The Real Effects Of Short Selling On Firm Risk-Taking: Evidence From A Quasi-Natural Experiment In China

Xiaoran Ni

Tsinghua University – School of Economics & Management

September 15, 2015

Abstract:

This paper finds that firms react to short-sales pressures by undertaking less risk. Using a regulatory change (the pilot program on margin trading) on Chinese A-share market as a quasi-natural experiment, this paper finds that after the inclusion of the short-sales list, firms’ cash-flow volatilities decrease significantly. This is robust to matching and using alternative control groups. Also, these pilot firms hold more cash, take less debt, invest less in R&D and involve in fewer mergers as acquirers comparing to an average firm in the same industry. Further analyses indicate that the negative impact of short selling is more pronounced in the subsamples with weaker internal governance. On the contrary, firms with stronger internal governance increase managerial risk exposures by increasing managerial ownership. In addition, short selling can impede firm risk-taking by decreasing the holdings of dedicated institutional investors. These findings confirm that short selling has real effects on firm risk-taking, and reveal a channel through which capital market frictions can affect real economic activities.

The Real Effects Of Short Selling On Firm Risk-Taking: Evidence From A Quasi-Natural Experiment In China – Introduction

There has been an intense debate over the economic impact of short sellers. In support of the view that the financial market is not just a side-show (Bond, Edmans and Goldstein, 2012), several recent studies suggest that short selling can influence firm decision making directly. However, whether short selling has a direct effect on firm risk-taking has not received much concern. In this paper, I concentrate on a regulatory change (the pilot program on margin trading) in China that cause a positiveexogenous shock in short-sales activity and establish a causal relation between short selling and firm risk-taking. I find that firms react to this exogenous increase of short-sales pressure by undertaking less risk. As taking risk is almost always a prerequisite for creating shareholder value and a fundamental underpinning of long-term economic growth (Acemoglu and Zilibotti, 1997; John, Litov and Yeung,2008; Faccio, Marchica and Mura, 2011; Gormley and Matsa, 2014), short selling can therefore result in dead-weight costs to firm operations and hamper economic growth.

The financial crisis of 2008–2009 brought new scrutiny to the economic impacts of short selling around the world. Although academic literatures provide numerous evidences in support of short sellers acting as sophisticated traders by proving that they are more informed than average traders (Dechow, Hutton and Meulbroek, 2001; Desai et al., 2002; Christophe, Ferri and Angel, 2004), and can improve market efficiency (Saffi and Sigurdsson, 2011), facilitate the price discovery process (Chang, Cheng and Yu, 2007; Boehme and Wu, 2013), detect financial misconduct (Karpoff and Lou, 2010), most regulators around the world reacted to the 2007–09 crisis by imposing bans on short selling, which are suggested to have slowed price discovery and were detrimental for liquidity (Battalio and Schultz, 2011; Beber and Pagano, 2013). One of the ultimate critics of short sellers is that they play a detrimental role to the economy by creating panic in capital markets and lead to distortion in real economic activities. In line with recent literature on the real effects of short selling on firm investment (Grullon, Michenaud and Weston, 2015), strategic disclosure decisions (Li and Zhang, 2015), and earnings management (Massa, Zhang and Zhang, 2015; Fang, Huang and Karpoff, forthcoming), I provide new insights on how capital market frictions can affect real economic activities by focusing on the relation between short selling and firm risk-taking.

Short Selling

My objective is to determine whether and how short selling can affect firm risk-taking in a series of empirical work. Due to the endogenous nature of short selling, identifying the causal effects of short-sales activity on firm risk-taking is empirically challenging. To address this issue, I exploit a quasi-natural experiment to establish a causal relation between short selling and firm risk-taking. Using an exogenous change that caused an increase in short-sell pressure in Chinese stock market, I conducts a DiD approach and find that short selling has negative causal effects on firm risk-taking.

Chinese stock market has a unique regulatory feature that allows short selling only of securities that are included in an official short-sales list. This list is revised over time. which creates both time-series and cross-sectional variation in terms of short-sales pressure for finns listed in Chinese stock market. Previously, there are several studies focus on short selling based on the US. SHO experiment during 2005-2007. when the SEC ordered a pilot program in which one-third of the Russell 3000 were arbitrarily chosen as pilot stocks and exempted from short-sale price tests (Fang. Huang and Karpoff. forthcoming). Compared with that experiment. since short-sales restrictions for different stocks are released at different times in China, this cross-Sectional analysis suffers less from the potential confounding effects of other concurrent events. Moreover. China is the largest emerging market in the world and the largest stock market outside the U.S., and economic growth is a crucial issue of Chinese govemment, especially in post-crisis periods. Thus, China provides us a suitable enviromnent to study the real effects of short selling on economic activities. and can also throw light on how government intervention affects economic growth in a representative undeveloped market.

 

Short Selling

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