Debt Financing, Soft Budget Constraints, and
Government Ownership: Evidence from China1
Lihui Tian* and Saul Estrin**
*Guanghua School of Management, Peking University, Beijing 100871. Email:
**CEPR and London School of Economics, LondonWC2 2AE. Email: firstname.lastname@example.org
Debt financing is expected to improve the quality of corporate governance, but this
depends on the institutional setting. Using a large sample of public listed companies
from China, however, we find that, in China, an increase in bank loans increases the
size of managerial perks and free cash flows and decreases corporate efficiency.
Bank lending facilitates managerial exploitation of corporate wealth in China in
government-controlled firms, but may constrain managerial agency costs in firms
controlled by private owners. We argue that the failure of corporate governance may
derive from the shared government ownership of lenders and borrowers, which
nurtures soft budget constraints.
JEL classification: G32, G34, P34
Key words: bank lending, corporate governance, government ownership,
soft budget constraints
1 This paper benefits from comments from the anonymous referee, Simon Commander, Julian Franks,
Colin Mayer, Henri Servaes, Jan Svejnar and participants in seminars at INSEAD, Lancaster University,
London Business School, and University of Michigan. Data collection for this paper would not have been
possible without the help of Dr. Yaping Xu from the China Securities Regulatory Commission, Hui Gong
from Genius Co. and Yun Xia from Hairong Co., and Dr Houqi Zhang from Hua Xia Securities Co. Any
errors are the authors.
It is argued that debt financing operates as a device to discipline corporate managers. For
example, Jensen and Meckling (1976) and Dewatripont and Tirole (1994) argue that debt
keeps a tight rein on managerial agency costs; a view accepted by practitioners, e.g.
“…leverage is a financial discipline” (Jonathan Meggs, JP Morgan quoted in Financial
Times, June 14th, 2001). However, it is not clear whether these arguments generalize to
different institutional settings; for example, China. In this paper, we examine empirically
the role of debt in corporate governance in China’s public listed companies (PLCs).
In the Western literature, the governance role of debt comes from the threat of
bankruptcy, the reduction of free cash flows, and due diligence monitoring by creditors.
A high financial leverage is associated with a greater probability of financial distress that
causes managerial replacements. Aghion and Bolton (1992) model the shift of control to
debt holders when profits are low. Gilson (1990) argues that when firms are in financial
distress, creditors take over the dominant role in disciplining the managers, replacing
incumbent managers that were assigned by the shareholders.2 Debt can also have an
incentive effect on shareholders’ monitoring efforts because the shift of control to
creditors drives out the private benefits of the controlling shareholder. With a sample of
British firms, Franks et al. (2002) find that the turnover frequency of board-members is
higher with a higher financial leverage.3
2 Managers are punished for exploitation of corporate wealth through a reputation effect in the managerial
3 Harris and Raviv (1988) and Stulz (1988) argue that voting rights of outsiders are reduced, and of insiders
increased, with an increase in leverage. Friend and Lang (1988) and Berger et al. (1997) provide empirical
Grossman and Hart (1982) and Jensen (1986) argue that debt carves out free cash
flows and reduces managerial agency costs. Under the separation of ownership and
control, the managers are reluctant to distribute cash flows to shareholders and prone to
overinvestment. Over-expansion of corporate operations - “empire-building” - suits the
interests of managers at the cost of shareholders. With the legal requirement to repay
interest and loans, debt can force out cash flows. Moreover, debt holders can impose
rules and restrictions on management through loan indenture. McConnell and Servaes
(1995) find that leverage is positively correlated with firm value when growth
opportunities are scarce.
Furthermore, the theory of financial intermediation argues that banks have
incentives to collect information and monitor firms to ensure the returns to the depositors
(e.g., Diamond 1984). Information asymmetry between corporate managers and investors
can be reduced by the specialized knowledge of bankers. Since bank loans are typically
quite short term, during their renewal, bankers can investigate corporate quality and
evaluate investment risk (Shleifer and Vishny, 1997). If managerial agency costs are
excessive or credit risks are high, banks tend to reject renewal and this signals the quality
of management and may trigger a disciplinary action from equity holders (Harris and
China is transforming into a market economy and corporate governance is taken
as a paramount issue (Bai et al. 2004). Since 1994, Chinese PLCs have been modeled on
evidence that financial leverage is negatively correlated to managerial entrenchment in developed
economies. However, the average voting rights of the management teams in China’s PLCs were as small as
0.005% of the total shares so the Stulz leverage impact will probably not be influential.
an Anglo-American governance structure though government ownership is still prevalent
in both PLCs and banks (Tian and Estrin 2006). According to China’s Securities
Regulatory Commission, the government owns on average more than one third of all PLC
shares. Indeed, the government has a majority holding in around one quarter of Chinese
PLCs, and a large stake (more than 30%) in around one half of firms. Moreover, bank
loans are a significant source of financing in Chinese PLCs, representing 22% of total
assets but the Chinese government is the owner of most commercial banks and the
government extensively intervened in banking operations, particularly before 1999. In
this paper we test whether debt financing can discipline PLC managers in China, in a
situation where the government retains substantial shareholdings in the firms, and also in
Using a panel dataset we have constructed, we show that an increase in financial
leverage increases the size of managerial perquisites and free cash flows in Chinese PLCs,
but there is no significant relationship between debt levels and board-member turnover.
At first sight, our findings indicate that, in contrast to Western economies, in China, debt
does not play a governance role; on the contrary, debt financing facilitates managerial
agency costs. However, the story is more subtle. The facilitator role of debt on
managerial agency costs pertains in companies with a large government shareholder but
not those with primarily private shareholders. This suggests that the failure of governance
functions of debt financing in Chinese PLCs may result from government ownership
being shared by creditors and debtors; loans from state owned banks expand the
resources under the control of the managers in majority state owned PLCs. Kornai (1998)
argues that soft budget constraints come with government ownership. By indicating a
consequence of soft budget constraints on managerial behavior, our study contributes to
understanding the governance impacts of soft budget constraints and therefore takes the
literature a step further.4
In the following section, we set the scene by illustrating the institutional
backgrounds of China’s firms and banks. We describe our dataset and discuss the proxies
for agency costs and leverage in the third section, and report our empirical findings in the
fourth, before drawing conclusions in the fifth.
2. China’s Commercial Banks and Modern Firms
The Chinese stock market has been growing very fast, providing a reasonable panel of
data, though the financial system remains bank dominated.5 Thus Chinese PLCs, which
represent a substantial share of the industrial economy, provide a good laboratory to
understand the influence of debt financing on managerial behavior.
2.1 Banking Sector and Bad Loans
Enterprise debt is mainly financed by state-controlled banks. The government
fully owns the Industrial and Commercial Bank of China, Agricultural Bank of China,
China Construction Bank and Bank of China, all of which functioned as a department of
the Ministry of Finance during the planning era. According to the China Banking
Regulation Commission, these four banks still provide more than 80% of all the loans to
the Chinese firms. Most other banks are also under the control of the government.
4 La Porta et al. (2002) find government ownership of banks to be prevalent in emerging markets while La
Porta et al. (1999) report that government ownership of firms remains widespread, especially in developing
economies. The joint government ownership may not be unique in China.
5 Total loans reached US$1.1 trillion and the ratio of loans to GDP exceeds 100% (Merrill Lynch, 2000).
The 1995 Commercial Banking Law created commercial banks as independent
legal entities required to pursue profits. However, Lardy (1998) argues that the legal
reform in China has so far done little to improve the allocation and use of bank capital.
Given that the state was until very recently the sole owner, the four largest banks usually
followed the strategic direction of the government, and have therefore been reluctant to
allow the liquidation of the loss-making firms, because of political concerns about
unemployment. Consequently, the government as owner may request that the banks
refinance these loss makers and, for their own career concerns, bankers may respond
positively, even if they are also supposed to generating profits.
Such conflicts of interests probably explain the accumulation of non-performing
loans, estimated as 25.37% of total loans by the former governor of China’s central bank
in 2001 (Dai, 2002). In 2006, Ernst & Young estimated the non-performing loans (NPL)
over 900 billion US dollars, more than any other country, although the current official
statistics shows NPL as 133 billion.6 As the nonperforming loans are larger than net
assets, some banks are technically insolvent. These bad loans are not a legacy of the
planned economy, but have been accumulated during the reform period.
2.2 China’s Stock Market and Public Listed Firms
The Chinese stock market has been growing very rapidly. Between 1992 and
2003, market capitalization increased at the average rate of 63.3% per year. At the end of
2003, the total market capitalization was 36.4% of China’s GDP. The number of listed
companies grew 43.4% annually, from 53 PLCs in 1992 to 851 PLCs in 1998 and to 1287
6 This report was withdrawn after criticism from the Chinese government.
PLCs in 2003. On the equity side, authority is based on the rule of one-share-one-vote, so
control rights depend on the shareholding size. However, government retained ownership
remains widespread though it is declining. Half way through our sample period, in 1998,
41% PLCs had a controlling (more than 50%) government shareholder, but only 32% a
controlling private one. The government asset management companies and other agents
of the government hold the shares and report to a special branch of the government—the
Bureau of State Asset Administration.
Turning to debt finance, there is no substantial corporate bond market in China.
Debt financing mainly comes from bank loans, except for temporary financing from
enterprise arrears or trade credits. Banks are not allowed to own shares of PLCs.7
[Insert Table 1 approximately here.]
Panel A in Table 1 reports that the public listed firms are not heavily indebted.
The total liabilities are 42.9% of total assets, and the bank loans are 21.6% of total assets.
Given that the PLCs are typically large, their loans mainly come from state-owned banks.
In a balanced panel comprising the PLCs listed continuously 1992 (excluding all
subsequent newly listed firms), financial leverages is increasing over time. Panel B shows
that the financial structure of these Chinese firms is similar to that of the firms in western
Corporate governance structures of China’s PLCs, such as boards of directors, are
also conventional. However, though there is a trial code of Bankruptcy Law, enforcement
7 This rule came into effect in 1995, but it did not require a bank to sell out its shares in a firm purchased
remains rare; very few large firms have been liquidated and until recently no PLCs had
gone into bankruptcy.8
2. 3 Data Sample
There are three main electronic databases for the historical data about Chinese
PLCs. Internationally, the leading vendor of Chinese data is the Taiwan Economic
Journal (TEJ), but the TEJ database has a number of missing values. Our accountancy
data before IPO and the information about directors come from this source. More than
80% of Chinese investment bankers and security analysts rely on the data provided by the
Genius database. We use their accountancy data post-IPO as well as their information
about ownership. The industrial classification uses the data from Securities Times, a
leading Chinese newspaper of security markets. The share price data comes from
Datastream. With regards to accountancy and ownership data, the validity of the data sets
was crosschecked, and initially missing points were filled, using the annual reports from
the Shenzhen Stock Exchange.
Two restrictions have been imposed on our sample. We excluded fund
management companies, as their operations are distinctly different from industrial firms.9
We also excluded the firms that do not issue shares for domestic investors; otherwise, we
would have had to use the share prices from the markets of foreign investors, and such
market values are not comparable. After these restrictions, the sample includes 287
8 The Enterprises Bankruptcy Law was legislated in 1986, only as a trial version. In 2001, the Huarong
Asset Management Company and other two creditors requested the Hubei Supreme Court to liquidate the
Monkey King PLC. It is expected to be the first bankruptcy case of a public listed company.
9 Furthermore, due to regulations, fund management companies are excluded the government shareholder.
companies in 1994, 311 in 1995, 517 in 1996, 719 in 1997 and 826 in 1998. The 1994
Company Law created a modern corporate governance structure for Chinese PLCs, and
in the same year, the China Securities Regulatory Commission introduced a series of six
rules called the Contents and Forms of the Information Release by PLCs, which
formatted the annual reports. Our data sample therefore starts from 1994 and ends in
1998; new measures were implemented in banks and a new company law was introduced
in 1999. The data set has 2660 firm-year observations.
3. Agency Costs and Financial Leverage in Chinese
In this section we outline our indicators of managerial agency costs and present their
distributions under different levels of financial leverages and ownership structures.
3.1 Financial Leverage
As there is no substantial domestic corporate bond market and trade credits do not
contribute greatly to corporate governance, our main measure of financial leverage in
Chinese PLCs is the ratio of bank loans to total assets. This ratio indicates the liability of
the firm and the probability of financial distress, and approximates the influence of
bankers in corporate management. In Table 2, we group the firms into three clusters:
firms whose financial leverage is below 10%; firms with leverage between 10% and
30%; and firms with leverage above 30%. There are 23% of firms in the first category,
51% in the second, and 26% in the third.
[Insert Table 2 approximately here.]
3.2 Ownership Clusters
In Table 2, we also separate the firms into two sub-samples by controlling
shareholders; government and commerce. Non-government (or commercial) shareholders
include family investors, another industrial company, investment funds, and foreign
investors.10 According to China Security Regulation Commission, the relative controlling
threshold is 30% and we use this in the Table. We have used other cutoff points including
50% and the empirical findings remain more or less the same. There is clearly the
theoretical possibility of endogeneity between managerial exploitation and ownership
structures, for example if the government retained shares in less efficient companies. This
issue has been explored thoroughly in a companion paper (Tian and Estrin, 2006), which
established that retained government shareholding was not significantly associated with
prior enterprise performance, and, in fact, ownership structures within PLCs do not vary
greatly over the period. We therefore do not consider ownership selection issues in our
3.3 Managerial Perks
The literature highlights three dimensions of managerial exploitation that can
affect operational efficiency and corporate value: perquisites, empire-building and
entrenchment. Managerial perks represent disguised income for management teams. In
fact, such perks were the main income for Chinese managers, since the average nominal
annual salary of the general managers was only $12,000 (Kato and Long, 2006); for
10 Before 1999, these commercial shareholders were not allowed to hold a significant ownership stake in
China’s major commercial banks, except for the Minsheng Bank whose loans to PLCs are however