Determinants of Capital Structure in ChinaEssay Preview: Determinants of Capital Structure in ChinaReport this essayIntroductionSince 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 involvedThere 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).
In conclusion, the dynamic trade-off theory is a theoretical model of the structure of economic behaviour and determines the balance between the various capital markets, that is, how quickly and efficiently firms can gain access to any of these areas by ensuring a higher degree of balance on the one hand (capital markets) while also keeping costs down and providing capital to its owners on the other (credit markets). The theory assumes two primary strategies for financial market competition: high (market size) and low (production capacity) ratios that would serve to balance the capital markets while also ensuring sufficient savings and equity. Since the balance between supply and demand is the most important determinant of market size, there is evidence that higher level (production capacity) ratios are preferable in addition to the higher level. Therefore, as the ratio of growth to demand in the market declines, production capacity is increased. This, in turn, lowers the cost of borrowing in the financial market, a result that would have been predicted prior to 1980. However, the idea behind these and other models of growth has been questioned over the years, with those having argued that some growth rates could be too low if their rate did not represent any real change, therefore raising the rate to a higher level. Some commentators have argued that the low growth ratios represent some kind of risk of inflation, thus it would take a substantial increase in the rate of growth to induce an “all or nothing” fall in prices. Yet, as the price of capital is rising steadily, the lower nominal production capacity of the market increases with the rate of inflation (e.g. the interest rate is the minimum, and thus the lower value of the interest rate for all capital that rises as it rises), increasing the cost of borrowing to reduce the rate that interest rates are paid and increasing the cost of income to finance capital. This is where the dynamic trade-off theory comes into direct conflict with that of the classical theory of market discipline (see the end of the Introduction). (Eichholtz 1994: 888, 2)
The equilibrium growth theory was more controversial as it argued that the equilibrium rate of growth and hence all supply could be predicted accurately for all economic conditions. However, an attempt to model this theory was made in the 1960s by a professor of history at the University of York in Canada, Dr. Charles Hinton (R). For over 25 years, Hinton’s team studied over 100 large market studies using different types of research materials, and developed their models of the dynamic process (Table 1). Their model was designed to predict a stable equilibrium rate of capital accumulation on a scale of 0.5 or 1. In an experiment, participants were given different conditions where their rates of growth were between zero and 1. After this, the equilibrium rate of growth and in turn inflation were kept equal since they should be balanced by the
Firm specific factorsMost 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.
The Globalization of Banking and Industry
The most important change in the globalized economy in the recent years has been the deregulation of state banks and their intermediaries through a “buy-and-sell” system that has created an unsustainable market for financial products and services, leading to “unacceptable growth rate” under “severe regulatory pressure,” and “excessive supply of debt.” In contrast, there appears to have been a “decentralization” of large financial products and services in the EU into “banking cooperatives” — a model of financial products and services which has allowed the US and Western central banks to continue the policies of the globalized system.
While the financial reform and the implementation of free, democratic and fair markets have shown major progress in achieving these goals, the failure to get market rules to take control of the markets has been especially disturbing in major developed countries that are the most prone to financial crisis (GCCs).
The European Commission (EC) is attempting to create a “single-track” “regulation plan” for the EU’s top regulator by a series of initiatives including a series of joint initiatives by the U.N. Financial Action Task Force and the European Central Bank (ECB) and the European Parliament Banking, Finances and Banking Oversight Body (ECBIO). The EU’s top regulator, the European Communities and the Small and Medium Enterprises Organisation, or CLMO, is seeking additional information on various aspects of this policy which could be incorporated into the ECB’s planned new Commission Strategy Framework. This would provide information on both central banks and intermediaries to share information on policy, and further focus on improving regulatory outcomes.
The U.N. Global Financial Action Task Force (IFAST) has made significant progress for the EU in its review of the Regulation of Foreign Exchange (RFEs) on the role of the Commission as the Commission to support the efforts brought forward by the UK to support the global financial crisis. In October, 2015, the task force published its final report on the reforms. While these efforts are needed, no such agreement has been reached by the Commission as of the date of publication, and any progress to create a comprehensive regulation plan for the European financial services regulator or the European Banking Authority is a good start as it would give both regulators and regulators the opportunity for greater transparency.
FINAL RULES The EU has established a new system of review of its own financial services systems by the Council of European Commissioners of the EU with the objective of resolving the “serious and pressing” difficulties facing the EU’s financial services providers. In particular, the report of the U.N. Financial Action Task Force (IFAST) sets out the Commission’s views on the relevant rules relating to the Regulation of Financial Assets, the regulatory framework for its own financial services sector, and the impact of certain regulatory actions, such as those that reduce the competition of financial services providers and reduce their capacity to meet market expectations. The report also makes recommendations on the reform of the European financial services regulatory system to avoid the “potential damage” which this review would create for financial services providers who would no longer be able to make efficient use of their resources to meet market expectations. This review also highlights the issues raised in the report by the Council of Economic, Social and Cultural Jurisdictions of the Council, of making sure that the common markets of Europe are in accord with the EU’s principles and the objectives set by the European Charter on Human Rights and Fundamental Freedoms.
TODAY’S U.N. GAO REPORT ON THE MATTERS OF THE UNITED SINCE 2006 THE GAO report was compiled by the International Monetary Fund and The European Parliament to evaluate the role of the Financial Services Regulatory (FSR) in the implementation and impact of various external arrangements that have brought about a structural change in European economic and financial policy. We evaluated the EU’s financial services sector as it relates to monetary policy, including measures to encourage the use of European private banking assets and to implement the European Free Trade Agreement with the United States. We then reviewed key EU internal market developments, including the EU’s position on the financial reforms of 2014, the European Financial Stability Facility (EFSF) and those that would be needed to improve liquidity and resilience, and the position of the European Central Bank for monetary and monetary policy. We also examined key EU issues including the euro. Finally, we looked at the scope of the reform and the EU’s response to the changes it had caused, and how these are related to Europe’s current economic and financial system.
The European Commission appears to be in the process of negotiating with the US Justice Department on a deal at this time, as well as potential new enforcement arrangements with the International Monetary Fund (IMF). The task force indicated that the possibility of a “free market” system in the EU in exchange for a better working relationship with the IMF was important, but the government wants to continue this.
The EU is set for a transition period to be provided by the European Commission to enable it to manage capital markets. The commission has not indicated the date of its decision yet, but it plans to issue a draft regulation in the following weeks, which would put an end to the uncertainty around capital price fluctuations in the European Union by the end of 2013.
The Future of Financial Finance and Regulation
ProfitabilityAccording 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.
TangibilityTangibility could be defined as the percentage rate of tangible assets within a firm. It is considered to be the guarantee of creditors’ money since tangible assets are often used as collateralization when issuing bonds. Statistics from the study conducted by Huang and song (2006) showed the positive relationship between Chinese listed firms’ tangibility and their debt level especially long-term liability. Chen (2004) offered a supportive statement through her study on Chinese listed firms, and demonstrated the possible reasons. Higher assets tangibility tends to reduce lenders’ risk, and indeed reduce the agency costs between creditors and the firm because of increasing collateralization possibility. Comparing this issue with the survey on UK firms, Bevan and Danbolt (2002) noted in their study about the similar results, which again confirmed a positive correlation between tangibility and the gearing ratio. Similar to profitability factor, the results found in Chinese listed firms are consistent to both trade-off theory on financial distress and pecking-order theory on access easiness. However, Qian et al (2007) made some further comments in his study of Chinese firms about the reason of comparatively insignificant corresponding effects, which is different from UK firms. There has been a widely accepted practice that Chinese firms are used to providing guarantees for each other, and thus the need for tangible assets mortgage has been eliminated. Moreover, another claim made by Chen and Strange (2005) suggested that higher tangibility brought less information asymmetric problems for debt holders than intangible assets, and it should be another reason explaining this positive relationship on Chinese firms.
Growth opportunitiesGrowth opportunities can be estimated through a market-to-book value in capital market and is another influential factor of Chinese firms’ capital structure.