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Public Governance and Tunneling: Evidence from a Quasi-Experiment in China

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Public Governance and Tunneling: Evidence from a Quasi-Experiment in China Public Governance and Tunneling: Evidence from a Quasi-Experiment in China Guowei Xu PhD Candidate Department of Finance Renmin University of China Beijing, China and Department of Accountancy and Law Hong Kong Baptist University Hong Kong, China [email protected] Wenming Wang Department of Accountancy and Law Hong Kong Baptist University Hong Kong, China [email protected] Danhua Zhou MBA student Andersen School of Management University of California, Riverside California, U.S.A [email protected] Gaoguang Zhou Department of Accountancy and Law Hong Kong Baptist University Hong Kong, China [email protected] This version: 2016 Oct 1 Public Governance and Tunneling: Evidence from a Quasi-Experiment in China Abstract: In this study, we take advantage of the unprecedented anti-corruption campaign launched in December 2012 to examine the effect of improved public governance on tunneling in China. Using a sample of Shanghai and Shenzhen Stock Exchange listed companies from 2010 to 2014, we find that the scale of tunneling decreases significantly after the campaign, supporting the notion that increased public governance effectively curbs tunneling. Cross-sectional results show that such effect is more pronounced in firms controlled by private entrepreneurs, in private firms having political connections, in firms audited by non-Big 8 auditors, in firms with large divergence between control right and ownership right, and in firms located in areas with low marketization. Our results highlight the importance of anti-corruption initiatives in improving public governance and in turn reducing expropriation. Our study provides implications for many emerging economies with similar institutional background. Keywords: Anti-corruption, Public governance, Tunneling, China. JEL classification: D73 G34 2 I. INTRODUCTION Tunneling is the process of transferring assets or profit out from a company to the controlling shareholders (Johnson et al. 2000).1 Such expropriation behaviors are prevalent especially in emerging economies where legal protection is under-developed (e.g. Johnson et al. 2000; Shleifer and Vishny 1997; La Porta et al. 1997, 1998; Shleifer and Wolfenzon 2002). Although the governments in many emerging economies have launched initiatives to combat corruption in order to improve public governance, scant studies examine whether such initiatives are effective in deterring misconducts. In this study, we take advantage of China’s unprecedented anti- corruption campaign initiated in December 2012 as an exogenous event to examine whether the campaign could curb tunneling. We use China as a setting to examine aforementioned research question for the following three major reasons. First, the anti-corruption campaign is an exogenous event that is believed to improve public governance in China. In December 2012, Mr. Xi Jinping launched this campaign shortly after his assumption of General Secretary of Communist Party of China (CPC). He demonstrates his determination to tackle corruption and vow to target all the party members regardless of their ranks in the government. The campaign is unexpected and shocks even the most seasoned political observers (Griffin et al. 2016). Our study using this exogenous event as a setting could alleviate endogeneity problems that are major concerns in prior cross-country studies (e.g. Nenova 2003; Dyck and Zingales 2004; Lemmon and Lins 2003).2 Second, China’s listed firms are prone to engage in tunneling because of concentrated ownership, weak legal protection, and the limited authority of the security market regulators (Jiang et al. 2010). Several 1 Tunneling is also called self-dealing (e.g. Djankov et al. 2008). In this study, self-dealing and tunneling are interchangeable. 2 The studies based on cross-country data are subject to endogeneity problems, which may weaken the inference (Fan, et al. 2008). 3 studies show that the controlling shareholders in China extract private benefits from the listed companies using various methods, including inter-corporate loans (Jiang et al. 2010), loan guarantees (Beckman et al. 2009), and related party transactions (Jian and Wong 2010). As such, China is an ideal lab to examine tunneling. Finally, the wide variations of institution background in different areas in China allow us to examine how local institutions moderate the relation between public governance and tunneling within one country. By doing so, we are able to extend prior tunneling literature and deepen our understanding of tunneling. We argue that the anti-corruption campaign provides profound effects on the governance environment and thus reduce tunneling. The anti-corruption campaign significantly improves public governance (Shleifer and Vishny 1997) and thus reduce tunneling (e.g. Johnson et al. 2000; Nenova 2003; Dyck and Zingales 2004; Lemmon and Lins 2003). In particular, the measures taken by the CPC to pose restrictions on government officials’ ties with firms and punishments for detected misconduct force the regulators to monitor the firms closely. The anti- corruption campaign also improves corporate governance at firm level and thus reduce tunneling (Jiang et al. 2010; Gao and Kling 2008). Based on the above arguments, we hypothesize that the level of tunneling decreases following the anti-corruption campaign in China. We further examine whether the mitigating effect of the anti-corruption campaign on tunneling varies with firm characteristics, including ownership structure, political connection, quality of audits, and marketization at province level. One feature of China’s economy is that the government is the controlling shareholder in many large listed companies (or SOEs). As the controlling shareholders in SOEs, the governments appoint high ranked officials as executives in the firms. The promotion prospects coupled with high costs of misconducts discourage them to 4 engage in tunneling.3 In contrast, private companies have strong incentive to extract private benefits through tunneling. As a result, we expect that non-SOEs are more affected by the campaign. Another feature of China’s corporate sector is the wide use of political ties to obtain favorable treatment in regulatory process (Wu et al. 2016). However, such strategy is no longer effective after the carrying out of the campaign because the regulators are receiving greater scrutiny from the party and the public than ever before. We thus hypothesize that the deterrence of tunneling after the campaign is more significant for companies with more political connections. In China, large auditors are more effective in curbing tunneling compared to small auditors (Gao and Kling 2008; Jiang et al. 2010). In response to increased audit risk caused by the campaign, small auditors take more efforts to detect and report tunneling which is conductive to fraud and regulatory sanctions (Firth et al. 2005). As such, we expect that the effect of the anti-corruption campaign on tunneling is more pronounced for firms hiring small auditors. Like firms in other emerging economies, the firms in China exhibit large divergence between control right and ownership right (C/O ratio), providing the controlling shareholders strong incentive to expropriate the minority shareholders (e.g. Lemmon and Lins 2003; Claessens, et al. 2002; Jiang et al. 2010). The anti-corruption campaign enhances corporate governance and public enforcement and deters these firms to commit tunneling. Hence, we expect that the effect of the anti-corruption campaign in curbing tunneling is more pronounced in firms with high C/O compared to those with low C/O. Finally, we expect that the effect of the anti-corruption campaign is more effective in low marketization regions as tunneling is pervasive in these regions before the campaign. 3 Indeed, according to China’s laws and regulations, the executives of SOEs engaging in tunneling bear rather high litigation and administrative costs. 5 Using a sample of China’s listed firms during a four-year period around the launch of the anti-corruption campaign in 2012, we find that the tunneling activities undertaken by Chinese listed firms are significantly reduced in the post-campaign period relative to the prior-campaign period. These results suggest that the anti-corruption campaign materially improve public governance via strengthened regulation enforcement and increased investor protection, which in turn effectively deters the controlling shareholders from tunneling resources from their listed firms. Further analyses reveal that the mitigating effect of the anti-corruption campaign on tunneling is more pronounced for firms that are controlled by private, audited by non-Big 8 auditors, controlled by the largest owner via the pyramidal structure, located in the regions with low marketization, and non-SOE firms with political connections. All those firms are believed to have a higher propensity to conduct tunneling in the pre-campaign period. Our results are robust to several sensitivity tests including alternative measure of tunneling and alternative sampling. Our study provides several contributions to the literature. First, this study enriches our understanding of the effect of institutions on expropriation. (e.g. Johnson et al. 2000; Nenova 2003; Dyck and Zingales 2004; Lemmon and Lins 2003). Prior studies examining the effect of public enforcement on tunneling are predominantly based on cross-country data, which is subject to omitted-correlated variable problems. Our study using a quasi-experiment approach alleviates endogeneity problems
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