The Effect of government monitoring on listed firms in China

Relative to developed countries, listed firms in developing economies generally lack sufficient monitoring from market forces, which can greatly impede the protection of minority shareholders’ rights. Therefore, it is vital in particular to examine the costs and benefits of government monitoring on the functions of publicly listed firms in developing economies. My thesis systematically examines the influences of two most commonly used government mechanisms for monitoring of listed firms in China: the enforcement activities launched by government regulators towards listed firms; and the exertion of direct influence on the appointment (promotion) of senior management of SOEs by government owners.

The first study, “Does the threat of enforcement of financial regulations affect the cost of equity in weak institutional environments?”, exploits the imposition of annual onsite inspections of publicly listed firms by the local CSRC offices as a quasi-natural experiment, to examine how the threat of enforcement activities by financial regulators affects firms’ implied cost of equity in weak institutional environments. In a staggered DID framework, I show that, compared with firms subject to the lottery of prospective on-site inspections, firms that are exempt from on-site inspections for three consecutive years generally face an average of 210 basis points increase in the cost of equity. Such an effect is more pronounced for firms with regulatory penalty records, firms domiciled in the jurisdictions with more actions imposed on listed firms during past on-site inspections, and SOEs. My further analysis suggests that the exemption increases firms’ cost of equity through the channels of increased tunnelling activities from controlling shareholders, reduced financial reporting quality, and more severe information asymmetry faced by external investors. Thus, the valuation of exempt firms significantly decreases. My findings suggest that, in weak institutional environments, the threat of financial regulators’ enforcement ex ante increases firm value by reducing the external investors’ estimation of firms’ long-term risks. 

The second study, “The effect of GCs’ mandatory appointment as senior management by state business groups on subsidiary SOEs’ debt financing activities”, exploits the staggered regulations that mandated certain local state business groups to appoint GCs in parent SOEs from 2002 in China, as a quasi-natural experiment to empirically examine how GCs appointed by the group board intervene with subsidiary SOEs’ debt financing activities. The findings suggest that local SOEs affiliated with the state business groups that are mandated to appoint GCs in parent SOEs face significantly VII less litigation risk. They annually obtain fewer loans, especially short-term loans to prevent debt-related lawsuits, and further are less likely to adopt the SFLI strategy, that is, use short-term loans for long-term investment. The above findings indicate that the appointment of GCs by local state business groups in China can effectively reduce subsidiary SOEs’ risks via the financing channel. 

The third study, “The effect of GCs’ mandatory appointment as senior management by state business groups on subsidiary SOEs’ investment activities”, utilises the same institutional setting as the second study to test whether GCs appointed as senior management in the parent SOEs of state business groups would affect subsidiary SOEs’ investment activities. The findings suggest that local SOEs affiliated with the state business groups that are mandated to appoint GCs in parent SOEs face significantly less litigation risk. They engage in fewer investment activities to avoid litigation risks, which nevertheless, results in less investment efficiency. More specifically, the appointment of GCs by state business groups exaggerates the subsidiary SOEs’ under-investment problem, but does not effectively alleviate their over-investment phenomenon. This effect is only concentrated in SOEs that have prior lawsuit records, SOEs with few layers to the parent SOEs within the pyramidal group structure, SOEs not bearing a heavy political burden and SOEs that have not appointed executives with a legal background themselves. I also find that, after the state business groups appoint GCs in parent SOEs, subsidiary SOEs are involved in fewer innovation activities and have lower shareholder value in the long term. All in all, the results of my study show that GCs appointed by local state business groups in China in overall exaggerate unintended agency conflicts for subsidiary SOEs, which in turn distorts their behavior in capital allocation.