the capital structure of chinese companies

The Capital Structure of Chinese Companies


Studies carried before relating to capital structure have often concentrated on data gathered from the US and UK in coming up with tangible theoretical or statistical arguments. However, the manner in which these theories pose an implication to other countries such as China has not been explored in full details. Studies carried out by Prasad et al (2001) were based on an empirical survey of capital structure and this group of scholars made an observation that much of the empirical studies on capital structure was more concerned with countries that are considered to be major industrialized and that there is indeed relatively less studies conducted on the developing economies and those that are in transition such as China and Japan.

China attracts interest from current scholars based on the fact that it is in transition coming from a command economy towards an economy that is market based; and that many of the companies listed in China were at some point owned and controlled by the state. The basic aim of having an optimized capital structure is to make a clear decision regarding the proportion relating to the a number of forms of debts as well as equities which could be able to maximize the value of the firm, while at the same time being in a position to minimize the total average cost that is incurred in capital acquisition.

The relationship that has often existed between capital structure and the value of the firm has been quite controversial as far as finance is concerned. Many theories put in place in trying to explain this relationship either theoretically or empirically have often predicted positive, negative or at some point none-existence of any statistically significant relationship as far as Modigliani and Miller (1963); Jensen and Meckling (1976); Myer (1984); Graham (2000); Baker and Wurgler (2002); and lately, Welch (2004) are concerned. Empirical results have also been viewed as producing mixed results if studies conducted by Abor (2005) and Kyerboach-Coleman (2007) are anything to go by and this could be attributed to two problems one being the model specification and the other one relating to the estimation of the model.

The most remarkable development in reforming both large and medium enterprises that are state-owned was China’s corporatization. However, even at present times, it is seen that the government still controls the majority shares in these corporatized SOEs through either direct or indirect shareholding by means of state-owned institutions like the investment companies owned by the state, state asset management agencies, and state holding companies.

Studies show that the main ownership that is devoid of the state is that of individual shareholding thus making it rare for the independent non-state institutional investors to exist. However, it is important to note that the process of corporatizing state-owned enterprises (SOEs) has been a major driving force in the changes seen within the financial system of China. This has been evidenced by the emergence of two capital markets namely the Shanghai Stock Exchange (SHSE) as well as the Shenzhen Stock Exchange (SZSE) in the early 1990s, which have since then developed rapidly to become world renowned stock exchange players if the 1088 listed companies by mid-2002 are anything to go by (Li, 2009). This introductory presentation leads to the main aim of this study report which follows below.

Study Aim
The main aim of this research paper is to examine contemporary academic research information and actual business practices that relates to various issues in the Chinese financial markets. In this study the paper specifically addresses the issue of capital structure in Chinese firms. This study has been supported by secondary data that was collected from various academic journals as well as documented evidence gathered from various empirical studies that have been conducted before on the matter. It thus employs both theory and empirics in trying to demystify the capital structure of Chinese firms. This is important in trying to bring on the table the facts and figures pertaining to the structure of capital in the firms that operate within the legal framework of the Chinese economy.

China being an economy in transition, it would be very interesting to establish the capital structure of its firms. This is because of the intricate nature in which the Chinese firms that have a history of state-ownership and control are emerging as corporatized firms which equally compete with the individual private owned firms in the stock market. The importance of establishing the capital structure and firm value cannot be dismissed.

Prior studies have concentrated on developed or industrialized countries but failed to pay attention to the upcoming economies (Li, 2009). The current paradigm shift in economic power between the west and BRIC countries has elicited a lot of interest as to whether similar findings, both theoretical and empirical could be applied in the emerging major economies such as China and India.

The interest that China elicits emanates from the fact that it has historically presented itself as a command economy where the military state as well as socialist establishments of governance has had a major impact on how firms conduct businesses. Further, the long arm of the state cannot be overruled in firm ownership in China as far as capital structure is concerned. The recent spate of corporatization reforms have left many questions unanswered as far as the capital structure of Chinese firms is concerned. This is why the study of the Capital Structure of Chinese Companies is more relevant at this point in time and this stands to support this study report.

Theoretical Perspectives
The method for business financing has over the years been viewed as the specific way in which firms raise funds. This relates to internal and external sources of financing, indirect and more direct financing, as well as equity and debt financing. A number of factors are in place, which affect the financing decisions and these could be national, macroeconomic, industry, as well as firm specific characteristic factors. Considering the capital structure of the Chinese firms, this study happens to lean more towards firm specific factors based on financial leverage. Thus, the issues of asset composition and uniqueness set in (Kyerboach-Coleman, 2007).

Four theories regarding capital structure have been widely acknowledged and these are the capital structure irrelevance, the static trade-off, capital structure relevance, and the pecking order theories.

In cases where there exists no friction as well as perfect markets, Modigliani and Miller (1958) did argue that the value of the firm becomes independent of the capital structure of that firm and as such there is expected to be no optimal capital structure for a particular firm. However, these assumptions are quite farfetched and unrealistic as one cannot expect that in such a competitive market place there would be no transaction costs, no taxes levied, and that there would be symmetric information available as well as homogenous expectations. This is quite unrealistic and definitely not applicable since friction, taxes, differences in information availability, and agency costs must exist in the real world as Jensen and Meckling (1976) and Myer (1984) later established.

Following the capital irrelevance theory, subsequent studies did incorporate benefits of tax being determinants of a firm’s capital structure. It is evident that the key feature pertaining to taxation is the interest recognition aspect treated as an expense that is tax-deductible. In this regard, for example, a firm which pays taxes does end up receiving a slight form of offsetting interest that is considered as a tax shield normally known to be lower tax paid. This means that the value of the firm gets increased by means of debt within the capital structure as a result of the tax deductibility relating to the payments of interest on the debt. This actually presents a factual admission that capital structure is not irrelevant but rather affects the value that a firm has.

Recent studies conducted by Graham (2000) showed that benefit of capital tax on debt actually did amount to roughly 10% of the value of the firm and additionally, tax penalty was seen to lower the benefit by around 2/3 before the 1986’s Tax Reform Act and even after the reforms it still went to almost half.

The static trade-off theory presented by Myers (1977) did argue that there exists an optimal capital structure. In this regard, the proposition was that a firm that is maximizing its value will have to find an optimal capital structure through the trade-off between costs and benefits associated with debt financing. Firms do borrow to that point which does equate marginal costs as well as benefits of every additional financing unit. Benefits of debt stand for the tax advantages as well as reduced agency costs relating to free cash flow while debt costs represent bankruptcy costs and a rise in agency costs when the creditworthiness of a firm is thrown in serious doubt (Li, 2009).

The pecking order theory was proposed by Myers (1984) and Myers and Majluf (1984) and it did suggest the existence of a hierarchy of preferences in a firm pertaining to the investment financing and the absence of a target debt ratio that is well-defined. This is attributed to the asymmetry in information between the company and the potential financiers. Internally generated funds are employed in initial financing of firms and this is followed by acquisition of less risky debt in case additional funds are required and then eventually risky external equity issue is acquired in order to foot the remaining capital needs. The order of preferences does reflects some form of relative costs regarding to finance, which vary between a number of different financial sources.

Analysis of Financing Options of China’s Stock Listed Companies
This analysis is based on the internal and external financing sources, direct and indirect financing and equity and debt forms of financing. In the capital structure of China’s listed companies, there are relatively low levels of internal financing sources as far as proportionality is concerned. The listed companies that have positive profits which are undistributed, the current proportion held by the external financing sources stands at between 80 and 90%, which is actually much higher than that of the internal financing sources (Li, 2009).

On the other hand, the listed companies which have reported negative retained earnings are seen to be almost fully dependent on the external financing source and this proportion is above 90%. For instance, looking at the data from 1998, these listed companies with negative retained earnings posted a ratio of internal financing source that was more than -10%, a scenario which vividly shows total reliance on the external financing above normal. This observation elicits the common conclusion that on the whole, the listed companies in China actually do heavily rely on financing from external sources (Kyerboach-Coleman, 2007).

When it comes to direct and indirect financing, it is seen that the asset debt ratios of China’s companies that are listed on the stock exchange actually fall below the set national average level and this has been observed to take a negative trend that shows decline over the years.

Financial observers attribute this trend to the single financial system that has been long standing for years, a factor that in reality did lead to the currently seen status of over-indebtedness in these state-owned firms. When the state firms have reorganized their share system and got market approvals, they are allowed to get much capital through activities of direct financing like issuing out of new shares as well as follow-up distributing shares and therefore lower the asset-liability ratio. The given ratio of assets and liabilities within the listed companies in China is lower and this does reflect the fact that most of the debts incurred by listed companies are actually written off (Graham, 2000).

Equity and debt financing have been considered to be the two basic forms of external financing. Usually, in a stock market that is mature, the proportion held by the bond market is normally quite larger as is opposed to the stock market, at around 20 to 30% in the stock market and 70 to 80% for the bond market. However, when one takes a keen look at the Chinese market, there exist a quite contrary situation that is being presented between equity financing and debt financing for the listed companies.

There is a feature of light debt financing and on the other hand, heavy equity financing which presents a very interesting scenario that should elicit much research. This scenario typically shows the common preference for financing through equity to that of debt financing within the Chinese economy and this brings about a very serious syndrome of misappropriation bringing conflicting arguments in relation to the pecking order theory discussed above as far as the structures of modern finance theory are concerned. Listed companies have to be quite sensitive to the use of equity financing since giving out of equity in order to raise funds has been considered by capitalists as being information relating to poor prospect as far as the company is concerned.

For example, within the US, the companies that have been listed do make an allocation of one on every 18.5 years averagely. From the time of 1960s, there has been a negative outcome for cancellation and subsequent buyback of shares from any listed company that is in excess of the total shares issued as well as net increments in the offerings of stock. As such, any form of issuing stock in order to finance these companies is considered a taboo for any US company that is listed. However, this scenario is different when it comes to China and is a direct opposite of what happens in the US. Recently, the companies listed in China have undoubtedly developed a preference for equity financing and at the same time indicating a stronger preference for the allotment and issuing of new stocks based on the choice of making re-financing (Li, 2009).

Chinese stock markets have presented some special features. Shares are either classified as A shares or B shares. The A shares are for the government either owned directly or indirectly while the B shares are the ones left to the overseas and local investors. Even though stock markets in China seem to be growing the financial sector has remained under the strong control exercised by the state. This presents the situation whereby there is state monopoly over the financial sector thus hindering the good development of capital markets in China as well as the growth of the financial institutions that are not state-owned, particularly in the bond market.

Accessing of long term debts which is given through state banks by Chinese firms has often hit setbacks due to strict control exercised by the state thus making the risk of defaulting on debts very high. This implies that even in cases whereby bankruptcy is enforced, it ends up not being efficient. To add more problems to these, the legal and institutional frameworks of Chinese economy are still quite immature as well as incomplete and this could be due to the long term nature that reforms need and the fact that China is still within the transition window. For example, as it stands the company laws as regard to the rights of debt-holders is still very much ambiguous and not feasibly enforceable. This is because it is flawed when it comes to giving government agencies and shareholders a lot of powers as far as bankruptcy procedures are concerned (Graham, 2000).

Empirical Review
In finding the determinants of Capital structure in Chinese firms, Demirguc-Kunt and Maksimovic (1999) run a reduced equation as shown below and incorporates ownership and institutional characteristics:

The firm being i and the year t. variables of interest happened to be only those related to the quality of institutional framework and the ownership structures. Findings of the above formula are attached under the appendices for the sake of interest groups using this study (Kai, Heng & Longkai, 2006).

Empirical data shows that using financial leverage in China’s companies has become polarized. Average debt ratio in SOEs stands at over 80% and current liabilities ratio is at a tune of 90% or even more, which is beyond the norm in debt level. The only source of external financing is from state-owned bank loans and recently these commercial state-owned banks reported a ratio of bad debts of up to 30% which exceeded the 17% level set by the central bank. The asset liability ratio of the SOEs stands at 86.5% compared to a lower asset liability ratio which stood at less than 50% in the Chinese listed companies. The analysis in the table below relates to the research study carried out by Li Lei (2009) on non-financial listed companies in relation to their financial leverage.

Average financial leverage
Less than 50%
More than 50%
More than 70%
An increment on average utility of financial leverage within the listed companies in China did increase by each year. There was however uneven distribution of financial leverage thus those enterprises at lower levels of between 10 and 30% did decline. There was an increment in the level of uncertainty in company operations since more than 50% of the companies could be listed as being in safe state. The capital structure of the Chinese listed companies as far as financial leverage is concerned could be classified as unreasonable (Li, 2009).

Theories of capital structure have been vividly explained. It has been seen that there exists a big problem as far as the capital structure of Chinese companies is concerned. This is because of the dominant lean towards equity financing as is opposed to debt financing and the fact that there is almost zero internal financing as opposed to over 90% external financing sources. The state control level is still very high as this has been established to be implemented either directly or indirectly through state agencies, firms and institutions. Classification of shares as A and B and putting restrictions on which shares investors can have seems unique for this market. The trend has also been reviewed under the empirical data presented.

Based on the findings of this research, it was prudent that certain policy recommendations be put forward to assist the policy makers in charting the way forward. These recommendations are:

That China’s policy makers should develop positive debt financing. There is thus the need to shift from equity financing to debt financing since equity financing frequently changes and also it lacks measures for supervision thus having no impact on company performance. Thus bank market reforms are needed and also there should be developed corporate bonds.

There is need to promote financing of corporate bonds since bond financing has been proven effective in western or developed countries. In this regard, the government should be able to strengthen its policy orientation process and try reversing development policies seen having biasness towards the capital market. It should open the current restrictions on and relieve the obstacle put on issuance of corporate bonds as well as improving the liquidity level for these corporate bonds.

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