Elsevier

Emerging Markets Review

Volume 36, September 2018, Pages 110-129
Emerging Markets Review

Government connections and the persistence of profitability: Evidence from Chinese listed firms

https://doi.org/10.1016/j.ememar.2018.04.002Get rights and content

Highlights

  • Government connections bring a competitive advantage to firms.

  • Firms with connections retain positive abnormal profits for a longer period.

  • Firms with connections recover more quickly from negative abnormal profits.

  • Firms with connections have a much higher survival rate.

  • Our results are robust when we use alternative measure to proxy profitability.

Abstract

We find that state owned enterprises (SOEs hereafter) have lower (higher) mean-reverting rates when profitability is better (worse) than the norm; while non-SOEs with politically connected executives have lower (higher) mean-reverting rates when profitability is extremely better (worse) than the norm. In addition, SOEs controlled by the central government have lower mean-reverting rates than those controlled by local governments. Our results are robust to a series of robustness tests and a test using alternative measures of profitability. We argue that government connections help firms maintain a relatively competitive advantage and thus have an important influence on mean-reverting patterns of profitability for Chinese firms.

Introduction

The topic of persistence of profitability derives from economic competition theory, which presumes that, if a market is efficient and competitive, profit above or below the norm should quickly vanish. This is because market competition works to bring all returns back to competitive levels, through driving investment away from unprofitable firms and flowing into profitable firms. This means that corporate profitability should follow a mean-reverting pattern in a competitive market. Empirical evidence has provided substantial proof of the mean-reverting process of profitability of firms for a number of countries, including the US, UK, Norway and China.1 However, there is still a lack of evidence for how the mean-reversion pattern is impacted by the competitive advantages of firms that are created by their strategic resources, such as government connections (including both state control and politically connected executives).

Previous studies have documented that the phenomenon of political connections is widespread (Faccio, 2006). Firms with government connections tend to receive preferential treatment in accessing various resources, such as better access to bank loans, lower bank borrowing costs, being more likely to receive government bailouts, favourable tax treatment, and even having better access to the equity financing market.2 Therefore, government connections serve as important political capital for connected firms. We argue that, according to resource-based theory, government connections can be considered as a valuable resource as they create a competitive advantage over other firms. Empirical evidence also shows that state ownership and political connections have an important influence on firm value.3 However, most previous studies focus on the cross-sectional analysis of firm value or performance, and reach opposite conclusions. Less attention has been paid to the issue of whether government connections have any impact on the time-series properties of profitability, that is, the impact of government connections on the persistence of abnormal profit. We argue that the traces of movement in profitability along a time series capture the value of government connections more appropriately. Moreover, although firms of all types tend to follow the mean-reverting pattern in a competitive market, the mean-reverting rate may differ because firms with government connections may have a competitive advantage compared to other firms, at least in short term. For example, according to resource-based theory, government connections bring additional financial resources and competitive advantage to firms, thus we may observe that positive (negative) abnormal profitability should persist for a longer (shorter) period of time in those firms. In this study, we aim to fill this gap in the current literature, and provide empirical evidence using a sample of Chinese listed firms.

Compared to prior studies that examine state ownership using a broad set of European firms (Borisova and Megginson, 2011) and US banks (Bayazitova and Shivdasani, 2012), this study takes advantage of Chinese listed firms. This is because an institutional environment with the following characteristics is necessary to conduct the present study: firstly, government intervenes in the economy and plays an important role in listed firms, hence firms' government connections are considered valuable; and secondly, overall the market is competitive. The emerging market of China provides us with an ideal environment to conduct our study. After 30 years of economic reform, China has transferred from being a regulated economy to a market economy. It has established a competitive market and direct government intervention has been greatly reduced. Firms in the Chinese market nowadays have equal access to the resource market, for instance they can freely apply for loans and choose projects to invest in. Therefore, firms with government connections are expected to be less likely to enjoy persistent competitive advantage over firms without such connections. Although direct government intervention has been minimized, the literature has shown that firms with government connections, through either state ownership or politically connected managers, can always obtain favourable terms and treatment, bringing competitive advantage to connected firms over firms without such connections. However, these competitive advantages are assumed to be short-lived, for the following reasons: (1) the provision of indirect favourable government treatment has become more expensive over time and has attracted criticism as the overall market environment has become competitive. Therefore, the government has attempted to limit such favourable treatment, to some extent. Government support is frequently observed when connected firms have bad or extremely bad performance, resulting in a faster mean-reverting rate in these connected firms compared with firms without government connections. (2) Government connections, especially the ones through politically connected managers, in our context, are a valuable asset to connected firms. This type of government connection can be replicated, although this is not easy and takes long time; therefore, over time some firms may establish political connections and other firms lose political connections for various reasons. Hence, we expect that government connections in China could not bring persistently abnormal profitability to those connected firms, which means firms with government connections should also follow a mean-reverting pattern. However, because government connections bring competitive advantages to connected firms, even though these are short-lived, we expect that connected firms retain positive abnormal profitability for a longer period of time and recover more quickly from poor profitability.

We first conduct our estimation by applying Fama and French's (2000) partial adjustment model to investigate whether the mean-revering rate (speed) and pattern differ between firms with and without government connections, using a sample of firms from 2002 to 2010. We select this research period starting from 2002 because China joined the World Trade Organisation (WTO) in 2001, and since then the Chinese market has been widely identified as being a more competitive market than previously. We find that the overall mean-reverting rate of Chinese listed firms is about 70.05%. This suggests that the profitability of Chinese firms can close more than two-thirds of their deviation from the mean within one year. There is no significant difference between the mean-reverting rate of SOEs (71.80%) and non-SOEs (68.04%). However, the non-linearity and asymmetry in the mean-reverting processes are significantly different for SOEs and non-SOEs. In particular, the profitability of SOEs tends to rebound more quickly when it is below the expected value, and reverts to the norm at a lower rate when profitability is above the norm. Our findings indicate that SOEs have the ability to maintain a superior performance once they have performed better than the predicted company-specific mean level, and they can recover more quickly from poor performance; whereas non-SOEs find it harder to maintain their competitive advantage in the market than do SOEs.

We further examine the mean-reverting rate of firms with and without politically connected executives. We find that the mean-reverting rates of SOEs with and without politically connected executives are similar; whereas, unlike non-SOEs without politically connected executives, non-SOEs with politically connected executives tend to recover from extremely poor performance more quickly. In sum, although the Chinese market is competitive, non-SOEs could establish a competitive advantage by employing a politically connected executive.

In addition, we investigate whether the mean-reverting rates between central government-controlled SOEs and local government-controlled SOEs differ. Our findings show that the average mean-reverting rate of local government-owned firms is significantly higher than that of central government-owned firms. Furthermore, we find that SOEs controlled by the central government have a very slow mean-reverting pattern when their profits are better than the norm. These results are reasonable, given that SOEs controlled by local governments are subject to much more intense competition than are those controlled by the central government.

Our additional tests confirm that government connections do bring benefits to connected firms, and are helpful for firms to overcome the negative effect from the global financial crisis; thus, firms with government connections are more likely to survive (less likely to receive “special treatment”). Our results are robust when we use cash flow from operation as an alternative measure of profitability.

By examining the mean-reverting rate of Chinese listed firms, this study makes the following contributions to the literature. Firstly, previous studies on government connections (state control and political connections) mainly focus on how government connections affect firm value/performance based on cross-sectional analyses. Our study extends the literature by examining the effect of government connections on the time-series change in firms' performance. Our results confirm the value of government connections in an emerging market such as China, by providing additional evidence that, although the Chinese market is competitive overall, SOEs and non-SOEs with politically connected executives can still enjoy competitive advantages that enable them to maintain positive abnormal profitability for a longer period and to recover from negative abnormal profitability more quickly. Therefore, this study makes a substantial contribution to the literature on the value of government connections in emerging markets. In addition, although the time-series properties of profitability have been documented by previous studies, our study extends the literature by providing evidence that the mean-reverting rates of SOEs and non-SOEs on the one hand, and firms with and without politically connected executives on the other hand, differ. The dual role played by the Chinese government, as owner of SOEs and as the regulator, is attracting increasing criticism. This study provides direct evidence that, although China has established a generally competitive market in the post-WTO period, SOEs and firms with politically connected executives still enjoy a competitive advantage because the government still intervenes in the economy. Thus, proper measures that could minimize government intervention would assist overall market competition and create a fairer and more competitive environment.

The remainder of this paper is organized as follows. Section 2 reviews prior literature and develops testable hypotheses. Section 3 examines the association between the mean-reversion pattern of profitability and government connections. Section 4 presents and discusses the additional empirical analyses; and Section 5 concludes the paper.

Section snippets

Related literature

This study relates to two main strands in the literature: the time-series properties of profitability; and the effect of government connections on firm performance. The first strand of literature, built upon economic competition theory, suggests that profits usually follow a mean-reverting trend, under the assumption that the market is competitive. The first paper that documented the mean-reverting trend of profit is Mueller (1977), which examines the persistence of excess profits and finds

Government connection and mean-reverting rate of profitability

In this section, we aim to provide empirical evidence to our main hypotheses through examining whether the mean-reverting rate of profitability varies across different groups of firms, especially firms with and without government connections.

Robustness tests

We conduct the following additional tests to provide robustness evidence to our findings: (1) we examine the channel through which government connections yield economic benefits; (2) we further examine how our results are influenced by the global financial crisis; (3) we examine whether firms' survival rate differs between firms with and without government connections; and (4) we re-estimate our main results using operational cash flow rather than ROA as an alternative measure of firm

Conclusion

This study investigates whether and how government connections affect the time-series properties of firm profitability. More specifically, we study the mean-reverting pattern of Chinese firms and whether the mean-reversion pattern can be influenced by both government ownership control and politically connected executives. Based on a sample of Chinese listed firms during the post-WTO period from 2002 to 2010, we find that, overall, Chinese listed firms follow a mean-reverting pattern at a rate

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    Qigui Liu acknowledge the financial support from the National Natural Science Foundation of China (Grant No. 71702163).

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