Testing capital structure theories using error correction models: Evidence from China, India, and South Africa

Abstract

The objective of this study is to empirically examine the capital structure theories that can explain the capital structure choice made by the firms that are operating in China, India, and South Africa. The study tests the capital structure theories as a stand-alone basis as well as an integrated framework of nested models using advanced dynamic panel data methods with a data-set of 1,183 firms with 12,187 firm-year observations spanning the period 1999-2016. Findings suggest that the firms adjust toward target leverage very quickly and trade-off theory explains the firms' capital structure choice better than pecking order theory in the stand-alone model as well as the model nesting these two theories. This study contributes to the empirical literature of capital structure in the following way. First, this study uses error correction framework as a general specification of the widely used partial adjustment model. Second, the study uses advanced panel data estimators to estimate partial adjustment model and error correction model. Finally, the different specifications are tested using a large data-set of firms in China, India, and South Africa that has not been done so far.

Capital structure dynamics: China and India (Chindia) perspective

“…However, because of imperfections in the form of adjustment costs, there exists partial adjustment towards the target. The partial adjustment mechanism is based on the general framework explained by Flannery and Rangan (2006), Qian et al (2009), Cook and Tang (2010), McMillan and Camara (2012), Dang et al (2014), Zhou and Xie (2016) and Kannadhasan et al (2018) [Equation (2)]: …”

“…System generalized method of moments (GMM) is deployed for the research (Blundell and Bond, 1998) because of the use of short panel data. It is suitable for a framework with endogenous explanatory variables and has the capability for securing consistent and efficient estimates in endogeneity issue[2] (Qian et al , 2009; De Jong, 2011; Dang et al , 2014; Ben-Nasr et al , 2015; Zhou et al , 2016; Belkhir et al , 2016; Kannadhasan et al , 2018).…”

“…Following, Kannadhasan et al (2018), the Indian firms adjust back to targets quickly in comparison to the Chinese firms. Hence, the management of Indian firms is agile in capital structure adjustments relative to the management of Chinese firms.…”

“…The dynamic trade-off model proposed by Fischer et al (1989) argues that firms rebalance their capital structure because of changes in various internal and external factors. Considering the turbulence and dynamism in the current corporate environment and recent empirical shreds of evidence of the trade-off theory (Drobetz et al , 2015; Zhou et al , 2016; Tao et al , 2017; Chung et al , 2018; Kannadhasan et al , 2018), this study attempts to investigate the capital structure dynamics for sample firms.…”

An Empirical Test of Capital Structure Theories for the Vietnamese Listed Firms

“…Flannery and Rangan (2006) and Nunkoo and Boateng (2010) observed that recent studies in developed countries have a tendency to use the GMM estimation technique to conduct empirical analyses on the capital structure issues. In addition, Kannadhasan et al (2018) emphasized that the GMM consistently estimates the dynamic model and deals with the endogenous problems by employing efficient instrumental variable (IV) techniques.…”