Political Connections: An Explanation For The Consistently Poor Performance Of China’s Stock Markets
Central University of Finance and Economics (CUFE) – School of Accountancy
Central University of Finance and Economics, Beijing China
January 19, 2016
Abstract:
The fact that the consistently poor performance of China’s stock markets has not matched China’s rapid economic growth has been puzzling. Using samples of private-owned enterprises publicly traded on China’s stock markets, this article finds that 74% of these firms are politically-connected and that politically-connected firms are more likely to report significant deterioration in financial performance upon completing IPOs. The widespread existence and ubiquitous importance of political connections in China’s stock markets suggests that to some degree, China’s stock markets have been regulated on a political connections-based regime, which may explain the poor performance of China’s stock markets.
Political Connections: An Explanation For The Consistently Poor Performance Of China’s Stock Markets – Introduction
It has been widely observed in China that during the past two decades since China opened its two primary stock exchanges, i.e., Shanghai Stock Exchange (SSE) and Shenzhen Stock Exchange (SZSE) in 1990, while China has had the fastest growing and the most stable economy among the major economies in the world, China’s domestic stock markets have been among the worst-performers in terms of both financial performance and law-compliance records among major stock markets in the world. Such a paradox has being puzzled the Chinese public, economists and policy-makers alike. When the composite indexes of SSE and SZSE fell back to where they were ten years ago in early 2012, Xiaoling Wu, a former deputy governor of People’s Bank of China (PBoC), China’s central bank and currently a vice-chairwoman of Committee on Public Finance and Economy of National People’s Congress of China, China’s legislature, commented that the poor performance of China’s stock markets contradicted the basic principles of economics.
This purpose of this article is to explain the paradox that China’s rapid economic growth has not translated into wealth for its huge public investing in domestic stock markets from the perspective of political connections. This article proposes that the consistently poor performance of China’s stock markets can be related to the fact that under China’s state-controlled going public regime, the widespread existence and ubiquitous importance of political connections in China’s stock markets has let many politically-connected firms go public on China’s domestic stock markets by falsifying financial statements without being prosecuted by regulatory authority.
The findings of this article are as follows: first, politically-connected firms are very common in China’s domestic stock markets. Specifically, as many as 74% of the private-owned enterprises (POEs) publicly traded on China’s domestic stock markets are politically-connected one way or another; second, politically-connected firms are significantly more likely to report significant deterioration in financial performance immediately upon being approved for IPO or completing IPOs, more likely to engage in law-breaking activities such as falsify financial statements while significantly less likely to be punished by regulatory authority, and to significantly under-perform firms without political connections in terms of long-term financial performance. The widespread existence and ubiquitous importance of political connections in China’s stock markets suggests that to some degree, China’s stock markets are regulated under a de facto political connections-based regime, which may help explain the consistently poor performance of China’s stock markets.
This study makes three major contributions to literature on China’s domestic stock markets. First, being the first academic attempt to explain the remarkable and consistent paradox between the poor performance of China’s stock markets and the rapid growth of Chinese economy, this article may provide answer to the question how China, the fastest growing major economy in the world, can translate rapid economic growth into wealth for its huge investing public. Second, being the first research to empirically test the factors that regulatory authority takes into consideration in making decisions on IPO applications, this article sheds light on what really determines firms’ chances of being approved for IPOs under China’s merit-review regulatory regime. Third, by shedding light on the causes of the ubiquitous importance of political connections in China’s stock markets, this article helps understand how China’s stock markets are actually operated. The findings of this study have some important implications for China’s policies regarding how to develop wealth-creating domestic stock markets.
This study focuses exclusively on POEs. POEs are defined as enterprises whose ultimate controlling shareholders are individuals or private-owned entities.State-owned enterprises (SOEs), defined as enterprises whose ultimate controlling shareholders are government agencies (e.g., state-owned assets supervision and administration commission) or state-owned entities, are all politically connected ex officio. For one reason, top managers (e.g., chairmen of boards of directors, CEOs and CFOs) of SOEs are appointed by the government and CCP. Unlike previous studies that pool POEs and SOEs together, this study, by focusing exclusively on POEs, avoids the issue of ownership-related effects and thus can provide better insights into the role of political connections in China’s stock markets.
The rest of this article proceeds as follows. Section II presents evidence on the consistently poor performance of China’s stock markets in both financial and law-complying terms during the past two decades. Section III reviews literature on the performance of China’s stock markets, the value of political connections in financial markets, and the relationship between political connections and firms’ performance. Section IV provides institutional background on China’s stock markets, defines key terms such as “political connections”, and develops the hypotheses to be tested in this study. Section V presents the data, variables and models. Section VI presents empirical test results. Section VII concludes the article with discussions on the policy implications for the development of China’s stock markets.
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