Corporate financenext term and state enterprise reform in previous termChinanext term

8/14/2019 Corporate financenext term and state enterprise reform in previous termChinanext term

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Corporate finance and state enterprise reform

in China

Dongwei SU*

Department of Finance, Jinan University, Guangzhou, Guangdong 510632, Peoples Republic of China

Accepted 20 September 2004

Abstract

This paper uses a novel approach in addressing two puzzles in the field of corporate finance in

China, where government is a major player. In addition to the traditional approach based on agency

theory and information asymmetry, the paper uses the political costs approach in studying the stock

dividend puzzle and rights issues puzzle. The paper finds that the extent of political interference,

managerial entrenchment, and institutional control affects corporate financing choices and dividend

distribution decisions. The result sheds new light on improving the important corporate governance

aspects of state enterprise reform in China.

D 2004 Elsevier Inc. All rights reserved.

JEL classification: G32; G35; O53; P21

Keywords: Corporate finance; Dividend policy; Agency costs; Political costs; State enterprise reform

1. Introduction

The Chinese Communist government, wishing to avoid the political and economic

turmoil that accompanied the mass privatization of the former Soviet Union and other

Eastern European governments, has chosen, as a cornerstone of its political survival, the

commercialization and partial privatization of claims over assets and profits and of its

1043-951X/$ - see front matterD 2004 Elsevier Inc. All rights reserved.

doi:10.1016/j.chieco.2004.09.003

* Tel.: +86 20 8522 4798.

E-mail address: [email protected].

China Economic Review 16 (2005) 118148


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state-owned enterprises (SOEs). Its SOE reform strategy hinges on the modern enterprise

system (MES) characterized by the separation of ownership and control. Ownership of an

SOEs assets is distributed among the government, institutional investors, managers,

employees, and private investors. Effective control rights are assigned to the management,

which generally has a very small, or even nonexistent, ownership stake.

The separation of ownership and control creates a conflict of interest between

management and newly enfranchised private investors that is the root cause of the

principal-agent problem in traditional corporate finance theory (Jensen & Meckling,

1976). Moreover, because government desires to retain some control, in part, through

partial retained ownership of commercialized SOEs, further conflicts arise between

politicians and firms (Shleifer & Vishny, 1994). In addition to agency costs of managerial

discretion, the newly corporatized SOEs face political costs of government control,

defined as the reduction in firm value due to government administrative interference. Thegames played by the government, management, and outside investors become more

complex than those addressed in the traditional corporate finance models. The principle

challenge of this paper is to assess whether and to what extent the unique ownership

conflicts under the MES can serve as a foundation for solving two puzzles in corporate

China.

While stockholders respond positively to stock dividend announcements in the United

States, which can be explained by the signaling theory, stockholders react negatively to

stock dividend distributions in China. If stock dividend does not signal good news, why do

so many Chinese firms bother to distribute stock dividends? While fewer and fewer firms

issue uninsured rights in the United States and elsewhere, Chinese firms predominantlyuse uninsured rights in seasoned equity offerings (SEOs). Models of information

asymmetry argue that firms issuing uninsured rights are of better quality, but Chinese

firms using uninsured rights exhibit no evidence of superior investment opportunities and

experience significant drop in their stock prices. The main contribution of this research is

to analyze these apparent deviations from the prediction of the traditional corporate

finance theory in terms of political and agency costs of the governmentmanagement

investor conflicts unique to the state enterprise reform in China. The papers find that

dividend policies and financing choices are affected by ownership conflicts (agency and

political costs) and the effectiveness of monitoring.

The rest of the paper is organized as follows: Section 2 discusses how earlier attemptsto commercialize SOEs without privatizing them created adverse incentives that defeated

the intent to increase profitability and reduce the need for continual government subsidies.

This failure led to the establishment of the MES, with its unique ownership conflicts and

lack of effective monitoring. Section 3 contains theoretical discussions on the dividend

policies and post-IPO equity financing choices of Chinese firms. It explores the rationale

behind the frequent use of stock dividends and the predominant use of uninsured rights in

seasoned equity offerings in China. Three testable hypotheses are then formulated. Section

4 empirically investigates the stock dividend and rights issues puzzles, discusses the long-

term performance of dividend distribution firms, and explains the negative valuation effect

of stock dividends and rights issues announcements in terms of firm characteristics

associated with agency and political costs. Section 5 concludes with a summary of

findings.

D. Su / China Economic Review 16 (2005) 118148 119


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2. Institutional framework surrounding SOE reform

The reform of SOEs in China has been characterized by efforts to decentralize,

commercialize, and, of necessity, to separate ownership and (effective) control. In general,

the government is reluctant to initiate deep institutional reform and is loath to surrender its

control over enterprises because doing so increases the cost of maintaining political

support in the form of attaining worker satisfaction and a bquietQ population. At the same

time, the inefficiencies and waste inherent in socialist economies, in practice, limit the

governments ability to maintain its base without resorting to totalitarian controls that have

proven impossible to sustain in a few societies. Therefore, the privatization of SOEs has

been adopted only because it is the only viable means to assure the survival of the existing

political order, which, in the case of China, means the survival of the Chinese Communist

Party. The government, by reforming the agricultural industry, restructuring SOEs viapartial privatization, and encouraging rapid growth of Township and Village Enterprises,

seeks to obtain the benefits of a market economy for the mobilization of private savings,

economic growth and an improved standard of living, while retaining political control.

SOE reform began with the Management Responsibility Contract System (MRCS) in

1987, in which the government transferred management authority to the enterprises and

allowed them to retain some of their profits.1 Under the MRCS, managers of SOEs were

given specific control rights in production, investment, sales, profits, personnel manage-

ment, and distribution of fringe benefits via contracts, therefore, managers have partial

incentives to generate cash flows and expand wages in the form of bonuses and fringe

benefits. However, the contractual relationship between managers and the government wasasymmetric and incomplete. A critical defect was that profit retention by management had

no downside. The state, in fact, remained responsible for final losses, mainly through the

state-owned banks, which were not contractual parties in the enterprise-commercialization

process. Employee bonuses and welfare expenditures, including housing, medical and

schooling expenses, and other fringe benefits, were deductible from enterprise revenue in

calculating profits. Therefore, it is not difficult to see why profit maximization was not the

managements primary objective and why SOEs continued to function as government

agencies or social security institutions providing bcradle-to-graveQ services to employees

rather than as even approximately profit-maximizing businesses.

Grossman and Hart (1982, 1986) and Hart and Moore (1990) argue that residual rightsof control, not specific rights via contracts, are critical determinants of managerial

incentives. Shleifer and Vishny (1994) also argue that commercialization without

allocation of residual rights to management is unlikely to guarantee more productive or

profitable uses of resources. Moreover, when the government can indirectly subsidize the

management to maintain bloated employment levels, employee housing, schooling, and

other political objectives through control over transfers from the treasury, thus creating a

soft budget constraint, privatization alone is unlikely to enhance productivity. Under

MRCS, managers had little residual rights of control and were subject to strong political

influences to maintain SOEs social responsibilities. Consequently, they had little interest

1 SOEs had to operate at state-controlled prices and remit all profits to the state before MRCS.

D. Su / China Economic Review 16 (2005) 118148120


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in technology investment, profit maximization, and efficient resource allocation, all of

which inevitably led to high political costs of government control.

Groves, Hong, McMillan, and Naughton (1994) provide evidence that MRCS

strengthened workers incentives and increased productivity and workers compensation,

but neither reduced government subsidies nor increased overall profits. With the adverse

incentive structure as described above, SOEs were able to rely on easy bank credit to pay

production and otherboperatingQ expenses. Thus, as of 1994, over 40% of SOEs were

unprofitable, and while SOEs accounted for 34% of GDP, they absorbed three quarters of

domestic credit. Their ever-increasing triangular debt (unpaid bills between state

enterprises, state banks, and the government) had accumulated to over 4900 billion

Renminbi Yuan (or 95% of GDP), and bad debt was estimated to be as much as 25% of

state bank assets in 1996. Many troubled SOEs were unable to pay back these accrued

loans, thus threatening the collapse of Chinas banking system. MRCS did not achieve thegoal of effectively reforming SOEs and was terminated nationwide in 1994. The process of

partial privatization through the creation of joint-stock companies (corporatization) began

through the establishment of Modern Enterprise System (MES), or Cooperative Share-

holding System (CSS).2

Under the MES, there are five types of shares. Those shares not retained by the

government, state enterprises, managers, and employees are transferred to outside

investors through initial public offerings (IPOs) and seasoned equity offerings (SEOs).3

Each share type is entitled to the same voting rights and dividend. After corporatization,

all shareholders have residual claims on the companys assets. Boards of directors are

established to represent the interests of all shareholders. A major characteristic of Chinesejoint-stock companies is that share ownership is dominated by the state or legal person

shareholders. The State Assets Management Bureau (SAMB) retains majority ownership

for about one-third of the listed firms, and legal person shareholders have controlling

shares for the other two-thirds.

To facilitate the privatization process and to wean doomed firms from eternal subsidies,

the government set up an annual reserve fund to support mergers and bankruptcies, to train

surplus workers for new jobs, to free enterprises from some of their responsibility to

provide social services, and thus, to promote a system in which enterprise survival depends

only on market-oriented performance. By the end of 1996, 675 SOEs had declared

bankruptcy, 1801 had been merged or downsized, 9200 SOEs had been corporatized, and

2 In November 1993, the 14th Central Communist Party of China issued the Decision on Issues Concerning the

Establishment of a Socialist Market Economic Structure, which formally introduced the modern corporate system

to the SOEs. The major reform objectives in the system include transforming the SOEs into corporations by the

separation of ownership and control and the establishment of efficient corporate governance structure.3 Among the five share types, state shares are retained by the State Assets Management Bureau (SAMB) for

central government or local government. Legal person shares are held by other SOEs and nonbank financial

institutions (including investment companies, finance corporations, and mutual funds). Employee shares are those

sold to managers and workers within a company and cannot be traded within the first 3 years. Domestic individualshares, or A shares, are those held and traded by private Chinese citizens in the two official exchanges in China.

Foreign shares are those held and traded by foreign investors in security exchanges in China (B shares), in Hong

Kong (H shares), or in NYSE (N shares).



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of these, 485 of the most profitable had been listed in the two stock exchanges with a total

market capitalization of about 400 billion Renminbi Yuan (equivalent to approximately

U.S. $50 billion).

The extent to which SOE partial privatization leads to benefits in the form of more rapid

productivity and GDP growth is limited by the political- and agency-cost problems. The

games played by government, management, and investors become more and more

complex than those addressed in traditional corporate finance theory.

In traditional corporate finance theory, private firms are viewed as a nexus of contracts

between various economic entities, particularly owners (principals) and managers (agents).

In the absence of complete and fully enforceable contracts, principal-agent problems arise

because owners want to maximize firm value while managers maximize their own utility,

which, in general, reduces the value of the firm. When the government is also an actor, the

traditional agency approach will not be the whole story because the government isinterested in its survival, which may require the use of resources that might otherwise

contribute to the managements utility or the private investors wealth (firm value). These

interrelationships are complicated by the fact that the government is by no means

monolithic and constitutes a collection of agents with conflicting goals: politicians, civil

employees, and citizens themselves (Hart, 1995). An exacerbating characteristic of the

Chinese situation is that the vast majority of private shares are held by small investors.

Dispersed public ownership creates a classic free-rider problem: Small shareholders do not

have the incentive to monitor management because the benefit is enjoyed by all while the

cost is totally borne by a few, active investors.

Several factors can mitigate the agency costs of managerial discretion, including debt(in conjunction with appropriate bankruptcy procedures), takeover threats, legal protection

of investors, product market competition, etc. Jensen (1986) and Stulz (1990) show that

debt with the threat of bankruptcy imposes a hard budget constraint on managers and

limits the managements control over firms free cash flows. When managers are faced

with choices of reducing empire building and lavish perquisites or going bankrupt, they

are likely to choose the first option. Therefore, leverage reduces agency costs of

managerial discretion. Shleifer and Vishny (1986) show that takeover threats discipline the

management in the presence of many small shareholders. The reason is that if a company

is badly managed, then there is an incentive for someone to acquire a large stake of the

company, improve its performance, and profit on the shares purchased. The threat of suchaction can persuade the management to act in the interest of shareholders. Weisbach

(1988) shows that the level of investor protection, including the extent of board

independence, the ability of a board to dismiss managers following poor performance, and

the degree of shareholder activism, is negatively related to agency costs and positively

related to firm performance. Maksimovic and Titman (1991) argue that product market

competition makes profits more sensitive to managerial effort, reduces agency costs, and

enhances investment efficiency. The reason is that temptation to retain cash and engage in

less productive activities is less severe for firms in a more competitive environment.

Unfortunately, because of the political nature of the privatization process itself, bank-

debt financing of corporate investments is not a viable means to assure a hard budget

constraint in transitional economies, such as China (Shleifer & Vishny, 1994). Bank loans

have traditionally been viewed as grants from the state designed to bail out failing firms.



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State-owned banks retain a monopoly in the Chinese banking sector, and profit is not their

overriding objective. If political favor is deemed appropriate, subsidized loans,

rescheduling of overdue debt, or even outright transfer of funds can be arranged with

SOEs (soft budget constraints). A banking system that is so heavily controlled by the

governments political objectives can hardly exert any real influence on management.

Moreover, a market for private, nonbank debt has yet to be established. There is no active

merger or takeover activity in stock markets to discipline management. Information

available in the capital markets is insufficient to keep at arms length of the managerial

decisions. Despite the existence of a bankruptcy law since 1986, the rate of bankruptcies

has remained at a very low level. In light of the above peculiarities, direct control by

(large) shareholders through the board of directors appears to be the only means for

shareholders to monitor managers.

With good corporate governance structure, boards of directors would consist ofdelegates of large institutional shareholders and minority investors, representing all

shareholders interests. Such boards would make critical investment and reorganization

decisions, select top managers, and provide managers with incentives and compensation

appropriate to the investors interests. However, board members in Chinese joint-stock

companies consist mainly of representatives or officials from the SAMB, local govern-

ment, and other state enterprises, whose interests are not the same as those of outside

investors. On average, 90% of the board members are government officials and delegates

of other state enterprises.4 Moreover, there is, at best, an inadequately functioning

managerial labor market that can discipline managers and help solve incentive problems

caused by the separation of ownership and control. All top managers must be approved bythe Organization Department of the local or central government. The government

maintains ultimate rights for changing managerial positions.5 With state-controlled stock

companies, political considerations still dominate economic performance in the selection

of managers and adversely affect managerial incentives. Managers, no doubt, care more

about carrying out the wishes of the Party and the government, such as avoiding worker

layoffs and maintaining some level of worker social security, than about the concerns of

shareholders. As a result, many management decisions still reflect the old political

concerns (political costs). In addition, managerial and board member compensation

4 For example, in a report in Financial Times, Lin (1999) highlights the continued government interference in

investment decisions of PetroChina, which has just gone public: bGiven the oil industrys strategic importance to

the Chinese economy, it is particularly likely that political factors will play a major role in the future governance

of PetroChina. In its role as controlling shareholder, the Chinese government will face many potential conflicts of

interest inherent in its role as owner, regulator, tax authority and primary borrower. PetroChinas board of

directors appears not to be structured so as to act as a check on the power and interests of the controlling

shareholder and the Chinese government. The new board of directors will have 12 members, all have close ties

with the governmentQ.5 For example, on January 19, 2000, the Wall Street Journal reported that Li Yizhong, the President of Sinopec,

Chinas second major oil company listed in Shanghai Securities Exchange, had been removed from his post and

appointed as the communist party secretary of the Gansu province in northwest China. The Journal commented:bThe managerial overhaul sends a confusing signal to the oil industry. The moves appear to be motivated by

domestic political considerations and are seen as part of the governments strategy to accelerate the development

of northwestern ChinaQ.



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packages are determined by the government and are seldom directly linked to profits.

Management is not severely constrained from self-dealing behavior, such as diverting SOE

assets outside the state sector for private use, such as charging meals and travel expenses to

company accounts, obtaining large apartments, and purchasing fancy cars and furniture for

personal consumption. Spending cash flow on acquisitions or other unprofitable projects

undertaken with the aid of unrealistically high forecasts of future profitability gives the

management a bigger company to run, thereby increasing their power and prestige in the

community (agency costs).

The allocation of effective control rights to management without clearly defined

corporate laws and bankruptcy procedures gives managers a chance to enrich themselves

by such means as undervaluing state assets and spinning off subsidiaries to be controlled

by the managers relatives. In a study conducted by Kernen (1997), some managers of

SOEs admitted to have created a number of collective or private enterprises for theirrelatives using SOEs assets. Furthermore, Chinas embryonic regulatory regime and

rudimentary accounting standards provide very little protection for investors rights

because they limit the boards ability to monitor abuses of governmental influence and

managerial discretion and thus limit political and agency costs that diminish the

productivity-enhancing effects of privatization and reduce firm value.

It should be noted, however, that agency and political costs do not imply that

managers are totally insensitive to the performance of their firms. Boycko, Shleifer, and

Vishny (1996) argue that managers are more concerned with profits than politicians are.

Bai, Li, Tao, and Wang (2000) posit that, during transition, SOEs are charged with the

multitasks of social welfare provision and efficient production. One implication is thatSOEs are given low profit incentive, and the governments concern for income

distribution and wage regulation is the root cause for the imperfection in managerial

market. Another implication is that, depending on the speed of emergence of supporting

institutions, managers may be able to escape government monitoring and divert efforts

from providing social services to seeking higher profits. Chang and Wong (2003) find

that the decision-making power of local Party committees relative to the largest

shareholders is positively associated with firm performance, indicating that political

control may help improve firm performance through the mitigation of large shareholders

agency costs. On the other hand, the decision-making power of local Party committees

relative to managers is negatively associated with firm performance, suggesting that theexisting level of political control is excessive when viewed from the perspective of

managers. On net, they find that reducing political control tends to improve the

performance of listed firms.

In summary, the partial privatization and separation of ownership and control have

transferred residual rights of control from government to managers but have not provided

effective monitoring mechanisms. The traditional government goals characterized by the

biron rice bowlQ concept still exert some control through the selection of managers and

board members. Profit is not the overriding objective for the managers, and the

management has considerable leeway to seek its own self-interest at the expense of

shareholders. In the next two sections, we present theories and empirical evidence bearing

on the influence of agency and political costs revealed in the dividend distributions and

corporate financing choices of Chinese joint-stock companies.



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3. Dividend policy and equity financing choices

3.1. Agency costs, political costs, and stock dividend puzzle

The separation of ownership from control inevitably leads to agency problem among all

Chinese SOEs. Dividends can play a role in reducing agency costs because they remove

corporate wealth from insider control. Jensen (1986) suggests that managers, motivated by

compensation and human capital considerations, have incentives to overinvest free cash

flows, even in the absence of profitable growth opportunities. Dividend payout policy can

be a vehicle for monitoring the use of funds by the management. Thus, the observed positive

stock-market reaction on dividend increases is consistent with a reduction in agency costs.

La Porta, Lopez-DeSilanes, Shleifer, and Vishny (2000) also argue that corporate

dividend policies reveal agency problems and vary across legal regimes, with differentlevels of shareholder rights protection. Under an effective corporate governance system,

shareholders have the legal power to prevent insiders (managers) from using a large

proportion of the companys free cash to benefit themselves. This implies that cash

dividends are an outcome of less serious agency conflicts. Cash dividends are paid because

shareholders are able to pressure corporate insiders to disgorge cash.

Lu and Wang (1999) and Wei (2000) find that both cash and stock dividends are

important forms of dividend distribution in China. This empirical result is puzzling: While

fewer and fewer firms distribute stock dividends in the United States, why are stock

dividends widely used in China?

Taken at their face value, stock dividends are small-scale stock splits and bfiner slicingof a given cakethe total market value of a firm Q. They do not generate funds for the firm

nor alter the proportional ownership of the firm on the part of the existing shareholders.

But if stock dividends are merely cosmetic changes in a firms balance sheet, why do a lot

of firms continue to engage in such financial manipulation, particularly when there are

costs of doing so? Grinblatt, Masulis, and Titman (1984) propose the bsignaling

hypothesisQ (or bretained earnings hypothesisQ). They argue that accounting principles

require that stock dividend distributions be accompanied by a reduction in retained

earnings in the balance sheet. In the presence of information asymmetry, i.e., when

managers (insiders) know more about the future prospects of the firm than investors

(outsiders) do, managers of high-quality firms can use stock dividend distributions toconvey favorable information to the investors. These managers can afford to signal

because they do not expect the reduction in the balance of retained earnings to constrain

future cash dividend payments. On the other hand, managers who anticipate poor future

earnings will find it costly to mimic the signal of a high-quality firm. An empirical

implication is that stock prices, on average, react positively to stock dividend announce-

ments, ceteris paribus. Grinblatt et al. (1984) document significantly positive abnormal

returns on and around the announcement day of stock dividends. Their results are further

substantiated in a recent article by Rankine and Stice (1997), who find additional evidence

of positive relationship between abnormal returns around stock dividend distributions and

subsequent earnings growth.

In China, information asymmetry may not be the entire story because dividend policy is

severely influenced by agency problem and political interference. Managers of a number



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of firms own a very small percentage of shares. They have virtually no incentive to

increase the stock prices of their firms. In addition, institutional investors have little voice

in some of the boards, bank debt does not provide monitoring on management, the market

for public debt is yet to be developed, and there is no active merger or takeover activity in

the stock market to discipline managers. Moreover, in the process of privatizing SOEs, the

government cannot withhold the temptation to control managers. Political interference by

the government leads to political costs of government failure. Under these circumstances,

managers could and would hold on cash as much as possible for the purpose of covering

their own mistakes, consuming perks, doing favors for politicians, or having financial

flexibility. Because cash dividends reduce the free cash level in the firm and add

disciplines to the management, managers will try to avoid distributing cash dividends to

shareholders as much as possible.

Therefore, we propose theb

agency/political cost hypothesisQ dividend policies in

corporate China are direct consequences of ownership conflicts and monitoring (as

opposed to consequences of differential investment opportunities).6 Firms with very high

agency and political costs and without effective monitoring have neither the pressure nor

the incentive to distribute any dividend. On the contrary, firms with low agency and

political costs and effective institutional monitoring are more likely to pay cash dividends.

Firms with mild agency and political costs may use stock dividend as a substitute for cash

dividend. They are willing to incur costs associated with stock dividends because they

have the incentive to separate themselves from the worst firms (firms plagued with high

agency/political costs).7

The alternative to the agency/political costs hypothesis is the bliquidity/investmentopportunities hypothesisQ. Because firms with good investment opportunities have less

free cash at hand, they would distribute stock dividend or no dividend rather than paying

cash dividend. Furthermore, firms with the best investment opportunities will distribute

stock dividends to separate themselves from those that pay no dividends.

Therefore, we hypothesize that:

H3.1. Managers will have the incentive to distribute cash dividends when the agency and

political costs are small. Between the choices of cash dividend and no dividend, or

between the choices of cash dividend and stock dividend, the probability that a firm will

distribute cash dividend is positively related to management and institutional ownershipand negatively related to government ownership and nonessential expenditures.

6 We acknowledge that the impacts of agency and political costs on firms dividend policies and financing

decisions can be quite different. However, we do not delineate agency costs from political costs in our

econometric investigations because we do not have good enough proxies. We plan to conduct further research on

this topic in the future.7 The reason that stock dividends can also serve as credible signals is as follows: Given information asymmetry

between managers and investors, stock dividends are costly signals that convey the managements private

information about the firms level of agency/political costs. Specifically, in China, firms must maintain a

minimum level of retained earnings to qualify for future share issues. For instance, prior to 1998, the CSRC

requires firms to have at least 10% return on assets for three consecutive years to issue new shares. Therefore,managers would transfer retained earnings to common stock (and issue free shares) only if they expect future

earnings to increase and do not need to keep large amount of free cash. Investors, therefore, may interpret stock

dividends as good news, although not as good as they do for cash dividends.



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The alternative hypothesis is that managers issue cash dividends because they do not

have very profitable net present value projects. The probability of cash dividend

distribution is negatively related to the firms investment opportunities, such as market-to-

book ratios, and long-term investment to total asset ratios, and positively related to its

liquidity measured by leverage ratios.

H3.2. Firms with mild agency/political costs distribute stock dividends (compared with

doing nothing) to separate themselves from firms with high agency/political costs.

Between the choices of stock dividend and no dividend, the probability that a firm will

distribute stock dividend is positively related to management and institutional ownership

and negatively related to government ownership and nonessential expenditures.

The alternative hypothesis is that stock dividends are signals of better investment

opportunities. The probability of stock dividend distributions is positively related to thefirms investment opportunities, but negatively related to its liquidity.

3.2. Agency costs, political costs and rights issues puzzle

Myers and Majluf (1984) argue that when managers know more about the future

prospects of the firm than outside investors do, managers may convey positive news to the

investors by means of the financing method chosen, with internal financing being the

highest in the pecking order, riskless debt the next highest, followed by equity issues (the

so-called bpecking order paradigmQ). Because new bank debt is likely to be a signal of bad

news in the Chinese situation (and in transitional economies with soft budget constraints,in general), and because markets for private nonbank debt have not yet emerged, loan

financing of new, profitable investment projects does not appear in the pecking order for

newly privatized SOEs. Consistent with this argument, we observe no corporate debt issues

over the period covered in this study. Therefore, we focus on equity financing choices.

When a firm wishes to raise capital through outside equities, it can choose a number of

flotation methods, including uninsured rights issues, rights issues with standby underwriters,

and fully underwritten offers. The direct flotation costs (e.g., registration fees, mailing costs,

and underwriting fees) are generally smaller for rights issues than they are for firm

commitment underwritten offers. However, managers have to set a sufficiently low

subscription price to guarantee the full subscription of rights, which may lead to prohibitively high indirect flotation costs for rights issues. When choosing a flotation

method in the absence of information asymmetry, managers typically weigh the costs of

underwriter certification and the costs of a rights offer subscription discount. Under

information asymmetry, the true value of a firm is unobservable to the market. Heinkel and

Schwartz (1986) show that managers who know of profitable investment projects and are

willing to incur investigation costs will ensure the success of their rights issues with

underwriters standby offer; managers who have profitable investment projects but are

unwilling to incur additional investigation costs will signal their true value in the choice of a

subscription price in an uninsured rights offer; while managers with lower-quality projects

make fully underwritten offers. Their signaling model implies that the quality of a firm is

revealed through the financing method chosen, with firms using standby rights being the

highest, those using uninsured rights the next, and those using firm commitment the lowest.



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Eckbo and Masulis (1992) argue that issuers expecting low shareholder take-up of

rights offers will turn to underwriters for quality certification to avoid the large adverse-

selection costs of a deep subscription discount. As a result, a deep discount in an uninsured

rights issue signals more positive information about firm quality than standby rights do

and should be followed by significantly positive announcement day abnormal returns.

Bohren, Eckbo, and Michalsen (1997) find empirical evidence consistent with the adverse-

selection argument using data on rights offers on the Norwegian stock market.

One common assumption among models of equity financing choices under information

asymmetry is that managers of an issuing firm maximize the value of the firm, which may

not be valid in the Chinese case. In fact, a number of studies have shown that Chinese

firms predominantly use uninsured rights in floating SEOs and that their announcements

are, on average, followed by significantly negative market reactions (Han & Li, 2002;

Yuan, 2003; Zhang & Wang, 2001). Therefore, we conjecture the possibility that, becauseof high agency and political costs, uninsured rights offerings in China (having low direct

flotation costs but large indirect costs of share depreciation) represent an attempt by the

management to exploit existing shareholders. That is, uninsured rights are not the outcome

of firms value-maximization behavior, but rather a result of ownership conflicts and low

monitoring. Managers of firms that are subject to low agency and political costs will act

upon the shareholders interests. When these managers foresee profitable investment

projects but are unable to use internal financing, they will maximize the value of the firm

by choosing the least expensive (in terms of direct and indirect costs) flotation method,

i.e., firm commitment underwritten offers under the Chinese situation. We hypothesize that

H3.3. In the existence of agency conflicts and political interference, equity financing

choices reveal the extent of agency and political problems and the effectiveness of

shareholder monitoring. The probability that a firm will issue uninsured rights offers is

negatively related to managerial and institutional ownership and positively related to

government ownership and nonessential expenditures.

The alternative to the agency/political costs hypothesis is the binvestment opportunities

hypothesisQ that firms employ underwriters for public offerings of seasoned equities

because they have more profitable investment projects than do those that issue uninsured

rights. Therefore, the probability that a firm will use rights offer is negatively related to

proxies of investment opportunities but positively related to leverage ratios.In the next section, we discuss empirical irregularities surrounding announcements of

dividend distributions and SEOs and conduct empirical tests of the agency/political costs

null against the investment opportunities alternative.

4. Empirical evidence

4.1. Data

We examine dividend policies and post-IPO equity financing choices for a sample of

508 SOEs that went public before December 31, 1996. Over the period from January 1996

through July 2000, 377 of these firms recorded a total of 1095 annual dividend



12/31

announcements, including 513 stock dividends and 582 cash dividends.8 Each cash

dividend announcement is compared with the previous dividend (if there is any) and is

then classified as an increase, a decrease, or a no-change in dividends. Forty-three cash

dividend announcements that have no previous dividend announcements for comparison

are eliminated from the sample. Of the total 539 cash dividend announcements remained

in the sample, 226 are dividend increases, 191 are dividend decreases, and 122 have no

changes. The sample classification is detailed in Table 1.

Over the period from January 1996 through July 2000, 348 of our sample firms

recorded a total of 547 announcements of seasoned equity offerings (SEOs) after their

IPOs, including announcements of 469 uninsured rights issues and 78 firm commitment

underwritten offers.9 The sample classification presented in Table 2 is striking. While there

is a trend toward using underwriter certification in issuing SEOs across countries (Bohren

et al., 1997), uninsured rights continue to be very popular (representing about 87% of allSEOs) in corporate China.

We use the following variables to proxy agency costs, political costs, liquidity, and

investment opportunities:

Because managers will be more likely to strip assets and transfer resources from SOEs

to themselves if the managers fractional investment is small, we use the number of shares

held by managers and board members as a fraction of total shares outstanding

(MANAGER) as one of the proxies for agency costs of managerial discretion.

Because large shareholders may have more incentive to monitor management, which

may, in turn, reduce agency costs, we use the percentage of shares held by the top 10

shareholders (TOPTEN), including institutional and private investors but excluding stategovernment, as the second proxy for agency costs of managerial discretion.

With large government ownership and heavy presence of government officials in the

board, managers are more likely to try to please politicians by maintaining high fringe

benefits and other social responsibility programs rather than to maximize firms residuals

(Chang & Wong, 2003). We use the percentage of shares retained by the local, state, and

8 There are three principal reasons for choosing the January 1996 to July 2000 sample period. First, information

on corporate fundamentals, such as earnings and dividends, may not be reliable in the early stage of development

of an emerging market. Second, the traditional Chinese accounting system was brought from the former SovietUnion in early 1950s for the highly centralized economy and was quite different from the generally accepted

accounting principles (GAAP) in the market economies. Different industries have different accounting regulations

enforced by their own ministries. On July 1, 1993, the new bEnterprise Accounting StandardsQ and bEnterprise

Financial Accounting PrinciplesQ came into effect and brought the Chinese accounting practices more close to the

international standards. The January 1996 cut-off allows us to compute financial variables from the new

standardized financial statements. Third, the stock price data end in July 2002. To calculate buy-and-hold returns

over a 2-year period, the July 2000 cut-off is necessary. All data are compiled from China Securities Market and

Accounting Research (CSMAR) data base produced by Shenzhen Guo Tai An Information and verified with

information from www.cninfo.com.9 We note that a Chinese joint-stock company, subject to certain regulations and approval, can issue equities in

the form of A shares (available only to domestic investors and traded in Chinese exchanges), B shares (available

only to foreign investors and traded in Chinese exchanges), H shares (listed and traded in Hong Kong), N shares(listed and traded in New York), or a combination of these share types. Because of the small number of

observations associated with the issuance of B-, H-, and N-shares through alternative flotation methods, we focus

only on A-share decisions in this paper.

http:///reader/full/www.cninfo.comhttp:///reader/full/www.cninfo.comhttp:///reader/full/www.cninfo.comhttp:///reader/full/www.cninfo.com


13/31

central government (GOVNT) as a proxy for the political costs of government interference

on enterprises.

We use welfare expense ratio (WELFARE) as a common proxy for agency and political

costs.10 WELFARE measures the extent of perquisite consumption, employee welfare

expenses (such as housing subsidies and schooling), and other nonessential expenses.

Welfare expenses provide managers opportunities to divert firms assets to their private use

and to politicians social responsibility programs.

We use two proxies for a firms investment opportunities: market-to-book ratio (MTB),

calculated as the average market value of equity 3 months prior to the event day plus book

value of assets in the previous year minus book value of equity in the previous year

divided by the book value of total assets in the previous year, and long-term investment to

total assets ratio (LONGINV).

We use two proxies for a firms liquidity: cash flow to total assets ratio (CASHTA),

defined as the operating income before depreciation minus total taxes adjusted for changes

in deferred taxes minus gross interest expenses and dividends and divided by total assets,and leverage (LEVERAGE), defined as the ratio of long-term debt and the book value of

total assets.

4.2. The determinants of dividend distribution decisions

In the spirit of Grinblatt et al. (1984), we compare the valuation effect of stock

dividends and cash dividends on and around the day of the China Security Daily

announcement of dividend distributions. If shareholders react positively to the announce-

10 Welfare expenses are total expenses minus costs of goods sold, wage expenses, and interest expenses. Welfare

expense is listed as a separate item on the balance sheet for a Chinese firm. Welfare expense ratio is welfare

expenses divided by total expenses.

Table 1

Sample classification for dividend distributions

Year Types of distribution

Stock dividend Cash dividend All

Increases No changes Decreases

1996 121 30 45 26 222

1997 98 52 41 38 229

1998 135 74 28 19 256

1999 104 53 54 28 239

2000 (first half) 55 17 23 11 106

Total 513 226 191 122 1052

The sample consists of 508 SOEs that went public before December 31, 1996. Over the period from January 1996

through July 2000, 377 of these firms recorded a total of 1095 annual dividend announcements including 513

stock dividends and 582 cash dividends. Each cash dividend announcement is compared with the previousdividend (if there is any) and is then classified as an increase, a decrease, or a no change in dividends. Forty-three

cash dividend announcements that have no previous dividend announcements for comparison are eliminated. Of

the total 539 cash dividend announcements remained in the sample, 226 are dividend increases, 191 are dividend

decreases, and 122 have no changes.



14/31

ments of stock dividends, then the signaling theory can potentially explain the stock

dividend puzzle in China. Appendix A details the method used in computing the abnormal

return (AR) and cumulative abnormal return (CAR) in this paper. Table 3 presents average

AR and CAR on and around the stock dividend and cash dividend distributions.

The examination of the table reveals a striking result. The mean 2-day abnormal return

is significantly negative at the 5% level for stock dividend announcements, significantly

Table 3

Average abnormal and cumulative abnormal returns on and around dividend announcement days

Event day Stock dividends Cash dividends

AR CAR t-statistic Increases No change Decreases

(%) (%)AR

(%)

CAR

(%)

t-statistic AR

(%)

CAR

(%)

t-statistic AR

(%)

CAR

(%)

t-statistic

10 0.13 0.13 1.21 0.19 0.19 1.17 0.08 0.08 0.16 0.14 0.14 0.269 0.11 0.02 0.23 1.07 0.26 1.29 0.10 0.18 0.69 0.06 0.20 0.428 0.25 0.27 1.69 0.21 0.05 0.21 0.12 0.30 1.16 0.11 0.31 1.067 0.12 0.15 1.26 0.13 0.18 1.15 0.13 0.17 0.59 0.08 0.39 1.196 0.30 0.15 1.29 0.03 0.21 1.22 0.08 0.09 0.24 0.20 0.19 0.38

5 0.39 0.54 2.25 0.08 0.29 1.35 0.11 0.20 0.73 0.07 0.26 0.65

4 0.21 0.75 2.68 0.10 0.39 1.46 0.17 0.37 1.21 0.08 0.18 0.343 0.12 0.87 2.87 0.19 0.20 1.21 0.26 0.11 0.32 0.13 0.05 0.122 0.16 0.71 2.63 0.13 0.07 0.25 0.08 0.19 0.73 0.04 0.09 0.201 0.15 0.56 2.27 0.14 0.21 1.22 0.11 0.30 1.24 0.16 0.07 0.160 1.02 0.46 2.16 0.93 1.14 3.55 0.28 0.58 1.56 0.15 0.22 0.511 0.18 0.64 2.52 0.27 1.41 3.82 0.19 0.39 1.32 0.06 0.28 0.732 0.16 0.80 2.79 0.24 1.17 3.59 0.12 0.51 1.49 0.11 0.17 0.353 0.29 1.09 3.46 0.11 1.06 3.47 0.09 0.60 1.61 0.08 0.09 0.214 0.18 0.91 2.95 0.26 1.32 3.73 0.16 0.44 1.38 0.10 0.19 0.385 0.24 0.67 2.57 0.19 1.13 3.54 0.13 0.31 1.19 0.16 0.03 0.106 0.17 0.50 2.20 0.16 1.29 3.68 0.14 0.45 1.40 0.04 0.01 0.06

7 0.10 0.40 2.01 0.20 1.49 3.90 0.16 0.29 1.22 0.14 0.13 0.218 0.15 0.55 2.26 0.25 1.24 3 .62 0.12 0.41 1.35 0.09 0.22 0.529 0.18 0.37 1.95 0.08 1.16 3.57 0.17 0.24 0.78 0.12 0.10 0.2610 0.11 0.26 1.65 0.12 1.04 3.44 0.05 0.19 0.65 0.13 0.23 0.56

Table 2

Sample classification for corporate financing choices

Year Types of offering

Uninsured rights Underwritten All

1996 82 11 93

1997 66 24 90

1998 114 16 130

1999 159 18 177

2000 (first half) 48 9 57

Total 469 78 547

The sample consists of 508 SOEs that went public before December 31, 1995. Over the period from January 1996

through July 2000, 348 of these firms recorded a total of 547 announcements of seasoned equity offerings (SEOs)

after their IPOs, including announcements of 469 uninsured rights issues and 78 firm commitment underwritten

offers.



15/31

positive at the 5% level for dividend increases, insignificantly positive for no-change in

dividends, and insignificantly negative for dividend reductions. Fig. 1 portrays the

behavior of the daily average cumulative abnormal returns around dividend announce-

ments. A large and pronounced decline in CAR is observed for stock dividends, and a

large and pronounced increase is observed for cash dividend increases during the event

window. On average, Chinese investors react negatively to stock dividend distributions but

positively to cash dividend distributions. Therefore, the bsignaling/retained earning

hypothesisQ of Grinblatt et al. (1984) cannot explain the predominant use of stock

dividends in China. This begs the question: If stock dividends cannot signal good news on

the future prospects, why do firms in China bother to distribute stock dividends?

To shed some light on the answer to this question, we first examine sample statistics for

proxies of firms agency and political costs, liquidity, and investment opportunities. The

results are presented in Table 4. Two important regularities emerge from the table: (1)Firms distributing cash dividends have, on average, larger managerial and institutional

ownership of shares, smaller fractional government ownership, and less nonessential

expense ratio than do firms issuing stock dividends or no dividend. (2) Firms distributing

stock dividends appear to have, on average, larger managerial and institutional share

ownership, smaller government control, and less welfare expenses than do firms that pay

no dividend.

We then proceed to test the agency/political costs versus the liquidity/investment

opportunities hypotheses by estimating multinomial logit regressions predicting whether a

firm will distribute cash dividend, stock dividend, or no dividend. These regressions allow

us to observe important nonlinear effects while simultaneously controlling for a variety offactors, which are hypothesized to affect corporate dividend policies in China. Table 5

presents empirical results from the multinomial logit regressions. The first two sets of

regressions in the table estimate the determinants of cash dividend distributions, while the

Fig. 1. Cumulative abnormal returns on and around the dividend announcement day.



16/31

last set of regressions estimates the determinants of stock dividends. To account for

possible multicollinearities among independent variables, each set of regressions is

estimated with and without MTB and LEVERAGE.11

In regression sets 1 and 2, the coefficient estimates for MANAGER are significantly

positive at the 5% and 10% level, respectively, no matter whether MTB and LEVERAGE

are included in the regressions. The coefficient estimates for TOPTEN are significantly

positive at the 5% level in regression set 1 but are only significantly positive at the 10%

when all variables are included in regression set 2. If either MTB or LEVERAGE, or both,

is dropped from the regression, TOPTEN is insignificant, although it has the right sign.

The coefficient estimates for GOVNT and WELFARE are significantly negative, all at the

5% level. These results, by and large, are consistent with the prediction of theb

agency/political costs hypothesisQ. Firms with higher managerial and institutional stock owner-

ship, smaller government control, and lower nonessential expenditures are more likely to

distribute cash dividends. The coefficient estimates for MTB, LONGINV, CASHTA, and

LEVERAGE have the same signs as predicted by the alternative liquidity/investment

opportunities hypothesis, but none is statistically significant. There is little evidence that

firms with better investment opportunities withhold cash dividends.

In regression set 3, the coefficient estimates for MANAGER is significantly positive at

the 10% level when only MTB is omitted or when all variables are included in the

regression. The coefficient estimates for GOVNT are significantly negative at the 5% level

Table 4

Sample statistics for variables used in studying corporate dividend policy

Cash dividend (N=539) Stock dividend (N=513) No dividend (N=54)

Mean S.D. Median S.D. Mean S.D. Median S.D. Mean S.D. Median S.D.

MANAGER 1.44 1.20 1.53 1.64 0.57 1.25 0.69 1.85 0.10 0.35 0.08 0.21

TOPTEN 24.54 14.15 27.64 19.22 16.25 14.49 17.88 20.07 11.48 10.96 13.10 15.94

GOVNT 13.39 17.21 15.60 20.85 19.24 21.93 18.66 24.64 31.03 19.74 28.41 22.80

WELFARE 1.26 0.85 1.44 2.06 3.35 1.57 2.96 3.55 4.84 1.77 4.29 2.90

MTB 1.68 1.14 2.04 2.96 1.29 0.83 1.55 1.18 1.10 0.76 1.26 1.14

CASHTA 9.27 2.14 11.13 8.62 8.54 2.33 9.30 7.26 8.32 2.09 9.14 7.51

LEVERAGE 10.17 4.35 13.02 8.44 11.30 3.69 10.80 6.58 12.16 5.77 11.04 7.33

LONGINV 10.22 1.72 9.09 5.27 9.07 1.55 8.25 5.29 9.29 2.16 7.92 4.51

MANAGER is the number of shares held by managers and board members divided by the total number of shares

outstanding. TOPTEN is the percentage of shares held by the top 10 shareholders, including institutional and

private investors but excluding the state government. GOVNT is the percentage of shares retained by the state

government. WELFARE is the nonessential expenditures (total expenses minus costs of goods sold, wage

expenses, and interest expenses) as a fraction of total expenses. CASHTA is cash flow to total assets ratio,

calculated as the operating income before depreciation minus total taxes adjusted for changes in deferred taxes

minus gross interest expenses and dividends and divided by total assets. LEVERAGE is the long-term debt as a

fraction of the book value of total assets. MTB is the market-to-book ratio, calculated as the average market value

of equity 3 months prior to the event day plus the book value of assets in the previous year minus book value of

equity in the previous year divided by the book value of total assets in the previous year. LONGINV is long-term

investment expenditure to total asset ratio.

11 Xu and Wang (1999) documents a significantly positive relation between market-to-book ratios and

ownership concentration. Leverage ratios are also suspected to be correlated to both ownership structures and

market-to-book ratios.



17/31

Table 5

Multinomial logit regression on corporate dividend decisions

(1) Cash dividend vs. no dividend (2) Cash dividend vs. stock dividend (3) StoIntercept 2.261*

(5.250)1.637*(3.966)

1.908*(4.607)

1.162*(3.438)

2.600*(5.861)

3.288*(6.522)

2.039*(1.925)

1.735*(4.193)

2.11(4.62

MANAGER 0.840*

(2.044)

0.868*

(2.183)

1.207*

(2.642)

0.923*

(2.349)

0.720y

(1.825)

0.615y

(1.870)

0.795y

(1.863)

0.866*

(2.106)

0.42

(1.388

TOPTEN 0.507*

(2.182)

0.581*

(2.609)

0.484*

(2.366)

0.410*

(2.204)

0.109

(1.085)

0.241

(1.482)

0.200

(1.399)

0.323y

(1.858)

0.08

(0.863

GOVNT 1.307*(3.014)

1.622*(3.960)

0.874*(2.533)

0.791*(2.362)

1.382*(2.961)

1.490*(3.225)

0.925*(2.530)

0.724*(2.141)

1.09(2.30

WELFARE 1.911*(2.860)

2.240*(3.244)

1.828*(2.715)

1.465*(2.165)

2.019*(3.007)

1.258*(2.013)

1.833*(2.450)

1.503*(2.220)

0.70(1.16

MTB 1.119

(1.299)

0.719

(1.189)

1.065

(1.220)

0.834

(1.305)

LONGINV 0.229

(0.797)

0.304

(0.824)

0.105

(0.400)

0.141

(0.584)

0.344

(0.975)

0.120

(0.522)

0.086

(0.603)

0.195

(0.733)

0.24

(0.755

CASHTA 0.144

(0.650)

0.285

(1.232)

0.160

(0.750)

0.206

(0.932)

0.315

(1.264)

0.466

(1.380)

0.207

(0.965)

0.293

(1.114)

0.24

(1.180

LEVERAGE 0.404(0.922)

0.247(0.719)

0.370(0.950)

0.318(0.802)

Pseudo R2 0.220 0.247 0.195 0.163 0.207 0.225 0.210 0.180 0.18

The dependent variable is zero for firms that distribute no dividend in a given year, one for firms that distribute stock dividen

dividends. The independent variables consist of the proportion of shares held by managers and directors (MANAGER), the prop

shareholders, excluding the government (TOPTEN), the proportion of shares held by the government (GOVNT), the ratio o

(WELFARE), market-to-book ratio (MTB), long-term investment expenditure to total asset ratio (LONGINV), cash flow to todebt to total asset ratio (LEVERAGE). Figures in parentheses are t-statistics.

* Level of significance: 5%.y Level of significance: 10%.


18/31

for all regressions, while the coefficient estimates for WELFARE are significant when all

variables are included in the regression. Although the coefficient estimates for TOPTEN

are of the right sign, they are not statistically significant. We also interpret this result as, by

and large, consistent with the prediction of the agency/political costs hypothesis. Firms

with higher insider share ownership, smaller government control, and lower nonessential

expenses are more likely to distribute stock dividends. Again, the coefficient estimates for

MTB, LONGINV, CASHTA, and LEVERAGE have the same sign as predicted by the

liquidity/investment opportunities hypothesis, but are not statistically significant. There is

sufficient evidence that stock dividends are not signals of better investment opportunities,

but rather signals of mild agency problem and political influence in the Chinese case.

4.3. Long-term performance of dividend distribution firms

The agency/political costs hypothesis predicts that firms with low agency and political

costs and effective shareholders monitoring will distribute cash dividend, and those with

moderate agency and political costs may use stock dividends in lieu of cash dividends to

separate themselves from firms having high agency and political costs. This indicates that

cash dividend firms will face better long-term stock-market valuation of their shares than

stock dividend firms will.

Under the alternative liquidity/investment opportunities hypothesis, firms that have the

best investment opportunities signal their quality through stock dividends. The short-term

negative market reaction to stock dividends announcements simply reflects under-

valuation of firms shares by investors. After the firms have successfully implementedtheir projects, their stock prices will eventually go up. A reversal of their fortune will be

expected in the market in the long run. Therefore, firms issuing stock dividends will have

better long-term stock performance than will those distributing cash as dividends.

We measure a firms long-term stock performance using the average and median buy-

and-hold abnormal return during 6-, 12-, 18-, and 24-month horizons after the dividend

announcement date (BHARs

). Appendix A details the methodology used in computing

BHARs

. The null hypothesis of no abnormal buy-and-hold return is tested using

skewness-adjusted t-statistics. A nonparametric Wilcoxon signed-rank test is also

constructed to test the null hypothesis that the median BHARs

is zero.

As shown in Table 6, the average and median buy-and-hold abnormal returns aresignificantly positive for firms paying cash dividends at the 6-, 18-, and 24-month holding

periods, while they are significantly negative for firms paying stock dividends at the 12-,

18-, and 24-month holding periods. The average and median buy-and-hold abnormal

returns are negative for firms with neither cash dividends nor stock dividends but are only

statistically significant for the 18-month holding period. We view the empirical evidence

described here as consistent with the bagency/political costs hypothesisQ.12

12 According to the agency/political cost hypotheses, firms distributing stock dividends have milder agency/

political costs than do firms distributing no dividends. Table 6 also shows that firms paying no dividends havenegative mean abnormal returns, although they are often not statistically significant and the magnitudes are often

smaller than that for the firms paying stock dividends. These kinds of results do not seem to be totally consistent

with the implication of the agency/political costs theory.



19/31

Some researchers may be skeptical about the use of market-based performance

measures because Chinese stock markets are often plagued with speculative activities. To

illustrate, at the end of 1999, more than 99% of the participants in the Shanghai SecuritiesExchange consisted of small individual investors rather than institutional investors. In

addition, share turnover (defined as trading volume divided by the total number of

outstanding shares, a measure for trading activities) exceeded 400%; that is, on average,

each stock changed hands more than four times per year, which is more than 10 times as

high as that of international markets. Therefore, it is of no surprise that Chinese stock

markets have been described as a bcasinoQ because of the tremendous short-term

speculation that takes place within it (Chang & Wong, 2003). For this reason, we

complement market-based performance measures with accounting-based ratios including

return on asset (ROA), return on equity (ROE), and return on sales (ROS).

Table 7 presents the mean and standard deviation of ROA, ROE, and ROS for cashdividend, stock dividend, and no-dividend firms in 1997, 1998, and 1999, respectively. As

shown in the table, the mean ROA, ROE, and ROS for cash dividend firms is higher than

those for stock dividend and no-dividend firms each year, suggesting that, on average,

firms paying cash dividends have better performance than do firms issuing stock dividends

or no dividends. However, the mean ROA, ROE, and ROS for stock dividend firms are

similar to those for no-dividend firms. The overall evidence seem to support the view that

dividend policies are value relevant in China.

4.4. The determinants of equity financing decisions

To explore in greater depth the financial characteristics of firms that use rights issues,

we first compare the liquidity and investment opportunities of firms that issue uninsured

Table 6

Long-term market-based performance of dividend distribution firms

Period

(months)

Average buy-and-hold abnormal return (%)

No dividend firms Cash dividend firms Stock dividend firms

Mean Median Mean Median Mean Median

6 1.21 (1.09) 1.08 [1.16] 2.93* (3.05) 2.28* [2.12] 1.79 (1.51) 1.39 [1.27]12 1.42 (1.15) 1.33 [1.18] 1.48 (1.36) 1.19 [1.04] 2.47* (2.75) 1.83y [1.82]18 2.18* (2.18) 1.80y [1.86] 2.36* (2.58) 1.95y [1.88] 3.12* (3.36) 2.16* [2.37]24 0.78 (0.91) 0.63 [0.84] 3.29* (3.61) 2.45* [2.31] 2.61* (3.18) 2.08* [2.24]The average buy-and-hold abnormal return (BHAR) for s months is calculated as BHARs 1N

PNi1

jst1 1 ri ; t jst1 1 rc ; i ; t , where ri,t is the monthly stock return for announcement firm i and rc,i,t is

the monthly return on control portfolio for firm i. The test statistic for the null hypothesis of no average buy-and-

hold abnormal return (figure in parentheses) is the skewness-adjusted t-statistic calculated as

adjusted tBHARs tBHARs 13ffiffiffiNp tBHARs 2skews ffiffiffiNp6 skews, where tBHARs is the usual t-statistic for BHARsand skew

sis the skewness of the BHARt series (t=1,2,. . .,s). The test statistic for the null hypothesis of the

median buy-and-hold abnormal return (figure in brackets) is the nonparametric Wilcoxon signed-rank test

statistic, calculated as sign ps 0:5 =ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi

ps 1 psNp

, where ps

is the percentage of positive abnormal buy-

and-hold returns during s months.

* Statistically significant at the 5% level.y Statistically significant at the 10% level.



20/31

rights with those that use firm commitment underwritten offers.13 We calculate the average

of CASHTA and LEVERAGE ratios, which represent a firms liquidity and debt capacity,

and MTB and LONGINV, which represent its investment opportunities. If a firm issues

new shares in 1996, we include it in computing the financial ratios of 1995, and so on and

so forth.

As shown in Table 8, cash flow as a fraction of total assets is slightly higher for firms

that use underwritten offers than it is for those that issue uninsured rights in every year

from 1995 through 1999, with the gap growing from one percentage point in 1995 to about

two percentage points in 1999. The average long-term debt as a fraction of total assets is

lower for firms that use underwritten offers than it is for those that issue uninsured rights

over the period covered. The market-to-book ratio, a measure of investors evaluation of a

firms investment opportunities and future profitability, and the expenditures on long-term

investment projects as a fraction of total assets are also higher for firms using underwritten

offers than they are for firms issuing uninsured rights. These comparative statistics are

inconsistent with the predictions of the signaling model.

We then compute the abnormal returns and cumulative abnormal returns on and aroundthe announcements of SEOs. Table 9 presents average AR and CAR, and Fig. 2 portrays

the behavior of the average CAR during the event window. A large and pronounced

decline in CAR is observed for uninsured rights issues, and a large and pronounced

increase is observed for underwritten offers. In fact, the mean abnormal returns over a 2-

day period that includes the day of the China Security Daily announcement and the day

preceding the announcement for underwritten offers and rights issues (t-statistics) are

4.40% (6.87) and 2.57% (4.36), respectively. On the average, investors react favorablyto firm commitment underwritten offers but negatively to uninsured rights issues. The

results are inconsistent with the predictions of the adverse-selection model.

Table 7

Accounting-based performance measures for dividend distribution firms

Accounting ratio No-dividend firms Cash dividend firms Stock dividend firms

Mean S.D. Mean S.D. Mean S.D.

ROA1997 0.046 (0.049) 0.060 (0.071) 0.044 (0.058)

ROA1998 0.038 (0.041) 0.065 (0.083) 0.031 (0.042)

ROA1999 0.044 (0.058) 0.055 (0.070) 0.049 (0.066)

ROE1997 0.074 (0.095) 0.082 (0.127) 0.069 (0.106)

ROE1998 0.072 (0.108) 0.086 (0.133) 0.073 (0.115)

ROE1999 0.068 (0.096) 0.080 (0.109) 0.058 (0.098)

ROS1997 0.087 (1.262) 0.104 (0.173) 0.091 (0.188)

ROS1998 0.092 (1.437) 0.115 (0.205) 0.086 (0.167)

ROS1999 0.085 (1.394) 0.108 (0.190) 0.082 (0.159)

Definitions of the performance variables are as follows: ROA (return on assets) is after-tax profits divided by thebook value of total assets. ROE (return on equity) is after-tax profits divided by the book value of shareholders

equity. ROS (return on sales) is after-tax profits divided by gross sales revenue. Figures in parentheses are

standard deviations.

13 Note that no standby rights issues are observed on Chinese stock markets over the period covered in this

study.



21/31

We believe that agency/political costs consideration can help explain why rights issues

and underwritten offers are followed by significantly negative and positive stock-market

valuations, respectively.

This leaves us with the following puzzle: If uninsured rights do not signal good news to

the market, why are they predominantly used by Chinese firms in floating SEOs?

To enhance the search for the underlying causes of the rights issue anomaly, Table 10 isconstructed to present the mean and median statistics for fractional managerial,

institutional, and government ownership, as well as the ratio of nonessential expenses

to total expenses, categorized by SEO flotation methods. An beyeball analysisQ ofTable 10

yields comparisons that are important regularities predicted by agency/political costs

paradigm: Firms using underwriter certification have, on average, larger managerial and

institutional ownership of shares than do firms using uninsured rights. The only exception

is that rights issuers have a slightly larger managerial ownership in 1997. Another

distinguishing feature of firms that issue uninsured rights is that the variable GOVNT, the

proportion of shares owned by the state government, is far larger than for firms using

underwritten offers. Moreover, firms using underwritten offers have, on average, less

nonessential expense ratio than do those issuing uninsured rights in every year during the

sample period.

Table 8

Liquidity and investment opportunities for firms classified by SEO flotation choices

Year Uninsured rights Underwritten offers

Mean S.D. Median S.D. Mean S.D. Median S.D.

CASHTA 1995 7.48 5.21 6.95 8.22 8.41 7.20 8.86 10.13

1996 7.33 5.10 7.08 8.29 9.11 7.86 9.39 11.20

1997 9.04 7.25 8.27 11.31 11.25 9.82 10.81 14.25

1998 9.58 6.84 8.92 11.26 11.60 9.00 10.73 13.51

1999 8.80 6.92 8.33 10.10 10.69 7.88 11.05 13.62

LEVERAGE 1995 11.84 6.02 12.07 7.55 8.43 5.31 7.91 5.10

1996 9.16 6.05 8.93 7.14 9.12 5.00 8.66 6.03

1997 9.55 5.39 8.82 5.80 6.18 3.95 5.83 4.41

1998 9.08 5.23 9.63 6.10 8.64 5.27 8.95 6.38

1999 10.14 6.38 10.52 7.33 8.94 6.12 8.50 6.60

MTB 1995 1.09 0.95 1.22 1.60 1.38 1.18 1.26 1.721996 1.28 1.04 1.31 1.66 1.48 1.23 1.44 1.70

1997 1.41 1.15 1.37 1.81 1.64 1.20 1.58 1.93

1998 1.31 0.97 1.28 1.70 1.35 1.06 1.39 1.82

1999 1.12 0.88 1.09 1.31 1.26 1.06 1.30 1.44

LONGINV 1995 8.02 2.37 6.91 4.55 10.93 3.60 9.84 6.11

1996 8.28 3.30 7.53 4.31 10.45 4.26 9.36 4.90

1997 9.54 4.02 9.18 5.33 11.93 3.89 11.08 6.00

1998 7.36 2.74 7.19 4.01 9.44 3.65 9.06 5.14

1999 8.62 3.43 8.95 5.06 10.25 3.11 9.68 4.62

CASHTA is the cash flow to total assets ratio, calculated as the operating income before depreciation minus total

taxes adjusted for changes in deferred taxes minus gross interest expenses and dividends and divided by totalassets. LEVERAGE is the long-term debt as a fraction of the book value of the total assets. MTB is the market-to-

book ratio, calculated as the average market value of equity 3 months prior to the event day plus the book value of

assets in the previous year minus the book value of equity in the previous year divided by the book value of total

assets in the previous year. LONGINV is the long-term investment expenditure to total asset ratio.



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Based on the preliminary analysis on statistics reported in Tables 10 and 11, the

more favorable characteristics belong to firms with underwritten offers, which exhibit

more liquidity, less leverage ratio, better investment opportunities, and evidence of

lower agency/political costs than do firms issuing uninsured rights. Perhaps, the most

striking feature is that the average abnormal return is distinctly positive for theissuers of firm commitment public offerings but negative for the issuers of uninsured

rights.

To test the above hypotheses, we test a logit model of a firms choice of alternative

SEO flotation methods. The dependent variable equals to 1 if a firm issues uninsured

rights, and 0 otherwise. The independent variables consist of proxies for agency costs,

political costs and investment opportunities, leverage ratio, the initial IPO return (IPOR),

and the logarithm of the proceeds from SEOs (SEOVALUE). IPOR is included in the

logit regression to proxy the quality of a firm. Su and Fleisher (1999) show that Chinese

firms of better quality tend to underprice more and return to the secondary market to

issue SEOs in greater amount more quickly. SEOVALUE is included to control for the

size effect. Perhaps, sheer size has an informational advantage in that economies of scale

increase the likelihood that investors will know something about these firms, enabling

Table 9

Average abnormal returns (ARt) and cumulative abnormal returns (CARK,L) on and around SEO announcement

days

Event day Rights issues Underwritten offers

ARt CARK,L t-statistic AR t CARK,L t-statistic

10 0.14 0.05 0.16 0.17 0.17 0.529 0.07 0.12 0.38 0.13 0.30 0.748 0.15 0.03 0.11 0.22 0.52 1.597 0.13 0.16 0.44 0.39 0.13 0.416 0.10 0.06 0.19 0.15 0.02 0.115 0.15 0.09 0.29 0.20 0.18 0.554 0.18 0.09 0.30 0.14 0.32 0.793 0.11 0.20 0.57 0.11 0.43 1.37

2 0.26 0.06 0.20 0.18 0.05 0.22

1 0.74 0.68 1.71 2.93 2.98 4.580 1.83 2.51 5.75 1.47 4.45 6.951 0.10 2.41 5.46 0.33 4.12 6.442 0.09 2.32 5.14 0.64 3.48 5.433 0.31 2.01 4.08 0.28 3.76 5.874 0.44 1.57 2.61 0.30 4.06 6.345 0.27 1.84 3.40 0.16 4.22 6.596 0.11 1.95 3.82 0.15 4.07 6.367 0.15 1.80 3.27 0.11 3.96 6.188 0.33 1.47 2.32 0.52 4.48 7.029 0.08 1.39 2.04 0.36 4.84 7.5610

0.09

1.48

2.35 0.21 5.05 7.89

The abnormal return for firm i on day t is ARi,t=Ri ,tRc,i,t, where Ri,t is the return for firm i on day t, andRc,i,t is the return for the control portfolio of firm i on day t. The average abnormal returns for each trading

day is ARt 1NPN

i1 ARi;t, where N is the number of stocks. The average cumulative abnormal returnsfrom day K to L is CARK;L 1N

PNi1 CARi;K;L.



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them to make better informed investment decisions when opportunities to purchase new

shares arise.

Empirical results from three logit estimations of the probability of rights issues are in

Table 12. The coefficient estimates on the MANAGER variable have the correct sign but

are insignificant in all three regressions. That is, the probability of rights issues does notdecrease directly with a firms managerial ownership. However, the coefficient estimates

for TOPTEN are significantly negative at the 5% level, as predicted by the agency/political

costs hypothesis. Firms that are more closely monitored by large institutional shareholders

are less likely to issue uninsured rights. The coefficient estimates for GOVNT are

significantly positive at the 5% level, indicating that firms with larger government

ownership and more political intervention are more likely to use uninsured rights in

issuing SEOs. In addition, the probability of rights issues are positively related to the

nonessential expenses, and the relationship is statistically significant at the 10% level. This

renders further support to the agency/political cost approach to explain rights issues puzzle

in China.The coefficient estimates for LONGINV and LEVERAGE are of the correct signs, as

predicted by the alternative investment opportunities hypothesis, but they are not

statistically significant. The coefficient estimates for MTB is not only of incorrect sign

but also statistically insignificant. The evidence presented in Table 12 provides no support

for the investment opportunities hypothesis.

It is interesting to note that the coefficient estimate for IPOR is insignificant, suggesting

that there is no relationship between the probability of using rights issues in floating SEOs

and the degree of IPO underpricing, which is consistent with Su (2003) and Su (2004).

However, the coefficient estimate for SEOVALUE is significantly negative, implying that

the probability of using a underwriter increases in the size of the issue. This is probably

because larger issues have more diverse ownership of shares and less government

interference.

Fig. 2. Cumulative abnormal returns on and around the SEO announcement day.



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4.5. Valuation effect of SEO announcements

We now study the stock price reaction to SEOs made by Chinese firms. A larger

number of studies on U.S. firms have convincingly showed that SEOs are associated

with a decrease in announcement firms stock price, especially when the flotation

method used is firm commitment underwritten offers. However, some studies (Bohrenet al., 1997; Kang & Stulz, 1996) document positive investors reaction to uninsured

rights issues in other countries. As mentioned in Section 4.1, on average, investors

respond negatively to uninsured rights offers but positively to underwritten offers in

China.

To explain the abnormal returns surrounding SEO issue announcements, we estimate

the following cross-section regression using generalized least squares (GLS):

CARi;1;0 a1 a2SEOVALUEi a3CARi;11;2 a4STDi a5SHAREi a6MANAGERi a7TOPTENi a8GOVNTi a9WELFAREi a10DUMMYi ni 1

Table 10

Agency and political costs for firms classified by SEO flotation choices

Year Uninsured rights Underwritten offers

Mean S.D. Median S.D. Mean S.D. Median S.D.

MANAGER 1995 0.46 0.51 0.52 0.60 1.63 1.67 1.49 1.73

1996 0.81 0.69 0.70 1.03 1.34 1.15 1.22 1.40

1997 1.09 0.96 1.10 1.22 1.07 0.98 1.05 1.31

1998 1.26 1.00 1.08 1.33 1.55 1.36 1.47 1.75

1999 1.14 0.96 1.07 1.24 1.83 1.47 1.68 2.05

TOPTEN 1995 5.05 6.22 5.28 8.15 14.62 12.30 13.20 15.17

1996 12.64 11.05 11.38 16.31 17.10 15.46 15.83 18.75

1997 9.82 8.61 9.39 13.05 21.44 18.20 19.60 25.13

1998 10.77 8.35 9.62 11.00 19.85 17.26 18.35 23.28

1999 8.83 7.18 8.40 11.33 24.06 20.26 22.39 31.05

GOVNT 1995 34.08 29.55 37.50 51.33 14.24 16.29 13.20 18.411996 30.03 27.60 32.85 46.34 12.62 14.08 14.80 19.36

1997 28.25 26.42 29.71 41.66 13.48 15.17 14.63 19.83

1998 31.50 34.00 34.62 52.04 11.60 13.52 12.48 16.00

1999 27.58 24.10 29.01 42.61 10.94 12.87 11.40 15.99

WELFARE 1995 5.72 1.73 5.48 6.91 2.36 1.03 2.08 3.44

1996 5.14 2.30 4.80 6.21 2.52 1.12 2.37 3.10

1997 6.03 3.22 5.64 7.84 1.82 0.90 1.65 2.10

1998 5.33 3.05 4.96 6.32 1.62 0.85 1.47 2.25

1999 4.85 2.68 4.61 5.96 1.73 1.01 1.50 2.24

MANAGER is the number of shares held by managers and board members divided by the total number of shares

outstanding. TOPTEN is the percentage of shares held by the top 10 shareholders, including institutional andprivate investors but excluding the state government. GOVNT is the percentage of shares retained by the state

government. WELFARE is the nonessential expenditures (total expenses minus costs of goods sold, wage

expenses, and interest expenses) as a fraction of total expenses.



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where DUMMYi is a dummy variable that takes value one if the issue uses uninsuredrights and zero otherwise; CARi,1,0 is the cumulative abnormal return during the 2-day

announcement window for the ith issue; SHAREi is the ratio of the number of shares

offered to the number of shares outstanding prior to the offer, a proxy for the extent of

share dilution in the case for underwritten offers and the degree of potential shareholder

take-up in the case of rights issues; CARi, 12,2 is the cumulative daily abnormal

returns during a 10-day period, beginning at 12 days before the issue announcement day,

a proxy detecting possible stock price run-up prior to the event day; and STDi is

standard deviation of stock returns calculated over a period from 122 days before the

announcement day and 122 days after the announcement, a proxy for the risk of the

issue.The results contained in Table 12 indicate that the proportion of shares retained by

state government and held by institutional investors are two important variables to

explain the cross-section variation in abnormal returns around SEO announcements. The

coefficient estimate for GOVNT is significantly negative at the 10% level in regressions

I, II, and IV and significantly negative at the 5% level in regression II when

SEOVALUE is added to the list of independent variables. There is strong evidence that

investors reaction more posit

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