The Financing of Private Enterprise in China

1. Introduction
a. China’s economy → undergone fundamental change:
i. From complete reliance on state-owned and collective enterprise → mixed economy where private enterprises play strong role
b. The discrepancy between the dynamism of the private sector and its limited use of intermediated financing → private sector may not be able to sustain its current rate of growth unless it can increase its access to financing

2. Financing Patterns
a. Survey of private firms in Beijing, Chengdu, Shunde, and Wenzhou → the private sector arm of the World Bank Group → 80% considered the lack of access to finance to be a serious constraint
i. More than 90% of their initial capital came from the principal owners, the start-up teams, and their families
b. The relative importance of different sources of financing among surveyed firms → depend on firms size
i. Smallest firms → external sources are mainly informal channels
ii. Larger Firms → internal sources become less important
c. Commercial banks → the second most important source of funds for the largest firms after retained earnings
d. Banks provide more support for larger and relatively successful private firms
e. Chinese firms rely more on internal sources of financing than do firms in transition and developed economies

3. Factors Affecting Access to Financing
a. Difficulty private Chinese firms face in obtaining financing is due partly to factors within the financial system and partly to the nature of Chinese private enterprise
i. Bank incentives
§ 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 bad loan to a private enterprise
§ Expectation → State-owned enterprise is helped by government → private enterprise does not
§ Banks will discriminate against private sector firms
§ Banks need added incentives to lend to private enterprises
§ Banks concentrate to avoiding losses and show little interest in sharing the rewards of projects that might be riskier but have higher expected return
§ There are controls on interest rates and transaction fee
§ Banks are taking advantage of this more flexible interest rate regime, but interest rates need to be liberalized further to encourage more lending to private firms
§ State banks charge effective interest rates that are comparable to those in the informal market
ii. Bank procedures
§ The procedures rely on collateral and personal relationship rather than on project appraisal
§ Collateral requirements, the cost of the application process, and relationship banking tend to make it harder for smaller firms to gain access to financing
iii. Collateral requirement
§ Inability to meet collateral requirements → the most frequent reason for not being able to obtain a bank loan
§ In practice → real estate assets appear to the most common kind of collateral accepted
iv. Information problems
§ Information problem → especially severe for state firms in China
§ The resulting of clear ownership management in structures imposes obvious constraint of borrowing

4. Policy Agenda for Financial Sector
a. Improving private firms’ access to external financing requires:
i. Strengthen banks’ incentives to lend to private enterprises
§ An important step → strengthen profit incentives through private ownership and competition
§ Private financial institutions are less likely to be swayed by political considerations and more likely to be profit oriented
§ The big state owned banks → likely to dominate the domestic financial landscape for the foreseeable future
§ Strengthening the profit incentives of these banks → have a major impact on improving private firm’s access to bank loans
ii. Further liberalize interest rates
§ Further liberalization of interest rates → needed to improve private firm’s access to bank loans
§ Access to financing is more important than the cost of funds
iii. Allow banks to charge transaction fees
§ Bank finds → lending to private companies → carries higher unit transaction cost
§ Transaction fees → encourage banks to consider:
o More proposals from small firms
o Develop a more service-oriented culture
o Promote greater transparency and better accounting standards
iv. Develop alternatives to bank lending (Leasing and Factoring)
§ Leasing and factoring are underdeveloped in China
§ In China, leasing faces obstacles:
o Rent arrears have long been a problem
o Accounting standards are unclear
o The regulatory environment does not provide equal treatment with other sources of capital investment financing
o Funding is a perpetual concern
§ Factoring → the sales of firm’s account receivables to a financial institution
§ Factoring → is a way to improve a company’s liquidity by substituting a cash balance for book debt
v. Create the framework for the development of private equity markets
§ Private equity markets in China are at an embryonic stage of development
§ Industrial investment funds → No regulations cover the organizational structures that can be used to establish private equity funds
§ Structure equity funds → can be developed is:
o Legal instruments are in place
o High ability of investors to use a variety of financial instruments to structure investment
§ Private enterprises → have lack of flexibility in their financial arrangements
vi. Improve access to public equity
§ The availability of exit mechanisms is a key condition for the development of private equity markets
§ Quota system on listing → private firms would have greater opportunity to acquire long-term funding through the equity market
§ Two ways to further improve private firm’s access to public equity:
o Broaden the range of exit mechanism available to investors
o Relax listing requirements

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

I. Introduction
a. Determine capital structure of a firm
i. Trade-off theory
§ A value-maximizing firm will pursue an optimal capital structure by considering → the marginal cost and benefits of each additional unit of financing → then choosing the form of financing that equates these marginal cost and benefits
o Benefits of debts → include its tax advantage and the reduced agency costs of FCF
o Cost → include the increase of risk of financial distress and increased monitoring and contracting costs associated with higher debt levels
ii. Pecking order theory
§ Based on the argument → asymmetric information creates a hierarchy of cost in the use of external financing which is broadly common to all firm
b. Distinguish the two theory in practice is not easy
i. Fama and French can only identify two predictions on which either theory performed better than another
§ Trade-off theory → better in “large equity issues of low leverage firms”
§ Pecking order theory → better in “the negative impact of profitability on leverage”
c. It is difficult to distinguish between trade-off and pecking order models because many determining variables are relevant in both models
d. Several reasons why one might expect firms in developing and transition economies (DTEs) to have different financing objectives from their counterparts in the industrial countries
i. Many private firms in DTEs were originally state enterprises and carry different goals and corporate strategies from this heritage
ii. Capital markets are less developed in DTEs → narrower range of financial instruments → wider range of constraints on financing decision
iii. Accounting and auditing standard in DTEs tend to be relatively lax → implementing asymmetric information is more problematic
e. Singh and Hamid (1992) and Singh (1995) → concluded that firms in developing economies rely more heavily on equity than on debt to finance growth than do their counterparts in the industrial economies
f. None of the researchers explicitly set out to discriminate between trade-off and pecking order theories in a manner designed to discriminate between them
g. This paper studies the determinants of capital structure decisions in a sample of listed Chinese companies
i. China is of interest for several reasons → but particularly because it is in the almost unique position of being both a developing economy and a transition economy

II. Hypotheses
Three related aspects of corporate financing where trade-off and pecking order theories give different predictions:
a. Determinants of Leverage: profitability, size, and growth
i. Trade-off theory and Pecking order theory
§ Trade-off theory → a positive relationship between leverages and profitability
o Unprofitable firms facing a positive NPV investment opportunity will avoid external finance in general and leverage in particular
§ Pecking orders theory → there will be negative relationships between leverage and profitability
o Firms will use retentions first then debt and equity issues as a last resort
o Less profitable firms facing a positive NPV investment opportunity will be more willing to use external funds if cash flow are weak
ii. Trade-off theory and Pecking order theory
§ Trade-off theory → a positive relation between leverage and firm size
o There are economic scale of bankruptcy → agency cost will be lower for larger company
§ Pecking order theory → a negative relation between leverage and size
o Larger the firm → more complex the organization →higher the cost of information asymmetries → more difficult to raise external finance

b. Leverage and Dividends
i. Trade-off theory → negative relationship between dividends and leverage
§ Dividend are high (retention low) → because external financing low
ii. Pecking order theory → Positive relationship between dividends and leverage
§ Firms with higher past dividends will have less financial slack → higher leverage → because they require more external funds

c. Corporate investment and financing
i. Trade-off theory → Leverage should be negatively related to investment → because of funding limitations arising from high leverage
ii. Pecking order theory → larger firms are less transparent than smaller firms

III. Data and Methodology
a. Use base in China
i. China → in transition from a planned economy to a market economy → continues to be characterized by a fragmented capital market, fragile banking system, poorly specified property rights and institutional uncertainty
ii. Chinese firms → have a relatively short operating history → have not accumulated much reputation
iii. Most listed companies→ originally state-owned enterprises → privatization has been incomplete with the state often retaining a controlling share
iv. Banks → often process commercial loans and collect debts in a preferential way → the market is subject to irregular government intervention
v. A well-functioning and fully-enforced accounting and auditing system has developed only gradually in China
vi. Firms could partially disclose, distort, and even forge information for transaction or taxation purposes with low risk of being caught
b. Study attention and methodology
i. China top 50 companies for the period 2001-2003 → data were extracted from the published accounts of non-financial companies listed on the Shanghai and Shenzhen stock exchange
ii. The listing is based on total assets, income from main businesses, net profit and market value
iii. For holding companies → the consolidated data were used
iv. Two datasets:
§ For 2002 and 2001 → using 2002 annual report
§ For 2003 and 2002 → using 2003 annual report
v. Two measure of leverage
§ Wide measure → ratio of total liabilities to total assets
§ Standard ways → two comments:
o In measuring ROA → one should ideally use the ratio of operating income to operating assets rather than total assets
o Dividend → scaled by book equity rather than the market value

IV. Results
a. More than 50% of the cross sectional variation in leverage
b. Profitability → mostly has a negative and generally significant coefficient irrespective of whether it is lagged in the regression →provide quite robust support for pecking order theory
c. Assets growth → highly significant and has a positive sign contrary to the predictions of trade-off theory
d. Size → signed positive, a finding that is more consistent with trade-off theory
e. Dividend → positively signed as predicted by pecking order theory
f. Dividend and size → signed negative but not significant → consistent with pecking order theory
g. Profitability:
i. Negative but significant in 2002 → consistent with trade-off theory
ii. Positive but significant in 2003 → consistent with pecking order theory
h. There is some degree of stability in the parameters across time periods