Government intervention and capital allocation in state firms

1
Government intervention and capital allocation in
state firms

• Joseph Piotroski
• T J Wong
• Tianyu Zhang
• Comments are welcome

2
Agenda

• Motivation
• Theoretical background
• Emergence of corporate pyramids as a device for
  decentralization
• Hypothesis development
• Effect of government intervention on investment
  decisions
• Sample and data
• Empirical Design
• Empirical evidence
• Going on analysis
• Conclusion

3
Motivation

• Investment behavior in widely-owned company is
  well investigated
• Capital allocation efficiency varies according to
  institutions, such as development of financial
  market and legal protection for minority
  shareholder.
• Lack of evidence of how government intervention
  affects investment efficiency.

4
Background

• Decentralization of decision rights from central
  to local since 1978 e.g. retention of most
  profits and harder budget constraint
• Increase product market and inter-jurisdictional
  competitions
• Improved incentives and information efficiency

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Emergence of corporate pyramids

• Property rights constraint
• State shares are not freely transferable in the
  market
• Thus, decentralization through selling off
  ownership of assets is impossible
• Pyramids emerge as a credible commitment to
  transfer decision rights to management
• Co-location of knowledge and decision rights
• Its credible because of the bureaucracy of
  pyramidal organization.

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Fan, Wong, and Zhang (2007a)

• Chinese listed firms have MORE layers if they are
  in regions with
• Less government intervention
• Fiscal surplus
• Unemployment rate
• Stronger discipline
• More developed markets
• Better property rights protection
• Better legal enforcements
• More market deregulation

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Backgroundtwo types of organization structure
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Research Question

• Can the pyramids increase investment efficiency?
• Less political intervention
• Co-location of knowledge and decision rights

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Hypothesis of pyramids on investment decision

• Distortion of investment due to the agency
  problem of manager
• Perquisite consumption and empire building
  (Jensen Meckling, 1976)
• Free cash flow problem (Jensen, 1986)
• Pain avoidance (Jensen, 1994)
• This line of theory does not work for state firms
  with concentrated ownership structure.

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Hypothesis of pyramids on investment
decision--Two problems related to government
ownership

• Soft budget constraint syndrome (Kornai,
  1979,1980, and 1986), which is more like helping
  hand.
• Inefficient company will be bailed out by
  government organs
• The investment will continue even its
  unprofitable
• Discourage innovation (Qian and Xu, 1998)
• Grabbing hand (Shleifer and Vishny, 1998)
• Politicians do not maximize social welfare and
  instead pursue their own selfish objective
• Government intervention will be evidenced by
  keeping excess employment in the company and
  subsidizing other non-performing SOE.

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Hypothesis of pyramids on investment
decision---Solution

• Decentralization increases operating efficiency
• Federalism (decentralization of information and
  authority) as a commitment to preserving market
  incentive (Qian and Weigast, 1997)
• Autonomy granted to manager changes the managers
  incentive over the design of workers incentive
  system, which in turn improves productivity of
  the company (Groves, Hong, McMillan and Naughton,
  1995)
• Performance improvement arising from
  privatization
• Meginson, Nash and Randenborgh, 1994 Barberies
  et al, 1996 Lepez-de-Silanes et al, 19999
  Fryeman et al, 1999 La Porta and
  Lopez-de-Silanes, 1999.

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Hypothesis of pyramids on investment decision

• Existing Evidence
• Capital allocation efficiency increases with
  regards to higher development of financial
  market, lower state ownership and stronger legal
  protection for shareholder(Wurgler, 2003).
• Bushman, Piotroski, and Smith (2006) TLR
  improves investment efficiency with regards to
  decreasing investment opportunity and weight of
  SOE in the economy undermine the efficiency.
• Johnson, McMillan, and Woodruff (2003) property
  rights dominates access to financing in determine
  investment

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Hypothesis of pyramids on investment decision

• Evidence from China
• Fan, Wong and Zhang (2007b) A political CEO
  undermines the performance during the partial
  privatization
• Cull and Xu (2005)--both property rights and
  external financing are important in determining
  firm reinvestment decision.
• An ongoing work by Piotroski, Wong and Zhang
  (2007) pyramids increase TLR in the local
  government firms.

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Hypothesis of pyramids on investment decision

• Hypothesis
• The pyramidal layers, as a proxy for less
  government intervention, will increase investment
  efficiency in the state-owned enterprises.

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Data

• Sample All local government-controlled firms
  between 1994 and 2005 from non-financial sector
  with required data available--5016 firm-year
  observations.
• Data sources
• Ownership--extending Fan, Wong and Zhang (2007a)
  to year 2005.
• Investment--No disclosure of capital expenditure
  by the company, thus, we manually collect the
  investment data from footnotes in the annual
  report
• Financial and stock trading data China Security
  Market and Accounting Research

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Empirical design

• Our paper builds on and extends Q theory
• Key variable
• It ---- investment made in year t, measured as
  Net (and Raw) increase in fixed assets (including
  project in process) scaled by beginning balance
  of fixed assets.
• Returnt-1 ----proxy for change in investment
  opportunities measured as firm-specific annual
  return in year t-1.
• Other specification of the investment model, such
  as non-linear relation between investment and
  return due to other fundamentals, is beyond our
  model

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Table 1 Sample
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Table 1 (continued)
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Table 2 Description
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Table 3 Baseline model
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Table 4 Effect of layers
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Omitted variables

• Other factors that may influence emergence of
  layers and investment decision
• Market development
• Development of financial market
• Legal factors
• Political incentives
• Culture

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Table 5 after control marketization
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Table 6 after control FD
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Table 7 after control legal factor
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Table 8 after control political incentive
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Table 9 after control culture
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Going on Analysis Helping hand or grabbing hand
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Going on Analysis

• Effect of government intervention on change
  rather than level of investment
• Financial constraint
• The channel, such as firm-year TLR, through which
  that government intervention influences
  investment.

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Conclusion

• More layers are associated with
• Higher investment efficiency
• The result is robust after controlling the
  institutional and political factors