The effect of the split share structure reform on working capital management of Chinese companies

Accepted Manuscript The effect of the split share structure reform on working capital management of Chinese companies

Wei He, Tarun K. Mukherjee, H. Kent Baker PII: DOI: Reference:

S1044-0283(16)30092-8 doi: 10.1016/j.gfj.2017.02.003 GLOFIN 366

To appear in: Received date: Revised date: Accepted date:

11 July 2016 14 February 2017 20 February 2017

Please cite this article as: Wei He, Tarun K. Mukherjee, H. Kent Baker , The effect of the split share structure reform on working capital management of Chinese companies. The address for the corresponding author was captured as affiliation for all authors. Please check if appropriate. Glofin(2017), doi: 10.1016/j.gfj.2017.02.003

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Wei He Mississippi State University Department of Finance and Economics College of Business Mississippi State, MS 39762 [email protected]

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The Effect of the Split Share Structure Reform on Working Capital Management of Chinese Companies

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Tarun K. Mukherjee University of New Orleans Department of Economics and Finance New Orleans, LA 70148 504-280-7146 [email protected]

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H. Kent Baker* American University Kogod School of Business Department of Finance and Real Estate 4400 Massachusetts Avenue, NW Washington, DC 20016 USA Telephone: 202-885-1949 Email: [email protected]

*Corresponding author.

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ACCEPTED MANUSCRIPT The Effect of the Split Share Structure Reform on Working Capital Management of Chinese Companies Abstract Before the introduction of the Split Share Structure Reform (SSSR) of 2005, a dual stock system characterized Chinese-listed firms. The states owned non-tradable shares and private owners held

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tradable shares. The dual system generated agency problems because state owners enjoyed all the

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rights reserved for tradable shares but escaped the stock market risk faced by non-state shareholders. Because executives of state-owned enterprises (SOEs) received rewards based on

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the book value of assets rather than the market price of shares, they had no incentive to maximize the share price. The SSSR led to the conversion of non-tradable shares to tradable shares, with

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two major implications: (1) the interests of government and private owners are now more closely

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aligned and (2) government agents of SOEs are now rewarded and punished based on a firm’s market performance. Thus, the expectation is that government agents turn their attention to

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improving a firm’s market performance rather than its book value during the post-reform era. We

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examine the impact of the SSSR on Chinese firms’ investments in working capital. Based on 511 manufacturing firms between 2003 and 2011, we find that the SSSR is associated with

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significant reductions in working capital investments during the post-reform period. The reduced

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investment in working capital is associated with improved market performance of these firms.

Keywords: Split Share Structure Reform; working capital management; cash conversion cycle; China JEL classification: G30, G38

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ACCEPTED MANUSCRIPT The Effect of the Split Share Structure Reform on Working Capital Management of Chinese Companies

1. Introduction Before the Split Share Structure Reform (SSSR) of 2005 in China, state-owned

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enterprises (SOEs) had dual classes of A-domestic shares: the states owned non-tradable shares

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and private owners held tradable shares. State-owned shares, although non-tradable, benefited

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from the same voting, cash flow, and other legal rights as their tradable counterparts. The split structure was especially problematic for minority shareholders in listed SOEs

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As the controlling shareholders, government agents owned stocks on behalf of the Chinese

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government. SOE executives enjoyed absolute control without sharing in the costs borne by the holders of minority tradable shares.1 The Chinese government appointed and evaluated the

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executives for the controlling shareholders who in turn appointed and evaluated executives for

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the SOEs. Before the SSSR, the basis of evaluating these agents was the book values of firms’ assets, revenues, or short-term profits, not share prices (Liao et al., 2014). Consequently, the

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split share system failed to motivate government agents to maximize the market price of the

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company they served. It also might have incentivized them to resort to decisions that undermined it. Such misalignments coupled with an inadequate regulatory environment including limited

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disclosure, poor investor protection, and over-reliance on the banking system might have contributed to suboptimal performances of tradable shares (Ang and Ma 1999; Qi et al. 2000; Sun and Tong 2003; Green and Ho 2004; Kato and Long 2005).

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The lack of concern for the market manifested itself in several ways. For example, controlling shareholders allowed these companies to issue seasoned offerings so that they could divert the cash to their private benefits such as borrowing from the company at cheap or zero rates (Liao et al., 2014).

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ACCEPTED MANUSCRIPT Over time, the Chinese government realized the problems associated with the split share structure. After several failed attempts, the China Securities Regulatory Commission (CSRC) launched the SSSR in April 2005 not necessarily to terminate government ownership or control but to make state-owned shares responsive to the stock market. The main purpose of the SSSR

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was to convert non-tradable shares to tradable shares by paying negotiated compensation to the

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holders of tradable shares, clearing their way to trade shares in the secondary market and

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providing easy transfer to public investors. An inevitable result of the SSSR is the new criteria that the government would use to evaluate agents: the basis of evaluating the performance of

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government agents would now be the market value of state-owned shares, instead of the book

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value of SOE assets as before the reform (Liau et al., 2014).

Empirical evidence shows positive effects of the SSSR. As Li et al. (2011) find, the share

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privatization process set forth in the SSSR led to the removal of market frictions and associated

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efficiency gains. Chen et al. (2012) report that the SSSR led to better incentive alignment between controlling and minority shareholders as well as relaxed financial constraints. Liao et al.

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(2014, p. 517) conclude that after the SSSR, state-owned enterprises (SOEs) “experienced a

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remarkable increase in output and employment without sacrificing operating efficiency.” SSSR adopted a market mechanism that played an effective information discovery role in aligning the

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interests of the government and public investors. Hou et al. (2016) report that the managers’ remuneration package during the post-reform period made them more sensitive to stock returns and incentivized them to make better financial decisions. Other studies finding a positive impact of the SSSR include Jiang et al. (2008) Tseng (2012), Yu (2013), and Bin et al. (2015). The purpose of this paper is to investigate the effect of the SSSR on the working capital management (WCM) decisions of the listed Chinese firms. An optimal WCM calls for

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ACCEPTED MANUSCRIPT minimizing the investment in working capital without adversely affecting profitability of the company. We posit that WCM policies in the pre-reform period are likely to be inefficient for two overlapping reasons. First, the government did not participate in stock price appreciation that could result from efficient WCM policies. Second, government agents had an incentive to

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overinvest in working capital because they received rewards based on the firms’ book value of

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assets (Liao et al. 2014).

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In the post-SSSR period, we expect the SOEs to pursue an efficient WCM policy, again for two overlapping reasons. First, controlling shareholders, by virtue of holding tradable shares,

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would now participate in capital gains resulting from efficient investment decisions. Second, the

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basis of rewarding government agents of SOEs would now be a firm’s market performance. Thus, we hypothesize that the potential over-investment problem in the pre-reform would

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diminish significantly during the post-reform period.

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During the post-reform era, the government agents are not only rewarded but also punished based on market performance of the SOEs they manage. According to Liao et al. (2014,

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p. 505), “…government agents will be rewarded with more control power and favorable

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promotion opportunities if they improve SOE performance and increase state-owned share values… On the other hand, the government could divest in underperforming SOEs to discipline

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their management. Sales of state-owned shares constitute a punitive mechanism to government agents, diluting their control and jeopardizing their future promotion.” Following this line of reasoning, we hypothesize that decreased investment in working capital would be associated with better firm performance. In testing these hypotheses, we measure a firm’s WCM policy by its cash conversion cycle (CCC), defined as the number of days between cash disbursements to suppliers of raw

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ACCEPTED MANUSCRIPT materials and cash recovery from sales of the final products. Efficient WCM often amounts to reducing the CCC in order to reduce the opportunity costs of cash holdings without negatively affecting a firm’s profitability. We decompose the CCC in three components and assess the SSSR’s impact on each component: (1) days sales outstanding (DSO), (2) days inventory

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outstanding (DIO), and (3) days payable outstanding (DPO). We also control for at least some

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factors that other studies identify such as Hill et al. (2010) as potential determinants of a firm’s

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WCM policy.

Our sample consists of all 511 manufacturing firms included in the China Stock Market

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& Accounting Research (CSMAR) database that began in 2003. To keep unrelated factors from

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affecting our results, we focus on the same 511 firms for the entire 2003-2011 study period. We define 2003 through 2005 as the pre-SSSR period and 2009 through 2011 as the post-SSSR

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period. By using both univariate and multivariate techniques, we find that listed Chinese firms

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significantly reduced investments in working capital in the post-reform period relative to the prereform period. Consistent with Shin and Soenen (1998) and Deloof (2003), we also find a

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positive relation between improved WCM efficiency and both accounting and market

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performance of these firms.

Our study contributes to the extant literature by documenting that operating efficiency of

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Chinese-listed firms, at least in terms of WCM, improves after the passage of the SSSR. The remainder of the paper has the following organization. We begin by discussing our sample, variables, and methodology. Next, we present and discuss the empirical results followed by the conclusions.

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ACCEPTED MANUSCRIPT 2. Sample, Variables, and Methodology 2.1 Sample In selecting the sample, we focus on the manufacturing sector because it is the largest industry in China and has a conventional flow of receivables and inventory. Our sample consists

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of all 511 manufacturing firms included in the 2003 CSMAR database. We compare the pre- and

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post-reform WCM policies of the same 511 firms (4,599 firm-year observations) between 2003

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and 2011.

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2.2 Variables 2.2.1 Dependent Variables: WCM Measures

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A widely accepted measure of a company’s working capital policy is the way it manages

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its CCC (Hill et al., 2010). Effectively managing CCC requires striking a balance between the

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associated costs and benefits. Funds tied up in CCC have opportunity costs and therefore benefits accrue when shortening CCC. However, the task of reducing CCC is fraught with adverse

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consequences. For example, tightening credit policies might reduce a company’s DSO while hurting its sales. Lowering DIO might reduce inventory costs but lead to under-stocking, lost

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orders, lower prices, and shortages of materials. Delaying payments of payables by extending

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DPO reduces the CCC, but repeated delays might also lead to foregone trade credits and damaged goodwill with suppliers. The CCC consists of the following components: CCC = (DSO + DIO – DPO)

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where DSO (days sales outstanding) is (net accounts receivables x 365)/Net sales; DIO (days inventory outstanding) is (inventory x 365)/cost of goods sold; and DPO (days payables outstanding) is (accounts payables x 365)/cost of goods sold. 7

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2.2.2 Independent Variables The independent variables used in our study consist of two groups: (1) SSSR-induced variables and (2) control variables. The two SSSR-induced variables are (1) state ownership of non-tradable shares in the pre-reform period and tradable shares in the post-reform period, and

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The SSSR-induced variables are as follows:

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2.2.2.1 Control Variables

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(2) managerial ownership in the pre- and post-reform periods.

State ownership (STATE). States and state agencies held majority ownership of Chinese-

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SOEs during both the pre-reform and post-reform periods. According to Ward (1988), Kahn and Henderson (1992), Mishra and McConaughy (1999), Morck et al. (2000), Dyer

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(2006), and Morck and Yeung (2003), concentrated ownership enhances agency

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problems between large and small shareholders and adversely affects firm performance.2 In the context of Chinese firms, two institutional factors further compound the

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agency problem in the pre-reform period. First, the government owned non-tradable

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shares only: the split share structure enabled the government to exercise control of the firm without being accountable to its market performance. Second, a major criterion for

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evaluating government agents was the book value of a firm’s assets, not the firm’s market performance. Consequently, these agents had incentives to maximize the book value of assets, including investments in working capital, even though these decisions might adversely affect the market value of shares. Such a perverse incentive structure might

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Concentrated ownerships could also play a positive role. For example, Shleifer and Vishny (1986), Barontini and Caprio (2005), and Villalonga and Amit (2006) conclude that having a large minority shareholder solves the problem of monitoring incentives in a corporation with many small shareholders.

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ACCEPTED MANUSCRIPT have contributed to poor market performances of these firms during the pre-reform period (Wei et al. 2003, Wei et al. 2005). The SSSR discontinued the split share structure by allowing the government to convert non-tradable shares to tradable shares through paying negotiated compensation to

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the holders of tradable shares. This change had at least two implications for the ways that

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firms made financial decisions in subsequent periods. First, the government and its agents

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now became mindful of the market sensitivity to their financial decisions. Second, for controlling shareholders who held stocks on behalf of the government for SOEs, market-

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based evaluation criteria replaced book value. The latter change directly affects our study

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in that the agents no longer have an incentive to overinvest in working capital. We hypothesize a positive relation (i.e., less efficient) between state holdings and the CCC in

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the pre-reform period and a negative relation (i.e., more efficient) between the two in the

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post-reform period. We measure the state ownership as the shares held by the government as a percentage of total shares (Nshrstt/Nshrttl), where Nshrstt is the total number of state

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owned shares as in the CSMAR database and Nshrttl is the total number of shares.

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CSMAR provides state holdings of only non-tradable shares for both pre- and postreform periods. In other words, CSMAR does not provide state holdings of tradable

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shares in the post-reform period. For this reason, we define state holdings of tradable shares (STATE_NEG) as (state holdings of non-tradable shares in t-1 minus state holdings of non-tradable shares in t0). This variable possibly overstates the actual state holdings for at least two reasons. First, it ignores likely sales of shares by states. However, a possible argument is that the number of shares sold by states might be small. According to Liau et al. (2014), the government would sell tradable shares mainly as a way of punishing its

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ACCEPTED MANUSCRIPT poor performing agents. Second, the SSSR requires that the holders of non-tradable shares pay compensation to the holders of tradable shares, thus reducing state holdings. Another interpretation of this variable is that it is the reduction in state holdings of nontradable shares after the reform that captures how much control of the firm state owners

Managerial holdings (MANG). As previously stated, during the pre-reform period, the

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efficiency increases as state owners give up more control.3

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have given up. Thus, we can restate the hypothesis as follows: the level of WCM

government appointed managers and evaluated them based on the book value of assets.

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After the SSSR, the basis of the incentive structure was a firm’s market performance and

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managers had no incentive to maximize the book value of assets. Additionally, as Hou et al. (2016) note, the managers’ remuneration package during the post-reform period made

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them more responsive to stock returns via more efficient financial decisions. Thus, we

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hypothesize that MANG has a negative impact on WCM during the pre-reform period (i.e., a positive correlation to the CCC). We assume that in the post-reform period, the

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managers’ holdings will mainly consist of tradable shares. Therefore. MANG_NEG will

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have a positive impact on the WCM policy (i.e., a negative relation to the CCC) during the post-reform period. We measure manager holdings (MANG) by the percentage of

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total shares held by managers to total shares outstanding (Nshrsms/ Nshrttl), Nshrsms is the number of executive shares as in CSMAR database and Nshrttl is the total number of shares outstanding.

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We also use the government holding of non-tradable shares as a proxy for STATE. Although not reported, the results show that the relation between CCC and STATE is significantly positive during the pre-reform period but insignificant during the post-reform period.

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ACCEPTED MANUSCRIPT 2.2.2.2. Control Variables Scholars identify several factors that might affect a firm’s WCM policies. To ascertain whether the effects of the SSSR-induced changes persist even in the presence of these factors, we choose control variables following Hill et al. (2010). We separate relevant factors into two

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groups: (1) a firm’s ability to finance its operating working capital and (2) its operating

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conditions. The first group consists of operating cash flows (OCF), capital market access (SIZE),

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market power (MKTSHR), and debt constraint (DR). The second group includes sales growth (GROWTH) and sales volatility (SALVOL). We also use institutional ownership (INST) as a

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control variable because institutions have incentives to see the firm making efficient financial

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decisions.

Operating cash flow (OCF). Greater OCF gives a firm more flexibility in managing its

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working capital and allows it to pursue a more conservative policy. For example, OCF

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enables a firm to be less dependent on cash released from a shortened CCC (e.g., reducing DSO without hurting sales). Good operating cash flows allow firms to take a

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relaxed approach to WCM, affording them a longer CCC. Additionally, good OCF

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enables firms to take advantage of supplier discounts, thereby reducing the DPO and extending the CCC. On the other hand, low or negative cash flows are likely to make

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firms more aggressive (i.e., shorten the CCC) in terms of their working capital policies in order to reduce the need for external financing. Consequently, we predict a positive sign for the OCF coefficient. Following Hill et al. (2010), we define OCF as lagged earnings before interest and taxes (EBIT) scaled by net assets. 

Capital market access (SIZE). According to Hill et al. (2010), larger firms are more capable of financing the working capital gap externally and therefore are able to follow

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ACCEPTED MANUSCRIPT relaxed credit and inventory policies. Because smaller firms are less able to issue commercial paper or negotiate lines of credit, they are likely to follow more aggressive WCM policies (i.e., lower the CCC). Following Hill et al., we define size (SIZE) as the natural logarithm of the lagged annual inflation-adjusted market value of equity and

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predict a positive relation between SIZE and the CCC.

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 Market power (MKTSHR): Hill et al. (2010) maintain that superior market power enables

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a firm to receive more generous credit terms from suppliers, offer shorter terms to

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customers, and gain better terms with vendors resulting in less investment in inventory. Thus, higher market power allows a firm to shorten its CCC by curtailing DSO and DIO

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and lengthening DPO, when necessary. Following Hill et al., we measure market share (MKTSHR) as the lagged ratio of a firm’s annual sales to the total annual sum of sales in

Debt constraint (DR). High leverage exposes a firm to a greater potential of financial

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a given industry and expect a negative relation between MKTSHR and the CCC.

distress and makes external financing more expensive. Consequently, if firms have a

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limited ability to issue external financing, they are more likely to pursue an aggressive

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WCM policy (Hill et. al. 2010). We measure leverage using the DR (debt ratio), which is a firm’s lagged total debt-to-total assets relative to its peer group. We expect a negative

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relation between DR and the CCC. The DR could also serve as a corporate governance variable based on the “control hypothesis” of debt proposed by Jensen (1986). This hypothesis also suggests a negative relation between the CCC and the DR. 

Sales Growth (GROWTH). Hill et al. (2010) find evidence that prior period growth leads to a tightening of credit policy upon achieving the planned sales growth. Following Hill et al., we define growth (GROWTH) as the percentage change in sales in the current year

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ACCEPTED MANUSCRIPT from the previous year and predict a negative relation between GROWTH and the CCC. The same relation might be justified based on a firm’s ability to raise external funding. According to Myers (1997), the growth option raises the cost of debt. Facing higher costs of external financing, firms might have to pursue an aggressive policy toward WCM. Sales Volatility (SALEVOL). According to Hill et al. (2010), sales volatility might affect

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the amount of inventory held in opposite directions. A firm would try to counteract

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volatility by keeping a higher level of inventory than what might be optimal. Yet, a firm with a lower cost of accounts receivables could carry a lower amount of inventory by

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advancing favorable credit terms. According to Hill et al. (p. 786), “the link between the

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net investment in operating working capital and sales volatility is an empirical question.” Accordingly, we refrain from predicting the sign of SALEVOL in relation to the WCM

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variables. Similar to Hill et al., we measure sales volatility (SALEVOL) as the standard

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deviation of a firm’s annual net sales over a rolling five-year period before each sample

Institutional Ownership (INST). The corporate governance literature is almost unanimous

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about the positive role that institutional holders play in disciplining managers to improve a firm’s performance. Institutional holding (INST) is the percentage of tradable ownership owned by mutual fund management companies in the CSMAR GTA_HLD

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year.

database. We expect a negative relation between INST and the CCC, DSO, and DIO. Larger institutional presence might also provide greater confidence to the suppliers of raw materials who might be open to negotiations that allow the firm to extend the accounts payable period (DPO). Table 1 provides the summary of the definitions of all variables.

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ACCEPTED MANUSCRIPT (Table 1 goes about here)

2.3. Data Sources We obtain financial data for the 511 firms from the CSMAR’s financial statements and trading databases, the ownership data from CSMAR’s shareholder database, and corporate

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governance data from CSMAR’s corporate governance database.

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2.4 The Model

We use the following regression model in both pre- and post-reform periods to test the

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hypothesis that the post-reform state holdings of tradable shares leads to improved WCM

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decisions by the Chinese-listed firms: CCC =

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f [STATE, MANG] + [OCF, SIZE, MKTSHR, DR, GROWTH, SALEVOL INST] + ε

(2)

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The regression results will be consistent with our hypothesis if we find that the coefficients of STATE and MANG (ownership of non-tradable shares) on the CCC are significantly positive,

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signifying inefficiency (i.e., potential overinvestment) in the pre-reform period, and the

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coefficients of STATE_NEG and MANG_NEG on CCC are significantly negative, implying

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improved WCM decisions in the post-reform period.

3. Results and Discussion 3.1 Summary Statistics Table 2 compares averages of all employed variables between the pre-reform (20032005) and post-reform (2009-2011) periods. The CCC, DSO, and DIO decrease while DPO increases significantly at the 0.01 level in the post-reform period, pointing to improved liquidity and WCM policy. The CCC decreases by 60.83 days between the two periods, which largely 14

ACCEPTED MANUSCRIPT results from a reduction of 47.51 days in the DSO followed by a 10.10-day drop in the DIO. The 3.22-day increase in the DPO is significant at the 0.05 level. These results are consistent with the SSSR-induced conversion of non-tradable shares to tradable shares. State ownership of tradable shares increases from 0% during the pre-reform period to an

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average of about 26% during the post-reform period. We assume that the management holding

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during the pre-reform period was mostly non-tradable shares and that during the post-reform

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period consisted mostly of tradable shares, The management ownership changes from less than 2.73% to 3.15% (both significant at the 0.01 level) between the two periods.

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(Table 2 goes about here)

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In terms of control variables, institutional ownership (INST) increases from 20.19% to 32.42%, which is significant at the 0.05 level. SIZE increases dramatically between the pre- and

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post-reform periods. MKTSHR and OCF increase significantly and debt-to-asset ratio decreases

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and both variables are significant at the 0.01 level. A more efficient management of sales might explain a reduction in sales volatility (SALEVOL) in the post-reform period. A drop in the

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annual sales growth rate in the post-reform period might be due to a much higher sales base for

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this period relative to the pre-reform period.

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3.2 Regression Analyses

Table 3 presents regression results showing the effect of the SSSR on WCM decisions of Chinese-listed firms in the presence of selected control variables. We divide our study period into two sub-periods: pre-reform (2003-2005) and post-reform (2009-2011). Panels A and B refer to the pre-reform and post-reform sub-periods, respectively. Dependent variables are the CCC (Column 1), DSO (Column 2), DIO (Column 3), and DPO (Column 4). In Panel A, state and management holdings (STATE and MGMT) represent ownership during the pre-reform 15

ACCEPTED MANUSCRIPT period while in Panel B STATE_NEG and MGMT_NEG represent ownership of tradable shares during the post-reform period. We consider the time fixed effects in all regressions. (Table 3 goes about here) We hypothesize that higher agency problems associated with concentrated STATE

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ownership of non-tradable shares and perverse evaluation criteria for government agents during

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the pre-reform period would have a negative effect on the WCM efficiency (i.e., a positive

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relation to CCC). We also expect that the changes brought about by the SSSR would have a positive effect on the WCM decisions and hypothesize a negative relation between STATE_NEG

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and MGMT_NEG with the CCC.

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For the pre-reform period, Panel A shows that the STATE coefficients are positive and significant in the CCC and DSO regressions. The negative sign of DPO is also consistent with

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our hypothesis (i.e., inefficiency in the pre-reform period). The negative sign on DIO (i.e., the

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higher the state ownership, the lower is the DIO) could signify good inventory management practices in the pre-reform period or a shortage of inventory (i.e., stock outs).

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As Table 3, Panel B shows, the relation between STATE_NEG and WCM supports our

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hypothesis of improved efficiency during the post-reform period. The coefficients of STATE_NEG are negative and statistically significant in the CCC, DSO, and DIO regressions.

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The coefficient of STATE_NEG on DPO is negative but statistically insignificant. Comparing the pre- and post-reform roles of institutional holdings (INST) lends further support to the positive role that STATE_NEG plays in improving the WCM. That is, INST exerts a greater monitoring task during the pre-reform period, but its role decreases during the post-reform period. Both MGMT and MGMT_NEG coefficients are, however, insignificant in both the pre-

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ACCEPTED MANUSCRIPT and post-reform periods. Relatively small management holdings might explain the absence of significance. Regarding the control variables, we offer the following observations. First, MKTSHR is consistently significant and appears with a negative sign for both the pre- and post-reform

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periods. This result is consistent with the prediction that a greater market share affords a firm

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better control over its CCC. Second, significantly negative DR coefficients on CCC, DSO, and

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DIO coupled with significantly positive coefficient on DPO point to debt’s influence in making firms adopt aggressive WCM policies. Third, taken together, the impact of growth in sales

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(GROWTH) and sales volatility (SALESVOL) gives rise to an interesting phenomenon.

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GROWTH, which plays a significant role in making the firm more aggressive toward the CCC during the pre-reform period, becomes insignificant in the second period. Yet, SALESVOL,

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which is insignificant in the pre-reform period, becomes significant in the post-reform period.

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One probable explanation is that Chinese firms faced a much higher growth rate during the preversus post-reform period forcing firms to be more aggressive in their WCM policies. During the

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in managing the CCC.

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second period, the growth rate becomes more manageable and the volatility plays a greater role

Finally, both operating cash flows (OCF) and firm size (SIZE) coefficients are negative

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and statistically significant. These results are inconsistent with our hypotheses that bigger size and greater operating cash flows allow firms to take a more relaxed approach to their WCM policies. An integral assumption behind the hypotheses is that these firms have easier access to external capital markets. However, in the context of China, this assumption may not hold. As Allen et al. (2005, p. 58) note, “With poor legal protection of minority and outside investors, (standard) external markets are weak” in China. Eichengreen (2015) reports alternative uses of

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ACCEPTED MANUSCRIPT excess funds for Chinese firms via extension of credit through “trust loans” to other firms. This provision increases the opportunity costs of working capital financing and could explain why firms with high OCF still have low CCC given that they could lend the excess cash flows to generate returns rather than to finance working capital needs.

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3.3 Robustness Tests

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The previously reported results could reflect a potential bias because of how we compute the state holdings of tradable shares during the post-SSSR period. Therefore, we examine the

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robustness of our results by performing two tests in which neither test depends on the accuracy of STATE_NEG data. More importantly, these tests also capture the differential impact of the

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SSSR on the SOEs (the government owns more than 50% of the company) and non-SOEs. Our

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premise here is that higher ownership of non-tradable shares during the pre-reform period provides greater inducement for government agents to overinvest in working capital. As a result,

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the linkage of rewards and punishments to the firm’s market performance should reduce (if not

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eliminate) the desire to overinvest during the post-reform period.

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3.3.1. Univariate Analysis

Table 4 presents the relation between the pre-reform state ownership and changes in the

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CCC from the pre-reform to the post-reform period. Panel A separates state ownership into the bottom 30% and top 30%. The results indicate that the decline in the CCC is significantly higher at the 0.01 level for the top 30% group than for the bottom 30% group. We obtain similar results by dividing state ownership into below and above the median. The decline in the CCC is significantly higher at the 0.01 level for the above-median group. (Table 4 goes about here)

18

ACCEPTED MANUSCRIPT 3.3.2 Regression Results Table 5 presents the regression results where changes in the CCC from the pre- to postreform period serve as the dependent variable while state holding of non-tradable shares serves as the main independent variable in the presence of control variables. Panel A divides the

T

ownership in two categories: below 30% and above 30%. We hypothesize that the top 30%

IP

group is associated with a significantly larger decrease in the CCC than the bottom 30% group.

39.63 compared with 4.53 for the bottom 30% group.

CR

The results are consistent with the hypothesis: the negative coefficient for the top 30% group is

US

Panel B separates the state ownership data into below and above the median. The

AN

hypothesis and related findings for Panel B are the same as those for Panel A. The negative coefficient for the above-median group is 26.22 compared to 7.82 for the below-median group.

M

(Table 5 goes about here)

ED

The results reported in Tables 4 and 5 corroborate the evidence provided in Tables 2 and 3. That is, the SSSR induced conversion of the pre-SSSR non-tradable shares into post-SSSR

PT

tradable shares and related changes in the incentive structures for government agents are

CE

associated with reduced investment in working capital in the post-reform period.

AC

3.4 Linkage between WCM and Firm Performance The improved efficiency (i.e., reduced overinvestment) in WCM should have a positive effect on firm performance. Tables 6 and Table 7 show whether firm performance improves and the extent to which improved WCM contributes to this performance. We measure performance using both accounting performance as measured by return on equity (ROE) and market performance as measured by price-to-book (PB). ROE is net income divided by common equity. PB is the market price per share divided by the book value per share. According to Liao et al. 19

ACCEPTED MANUSCRIPT (2014), ROE computed in the pre- versus post-reform period might be incompatible due to the introduction of Chinese generally accepted accounting principles (GAAP) in 2007. Table 6 shows the impact of the industry-adjusted CCC on industry-adjusted firm performance measures in the presence of industry-adjusted control variables. We select the

T

control variables based on the basic discounted cash flow model in which a stock’s price is a

IP

function of cash flows in the next period, future growth rates, and risk. To capture cash flows, we

CR

use industry-adjusted operating cash flows, industry-adjusted sales growth as a proxy for growth, industry-adjusted size, and an industry-adjusted debt ratio as proxies for risk. The results show

US

that the lower the industry-adjusted CCC, the higher is the industry-adjusted ROE (significant at

AN

the 0.10 level) and the industry-adjusted PB (significant at the 0.05 level). The results indicate

firms during the post-reform period.

M

that improved efficiency in WCM is associated with improved performance of Chinese-listed

ED

(Table 6 goes about here) Table 7 investigates the relation between changes in the CCC occurring during the 2003-

PT

2005 and 2009-2011 periods. The table also shows the corresponding changes in the firm

CE

performance in the presence of changes in the same control variables as in Table 6. The results are similar to those observed in Table 6. Specifically, negative changes in the CCC (improved

AC

efficiency) are associated with positive changes in both ROE and PB. (Table 7 goes about here)

Based on the results in Tables 6 and 7, we conclude that the SSSR succeeded in inducing the government to make financial decisions that are in alignment with private owners. Our evidence is similar to that of Li et al. (2011), Chen et al. (2012), Liao et al. (2014), and Hou et

20

ACCEPTED MANUSCRIPT al. (2016) Changing the incentive structure facing government agents helped them improve market performance of the firms they manage..

4. Conclusions Before 2005, listed state-owned enterprises had dual classes of A-domestic shares: the

IP

T

government owned non-tradable shares and private owners owned tradable shares. This

CR

dichotomy adversely affected the prices of tradable shares, especially for SOEs, in several ways. First, controlling shareholders, who held non-tradable shares on behalf of the government,

US

exercised absolute control of the SOEs they managed but did not experience any adverse effects their financial decisions engendered. Second, the basis of evaluating government agents (i.e.,

AN

controlling shareholders and executives) was the book value of the assets, not market

M

performance, which possibly provided a perverse incentive for agents to overinvest in both short

ED

and long-term assets.

The main reason for SSSR in 2005 was to make government shares responsive to the

PT

stock market by converting non-tradable shares to tradable shares after compensating the holders of tradable shares. The reform has two primary implications. First, government agents are now

CE

more mindful to avoid financial decisions that might adversely affect share prices. Second, the

AC

evaluation of government agents is now on a firm’s market performance, not its book value. We hypothesize that investments in working capital by Chinese firms are more efficient in the post-reform than in the pre-reform period. We contend that during the pre-reform period, government agents are unconcerned about the impact of their financial decisions on share prices. In fact, they have an incentive to overinvest in working capitals because their evaluation rests on the book value of assets. During the post-reform period, the urge to overinvest in working capital should diminish due to a new rewards structure based on a firm’s market performance. 21

ACCEPTED MANUSCRIPT Using a sample of 511 Chinese manufacturing firms between 2003 and 2011, we test this hypothesis and find that WCM policies significantly improve between the pre- and post-reform periods. We find that the greater the proportion of non-tradable shares held by the state during the pre-reform period, the larger is the reduction in the firm’s post-reform CCC. We also note

T

that the greater efficiency in WCM is associated with better post-reform performances of these

AC

CE

PT

ED

M

AN

US

CR

IP

firms.

22

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ACCEPTED MANUSCRIPT Hou, W., Lee, E., Stathopoulos, K., & Tong, Z. (2016). Executive compensation and the split share structure reform in China. European Journal of Finance, 22 (4‒ 6), 506‒ 528. Jensen, M. C. (1986). Agency costs of free cash flows, corporate finance, and takeovers. American Economic Review, 76 (2), 323−329.

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Jiang, B., Laurenceson, J., & Tang, K. (2008). Share reform and the performance of China's

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performance of China's newly privatized firms. Financial Management, 32 (2), 107126. Wei, Z., Xie, F., & Zhang, S. (2005). Ownership structure and firm value of China's privatized firms: 19912001. Journal of Financial and Quantitative Analysis, 40 (1), 87108. Villalonga, B., & Amit, R. (2006). How do family ownership, control and management affect firm value? Journal of Financial Economics, 80 (2), 385‒ 417. Yu, M. (2013). State ownership and firm performance: Empirical evidence from Chinese listed companies. China Journal Accounting Research, 6 (2), 75−87. 25

ACCEPTED MANUSCRIPT Table 1. Definitions of Variables

Name

Computation

Dependent variables

CR

Days sales outstanding + Days inventory outstanding – Days payables outstanding (Net accounts receivables x 365) / Net sales

Cash conversion cycle

DSO

Days sales outstanding

DIO

Days inventory outstanding

(Inventory x 365) / Costs of goods sold

DPO

Days payables outstanding

(Net accounts payable x 365) / Costs of goods sold

AN

SSSR-induced variables

Non-tradable Government ownership

STATE-NEG

Tradable Government Ownership

MANG

Managerial ownership

PT

ED

M

STATE

MANG_NEG

MKTSHR

Operating cash flow

AC

SIZE

CE

Managerial ownershipPost-reform OCF

US

CCC

Control variables

Expected Sign

IP

Variable

T

This table categorizes the variables in three groups: (1) dependent variables that measure a firm’s WCM decisions, (2) governance variables, and (3) control variables that might affect WCM decisions. The fourth column shows the expected sign of the coefficients of the independent variables relative to the CCC. The database items used in computing ownership variables include Nshrttl: Total number of shares; Nshrnn: Total number of Non-tradable shares; Nshrstt: Total number of state owned shares; Nshrsms: Number of Executive shares; and S0304a: Shareholding percentage of top 10 shareholders.

Firm size

Market share of the firm

DR

Debt ratio

GROWTH

Growth rate of the firm

SALEVOL

Sales volatility

INST

Institutional ownership

Percentage of non-tradable state ownership relative to total shares outstanding (Nshrstt / Nshrttl) Percentage of tradable state ownership relative to total shares outstanding Percentage of executive ownership relative to total shares outstanding (Nshrsms / Nshrttl)

‒

Percentage of executive ownership relative to total shares outstanding

-

Lagged earnings before interest and taxes scaled by net assets Natural logarithm of the lagged annual inflation-adjusted market value of equity Lagged ratio of a firm’s annual sales to the total annual sum of sales in a given industry

+

+

+ + ‒

Debt-to-asset ratio

‒

Percentage of changes in sales from the previous year Standard deviation of the past 5-year sales scaled by net assets Ownership of top 10 institutional shareholders (S0304a)

‒

26

? ‒

ACCEPTED MANUSCRIPT Table 2. Descriptive Analysis of Regression Variables

108.73 days 53.09 days 122.10 days

AC

CE

66.73 days 13.79% 3.15% 25.77%

4487 0.43*** 25.78**

8.19 12.24 0.14% 0.470 24.34% 0.166 32.42%

1.02*** 9.25*** 0.01*** ‒ 0.04*** 8 ‒ 0.71*** 12.24*

CR

7.17 2.99 0.13% 0.512 28.81% 0.871 20.19%

27

Difference    3.22 **

US

AN

63.51 days 58.66% 2.73% 0

IP

169.50 days 100.60 days 132.20 days

PT

DPO SSSR-induced variables STATE MANG/MANG_NEG STATE_NEG Control variables OCF SIZE (log) MKTSHR DR GROWTH SALEVOL INST

Post-reform Period Mean

M

Dependent variables CCC DSO DIO

Pre-reform Period Mean

ED

Variables

T

This table provides descriptive statistics of dependent variables, independent variables, and control variables in the regressions as defined in Table 1. The pre-reform period measures are the average values of period 2003-2005 and the post-reform measures are the average values of period 2009-2011. The fourth column shows the difference by subtracting the average values of each variable in post-reform period from the values in pre-reform period. *,**,*** significant at the 0.10, 0.05, and 0.01 levels, respectively.

ACCEPTED MANUSCRIPT Table 3. The Impact of SSSR Reform on Working Capital Management Decisions

IP

T

This table presents regression results showing the effect of SSSR-induced variables (STATE and MANG) in the presence of selected control variables on working capital management decisions of Chinese-listed firms over two sub-periods: pre-reform (2003-2005) and post-reform (20092011). Panel A represents the pre-SSSR period and Panel B represents the post-SSSR period. Dependent variables are the CCC (Column 1), DSO (Column 2), DIO (Column 3), and DPO (Column 4). Table 1 names and defines all variables. All regressions consider the time fixed effects. The sample size is 511 firms. *,**,*** significant at the 0.10, 0.05, and 0.01 levels, respectively.

MANG OCF

ED

SIZE

PT

MKTSHR

AC

SALEVOL INST

CE

DR GROWTH

US

Included

STATE

AN

Year dummies

Intercept

DSO 112.349*** < 0.000 20.270** 0.0254 ‒ 0.748 0.899 ‒ 2.713*** < 0.000 ‒ 1.148* 0.099 ‒ 37.352*** < 0.000 ‒ 25.076** 0.038 ‒ 26.498*** 0.000 0.501 0.851 ‒ 23.905** 0.022 0.132

M

R2

CCC 192.213*** < 0.000 14.182* 0.063 ‒ 8.428 0.391 ‒ 3.107*** < 0.000 ‒ 1.865 0.106 ‒ 68.595*** < 0.000 ‒ 94.178*** < 0.000 ‒ 38.760*** 0.002 6.293 0.155 ‒ 28.238** 0.036 0.108

CR

Panel A. Pre-Reform Period

Included

28

DIO 153.559*** 0.000 ‒ 8.447* 0.0715 ‒ 7.322 0.342 ‒ 1.069*** 0.007 ‒ 0.803 0.359 ‒ 46.802*** < 0.000 ‒ 58.571*** 0.000 ‒ 21.151** 0.032 3.871 0.265 ‒ 8.988* 0.051 0.053

DPO 73.695*** < 0.000 ‒ 2.359* 0.0780 ‒ 0.357 0.899 ‒ 0.674*** < 0.000 ‒ 0.113 0.733 ‒ 15.560*** < 0.000 10.531* 0.067 ‒ 8.889** 0.014 ‒ 1.921 0.130 ‒ 4.654** 0.035 0.063

Included

Included

ACCEPTED MANUSCRIPT

‒ 0.311

SIZE

0.513 ‒ 1.710*** 0.003 ‒ 35.303***

MKTSHR

0.001 ‒ 52.917***

GROWTH

0.001 ‒ 10.693 0.344

ED

DR

‒ 132.630*** 0.001 ‒ 15.999 0.344 0.077 Included

PT

SALEVOL

AC

R2 Year dummies

CE

INST

‒ 0.400**

T

DPO 79.512*** 0.001 ‒ 9.157 0.154 2.820 0.601

0.264

CR

OCF

DIO 155.081*** 0.001 ‒ 9.863** 0.022 7.973 0.575

0.554 ‒ 1.116** 0.041 ‒ 25.579*** 0.006

0.022 ‒ 0.097 0.651

‒ 12.452

10.336*

US

MANG_NEG

AN

STATE_NEG

DSO 159.230*** 0.001 ‒ 13.362** 0.032 7.723 0.276 ‒ 0.975*** 0.001 ‒ 0.698** 0.011 ‒ 17.959*** 0.001 ‒ 20.421*** 0.008 3.341 0.555 ‒ 49.053*** 0.001 ‒ 8.096 0.305 0.092 Included

M

CCC 162.889*** 0.001 ‒ 14.068* 0.063 12.872 0.394

Intercept

IP

Panel B. Post-Reform Period

29

0.273 ‒ 12.452 0.272 ‒ 131.041*** 0.001 ‒ 22.057 0.163 0.055 Included

‒ 8.235** 0.026

0.091 1.582 0.722 ‒ 47.415*** 0.001 ‒ 2.037 0.743 0.055 Included

ACCEPTED MANUSCRIPT Table 4. A Robustness Check of Non-tradable State Ownership This table compares the three-year average CCC of different subsamples around the SSSR reform. Panel A compares the subsamples of the top 30% and the bottom 30% of non-tradable state ownership before the reform. Panel B compares the subsamples separated by median values. Cash conversion cycle (CCC) is in days. *,**,*** significant at the 0.10, 0.05, and 0.01 levels, respectively.

Post-reform CCC

Change

Panel A Top 30% Bottom 30% Difference Panel B Above Median Below Median Difference

168.8 165.5 3.3***

AC

CE

PT

ED

M

AN

173.8 165.1 8.7***

CR

IP

T

Pre-reform CCC

30

103.3 111.7 ‒ 8.4***

‒ 65.5*** ‒ 53.8*** ‒ 11.7***

108.7 108.7 0.0

‒ 65.1*** ‒ 56.4*** ‒ 8.7***

US

Non-tradable State Ownerships before the Reform

ACCEPTED MANUSCRIPT Table 5. Comparison of WCM Efficiency of Firms with Different Non-tradable State Ownership before the SSSR

T

This table compares the WCM efficiency measures of the subsamples with different non-tradable state ownership. The dependent variable is the change in the 3-year average CCC for the postreform and pre-reform period. Panel A separates the pre-reform state ownership by top 30% and bottom 30%. Panel B separates them by below and above the median. Table 1 names and defines all variables. *,**,*** significant at the 0.10, 0.05, and 0.01 levels, respectively.

MANG OCF SIZE

ED

MKTSHR DR

R2

AC

INST

CE

SALEVOL

PT

GROWTH

Year dummies

Included

> Median

‒ 46.472** 0.079 ‒ 22.463** 0.047 ‒ 3.078** 0.039 27.690*** 0.816 ‒ 2.161** 0.025 23.865 0.123 ‒ 6.789 0.854 ‒ 23.965** 0.043 ‒ 31.167 0.533 ‒ 6.776** 0.029 0.064

‒ 14.766*** 0.001 ‒ 7.396* 0.082 ‒ 9.618** 0.032 30.477** 0.027 0.542 0.659 31.549 0.272 5.652 0.155 ‒ 1.289 0.825 ‒ 36.287 0.415 ‒ 8.321** 0.010 0.074

‒ 49.179* 0.066 ‒ 29.758** 0.037 ‒ 3.044** 0.036 90.964 0.414 ‒ 2.561** 0.009 20.341 0.181 ‒ 2.355 0.526 ‒ 8.727 0.643 ‒ 43.921 0.356 ‒ 7.858*** 0.006 0.073

Included

Included

CR

STATE

‒ 16.235*** 0.001 ‒ 8.018* 0.089 ‒ 7.582 0.412 23.365* 0.062 ‒ 0.027 0.983 17.729 0.516 3.951 0.313 ‒ 5.012 0.394 ‒ 41.269 0.321 ‒ 11.22*** 0.001 0.100

< Median

AN

Intercept

> 30%

US

< 30%

M

Variables

Panel B

IP

Panel A

Included

31

ACCEPTED MANUSCRIPT Table 6. The Impact of Working Capital Efficiency on Firm Performance for the Whole Sample Period

US

Industry-adjusted CCC

Industry–adjusted PB −0.330 0.221  0.037 9.706*** 0.001 0.079*** 0.001 1.336 0.221 0.659** 0.055 Included 0.162 49.486

Industry-adjusted SIZE Industry-adjusted DR

ED

Industry-adjusted GROWTH

M

AN

Industry-adjusted OCF

AC

CE

PT

Year dummies R2 F-statistic

Industry-adjusted ROE 0.036*** 0.005  0.064 0.828*** 0.001 0.001 0.750 0.187*** 0.001 0.011* 0.057 Included 0.222 68.704

CR

Dependent Variable Intercept

IP

T

This table presents the regression results depicting the relation between industry-adjusted CCC and industry-adjusted firm performance in the presence of selected control variables over the 2003-2011 sample period. Industry-adjusted PB is the market price per share divided by the book value per share of the firm minus the industry average of the same ratio. Industry-adjusted ROE is the firm’s net income divided by common equity minus the industry average of the same ratio. The sample size is 511 firms. Table 1 names and defines all variables. All equations consider the time fixed effects. *, **, *** significant at 0.10, 0.05, and 0.01, respectively.

32

ACCEPTED MANUSCRIPT Table 7. The Impact of Changes in Working Capital Efficiency on Firm Performance around SSSR

DPB 0.988*** 0.001 −0.004*** 0.005 −0.003 0.253 0.141** 0.033 1.001*** 0.002 0.479** 0.020

US

Dependent Variable Intercept

CR

IP

T

This table presents the regression results depicting the relation between the changes in the CCC and changes in firm performance around the SSSR in the presence of selected control variables. DPB is the change in the 3-year average market price per share divided by the book value per share around the reform. DROE is the change in 3-year average net income divided by common equity around the reform. DCCC is the change in 3-year average CCC around the reform. DOCF is the change in 3-year average operating cash flow measure around the reform. DSIZE is the change in 3-year average firm size around the reform. DDR is the change in 3-year average debt ratio around the reform. DGROWTH is the change in 3-year average growth rate around the reform. The sample size is 511 firms. *, **, *** significant at 0.10, 0.05, and 0.01, respectively.

DCCC

AN

DOCF

M

DSIZE

ED

DDR

PT

DGROWTH

0.066 3.835

AC

CE

R2 F-statistic

33

DROE −0.018** 0.027 −0.001*** 0.003 0.001* 0.053 0.002 0.104 0.021*** 0.001 0.004 0.178 0.117 7.192