Determinants of Capital Structure in China

Introduction

Since the economic reform in 1970’s, China is now in a process of transforming a command economy to a market economy, and has achieved a great success in economic development. The world is now paying more attention on Chinese economy. Capital structure is one of the issues that are worthy of consideration. However, most previous studies on capital structure and its determinants arisen from the practical experience of western developed countries such as UK and US. There have been few studies concerning the particular situation of China, where state still plays an essential role in all economic activities. Therefore, this paper will discuss the key determinants of the capital structure of Chinese firms, comparing to UK firms. Other than those demand side factors that have been frequently discussed, the paper focuses both firm-specific and non firm-specific issues, which are also apparently important in China. It will briefly go through the general theories involved at the beginning, and then analyze 5 major firm-specific factors influencing leverage level with comparison to firms in UK. Finally, two non firm-specific effects will be examined as the unique characteristics of Chinese firms.

Theories involved

There are two influential theories on capital structure determinants that will be focused mainly in the paper. One of them is the static trade-off theory developed in 1980s, which states that each firm should reach an optimal capital structure through balancing the tax field benefits and the financial stress brought by debts. (Brounen and Eichholtz 2001). The other one concerned is the pecking order theory claiming that firms make their finance choices based on how conveniently and easily they can access to the capital. As a result, internal capitals such as retained profit are preferred to external ones, while equity financing is considered to be the last resort. (Frank and Goyal 2002).

Firm specific factors

Most previous capital structure theories, such as static trade-off theory and pecking-order theory mentioned above, concerned the firm-specific issues like profitability or tangibility, and considered these as the major influences to leverage variation. It is definitely true for most firms in developed countries and listed companies in developing countries. China is indeed one of these cases. Empirical studies have concluded approximately 7 factors on demand side that affects leverage decisions, which are profitability, assets tangibility, growth opportunity, firm size, tax, non-debt tax shields and volatility. The following paragraphs will show the relationship between these factors and capital structure of Chinese firms comparing to UK firms.

Profitability

According to the study carried out by Huang and Song (2006), who researched more than 1200 Chinese listed companies, profitability has a strong negative relationship with the leverage level of these firms. A 1% increase in profitability (Return on investment) may lead to a 1.5% decrease in debt ratio. Further, Chen and Strange’s (2005) survey on 900 Chinese firms confirmed this result as well. It is also the case found in UK firms. Bevan and Danbolt (2002) indicated in their report that there has been significant statistical evidence showing the negative correlation between profitability and gearing rate of UK firms, and indeed, profitability has a strong explanatory power of leverage variation. Ozkan (2001) pointed out as well that there is a negative impact of profitability on UK firms’ borrowing decision. All these results match the statement in pecking order theory since great profitability means great retained profit which is preferred to debt capital in financing choices. Therefore, higher profitability will result in lower total debt level within the firm. However, Chen (2004) made some further arguments claiming that there must be some other reasons explaining the strong negative relationship between these two factors of Chinese firms. Because of the underdevelopment of Chinese bond market and equity market, little protection is enforced for individual equity investors, which makes equity a �low-cost’ financial capital to firms. As a result, equity financing is far more attractive and easier to access for listed companies in China. In addition, the major shareholder of listed companies is the government who is also the beneficiary of tax. Thus, there is little tax-field benefits enjoyed through debts and it makes debts even less attractive than equity. Although retained profit is still the most convenient way for capital, equity has become the second financing choice of Chinese listed firms instead of debt.

Tangibility

Tangibility could be defined as