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Financial Literacy and Risky Asset Holdings: Evidence from China

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Financial Literacy and Risky Asset Holdings: Evidence from China Accounting & Finance 57 (2017) 1383–1415 Financial literacy and risky asset holdings: evidence from China Li Liaoa, Jing Jian Xiaob, Weiqiang Zhanga, Congyi Zhoua aPBC School of Finance, Tsinghua University, Beijing, China bDepartment of Human Development and Family Studies, Transition Center, University of Rhode Island, Kingston, RI, USA Abstract Although financial literacy is important for participating in financial markets, the level of financial literacy of Chinese consumers is low compared with those in developed countries. Using data from the 2014 China Survey of Consumer Finances, we examine the relation between financial literacy and the risky asset holding behaviour of Chinese households, in the context of an emerging financial market with a distinct institutional background. The findings reveal that consumers with higher levels of financial literacy are more likely to hold risky financial assets than those with lower levels. The potential impacts are derived mainly from advanced financial literacy. Key words: Chinese households; Financial literacy; Risky asset holdings JEL classification: D12, D14, E21 doi: 10.1111/acfi.12329 1. Introduction In contemporary China, the financial industry is playing an essential role in boosting economic growth. The Chinese stock market has risen to one of the largest stock markets in the world. The market capitalisation of the Shanghai Stock Exchange and the Shenzhen Stock Exchange reached US $6.27 trillion at the end of January 2015, ranking second only to that of the U.S.A. (World Federation of Exchange, 2015). Over the past decade, the growing complexity of financial products spurred by financial innovations The authors acknowledge funding support from the National Natural Science Foundation of China (71232003 and 71573147) and China Postdoctoral Science Foundation (2016T90073, 2015M570066). © 2018 AFAANZ 1384 L. Liao et al./Accounting & Finance 57 (2017) 1383–1415 has transferred increasing financial risks to households and has imposed enormous pressures on consumers who are expected to absorb these risks. Risky financial assets, such as stocks, mutual funds, corporate bonds and commodity futures, as well as risk-free bank deposits, are available for household portfolio selection. The goal of portfolio allocation is to maximise the optimal level of growth in the wealth of a household. The classical portfolio theory implies that risky assets should be included in the household portfolio (Markowitz, 1952), yet research shows that many households do not establish their portfolio allocation in accordance with financial theory. Campbell (2006) observes that American households with less wealth prefer to allocate their assets to vehicles and cash rather than to risky assets such as stocks. Although households tend to hold stocks more than other risky assets when they accumulate wealth, many wealthy households nevertheless do not participate in the stock market. Previous studies have explored factors associated with risky asset holdings. An empirical study in Europe indicates several determinants of risky asset holdings, including labour income uncertainty and health risk (Atella et al., 2012). Moreover, Cardak and Wilkins (2009) find that financial awareness and knowledge play an important role in determining risky asset holdings among Australian households. It is worth noting that despite increasing access to financial markets, risky financial assets constitute a small percentage of Chinese households’ portfolios, possibly because of the lack of financial literacy. This study examines the potential effect of financial literacy on the risky asset holdings of Chinese households. In recent decades, financial literacy has attracted more attention regarding its great economic significance. Lusardi and Mitchell (2014) propose the theoretical and empirical importance of financial literacy. They argue that the gap between reality and theoretical models may originate in the hypothesis, which states that individuals have the capacity to undertake complex economic tasks and possess expertise in engaging with financial markets, a hypothesis contradicted by findings of prevailing financial illiteracy across countries. Financial illiteracy has been empirically linked to undesirable financial decisions (Agarwal et al., 2009). Consumers with low levels of financial literacy tend to save less and accumulate less wealth (Lusardi and Mitchell, 2007; Jappelli and Padula, 2013). To provide a solution to financial illiteracy, as much as 59 economies in the world are implementing or actively designing national strategies to improve financial education (OECD, 2015). Effective financial education programmes will contribute to higher financial literacy, more desirable financial behaviours, and better financial ability (Bernheim and Garrett, 2003; Collins, 2010; Carlin and Robinson, 2012; Luhrmann€ et al., 2015; Xiao and O’Neill, 2016). Based on previous research, we predict that financial literacy is an important factor for explaining the risky asset holding behaviour of Chinese households, given that China has experienced the transition of economic system, and © 2018 AFAANZ L. Liao et al./Accounting & Finance 57 (2017) 1383–1415 1385 therefore, many households remain unfamiliar with the emerging financial market and risky financial assets. Consequently, consumers with low levels of financial literacy may face high costs of participation in risky financial markets because financial literacy could be viewed as costly in terms of human capital. Although research on financial literacy in many countries, particularly developed countries, is growing, the financial literacy research in China is limited. To address this research gap, we use data from the 2014 China Survey of Consumer Finance to examine the role of financial literacy in determining the risky asset holdings of Chinese households. Based on descriptive statistics, we find that financial illiteracy in Chinese households is both prevailing and severe at the national level. We then employ regression models to examine the potential effect of financial literacy on risky asset holdings. After controlling for the potential endogeneity of financial literacy and risky asset holdings, the results and robustness checks show that financial literacy is associated with risky financial asset holdings among Chinese households. Moreover, advanced financial literacy is strongly associ- ated with risky asset holdings. Our study contributes to existing literature by adding new evidence from the emerging market. Although there has been increasing research on financial literacy and household portfolio, most studies are rooted in the context of mature markets, both theoretically and empirically (Lusardi and Mitchell, 2007; Cardak and Wilkins, 2009; Jappelli and Padula, 2013). However, consumers in emerging markets face more constraints than those in mature markets. Take the pension system as an example. The Chinese social pension account is managed as a mutual fund by a specialised government institution. Individual account holders are not in charge of the portfolio allocation of their own accounts. From the individuals’ perspective, the pension account works as a long-term saving account with a risk-free return. The opportunity for individual investors to allocate risky financial assets is largely narrowed by this systematic arrangement. These constraints and special institutional arrange- ments make the asset allocation pattern of Chinese households generally different from that of Western countries. Therefore, it is necessary to examine the impact of financial literacy on Chinese household behaviour to enrich the literature of financial literacy, even though there are rich existing studies using data from developed economies. To our knowledge, our study is the first to characterise Chinese financial literacy using international comparable data. Moreover, previous research has studied the potential effects of financial literacy on stock market participation (Van Rooij et al., 2011), but little attention has been given to the entire set of risky financial assets in household portfolios. This study attempts to fill this gap too. The paper is organised as follows. Section 2 presents a literature review on financial literacy and risky asset holdings, in which research hypotheses are proposed. Section 3 introduces the survey data, and section 4 describes the financial literacy situation of Chinese households. Section 5 reports the © 2018 AFAANZ 1386 L. Liao et al./Accounting & Finance 57 (2017) 1383–1415 empirical results regarding the association between the financial literacy and risky asset holdings of Chinese households. Section 6 concludes and discusses policy implications on national financial education. 2. Literature review and hypotheses 2.1. Research on financial literacy During the past decade, research on financial literacy has increased. Definitions of financial literacy vary in the literature (Hung et al.,2009). Lusardi and Mitchell (2014) define financial literacy as the ability to ‘process economic information and make informed decisions about financial planning, wealth accumulation, debt and pensions (p6)’. To measure financial literacy, they have designed three questions to examine people’s numeracy capability and their understanding of concepts such as inflation, interest and risk diversification. This set of questions is broadly adopted for conducting financial literacy surveys in different countries (Lusardi and Mitchell, 2011). Apart from Lusardi’s measurement, the International Network of Financial Education (INFE) has decomposed
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