Rent Seeking and Corporate Finance: Evidence from Corruption Cases

1. Rent Seeking and Corporate Finance: Evidence from Corruption Cases Joseph P.H. Fan* Oliver M. Rui* Mengxin Zhao** *Chinese University of Hong Kong **Bentley College

2. Corporate Financing Patterns in Emerging Markets • Companies in emerging markets rely on debt much more than equity to finance their investment • Moreover, they rely on short-term debt, even when they engage in long-term investment • Banks, not capital markets, are the primary sources of funds for firms in developing countries

3. Cross country pattern of corporate leverage (Fan, Titman, Twite, 2006)

4. Cross country pattern of corporate debt maturity (Fan, Titman, Twite, 2006)

5. Research Questions in This Study • To investigate the impact of political rent seeking on corporate financing behaviors in China • Research questions • How do rent seeking and corruption affect capital structure, debt maturity, and long-term debt financing of the Chinese firms? • In retrospect, whether political connections provide the firms financing advantages? • Are the financing advantages of the politically connected firms reflected in their stock prices? • Does corruption affect capital allocation efficiency?

6. Why China?Pervasive corruption • One of the world’s highly corrupted countries • According to China’s official record, during 1997-2002, there are totally • 861917 corruption cases under investigation • 842760 corruption cases concluded • 846150 people punished by communist laws, of which 137711 expelled from the communist party • Among the punished communist party members, • 28996 county （县）level • 2422 intermediate（厅,局）level • 98 provincial （省, 部）level or above

7. Corruption in Asian Economies(Source: Transparency International: mean Corruption Perception Index 1992-2000)

8. Why China?Dominant role of bank debt in corporate finance • Equity markets small • Banks as the primary external sources of funds • Big-four commercial banks dominate (accounting 63 percent of loans outstanding and 62 percent of deposits in 2001) • 10 national and 90 regional commercial banks, 3 policy banks, 3000 urban and 42000 rural credit cooperatives • Limited foreign bank activities • The banking system is largely state run, suffering from high NPL problem and scandals • Given the state control of banks and the highly corrupted system in China, connections with government bureaucrats are likely important in influencing bank loan decisions

9. Empirical Design • Identifying 23 high (provincial) level government officer corruption cases during 1995-2003 • Tracking publicly listed companies in China that are bribers or are connected with the corrupted bureaucrats • Track changes in financial leverage and debt maturities of the event (bribing or connected) firms from 3 years before to 3 years after the corruption event

10. Empirical Design • Compared with the prior studies, our single-economy time-serial empirical design provides advantages • Focusing on a specific institutional factor – rent seeking • Providing more directly link between corporate financing decisions with rent seeking and corruption • Mitigating endogeneity issues • The corruption events are likely shocks to connected firms. The connected firms are non-bribers, hence their financing policy changes upon the corruption events are likely caused by lost connections

11. A Corrupted Bureaucrat and His Allies

12. The Corruption List

13. Figure 1.1 Mean Total Debt/Assets (The event firms and the non-event firms)

14. Figure 2.1 Mean Long Term Debt/Total Debt(The event firms and the non-event firms)

15. Figure 3.1 Mean Long Term Debt/Assets(The event firms and the non-event firms)

16. Table 4 Fixed-Effect Regression: Event firms and non-event firms

17. Table 4 Fixed-Effect Regression: Event firms and matching firms

18. Table 7 Regressions of Long-term Changes in Performance on Changes in Financial Policy around the Corruption Scandals (Panel A Full Sample)

19. Does rent seeking facilitate capital allocation? • Examining efficiency (performance) around the corruption scandals • The endogeneity hypothesis • The event firms should outperform the non-event firms before the scandals, and should not underperform the non-event firms after the scandals • The social injustice hypothesis • Event firms should underperform non-event firms after the scandals • The randomness hypothesis • No difference in performance between event and non-even firms. Non-even firms outperform event firms after the scandals

20. Table 8 Mean and Median Differences in Performance between the Event Firms and the Non-event Firms before and after the Corruption Scandals (Panel A Differences Between the Event Firms and the Non-event Firms)

21. Summary of findings • An overall increasing trend of financial leverage, but decreasing trend of debt maturity • Significant lowered leverage, debt maturity, and the use of long-term debt of the bribing firms and the connected firms, relative to control (unconnected or matching) firms • The results hold even if we focus on the connected firms that are not involved in the corruption cases • The weakened debt financing ability in the sample is not just due to the corruption, but also due to loss of political connections • Change in stock value and change in leverage are significantly positively related around the corruption events • We find little evidence from the sample suggesting that rent seeking facilitates capital allocation in China.

22. Conclusions • Corporate financing policies are importantly affected by rent seeking and corruption activities • Connections with government bureaucrats provide firm financing advantages, in particular access to long-term bank debt • Compared with the prior studies, this paper provides more direct links between rent seeking and corporate finance, and empirical design less subject to endogeneity issues • The overall evidence is consistent with recent cross-country studies’ findings that country-level institutional factors matter to corporate financing decisions