The Impact of Policy risk on financing behavior of corporation: Evidence

from China's listed companies.

By

Zain Ul Abideen

Research proposal for the degree of Doctor of Philosophy in Finance

At the Central University of Finance and Economics

Introduction

The field of Corporate Finance might well be the area of economic research with the most

misleading name (by Behavioral Economics as a close second). Many of the research papers

identified as “Corporate Finance” deal neither with corporations nor with financing decisions.

Naturally, this enterprise entails discussing the key research questions and developments in the

field of Behavioral Corporate Finance. HoIver, the most important contribution of Behavioral

Corporate Finance might well go beyond the concrete applications of insights from psychology

to corporate-finance puzzles.

Many researchers and practitioners have studied corporate financing behaviors due to their

practical implications for corporate management and firm performance and even for the

economy as a whole (e.g., Seo and Chung 2017; Karpavičius and Yu, 2019). One prominent

strand of the literature has focused on identifying the determinants that guide companies to

choose their financing strategies (Anderson et al., 2003; Öztekin, 2015; Sun et al., 2016; Lee et

al., 2017b). Though the real impacts of firm-specific characteristics including size, profitability,

cash flow, and growth opportunity on financing behavior have been proven empirically, it is

doubtful whether these firm-level characteristics fully explain financing decisions (de Jong et al.,

2008; Graham et al., 2015).

From an alternative macro-based angle, the macroeconomic condition and policy implemented

by a government are of vital importance for changing the business environments in which firms

operate. For example, monetary policy has a pivotal influence on external financing and the

discount rates of investment projects (Baum et al., 2009; Panousi and Papanikolaou, 2012). On

the one hand, a contractionary monetary policy increases the interest rate and thereby the cost of

leverage. On the other hand, higher discount rates loIr the investment rate, thus leading to loIr
demand for external financing. Nevertheless, the influence of country-level factors including

macroeconomic conditions and institutional changes have not yet built up any appropriate

recognition (Erel et al., 2012; Pindado et al., 2017). My research will focus on understanding the

influence of firm-specific characteristics and knowing whether country-level factors impact

financing behaviors.

Background of study

Since shocks induced by the timing, content, and impact of policy change are frequently

regarded as the main smyces of uncertainty for the business environment, an immediate question

naturally arises as to whether this policy-related risk has a profound influence on corporate

financing decisions (Bernanke, 1983; Dixit and Pindyck, 1994). Due to previous data limitations,

extant works have ignored the issue of how policy-related risks affect corporate financial

decisions. This difficulty can be ameliorated by adopting the economic policy uncertainty (EPU)

of Baker et al. (2016), which includes news-based policy uncertainty, tax legislation expiration,

and dispersion in economic forecast, thereby capturing a widespread array of economicand

policyrelated uncertainties.

Also, there is an increasing recognition that a country’s geopolitical uncertainty and its political

risk are equally important factors that affect business cycles and financial market performance

(Antonakakis et al., 2017; Cheng and Chiu, 2018; Lee and Lee, 2019; Lee et al., 2019). The

recent developed geopolitical risk (GPR) index of Caldara and Iacoviello (2018) and the

International Country Risk Guide (ICRG) index also provide appropriate measures for

policyrelated risk. Using these newly released indices, my efforts aim to formulate a better

understanding about the effect of policy-related risk on corporate financing activities.

Problem Statement

Previous studies on the causes of the corporate financing decision have mainly

concentrated on capital markets in Istern industrialized or developed countries. Focusing on

nonfinancial U.S. firms over 1993-2003, for example, Baum et al. (2009) assess the effect of

macroeconomic and idiosyncratic uncertainties on leverage decisions and conclude that leverage

decreases with uncertainty. Using a large dataset of non-financial U.S. firms over 1950-2003,

Frank and Goyal (2009) evaluate the importance of firm- and country-level factors in financing

activities, showing results that firm financing decreases with profits and increases with firm size

and expected inflation.

Qiu and La (2010) explore the firm-level causes of Australian corporations’ capital structure

over the period 1992-2006 and find that the debt decreases with their profitability. HoIver,

relatively little attention has been given to the transitional economy. From the institutional

aspect, government control and political forces in transitional economies have a significant

influence on corporate behavior (Shleifer and Vishny, 1994).

China provides a unique setting for my investigation for several reasons. First, with its

fastgrowing national economy in recent decades, its capital markets, institutions, and corporate

practices are becoming more important in the global context (Jiang et al., 2017). Second, the

transition in China from a central planning economy to a market-based economy has been widely

documented (Firth et al., 2012; Wang et al., 2014). Although less intense than in the past, China

still represents a government-oriented country that often implements central policies to control

and influence economic behaviors of decision-making units (DMUs) in the economy. Third,

from the financial viewpoint, China’s capital market faces more serious problems of

imperfections and agency costs, which significantly impact a firm’s financial decisions.
These characteristics make China a good laboratory for assessing the impact of policyrelated

risk on financial behaviors. As shown in Figure 1, China’s EPU exhibits spikes around major

economic and political events. Whether and how its EPU affects Chinese firms’ financing

activities still await a more in-depth exploration, because findings can provide useful lessons and

implications for other transition economies.

Literature Review and Theoretical framework

Corporate financing decisions

The causes of corporate financing decisions have been extensively explored by a sizeable body

of theoretical and empirical investigations with mixed findings. The conventional capital

structure theory, including the trade-off theory (Miller, 1977), the agency theory (Jensen and

Meckling, 1976), and the pecking order theory (Myers, 1984; Myers and Mailuf, 1984), provide

an understanding of the role played by firm-level characteristics in affecting corporate financing

decisions. Scholars and practitioners have long recognized that firm size, growth opportunities,

and earning capacity are closely related to corporate financing.

For firm’s size effects, the trade-off theory postulates that sizeable companies are inclined to

have bankruptcy costs and more diversified portfolios with relatively easier access to credit

markets. The pecking order theory also suggests that sizeable companies are less likely to face

the problem of information asymmetry. Based on the exposition above, the influence of firm size

on corporate financing is forecasted to be positive. Previous empirical investigations also

demonstrate consistent findings (e.g., Rajan and Zingales, 1995; Islam and Khandaker, 2015;

Pindado et al.,

2017; Dang et al., 2018; Karpavičius and Yu, 2019).

In terms of the influence of growth opportunities, the agency theory assumes that debt is

regarded as an effective disciplinary device to mitigate opportunistic behavior and reduce

manager-shareholder conflicts. For firms with limited growth and scarce investment

opportunities, excess free cash flow can induce the problems of adverse selection and moral

hazard. In this regard, debt use can reduce the potential agency cost (Kayo and Kimura, 2011).
Nevertheless, the pecking order theory indicates that high growth firms with limited internal

funding are inclined to use debt for their investment opportunities (Kayo and Kimura, 2011).

Following these arguments, growth opportunities can be positively or negatively associated with

corporate financing. For the empirical aspect, the role played by growth opportunity is still

inconclusive. Some previous studies support a negative relation (e.g., Billett et al., 2007; Frank

and Goyal, 2009), while others are in favor of a positive relation (e.g., Gupta, 1969; Dewally and

Shao, 2014; Pindado et al., 2017; Chang et al., 2019; Karpavičius and Yu, 2019; Liu and Zhang,

2019).

As to the impact of earning capacity, the trade-off theory argues that high profitability

companies are less likely to expose themselves to bankruptcy and thus are more levered due to

the benefit of tax shields (Jensen, 1986; Frank and Goyal, 2003). Differently, the pecking order

theory highlights the preferences of profitable firms for internal funds, which reduce leverage. So

far, most empirical evidence on this issue suggests that earning capacity is negatively related

with firm financing (e.g., Rajan and Zingales, 1995; de Jong et al., 2008; Kayo and Kimura,

2011;

Karpavičius and Yu, 2017; Pindado et al., 2017; Dang et al., 2018; Chang et al., 2019). Though

the studies mentioned above contribute to my understanding of corporate financing decisions, it

is also frequently emphasized that country-level factors including macroeconomic conditions and

their uncertainties are important for firms when choosing their capital structure. On the one hand,

firms operating under different phases of business cycles typically have different financing

behaviors (Korajczyk and Levy, 2003; Halling et al., 2016). On the other hand, macroeconomic

variables are used to capture the influence of time-varying economic conditions on firms’

financing behavior (Baum et al., 2009; Frank and Goyal, 2009; Dewally and Shao, 2014;
Karpavičius and Yu, 2017). For example, Frank and Goyal (2009) evaluate the importance of a

wide range of influencing factors in the leverage decisions of non-financial firms in the U.S. over

1950-2003. Their empirical results reveal that firm leverage increases with gross domestic

product (GDP) growth and expected inflation.

Focusing on financial institutions in the U.S. during the global financial crisis period of 2007-

2009, for example, Dewally and Shao (2014) assess how liquidity shocks affect bank lending and

conclude that GDP growth has a significantly positive impact on banks’ lending behavior. Baum

et al. (2009) present empirical results supporting the inhibitory effect of macroeconomic and

idiosyncratic uncertainties on non-financial U.S. firms. To sum up, existing studies mostly

emphasize on the importance of firm characteristics as a determinant of corporate financing.

While recent experience highlights the role of country-level factors in affecting financing

activities, empirical evidence on the relation betIen macroeconomic uncertainties and firm

leverage is rather scarce.

In addition, uncertainties induced by policy changes have not yet built up any appropriate

recognition. To my best knowledge, a relative dearth of empirical works analyzes the influence

of policy-induced shocks on corporate financing decision. Differently, my research explores

looks into the influence of firm-level characteristics and country-level factors and also the impact

of policy-related risks on firm financing. My investigations thus fill the gaps in the literature and

provide insights into recent conflicting findings.

The impacts of policy-related risk

The role played by policy-related risk, including policy uncertainty, geopolitical risk, and

political risk, in affecting the real economy has been aptly identified in the literature (e.g.,

Bloom,
2009; Kang and Ratti., 2013; Apergis, 2015; Lee et al., 2017a; Lee and Lee, 2018; Gupta et al.,

2019; Zhang et al., 2019). These risks are regarded as the main influencing factors on business

cycle, employment, and economic growth. From a micro-level perspective, a growing and

burgeoning literature advocates that policy-related uncertainty is a considerable determinant for

the identification of corporate financial decisions.

The majority strand of these studies mainly targets investment behavior. The real option theory

postulates that the value of a waiting option rises with market fluctuations and uncertainty, and

thereby could delay a firm’s investment activities (e.g., Bernanke, 1983; Bloom, 2009; Kang et

al., 2014). As to other financial decisions, Francis et al. (2014) reveal that debt cost is influenced

by political uncertainty. Baum et al. (2006) also find that uncertainty about future economic

conditions has an apparent influence on firms’ demand for cash holdings. When uncertainty

increases, firms’ managers will become more conservative and thus conduct similar cash

management policies.

Demir and Ersan (2017) and Phan et al. (2019) further indicate due to precautionary motives that

firms facing high economic policy uncertainty have greater tendency to keep cash on hand.

Compared with those studies focusing on companies’ investment behavior, the impact of policy-

related risk on financing activities has drawn relatively less attention by academic researchers.

With particular emphasis on the role of macroeconomic uncertainty, Baum et al.

(2009) find evidence that a company’s leverage decision making negatively correlates with

uncertainty. Previous studies have shown that economic- and policy-related risks are likely to

increase financial market frictions, thus affecting the cost of external financing. These impacts

include the equity risk premium (Pástor and Veronesi, 2013), debt cost (Francis et al., 2014), and

default risk (Gilchrist et al., 2014). In a more recent paper, Lee et al. (2017b) also show that
policy uncertainty affects leverage behaviors in the U.S. banking industry. Therefore, it is

expected that policy-related risk has a significant influence on companies’ financing decisions.

Following this vein, I further extend the literature with non-financial firms and broaden its scope

by evaluating the effects of multidimensional policy-related risks, including economic policy

uncertainty, geopolitical risk, and political risk. My analyses thus complement the literature on

how these policy-related risks affect corporate financing decisions for non-financial firms in

China.

Methodology

Policy-induced shocks have been regarded theoretically as a main influencing factor of

economic activity and strongly correlate with corporate financing decisions through the

supplyside and demand-side channels. On the supply side, external uncertainty causes more

serious problems of information asymmetry, more volatile future cash flow, and more default

risk, which result in a credit crunch (Zhang et al., 2015). On the demand side, firms operating

under a highdegree of external uncertainty are more likely to maintain financial flexibility to

cope with its adverse impact (Graham and Harvey, 2001). On the one hand, when facing more

serious

uncertainty for future cash flow, firms will reduce their financing demands to mitigate the

financial risk and to avoid high external financing cost and bankruptcy cost. On the other hand,

policyrelated risk can depress corporate investment due to investment irreversibility, thus

decreasing the demand for financing (Pástor and Veronesi, 2013).

Based on the exposition above, it is essential to consider the association of policy-related risk

with firm financing from empirical aspects. The effect of policy-related risk I intend to examine

is mainly based on the model developed by Julio and Yook (2012), Gulen and Ion (2016), and
Lee et al. (2017b). Concerning firm-level determinants of corporate financing decisions, the

trade-off, the agency, and the pecking order theories identify several factors such as cash flow,

growth opportunity, size, and profitability that determine firm financing. Following convention,

empirical studies on this issue also account for these factors, as mentioned in the previous section

(e.g., Rajan and Zingales, 1995; de Jong et al., 2008; Kayo and Kimura, 2011; Islam and
Khandaker, 2015; Karpavičius and Yu, 2017; Pindado et al., 2017; Dang et al., 2018; Chang et
al.,

2019; Karpavičius and Yu, 2019).

Data Description

The China Stock Market and Accounting Research (CSMAR) database is used as a primary

smyce for accounting data and other macroeconomic indicators in China. Table 1 provides all

detailed information of the variables. To shed light on the short-term effects of policy-related

risk. To proxy for policy-related risk, I use three different aspects of uncertainties: policy-related

uncertainty, geopolitical risk, and political risk. The measure for policy uncertainty is based on

the Chinese EPU index constructed by Baker et al. (2016).2 The newspaper-based indices of

policy uncertainty are scaled monthly by quantifying uncertainty-related contents containing

economic, policy, and uncertainty via two Chinese newspapers. The measure for geopolitical risk

is smyced from the newly constructed index of geopolitical risk data by Caldara and Iacoviello

(2018).3 This index includes terrorist attacks and other forms of geopolitical tensions, thereby

capturing a widespread array of exogenous global uncertainty. Finally, political risk comes from

ICRG constructed by the PRS Group.

It evaluates a country’s socioeconomic conditions and political stability. All these indices

provide advantages to increase the data frequency in empirical works as they offer rigorous and
 consistent monthly ratings (Hoti, 2005; Lee et al., 2017a, 2019). In addition, as the property of

policy-related risk is divergent and cannot be reflected in any single proxy, these measures

present a more comprehensive evaluation under a unified framework. Based on the exposition

above, these indices are considered as good and appropriate proxies of policy-related risk (Kang

et al., 2014; Wang et al., 2014; Baker et al., 2016; Gulen and Ion, 2016; Caldara and Iacoviello,

2018; Lee et al., 2017a, 2019).

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