Institutions and Corporate Investment: Evidence from Investment-Implied Return on Capital in China

Abstract

We assess the impact of institutions on Chinese firms’ corporate investment in an investment Euler equation framework. We allow the variables measuring institutions to affect the rate at which firm managers discount future investment payoffs. Applying generalized method of moments estimators to large samples of Chinese firms, we estimate the stochastic discount rates derived from actual investment and examine how they vary across institutional variables. We document robust evidence that ownership is the primary institutional factor affecting corporate investment in China. The derived discount rate for a nonstate firm is approximately 10 percentage points higher than that of an otherwise equal state firm. State firms tend to use higher discount rates to invest after they are partially privatized. We also find that firms with higher levels of corporate governance use higher discount rates to make investment.

Does China overinvest? Evidence from a panel of Chinese firms

“…They are largest in absolute value for SOEs, followed by foreign firms. By contrast with conventional thinking and contrary to the finding in Dollar and Wei (2007) and Liu and Siu (2012), it is the private sector rather than the state sector that appears to have overinvested most in recent years. 9 One possible explanation is that the rising profitability in the non-state sectors generates abundant free cash flow, which leads to excessive investment.…”

“…Chen et al (2011) argue that government intervention through majority state ownership or the appointment of politically connected managers distorts SOEs' investment behaviour and harms investment efficiency of Chinese listed firms. Liu and Siu (2012) use a large sample of unlisted firms and find that, compared to SOEs, non-state firms use higher rates to discount future investment payoffs. They claim that, owing to soft budget constraints, managers of SOEs perceive a cost of capital that is inefficiently low, and therefore tend to overinvest.…”

Is there time discounting for risk premium?

“…Decision making for a future risky outcome is not limited only to individuals' everyday behavior. Some studies suggest that time preference also affects managers' decisions to invest in risky projects with a future outcome (Ivanovic, Karanovic, & Bogdan, 2010;Liu & Siu, 2011;Shavit & Adam, 2011). Again, the time preference effect on decisions concentrates on the discounting of outcomes.…”

Structural Changes in the Chinese Stock Market: A Review of Empirical Research

“…Table 1 shows that the empirical results are generally consistent with the hypothesis of an efficiency gain after the partial privatisation of SOEs. The increase in minority private ownership is shown to be associated with higher perceived firm value (Wei, Xie, and Zhang, 2005); higher profit reinvestment rate (Cull and Xu, 2005); higher discount rate in making investment decisions (Liu and Siu, 2011); improved firm's earnings ability, real sales, and workers' productivity (Sun and Tong, 2003); better transparency of firm's specific information (Gul, Kim, and Qiu, 2010); lower earnings management ; higher pay-for-performance sensitivity (Cao, Pan, and Tian, 2011); higher accounting conservatism ; and the choice of higher quality auditors (Wang, Wong, and Xia, 2008). The primary argument is that the stock market provides incentives for investors to gather information that is reflected in share price and this information can improve managerial incentives in a number of ways.…”

“…Non-state firms in China use a much higher discount rate in guiding their investment decisions than SOEs, and an SOE uses a higher discount rate to invest after privatisation. Liu and Siu (2011) Ownership & Transparency Synchronicity (a proxy of firm-specific information) is higher when the largest shareholder is government related, and foreign ownership and auditor quality is inversely associated with synchronicity. Gul, Kim, and Qiu (2010) …”