on internal sources → with at least 62% equity is owner’s
Public equity and public debt market → played an insignificant role
Relative importance of different sources of financing among surveyed firms → depend on firms size → Tend to become less important as firms grow larger
Share of commercial bank loans → increases with the firm size
Commercial banks → second most important source of fund → for the larger firms → but on average → Chinese banks tend to play a relatively small role
Factors affecting Access to Financing
Difficulty private Chinese firms face → financial system and the nature of Chinese private enterprise
Bank Incentives
Trough recent reforms → China has made significant progress in reducing government interference in bank lending
Bank still do not consider → a bad loan to a state-owned enterprise to be as serious as a bad loan to a private enterprise
Bank → discriminate against private sector firms → need added incentives to lend to private enterprises
Financial sector reforms focused on reducing the accumulation of nonperforming loans in the system are making banks more averse to risk
Bank concentrate on avoiding losses → show little interest in sharing of rewards of projects → that may be riskier → but have higher expected returns
Indeed → central banks requires all banks to implement → “responsibility to individuals” → credit officers personally responsible for loans → thereby discouraging them from making loans for private sector project
There are controls on interest rates and transaction fees → but still → interest rates are capped
Loans to small and m\medium-sized enterprises → allowed to be 30% higher the prescriptions rate →→ rural credit charge 50% higher
Government is expected to relax restrictions even further in preparation for China’s entry into WTO
Banks & Credit unions → creative ways → circumvent interest rate controls → requiring compensating balance and charging false late payment fees
Result → state banks charge effective interest rate
Bank Procedures
Chinese Banks → inflexible and tailored → “typical” state-owned enterprise
Applying for a loan → bureaucratic and costly process
Major obstacles to application for formal loan → Paperwork
Collateral requirement & relationship banking → make smaller firms hard to gain access to financing
Collateral Requirement
Most frequent reason for not being able to obtain a bank loan → The inability to meet collateral requirements
Legacy of public and collective ownership of land → can be a collateral → But many private firms does not have it yet
Assets can be collateral → but establishing the value of the firms → costly
Repeated and arbitrary fees → greatly reduced the incentive of small firms → to apply loans
Information Problem
Many had to present themselves as collectives or as foreign enterprises → to be allowed to operate or to obtain better treatment from the authorities
Lack of clear ownership an management structures → imposes obvius constrains on borrowing
In fact → banks are unable → to collect and process relevant information
Banks are naturally reluctant to accept financial statements → that cannot be trusted
Recently central bank → make mandatory for corporate borrowers to register in a national database
Central database more comprehensive and prevent company with poor records → getting loans

Policy Agenda for Financial Sector
Improve “bankability” → by strengthening transparency and clarifying ownership on the part of the government to establish and maintain a level playing field and to create incentives for lending to and investing in private enterprises
Strengthen Banks’ incentives to lend to private enterprises
Important step → strengthen profit incentives through private ownership and competition
The government should allow the entry of new domestic private financial institutions → which would open up entry opportunities → to foreign financial institutions
To alleviate regulatory concerns → stricter entry and prudential requirements could be applied to → new financial institutions in initial period
Private financial institutions → less likely swayed by political considerations → more likely profit oriented
New banks tend naturally focus on → younger and smaller firms
Big state-owned banks → likely to dominate the domestic financial landscape for the foreseeable future
Further Liberalize Interest Rates
Evidence suggest further liberalization of interest rates is needed to improve private firms’ access to bank loans
Most private enterprises that are able to borrow → already pay effective interest rate that → significantly higher that real one
Allow Banks to Charge Transaction Fees
Banks find → lending to private companies → carries higher unit transaction cost
Transaction fees would encourage banks to consider → more proposals from small firms, develop more service-oriented culture, promote greater transparency and better accounting standards
Develop Alternatives to Bank Lending, Such as Leasing and Factoring
Leasing and factoring → are useful ways to deal with insufficient collateral → with the enforcement of collateral
Leasing obstacles in China
Rent arrears have long been a problem
Accounting standards are unclear
Regulatory environment does not provide equal treatment with other sources of capital investment financing
Funding is a perpetual concern
Factoring is a way to improve a company’s liquidity by → substituting a cash balance for book debt →→ New contract law → make it possible
Create a Framework for the Development of Private Equity Markets
Offshore venture funds → appear to be a far more important source of capital for startups in China → than domestic
Corporations must abide by the company law → does not permit more than 50% of :Industrial Investment Funds” to be invested in subsidiaries or other legal entities
Legal instruments → must be develop
Legal organization of such funds
Use of a fund manager
Need for trustees → to protect investors from adverse actions of the fund managers
Tax treatment → to avoid double taxation
Improve Access to Public Equity
Availability of exit mechanism is → a key condition for development of private equity markets
Evolution of private equity markets → depends to a large extent on the state of the public equity market
Chinese Securities Regulatory Commission announced → quota system on listings → would be abolished
Private firms would have greater opportunity to acquire long term funding through the equity market

Hindsight and Foresight about Safe and Sound Banking

Robert A Eisenbeis. Economic Review - Federal Reserve Bank of Atlanta. Atlanta: First Quarter 2007. Vol. 92, Iss. 1/2; pg. 124, 5 pgs
Abstract (Summary)
The author reflects briefly on several different issues discussed in the study "Perspectives on Safe and Sound Banking." He focuses on the issues that were probably, in hindsight, overemphasized, those that were perhaps underemphasized, and those that were not fully appreciated but subsequently turned out to be important. A key issue in the finance literature and in the study was the desirability of gearing deposit insurance to risk and using options pricing theory to price that risk appropriately. Over the past twenty years the financial system has evolved in ways that have changed its structure and risk profiles, significantly changing the way that institutions take on risk and control their risk exposures. The author notes several issues that would be appropriate to consider as potential agenda items should a similar study be undertaken in the future. These include: 1. accounting reform, 2. identity theft and privacy issues, 3. shrinking role of intermediaries and the growth of capital markets, 4. consolidation risks, and 5. role of the lender of last resort.
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Full Text (2463 words)
Copyright Federal Reserve Bank of Atlanta First Quarter 2007
After hearing both the papers prepared for this conference and the discussions that followed the presentations, I want to reflect briefly on several different issues discussed in Perspectives on Safe and Sound Banking. I plan to first focus on the issues that were probably, in hindsight, overemphasized, those that were perhaps underemphasized, and those that were not fully appreciated but subsequently turned out to be important. Finally, I want to raise issues that should be on any agenda for the future.
Issues Overemphasized in the Study
Risk-based deposit insurance. A key issue in the finance literature and in the study was the desirability of gearing deposit insurance to risk and using options pricing theory to price that risk appropriately. While risk-based premiums were adopted in the Federal Deposit Insurance Corporation Improvement Act (FDICIA), implementation has proved to be problematic. Premiums are arguably too low and are collected only from more risky institutions. Beyond this, however, are two issues that limit risk-based pricing as a useful means to control risk taking. The first is the realization that appropriate pricing depends upon not only the ability to measure risk but also to close an institution promptly when it becomes insolvent. Second, effective risk monitoring and control involves a trade-off between the costs of monitoring a bank's risk exposure continually against both the expected costs of that monitoring and expected losses should an institution become insolvent between examinations or inspections.
Revisions to regulatory agency structure and lender of last resort. The report recommended several changes in bank regulatory agency structure, including creating a competing deposit insurance option to be administered by the Office of the Comptroller of the Currency, parceling out lender-of-last-resort administration to the insurance agencies using funds drawn from the Federal Reserve, and taking the Federal Reserve out of the prudential supervision area. It probably is not practical to consider such reforms, given that the United States has still not seen fit to combine depository institution insurance funds, and only the central bank can provide credible lenders-of-last-resort funds. However, two issues are important. First was the suggestion that the insurance funds should have a primary role in banking supervision because they have the strongest incentives to monitor bank risk exposures. In the United States, the Federal Deposit Insurance Corporation (FDIC) is in the first loss position should a failure occur. It also, under FDICIA, is acting as the agent for other banks that stand to lose should FDIC funds be exhausted. Second, this view on supervision stands in stark contrast to how deposit insurance and supervisory responsibilities are apportioned in the European Union, where generally deposit insurers are not involved in supervision.
Issues Underemphasized in the Study
Prompt corrective action. While the study did argue that institutions should be closed via a prompt corrective action (PCA) scheme before net worth fell to zero, the importance of PCA combined with structured early intervention and resolution (SEIR)-a concept that evolved later-as perhaps the best way to protect taxpayer interests was not fully realized. These concepts and their link to banking soundness have proved important not only in the United States, where they have been codified under FDICIA, but also as a framework for dealing with supervision and prudential soundness issues in a cross-border banking world.
Accounting issues. The report argued for market-value accounting, which, when combined with PCA and SEIR, is necessary to protect the taxpayer from the costs of regulatory forbearance. The importance of market-value accounting, or at least the need to calculate the market value of banks' equity, has yet to gain much traction in regulatory circles. Much attention has been given to the problem of implementing market-value accounting. But more focus has been directed to capital adequacy, which turns out to be diverting the attention of regulatory agencies from the fundamental problems of measuring net worth. Putting the valuation issue front and center, especially in a global environment with more and more derivatives and other exotic financial assets coming together, looms as the critically important-but as yet unrecognized-problem for banking supervisors.
Controlling regulatory incentives. One of the key problems in the past has been the tendency of regulatory and supervisory agencies to engage in forbearance toward troubled institutions. FDICIA requires the FDIC to minimize failure costs to taxpayers and requires disclosure and explanations when losses do occur. However, banking regulators-with differing mixes of goals and responsibilities-can still be faced with conflicts of interest and agency problems, which can sometime lead to less-than-optimal decisions in dealing with troubled institutions. Indeed, Eisenbeis and Wall (2002) have shown that many institutions are still closed with losses to the insurance fund, suggesting that PCA is not always having its desired outcome. Kane, for example, has devoted considerable attention to controlling regulatory incentives, which remains a problem both in the United States and abroad (see Hovakimian, Kane, and Laeven 2003; Kane 1988, 1989, 1991, 2000, 2003, 2006).
Consolidated risk management. The report argued that regulatory approaches that attempted to separate risk taking within a bank holding company structure- either to protect bank subsidiaries from risk taking in sister banks or from risks in non-banking subsidiaries-were fruitless. Subsequent developments show that increasingly banking organizations are consolidating risk management and operations functions so that subsidiaries and affiliates are not operationally independent of each other. This trend suggests that the report's conclusion about how conceptually to approach the supervision of complex institutions rings truer today than ever and should be an important focus of banking supervision and risk control going forward.
Underappreciated Issues
Over the past twenty years the financial system has evolved in ways that have changed its structure and risk profiles, significantly changing the way that institutions take on risk and control their risk exposures. Three such developments were underappreciated by authors at the time in terms of either the speed or significance with which they might affect bank safety and soundness. The first was the removal of McFadden Act restrictions on interstate banking and the speed and manner in which the banking system structure changed. Within a few short years, bank mergers significantly reduced the number of banking organizations, increased the size of the largest institutions, and concentrated their headquarters, principally in New York and Charlotte, North Carolina. The events of 9/11 in particular exposed the potential vulnerability of such concentration and the risks to a smooth functioning of our financial markets should one or more large institution experience financial difficulties.
The second underappreciated development was the spread of computer-related technologies in combination with the explosion of intellectual technologies in the form of financial engineering. This development radically changed both institutions' risk profiles and their ability to evolve and price assets and liabilities that had previously been provided only in bundled form or not at all. The resulting decoupling of the apparent risks-through the use of new derivative instruments-associated with given assets and liabilities traditionally inferred by looking at balance-sheet measures or direct inspections via the examination process no longer necessarily reflects an institution's true riskiness.
The third development was the growth and expansion of truly global institutions, which now suggest that the origins of risk and vulnerabilities are not only more complex but may oftentimes be more associated with developments in other parts of the world rather than in domestic markets. As a result, better communication, coordination, and sharing of information with non-U.S. regulators are now a necessity. Effective PCA and SEIR procedures to close institutions before net worth becomes negative combined with bankruptcy procedures that empower regulators to close institutions and resolve them promptly hold the greatest promise to limit systemic risk problems and to control financial crises.
Concluding Remarks and Some Key Issues for the Future
Having reflected upon the study and the papers prepared for the conference, I note several issues that would be appropriate to consider as potential agenda items should a similar study be undertaken in the future. The following is a brief list of concerns, in no particular order of importance.
Accounting reform. As mentioned earlier, the key to risk monitoring and control is effective valuation of net worth, which requires not only the ability to value assets and liabilities but also to appropriately consider the interactions among subsidiaries and affiliates within complex organizations and to understand the implications for valuation posed by new derivative instruments and contingent liabilities.
Identity theft and privacy issues. As financial markets become more global and dependent upon electronic transactions, the speed with which funds can be withdrawn from individuals' accounts and from entire banking entities is accelerated. Finding ways to both verify and protect individuals' identities is crucial to ensuring confidence in electronic payments media. There may be an important role for regulators in this sphere that has yet gone unexplored.
Shrinking role of intermediaries and the growth of capital markets. Many countries are now producing financial stability reports, and increasingly these reports are focusing on the risks and implications of potential systemic problems emanating from financial markets rather than from financial institutions. This concern is a natural reflection of the growing role that capital markets play in financial intermediation relative to financial institutions. Attention now needs to turn to what role regulators and central banks may need to play in dealing with such risks as well as the need to better understand cross market and cross-institution linkages that arise from the trading of instruments, such as derivatives, which now separate out some of the risks that typically had been embedded in financial instruments and loans.
PCA and SEIR as ways to enhance Basel I and Basel II initiatives. Present Basel I and Basel II initiatives have concentrated on the definition and measurement of capital for regulatory purposes and ways to employ them to limit bank risk taking. The benefit of this exercise has been that institutions are now more systematic and concerned about their internal risk measurement schemes and capital allocation methods. Going forward, attention should be given to how to deal with troubled institutions as their capital positions deteriorate and the role that PCA and SEIR might play to limit the negative spillover effects of failure and to better protect the taxpayer from potential liability should major institutions fail and exhaust their deposit insurance funds.
Consolidation risks. The relaxation of interstate banking restrictions and the resulting consolidation of the banking industry has resulted in more concentration in U.S. banking, with most of the nation's largest organizations headquartered in either New York or Charlotte. Should one of these large institutions experience financial difficulty, not only would the prompt resolution of such an institution be extremely difficult, but also the potential drain on the FDIC fund could be enormous because of the large size of these mega-institutions. Additionally, the experience of 9/11 has shown that certain events can actually close down U.S. financial markets and institutions. The concentration of our largest institutions reduces the geographic diversification that our banking system once had. So close attention now needs to be paid to how regulators and the Federal Reserve would respond to a similar event and how we can best ensure that our markets and institutions are robust.
Role of the lender of last resort. As risks to the smooth functioning of the financial system and markets are increasingly likely to be associated with liquidity problems or shocks to particular capital and instrument markets rather than to risks coming from banking organizations, additional consideration should be given to what role, if any, the Federal Reserve should play as lender of last resort in limiting the spread of these risks. In particular, what channels should be employed to provide liquidity? To whom should this liquidity be available? Would basic open market operations be sufficient to cushion markets? What role should central banks generally play in dealing with market liquidity shocks that are transnational in origin?
Cross-border banking. Cross-border banking is growing, and U.S. banking organizations are playing an increasingly important role in the financial systems and markets of other countries. At the same time, most of the world's largest banks are now conducting significant operations in the United States. As a result, these institutions are now faced with myriad different regulatory regimes, regulators are increasingly dependent upon their counterparts in other countries for information, and the failure of such institutions will have spillover effects in not only their domestic economies but perhaps even greater implications for financial systems that are hosting them (see Eisenbeis 2006; Eisenbeis and Kaufman 2005, 2006). Regulators need a better understanding of how to measure and monitor the risks that these institutions pose as well as to seek ways to harmonize their legal, bankruptcy, regulatory, and supervisory regimes.

JOB - Hindsight and Foresight about Safe and Sound Banking

Introduction
This paper → "Perspectives on Safe and Sound Banking."
Focus on the issues that were probably, in hindsight, overemphasized, those that were perhaps underemphasized, and those that were not fully appreciated but → subsequently turned out to be important.
Finally, I want to raise issues that should be on any agenda for the future
Issues Overemphasized in the Study
Risk-based deposit insurance
A key issue in the finance literature and in the study was → the desirability of gearing deposit insurance to risk and → using options pricing theory to price that risk appropriately
Risk-based premiums were adopted → in the Federal Deposit Insurance Corporation Improvement Act (FDICIA) → Premiums are arguably too low and are collected only from more risky institutions
Two issues that limit risk-based pricing as a useful means to control risk taking.
First → realization that appropriate pricing depends upon not only the ability to measure risk but also to close an institution promptly when it becomes insolvent.
Second → effective risk monitoring and control → involves a trade-off between the costs of monitoring a bank's risk exposure
Revisions to regulatory agency structure and lender of last resort
The report recommended several changes in bank regulatory agency structure
Creating a competing deposit insurance option to be administered by the Office of the Comptroller of the Currency
Parceling out lender-of-last-resort administration to the insurance agencies using funds drawn from the Federal Reserve
Taking the Federal Reserve out of the prudential supervision area
Two issues are important.
First → suggestion that the insurance funds should have a primary role in banking supervision → because they have the strongest incentives to monitor bank risk exposures.
Second → this view on supervision stands in stark contrast to how deposit insurance and supervisory responsibilities are apportioned in the European Union → where generally deposit insurers are not involved in supervision
Issues Underemphasized in the Study
Prompt corrective action (PCA)
PCA combined with Structured Early Intervention and Resolution (SEIR) → perhaps the best way to protect taxpayer interests → was not fully realized
Accounting issues
Report argued for market-value accounting → when combined with PCA and SEIR → is necessary to protect the taxpayer from the costs of regulatory forbearance
Much attention has been given to the problem of implementing market-value accounting → But more focus has been directed to capital adequacy → which turns out to be diverting the attention of regulatory agencies → from the fundamental problems of measuring net worth
Controlling regulatory incentives
One of the key problems in the past → the tendency of regulatory and supervisory agencies to engage in forbearance toward troubled institutions
FDICIA requires the FDIC to minimize failure costs to taxpayers and requires disclosure and explanations when losses do occur.
However, banking regulators-with differing mixes of goals and responsibilities → can still be faced with conflicts of interest and agency problems → which can sometime lead to less-than-optimal decisions in dealing with troubled institutions
Consolidated risk management
Regulatory approaches → attempted to separate risk taking within a bank holding company structure –either to protect bank subsidiaries from risk taking in sister banks or from risks in non-banking subsidiaries– were fruitless
Increasingly banking organizations are consolidating risk management and operations functions → subsidiaries and affiliates are not operationally independent of each other → supervision of complex institutions rings truer today than ever → should be an important focus of banking supervision → risk control going forward
Underappreciated Issues
Financial system → evolved → changed its structure and risk profiles → significantly changing the way that institutions take on risk → and control their risk exposures
Three such developments were underappreciated
First → removal of McFadden Act restrictions on interstate banking and the speed and manner in which the banking system structure → changed
Bank mergers significantly reduced the number of banking organizations
Increased the size of the largest institutions
Concentrated their headquarters especially in New York
Second → The spread of computer-related technologies in combination with → explosion of intellectual technologies in the form of financial engineering → This development radically changed both institutions' risk profiles → their ability to evolve → and price assets and liabilities that had previously been provided only in bundled form or not at all
Third → The growth and expansion of truly global institutions → which now suggest that the origins of risk and vulnerabilities are not only more complex → but may oftentimes be more associated with developments in other parts of the world rather than in domestic markets. → As a result, better communication, coordination, and sharing of information with non-U.S. regulators are now a necessity
Concluding Remarks and Some Key Issues for the Future
→ Several issues that would be appropriate to consider → as potential agenda items → should a similar study be undertaken in the future
Accounting reform
The key to risk monitoring and control is effective valuation of net worth, → which requires not only the ability to value assets and liabilities → but also to appropriately consider the interactions among subsidiaries and affiliates → within complex organizations → and to understand the implications for valuation posed by new derivative instruments and contingent liabilities
Identity theft and privacy issues
Finding ways to both → verify and protect individuals' identities → crucial to ensuring confidence in electronic payments media. There may be an important role for regulators in this sphere that has yet gone unexplored
Shrinking role of intermediaries and the growth of capital markets
Attention now needs to turn → what role regulators and central banks may need to play in dealing with such → risks as well as the need to better understand cross market and cross-institution linkages → that arise from the trading of instruments → such as derivatives → which now separate out some of the risks that typically had been embedded in financial instruments and loans
PCA and SEIR as ways to enhance Basel I and Basel II initiatives
Basel I and Basel II initiatives → the definition and measurement of capital for regulatory purposes → and ways to employ them to limit bank risk taking.
The benefit of this exercise → institutions are now more systematic and concerned about their internal risk measurement schemes and capital allocation methods
Going forward → role that PCA and SEIR → limit the negative spillover effects of failure → and to better protect the taxpayer from potential liability
Consolidation risks
Relaxation of interstate banking restrictions → and the resulting consolidation of the banking industry → resulted in more concentration in U.S. banking → most largest nation's organizations headquartered in → New York or Charlotte
Should one of these large institutions experience financial difficulty → not only would the prompt resolution of such an institution be extremely difficult → but also the potential drain on the FDIC fund → could be enormous → because of the large size of these mega-institutions
Role of the lender of last resort
Risks → of the financial system and markets are increasing → with liquidity problems → risks coming from banking organizations → Federal Reserve should play as lender of last resort in → limiting the spread of these risks
Cross-border banking
U.S. banking organizations are playing an increasingly important role in the financial systems and global markets + world's largest banks are now conducting significant operations in the United States =
these institutions are now faced with myriad different regulatory regimes
regulators are increasingly dependent upon their counterparts in other countries for information
failure of such institutions will have spillover effects in not only their domestic economies

Pecking Order or Trade-Off Hypothesis? – Evidence on the Capital Structure of Chinese Companies

Introduction
Finance Theory offers 2 broad competing models → determine the capital structure of firm → Trade-off theory and pecking theory order
Trade-off theory states → value-maximizing firm will pursue an optimal capital structure by considering the marginal costs and benefits of each additional unit of financing → equates these marginal cost and benefits
Benefits of debt → tax advantage, reduced agency cost of FCF
Cost of Debt → increased risk, increased monitoring, and contracting cost associated with higher debt levels
The pecking order hypothesis argue → asymmetric information creates a hierarchy of cost in the is of external financing which is broadly common to all firms
New investment are financed first by retention → then by low-risk debt followed by hybrids like convertibles. → equities only as the last resort
Trade-off → large equity issues of low-leverage firms → better
Pecking order → the negative impact of profitability on leverage → better
Reason might expect firms in developing and transition economies (DTEs) to have different financing objectives from their counterparts
First → many private firms in the DTEs were originally state enterprises and carry different goals and corporate strategies from this heritage → corporate strategy is a significant determinant of capital structure → basic goals of the company
Second → Capital markets are less developed in the DTEs → it is typically a narrower rage of financial instruments available and a wider range of financial countries
Finally → accounting an auditing standards in DTEs tend to be relatively lax
Singh & Hamid → Firms in developing economies rely more heavily on equity than n debt to finance growth than do their counterparts in the industrial economies
Difficulties in distinguishing between trade-off and pecking order → because many determining variables are relevant in both models
This paper → studies the determinant of capital structure decisions → of Chinese companies → China is of interest for several reason → but particularly → because it is in unique position of being both → developing economy and transition economy
Huang and Song (2002) find → correlation between leverage and these characteristics in Chinese state-controlled listed companies → surprisingly similar to what have been found in another country
Huang and Song also → static trade-off model explains the capital structure of Chinese listed companies better than the pecking order hypothesis
Hypotheses
→ Fama and French (2002) emphasize → many of the variables held to determine leverage under trade-off or pecking order theories are common to both theories
→ in present test → three related aspects of corporate financing where trade-off and pecking order theories give different predictions are examined:
Determinants of Leverage → profitability, size, growth
Since less profitable firms → provide low shareholders return → greater leverage → increase bankruptcy risk and cost of borrowing → will lower shareholder returns still further
Low shareholders returns will also limit equity issues → therefore → unprofitable firms facing a positive NPV investment opportunity → will avoid external finance in general and leverage in particular
Thus Trade-off theory predicts a positive relationships between leverage and profitability
Baskin (1989) regresses current leverage on current profitability → will necessarily result in a decrease in current debt given investment and dividends
The study also controls → firm size → help discriminate between trade-off and pecking order theories
Warner (1977) argues → that there are economies of scale in bankruptcy → implying that the agency cost of debt → will be lower for larger companies
The converse argument is that firm size is a proxy for information asymmetries between the firm and the market
Larger the firms → more complex its organization → higher cost of asymmetries → and more difficult to raise external finance
Leverage and Dividends
Pecking order theory does not provide a distinctive theory of dividend → but the theory can be combined with the Lintner dividend model (1956) → to generate predictions for the impact of dividend on leverage
Pecking order theory implies → firms with higher past dividends → will have less “financial Slack” → and therefore higher leverage → because they require more external funds
Baskin (1989) → a significant positive relationship between the past dividend rate an current leverage supports the pecking order hypothesis
Pecking Order or Trade-off Hypothesis
Asymmetric information may cause rejection of profitable investment opportunities → because of the cost associated with rising external finance
Unlike trade-off theory → this implies the existence of direct links between asset growth and financing
The asymmetric information which lies behind pecking-order theory implies → larger firms are less transparent than smaller firms
Data and Methodology
China is in transition form a planned economy to → market economy and continuous to be characterized by a fragmented capital market, fragile banking systems, poorly specified property rights and institutional uncertainty
Most listed companies were originally state-owned enterprises, and privatizations has been incomplete → because the state often retaining a controlling share
Firms could partially disclose, distort, and even forge information for transaction or taxation purposes → with low risk of being caught
China’s accounting system is now being gradually harmonized with international Financial Reporting Standards (IFRS)
January 1st 2001 → new Accounting System for Business Enterprise implemented → All listed companies were requires to follow a enforcement procedures → but for smaller companies remain problematic
Data Covering China’s top 50 listed companies for the period 2001-2003 → the listings based on total assets, income from main business, net profit, and market value
Moreover → the study checked for the robustness of the underlying models by carrying out cross-equation test for parameter equity as between the two years of the estimated model
Two measures of leverage
First → wide measure → the ratio of total liabilities to total assets → commonly used in leverage studies → this suggest that trade credit given should be deducted from total assets
Second leverage measures → account receivable are deducted from total assets
Two other variables → defined in standard ways
First → measuring profitability (ROA) → one should ideally use the ratio of operating income to operating assets → rather than total assets
Second → dividend are scaled by book equity rather than the market value
Chinese share price were very volatile in this period and use of the dividend yield would have created distortions in the dividend measure in the cross-section
It is difficult to compare → Chinese with other countries → because of the substantial variations in the applications of accounting standards in China
Results
In general→ model 1 performs well as it mostly explains more than 50% of the cross-sectional variation in leverage
Profitability mostly has a negative and generally significant coefficient irrespective of whether it is lagged in the regression → when larger profitability is entered on its own → negative and significant → robust support for pecking order theory
The performance of Interaction between investment and financing → rather less satisfactory
Dividends and size → negative but not significant → consistent with pecking order theory → on the other hand → positive sign on leverage are more consistent with → trade-off theory
Finally → results of parameter stability test → emphasized that there are severe test because of the accounting changes between 2002 and 2003 → the results show that there is some degree of stability in the parameter across time periods
Conclusion
This study aims → Shed light on the empirical debate between the trades-offs and pecking order theories in → Chinese companies.
Main findings:
First → Significant negative correlation between → leverage and profitability
Second → Significant positive correlation between → current leverage and past dividends → although at lower significant level
Third → Investment model is inconclusive since → an insignificant negative correlation between → growth of investment and the rate of past dividends
Fourth → There is some degree of stability in the parameter values
The Most important finding
→ Surprisingly simple and conventional model as capable of explaining a significant proportion of → cross-sectional variation in → leverage among Chinese companies
Overall → results provide → tentative support for the pecking order hypothesis → demonstrate that a conventional model of corporate capital structure → can explain the financing behavior of Chinese companies