Propping Through Related Party Loans: Evidences From Chinese Listed Companies

Known as the flip side of tunnelling, propping has generated a new stream of studies in the area of agency problems between controlling shareholders and the minority shareholders. These studies, though using different proxies for propping, are all based on two fundamental assumptions. First, prior literature commonly assumes that propping generates positive economic consequences. Relying on this assumption, researchers either consider greater resistance to negative economic shock as a symbol of receiving private benefits from the controlling shareholders (e.g. Friedman, Johnson and Mitton,2003; Dow and McGuire,2009) or view certain positive market response to certain transaction the evidence of its propping nature (e.g. Peng, Wei, and Young,2006; Cheung, Jing, Lu, Rau, and Stouraitis,2009; Jian and Wong, 2008). Second, moving further from the first assumption, existing studies also implicitly equalize the likelihood of incidence of propping with the easily measured "positive economic consequences" of propping, and thus use the latter as proxies for the former to examine the explanatory factors of the propping behaviours (Friedman et al.,2003; Dow and McGuire,2009; Peng et al.,2006; Cheung et al.2009). However, despite of the importance of these assumptions in current studies of propping, so far there is no direct empirical evidence to support the validity of these two assumptions and the methodologies based on them. The main reason of this problem is that propping behaviours are very hard to observe directly (Friedman et al.,2003). Unlike tunnelling, propping occurs only when there is a negative macroeconomics shock, and tends not to attract attention of minority shareholders and debt holders. Therefore, the existing studies have to rely on the assumption and methodologies above even if there is no empirical evidence supporting their validity.In my study, I identify the loans received by listed companies from related parties as a direct indicator of propping. This identification is based on two reasons. First, according to data from 2006 to 2009, I find that the number of the related party loans moves up and down exactly along with the macro economic conditions in China. In 2007 when the GDP growth rate reached the summit of 13%, only 38 loans were issued to Chinese listed companies from their related parties; however, the number leaped to 121 in 2009, when Chinese exports decreased by 16% and the GDP growth rate dropped below 9% for the first time in the past eight years. This trend satisfies the statement in Friedman et al. (2003) that propping occurs when there is a negative economic shock. Second, among the 91 related party loans occurred in 2009 with interest rate disclosed,74 loans have an interest rate no higher than the bank interest rate in the same period, indicating a transfer of private benefits from related parties to listed companies. Therefore, I hold that in China controlling shareholders use related party loan to prop up listed companies after the explosion of financial crisis.Thanks to the direct observation of propping, this study is able to directly investigate the explanatory factors and the economic consequences of propping. Further, the study can also provide empirical evidence of the validity of the two commonly adopted assumptions as well as the relevant methodologies in the existing studies in this area. I carry out the empirical analysis using a sample of 1,321 Chinese listed companies in 2009.The paper first uses a set of logistic regressions to document the explanatory factors of the likelihood of the incidence of related party loans. The regression results show that controlling shareholders are more likely to prop up listed companies with high leverage or high growth potential. Moreover, firms controlled by state institutions, especially the state non-corporate entities as the controlling shareholders are more likely to receive related party loans. In addition, the issuance of B shares or cross-listing also increases the probability of the incidence of propping. Finally, though the degree of the concentration of the largest shareholder does not affect the likelihood itself, its interaction with growth potential is significantly negatively associated with the likelihood of the incidence of propping.The second section of the empirical study consists of two parts. First, I run two independent linear regressions to examine the economic consequences of related party loans. I find that the companies receiving related party loans experience an improvement in operating performance while suffer a drop in the market value. More specifically, the incidence of related party loan is significantly positively associated with the changes in ROA but significantly negatively related to the changes in Tobin’s Q. This finding suggests that propping does not necessarily generate positive economic consequences. Propping behaviours could indicate to the market that the listed company has been so financially distressed that its controlling shareholder is forced to take actions. Moreover, outside investors can also predict prevalent future tunnelling behaviour from the incidence of propping activities (Bertrand and Mullainathan,2003). Therefore, viewing propping as a signal of poor financial condition and weak corporate governance, the market consequently undervalues the stocks of the propped listed company. Second, within the subsample of companies receiving related party loans, I regress the economic consequences of propping over a set of firm ownership variables. The results show that the shareholding concentration of the largest shareholders has a significant positive association with changes in ROA but a significant negative relationship with changes in Tobin’s Q. In addition, firms controlled by state non-corporate entities receive relatively better value effect as compared with the other listed companies within the subsample. These results, combined with those in the first section, prove that firm characteristics have different influences on the incidence and the economic consequences of propping, so it is misleading to use the latter to evaluate whether a listed company is more or less likely be propped up. Further, the results indicate that despite of the strong association between the incidence and the economic consequences of propping, they cannot be easily equalized since the latter is influenced by several factors other than the former.This study contributes to literature in three dimensions. First, using related party loans occurred during a negative economic shock as a direct mechanism of propping, this study provides direct empirical evidences of the explanatory factors and the economic consequences of propping behaviours. Second, these empirical findings uncover the problems associated with the two commonly adopted assumptions in propping studies and the methodologies based on these assumptions. Therefore the future studies in this area may need to reduce their reliance on them. Last but not least, thanks to the use of the latest financial and ownership structure data available, this study provides insights on the current condition of the interaction between controlling shareholders and minority shareholders of Chinese listed companies.