Capital structure in China : firm-specific factors, corporate governance and institutional factors

Abstract

Firms operating in a transition economy like China possess institutional characteristics that fundamentally differ from those of developed economies, it stands to reason: do existing theories on capital structure also apply to China in the context of its transition economy? Western capital structure theories such as trade-off theory, pecking order theory, and agency theory are all found to be able to explain the capital structure decision in Chinese listed firms, however, none of these theories suggests a prevailing explanation power. In addition, past studies have not accounted for cross-provincial differences in Chinese institutional settings and resolving multicollinearity issues with regards to corporate governance variables. This study seeks to address such concerns by analysing capital structure in China via firm-specific determinants, aggregate corporate governance index and other institutional factors all in one dynamic panel regression model namely Generalized Method of Moments (GMM). A result of this endeavour is that Trade-off theory may serve to best explain capital structure in China but only when having accounted for institutional settings in China. This study further found that shareholder theory may better explain the corporate governance issue in China. Moreover, government intervention as the variable represents institutional settings, is reported to be positively related to leverage, indicating that institution has strong influence on firms’ leverage as well. The findings of this study imply that, to instil better financial discipline among Chinese listed firms, regulators should focus reforms on Chinese stock and bond markets, which would optimise debt-equity mix. As a result, the implication on the industries is that well-targeted reforms would impose more accountability on managers in corporate financing choice as managers must decide debt-equity mixes based on market-valued costs, free from state intervention. The unique contribution of this study to the debate is empirical framework utilised, which incorporates institutional variables and governance factors (through the use of aggregated variables constructed by using Principal Component Analysis) into the analysis together with firm-specific variables. This improvisation advances the study a step further as econometric-related obstacles when examining governance factors are minimised as multicollinearity risk is reduced. Furthermore, the framework also utilise provincial-level data on institutional variables, which allows for distinction of the effect of each institutional factors on capital structure as there are no variations in accounting, taxation and bankruptcy regulations across provinces within China.