This chapter presents the overarching literature review for this PhD project. It first starts with the theoretical background of expropriation agency cost applied in this PhD thesis. As this study examines listed firms with “princelings” connections on the Chinese stock market, it is related to the theory on expropriation agency cost according to the previous relevant literature.
As this study investigates listed firms with political connections, it is natural to move forward to an overview of the Chinese stock market. In particular, Chapter 2 describes political influence on the Chinese stock market. The political system is dominated by the rule of one-party control, which motivates the authors to examine listed firms with connections to political elites through comparison to firms without such political ties. Therefore, it is necessary to illustrate political influence on the Chinese stock market.
Chapter 2 also fills the gap on expropriation agency cost in the Chinese stock market. To the best of our knowledge, this PhD study is the first to investigate whether there is expropriation in profit distributions. Previous researches relevant to dividends policy based on the Chinese stock market mainly focus on the phenomenon of low dividend payments by listed firms. However, this study not only exhibits the dividend puzzle, but also gives the reasons for the low level of dividend payments by Chinese listed firms. Looking ahead, this study notes that expropriation through profit sharing in China has stubborn roots. Although the Chinese government has made many efforts to improve dividend payments, the incentives that give rise to the expropriation are largely intact. For example, minority shareholders have no legal recourse and security regulators have limited jurisdiction over the controlling entities, even though an extremely transparent form of expropriation can persist for a long time. The findings of this study provide new insights into why existing legal and extra-legal governance mechanisms are inadequate to contain expropriation at the expense of minority shareholders.
Overall, the overarching literature review in Chapter 2 guides the readers logically into the motivations for this PhD study through the agency cost theory, an overview of the Chinese stock market, and corporate governance among Chinese listed firms.
CHAPTER THREE: ESSAY
ONE:
THE
DIFFERENCE
BETWEEN POLITICALLY CONNECTED AND NON-
CONNECTED FIRMS: A NEW TYPE AND EVIDENCE
FROM THE CHINESE STOCK MARKET
This chapter presents the first essay which systematically examines the differences between politically connected firms and non-connected firms in terms of accounting ratios drawn from three financial statements and corporate governance variables. A new type of political connections is defined and a new theory is developed to describe the observed differences. Section 3.1 introduces the chapter; section 3.2 reviews the relevant literature; and section 3.3 defines the special type of political connection and introduces the data. Section 3.4 develops the hypotheses and explains the theory, as well as discussing the methodology in detail. This empirical analysis is described in Section 3.5 and robustness testing is in Section 3.6. The conclusion is given in Section 3.7.
3.1 Introduction
The primary purpose of this study is to examine whether financial reporting outcomes vary systematically with the special type of political connectivity of “princelings” among the Chinese listed firms on the two primary stock exchanges: the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE).
Most of the available literature on Chinese political connections is based upon firms’ ownership structure (such as state ownership), or senior managers’ historic official government positions or relations. The uniqueness of this study is the special definition of political connections of “princelings”. A firm will be included in the grouping of politically connected firms (PCFs) if there is at least one important person (among top officers, directors or major shareholders) in a firm who has the characteristics of a “princeling”, namely, the person is a relative (including spouse, child, sibling, parent, cousin, or nephew/niece) of top state leaders’ families or other high-ranking public officials.
There are two groups of theory describing the impact or influence of political connectivity on a related firm. The first is the “helping” hand theory (Y.-L. Cheung et al., 2010; B. B. Francis et al., 2009) and the second is the “grabbing” hand theory (Lindbeck, 1976; Rajan and Zingales, 2003; Sappington and Stiglitz, 1987; Shleifer and Vishny, 1994). This study has examined literature reporting on the second group, including Fan et al. (2007) and
Cheung et al. (2010). Unlike previous research, this study fills a gap by using a special sample and finds that the major characteristics of the sample fit within the first group. The explanation for the result is that the “princelings” political connection does not usually have a direct influence on the operating business decision making, but instead has a possible indirect influence on the business activities, such as securing access to new business opportunities, cheaper materials or capital supplies because of their name and the network relations behind them.
Prior academic research shows that political connections are prevalent around the world, irrespective of a country’s level of economic development (Faccio, 2006). A substantial
body of empirical evidence documents that political connections may be beneficial to firms in various aspects, ranging from debt financing (Johnson and Mitton, 2003), tax payments, government bailouts (Faccio et al., 2006) and regulatory protection (Kroszner and Stratmann, 1998). However, some papers in the public choice literature argue that political connections lead to rent seeking and expropriation (Frye and Shleifer, 1996; Shleifer and Vishny, 1994; Stigler, 1971). Despite this mixed evidence on the value of political connections, the results of any single-country are specific to that country’s conditions.
As the second biggest economy in the world, China is an appealing case study for political connections for several reasons. First, China is a relationship-based capital market due to the impact of its deep-rooted culture. Under such circumstances, the phenomenon of cultivation of political ties in the Chinese stock market is not surprising (La Porta et al., 2000a; Ma et al., 2013). Second, Chinese crony capitalism under a stable single-party provides a particularly durable setting for examining the role of political connections on firm performance. Third, although China has one of the fastest growing economies in the world and its economic importance is likely to grow even more in coming decades, it has weak legal and financial systems (F. Allen et al., 2005). Thus, corporations operating in such an institutional background have incentives to build political connections in order to maintain sustainable growth.
Generally there are two important issues associated with political connections. One is the contrast between improved performance due to benefits of political connections, and impaired performance due to agency costs of political connections. The second is that the degree of political connection in Chinese firms may be changing over time, so previous findings may no longer hold true.
This study has developed the theory of “Golden hens vs. Chickens” to explain the specialties of the “princelings” connected firms. The “princelings” usually come from the “sky” and choose their preferred target firms in a manner as if they were “sky-diving”. They usually have no economic or technological power, and have no advantage in knowledge or skills. Combining the reality that they have a superpower by birth, and they have the freedom to choose those firms with which they prefer to work. They will naturally choose “good” firms (“Golden hens”) for their “landing” targets. The best use of
“Golden hens” is to have a larger harvest of “eggs” in the future; killing them for their current meat (such as through cash tunnelling) is not optimum.
To test the theory, this study focuses on two main research questions: 1) whether the politically connected firms (PCFs) differ from their non-connected peers in accounting performance; and 2) how these firms are different from their matched peers. Specifically, this study tests the differences from three angles; operating business efficiency, cash tunnelling levels, and reinvested capital as shown in retained earnings. This study hypothesize that the “princelings” firms should be outstanding in their business operations, associated with less cash tunnelling and have accumulated higher business profits in the form of retained earnings. The results of this study have produced some strong evidence to support these hypotheses.
The sample in this study is unique. It manually collects data on the PCFs identified if at least one of its large shareholders (anyone controlling at least 10% of voting rights, directly or indirectly) or top officers (CEO, chairman of the board, president, or secretary) is a current or former government bureaucrat for central or local governments or the military, or is closely related to a politician (Faccio, 2006). This study selected matching firms from the candidate firms identified as non-connected, for each connected firm. For the main tests, the matching firm for each connected firm met the following four criteria; belonged to the same industry, had the nearest total assets in the first year after IPO, had the same trading status, and had the closest age relative to listing. The final sample comprises 8387 firm-year observations between the PCFs and the non-connected firms.
The results show that the “princelings” and “Golden hens” are associated with each other; however this study presents no evidence on their causal relationship. For this question the authors suggest there are two possible reasons. One is that the “princelings” have brought some advantages to their “landed” firms and so have made them into “Golden hens”. The other is that these firms with a “Golden hens” ability have a better chance of being selected by the “princelings” (or these firms are more attractive to the “princelings”). Although this study cannot detect any reason to reject the possibility of the second reasoning, it has observed the tendencies of some accounting ratios, such as retained earnings and net profits, suggesting evidence in favour of the first reasoning.
Overall, the findings in this study contribute to the growing literature on political connections in several ways. First, it is the first to identify a special type of political connection, called “princelings” in this study. The second contribution is the development of the “Golden hens vs. Chickens” to explain the specialties possessed by the “princelings” firms. The third contribution is the empirical evidence produced that supports the new theory.
The rest of the chapter is organised as follows. Section 3.2 reviews the relevant literature and Section 3.3 defines the special type of political connection and introduces the data. In Section 3.4 this study develops the hypotheses and the explanatory theory, and then discusses the methodology in detail. Then empirical analysis is described in Section 3.5 and the robustness tests in Section 3.6. Then conclusion is given in Section 3.7.