Political Connections And The Cost Of Capital Of Listed Firms

Since Krueger’s (1974) seminal work on rent seeking, the nexus between business and government has been a topic of intense debate and academic research alike. China can serve as a test case to gauge the impact on firms of political connections. It is a counterexample writ large to the law-finance-growth nexus: Its legal and financial systems are underdeveloped, yet its economy is one of the fastest growing in history. Thus, Allen et al.(2005) argue that China must have alternative institutional arrangements and governing mechanisms to support economic growth, such as those based on reputation and relationships.Conceptually, it seems intuitive to expect that political connections have a positive effect on Chinese firms in light of resource-based theory. That is, firms will adjust themselves to line up the external environment to secure more resources controlled by the government. Throughout China’s long history, Chinese have been influenced deeply by the yin-yang theory of relative positioning advocated by Lao Tze, a philosopher who lived2,500years ago. The philosophy primarily guides people to adjust their behavior according to the external environment and utilize it by positioning themselves strategically. According to the resource-based theory and the relative positioning theory, it is expected that developing political connections helps firms obtain key resources and thereby increases value.Empirical evidence in the literature related to political connections in China shows both positive and negative effects on firm performance, a counterintuitive result. Some Chinese scholars demonstrate that managers’ political connections are positively related to firm’s performance. In contrast, other Chinese scholars show that firms with politicall connection underperform those without politically connected. Given the mixed evidence on the effect of political connections on the Chinese firms, further research on this issue is warranted.Previous studies pay more attention to the influence of political connections from the perspective of firms’value, but neglect the influence of political connections on cost of equity capital from the perspective of investors. Our paper collects and compiles a database of political connections for all Chinese firms listed on the Shanghai and Shenzhen Stock Exchanges to examine the relationship between political connections and the cost of equity capital. We find that politically connected firms enjoy a lower cost of equity capital than their non-connected peers. We also find that political connections are more significant for firms with stronger ties to government. In additional analyses, we find that the effect of political connection on firms’equity financing costs is influenced by the ultimate controllers. Collectively, our findings suggest that investors value firms with political connections for which they assign lower equity financing costs.Besides, this paper collects and compiles a database of political connections, and uses unbalanced panel data analysis to examine the relationship between political connections and the cost of debt capital in Chinese listed firms from2004to2010. We find that politically connected firms enjoy a lower cost of debt capital than their non-connected peers. We also find that political connections are more significant for firms with stronger ties to government. Collectively, our findings suggest that creditor value firms with political connections for which they assign lower risk premium.Moreover, with the deepening of reforms and opening up to the outside world, firms have begun to adopt more "market-oriented" way as an intuitive guide and a source of motivation in daily operation, with an increasing intrusion of the market, which provides resources freer of top-down control, firms may again relate more to others on instrumental/equity grounds rather than on the basis of previous social interactions. This pattern of change is uneven, however, with much variation from place to place and many pockets that are resistant to change. Thus, a further study is conducted on the effects of political connections under different marketization processes.The results consistently demonstrate a strong correlation between political connections and cost of capital under different marketization processes, a counterintuitive result, but consistent with the previous findings that political connections are positively related to firm’s performance in both developed and developing countries.This study contributes to the literature in several ways. First, we propose a new definition of political connections to improve upon the relatively diverse definition in earlier studies, which use official government titles, Party membership, or membership in the National People’s Congress in China as political connections. In doing so, we introduce two new concepts related to political connections. We define the firm-level political connections as whether the firm’s top managers or board members have strong political positions linked specifically to someone with a certain rank or above in the Chinese government. Political capital is expected to have a threshold effect on firms. That is, political connections with low-ranking government officials may lead to biased or unclear results because those officials may not have the real authority, power, or ability to achieve the intended objective of the rent-seeking firms. In addition, we explore political connections through the team effect of political capital in a firm by including top executives (CEOs and other executives) and board members instead of examining only the CEO. Including other top executives such as CFO and CIO expands the influence of political connections for the firm and thus reinforces the importance of the notion of the team effect of political connections. Firms acquire political capital that flows from political connections that will likely enable them to have real economic power in the market and thus improved performance. We also include the effect of membership in the People’s Congress (PC) and the Chinese People’s Political Consultative Conference (CPPCC) on firm’s capital cost for additional analysis. We argue here that PC and CPPCC members do not necessarily have real power to implement government policies and thus membership may not yield positive results.Second, while several studies examine the value of connections (e.g., Sapienza,2004; Dine,2005; Charumilind et al.,2006; Faccio,2006; among others), this paper provides the first evidence on the link between political connection and the cost of equity capital using Chinese sample. The findings suggest that the cost of equity capital is one of the channels through which political connections may affect valuation thus answering the call by Cooper et al.(2011) for the need to further analyze whether the correlations between firms’political connections and returns arise from mispricing or risk. Meanwhile, this study is closely related to Chaney et al.(2011) who examine the impact of political connections from the perspective of bondholders (i.e., on the cost of debt) in Chinese setting. This paper add to existing studies on the cost of capital of firms by showing that, in addition to the standard firm-level factors, political connection is a material determinant with economic significance, suggesting that due to their lower exposure to market-wide risk in recessions, politically connected firms are less risky compared to non-connected peers in the market.Last but not least, this study adds to the political connection literature from the perspective of the ultimate owners to examine how different controls affect the relationship between the political connections and the cost of capital of the Company. This study also adds to the political connection literature by showing that the effect of political connections on the cost of capital wheather is conditioned by interprovincial institutions.