Revisiting the Bright and Dark Sides of Capital Flows in Business Groups

We have to be cautious in not overstating that we can completely address the endogeneity problem facing other datasets. Even though firms do not individually decide on the carving out policy, the central government that decides on this might well take into consideration the firm characteristics such as firm profitability.

La Porta et al. (1999) document the widespread use of pyramids, Claessens et al. (2000) find a large divergence between cash flow rights and control rights in many East Asian firms, and Claessens et al. (2002), La Porta et al. (2002), Mitton (2002), Lemmon and Lins (2003), and Baek et al. (2004) find that the separation of cash flows and control rights of controlling shareholders negatively affect firm value.

There is also a growing literature on how financing constraints affect firm investments in developed markets. See, for example, Almeida et al. (2004, 2006), Almeida and Campello (2007), Fazzari et al. (1988, 2000), Fee et al. (2008), Hadlock and Pierce (2008), Kaplan and Zingales (1997, 2000), Moyen (2004), Rauh (2006), Whited and Wu (2006). Several contemporary case studies focus on the roles of managerial power on internal capital allocations (Cremers 2008; Glaser et al. 2008).

Fisman and Wang (2010) also point out that looking at only one component of the transfers within a group may lead to a very misleading view of the impact of pyramidal transactions. However, in their paper, the different effects of intra-group financing on the value of the whole group are not directly tested.

The fact that many of the heads of the controlling owners are bureaucrats in charge of the SOEs does not necessarily diminish the incentive to expropriate. Although the heads of SOEs may not have as strong monetary incentives from the better performance of their firms, they do have non-monetary incentives, such as their own promotion in the political hierarchy. It is thus not clear whether the reward for better performance is necessarily smaller. In addition, as implied in the analysis of Jiang et al. (2010) and others, the cost of expropriation might be low: both the odds of being caught and the odds of being disciplined when caught might be low in China, compared to those in other countries. We thus believe that it is quite possible that there are not many fewer expropriations in SOEs than in non-SOEs. In untabulated results, we find that the patterns documented in our paper are not significantly different across the SOE and non-SOE subsamples.

Consistent with the literature, we define “private benefits” broadly to include things like pet projects, managerial perks, and waste in the parent company. We measure the amount of private benefits as the difference between the benefit received and the cost of arranging such a transfer. For example, if the parent company transfers $1 from the subsidiary to itself and incurs a cost of $0.03 for such a transfer, then the net private benefit of the transfer would be $0.97.

We believe this assumption is consistent with the empirical observations in many emerging markets. In the specific case of China, we provide more details in the next section to justify this assumption.

This also means that there is a possibility, at least in theory, that a dollar transferred from the subsidiary to the parent could be worth more than a dollar to the parent. If the net private benefit of the dollar transfer is $0.9 and it also enables the undertaking of a positive NPV project with an NPV of 0.3, then the total value of the dollar transfer to the parent would be $1.2.

This asymmetry is an important characteristic that differentiates the intra-financing of a business group from that of a typical conglomerate and helps to differentiate intra-group capital flows and other mechanisms in terms of why shocks to cash flows might propagate through a business group, such as cross-subsidization and risk sharing among member firms. See also footnote 2 in Bertrand et al. (2002).

Beginning in 1993, all industrial firms in China, regardless of ownership type and size, have been required to report their financial statements according to the same “Accounting Standards for Enterprises.” As almost our entire sample is composed of industrial firms, the financial and operating information of the listed firms and the parent firms are thus consistent. Note that the NBS data is non-consolidated, and therefore the financial data reported for an entity does not incorporate the numbers for its legally separate affiliates.

This may occur, for example, when organizational changes (e.g., restructuring, mergers, or acquisitions) result in a firm legally changing its name and identification code such that the name and business of the parent firm recorded in a listed firm’s annual report might not be precisely the same as that recorded in the NBS Database. Data entry errors made during the NBS survey and data collection process may also account for some mismatches.

Although not all of the parent firms have an absolute majority stake in the associated listed firms, our descriptive statistics (not reported) show the cash flow rights of the parent firms to be about six times larger by mean, or ten times larger by median, than the sum of the cash flow rights of the second and third largest block holders. The non-listed parents in our sample are thus dominant shareholders because the other large shareholders are not sufficiently large to have a comparable impact on the listed firms.

We conducted robustness checks based on the enlarged sample where we did not drop these observations. The results are qualitatively unchanged.

When the listed subsidiary firms have negative adjusted cash flows, our regression can be interpreted differently. It implicitly assumes that when a listed subsidiary experiences a negative cash flow, the parent correspondingly invests less. In other words, capital may flow in the reverse direction, from the parent to the listed subsidiary, to support the subsidiary that might be in financial trouble. The literature documents ample evidence to show that even a controlling shareholder or a corporate insider of a listed firm may occasionally prop up a firm, if this would preserve future opportunities for more expropriation (Friedman et al. 2003; Jin and Myers 2006). However, there is no reason to believe that the extent of the prop up is the same as the extent of the intra-group capital flow, so as to generate the same slope coefficient β ₂ in the regressions. To avoid the potential asymmetry in the regression coefficients for the positive and negative cash flows and to allow us to focus on the intra-group capital flow “tunneling” aspect of intra-group financing, we exclude the small sub-sample of listed subsidiaries with a negative cash flow. The inclusion of the negative cash flow observations will not qualitatively change our main results.

In unreported robustness checks, we find that replacing the listed subsidiary industry average Q with its own Q does not qualitatively change any of our results.

The draft for open comments on this document was issued at the beginning of 2004. Details of the regulations can be found at http://​www.​csrc.​gov.​cn/​n575458/​n4239016/​n6634558/​n9768098/​n9768450/​index_​1.​html.

To evaluate our claim that the bank ownership variable is exogenous to firm decisions, we compare characteristics between firms with and firms without bank ownerships). We compare firm characteristics (parent’s cash flow right, government control, region effect, and some financial characteristics) but do not find significant differences in these characteristics between the two groups, for either the parent or the listed subsidiary samples. Overall, it does not appear that bank ownership in our sample is affected by those firm characteristics that also drive the pattern of related-party transactions. We thank our referee for this suggestion.

We have no data to calculate the adjusted cash flow measure 2 and measure 3 for the parent firms, but this is not that important since we are mainly focusing on how parent investment relies on the cash flow from the listed subsidiary, which has the three adjusted measures.

We are fully aware that not all inter-corporate loans are ill purposed. In fact, some might be due to legitimate reasons such as normal business interactions between business group members. If that is the case, these measures will overstate the true magnitude of the “abnormal” intra-group capital flows. The fact that we still find, despite the noise in the measure, that these activities are highly related to our proxies for conflicts of interest and financial constraints could be interpreted to mean that the true relationship might be even stronger.

An interesting study by Chow and Fung (2000) showed that in the earlier stage of China's economic reform, in the city of Shanghai, small firms might enjoy more financial flexibility than bigger firms, as small firms are more likely to be in the non-SOE sector, more nimble, and thus more profitable. They did warn that it might be difficult to extrapolate their results beyond the specific region and time period that they examined, as the higher profitability of smaller firms is unlikely to be sustainable. Indeed, more recent surveys, such as the study done by McKinsey (2006), indicate that smaller enterprises, particularly those non-SOE firms, are subject to more financial constraints in China.