Corporate Finance in China

29 Oct 2019 | Corporate Finance, The World Economy

China will soon become the largest economy in the world, but many Westerners (myself included) know very little about it. I’ve thus tried to educate myself about the Chinese economy, and earlier posted introductions to corporate governance in China and capital markets in China. This post is an introduction to corporate finance in China – capital structure, corporate investment, payout policy (dividends and repurchases) and cash holdings. It is taken from Jiang, Fuxiu, Zhan Jiang and Kenneth A. Kim (2018): “Capital Markets, Financial Institutions, and Corporate Finance in China.” Journal of Corporate Finance, forthcoming. All of these points I learned from the original article, so please cite it (not me) if you use anything from this post.

Capital Structure

  • 2015: average total liabilities / total assets of 46%, total debt / total assets of 20%. Not an outlier compared to other countries. But debt is unusually short-term
    • Government reserves long-term debt to finance projects consistent with national interests.
    • China Banking and Regulatory Commission (CBRC): to obtain long-term loans, firms must be engaged in industrial / land development / environmental / long-term investment management projects
    • SOEs are more likely to be engaged in such projects, so have higher long-term debt ratios than non-SOEs
  • Firms prefer external equity to debt – the opposite pecking order to Western firms. Reasons:
    • Firms pay little dividends, so equity involves a lower cash cost
    • P/E ratios are high, so raising equity is attractive
    • Loans are short-term, so equity is the primary source of long-term financing
  • While Chinese firms prefer to issue equity, the equity market is small and the regulatory hurdles are high: firms can only issue an SEO if they’ve paid dividends for three consecutive years and have an ROE of at least 6%. So they end up borrowing from banks, which explains they high bank financing documented in the “Capital Markets in China” post
  • Traditional capital structure determinants are unlikely to matter in China:
    • Bankruptcy.  Largely irrelevant given expectation that local or national government will bail out large firms and SOEs
    • Market Timing. Firms must meet China Securities Regulatory Commission (CSRC) requirements to issue SEOs; rejected, must wait another 6m. So, hard to time the market precisely
  • Contrary to common belief, little evidence that Chinese banks discriminate in lending in favor of SOEs: non-SOEs have higher debt ratios
  • Firms headquartered in west (east) have higher (lower) debt ratios
    • Since 2000, Western Develoment Strategy to increase credit to the west
    • Western firms are young, and many don’t meet the 6% ROE threshold to issue SOEs

Corporate Investment

  • China’s mean investment ratio is the highest among > 40 countries. Unsurprising given growth rate of Chinese economy
    • Manufacturing firms invest more than non manufacturing firms, due to high industry competition
  • Non-SOEs invest as intensely as SOEs, contrary to common belief that China’s high investment comes from SOEs
    • SOEs invest more in absolute terms because they’re bigger, but not when scaled by firm size
  • Government policy has a large effect on investment. Last two elections were 2002 and 2012
    • 2002: incoming government emphasized growth and investment; investment jumped from 2002 to 2003 for both manufacturing and non-manufacturing, SEOs and non-SEOs
    • 2012: incoming government deemphasised growth for the sake of growth, given overcapacity and environmental concerns. Investment fell in from 2012 to 2013 across all categories
  • High investment in R&D, with R&D/sales rising for both SOEs and non-SOEs in recent years
  • SOEs may be over investing – lower ROA than non-SOEs despite high investment
  • 1/3 of listed firms acquire other firms in a given year; most targets are unlisted private firms

Payout Policy

  • Number of firms paying dividends was 30% in 1998, 70% in 2015
    • Jumped from 32% to 64% in 2000 due to CSRC rule that a firm must pay dividends for three years in a row to issue SEOs.
      • CSRC then required dividend payout ratios of at least 20% (30%) from May 2006 (October 2008) so satisfy the 3-year rule
    • Contrasts the US, where the number of firms paying dividends is falling
  • Dividends are sticky, but for different reasons for the US
    • US: dividends are sticky as dividend cuts are a negative signal
    • China: dividends are sticky due to the 3-year rule
  • Payout ratio fell from 44% in 2005 to 30% in 2007 since 2005 split-share reform made nontradable shares tradable. Thus, investors could sell shares to realise returns, and had less reliance on dividends
  • Dividend yield of only 1%, low compared to other countries
    • Firms pay the minimum to satisfy the 3-year rule
    • Investors don’t demand dividends; their focus is short-run speculative gains
  • 97% of firms pay dividends in their first year of listing, compared to 5% in the US. Reasons:
    • Satisfy the 3-year rule
    • Shares held by executives and controlling shareholders are locked up for 3 years, so dividends are the only way to realise a return
    • IPO is often oversubscribed, increasing the offer price and leading to surplus capital
    • Paying dividends reduces book equity and helps meet the 6% ROE requirement
  • Overall, dividends are driven by regulation (3-year and 6% requirements) and catering (investors don’t want dividends) rather than signalling or free cash flow, unlike in Western firms.

Cash Holdings

  • Average cash holdings of 20% in 2015. Following shocks, Chinese firms increase cash for precautionary reasons (just like non-Chinese firms)
    • 1999-2001 after 1997 Asian financial crisis
    • 2008-2010 after 2008-9 global financial crisis
    • Increase strongest for non-SOEs, because SOEs are less risky due to government ownership
  • Dividend payers have more cash due to non-paying firms, since only dividend payers can conduct SEOs
    • Normally, dividend payers have less cash since they pay out their cash
  • Productive firms hold more cash, due to financial frictions – inefficient to pay out cash and raise it again
    • Normally, productive firms hold less cash as they invest it