The association between cost of debt and Hong Kong politically connected firms

Abstract

This paper investigates the association between Hong Kong politically connected (PCON) firms and their cost of debt and find these firms are associated with significantly lower interest rates being charged by lenders compared to other (non-PCON) firms. We compare our results with earlier investigations of Malaysian and U.S. PCON firms and find that our results are consistent with the results of the U.S. but inconsistent with that of Malaysia. Our results suggest that the economic wealth, the extent of political power, and the pervasiveness of firms having political connections could account for the cross-country differences between the cost of debt and PCON firms.

Introduction

The objective of this study is to improve our understanding of the association between politically connected (PCON) firms and their cost of debt, by examining this association using a new setting, namely Hong Kong. We are motivated by the conflicting results from two recent papers that investigated this association, namely Houston et al. (2014) [hereafter HJLM] who used U.S. data, and Bliss and Gul (2012) [hereafter BG], who used Malaysian data. Using S&P 500 (2003–2008) firms, HJLM find interest rates charged on bank loans to U.S. PCON firms to be significantly lower when compared to non-PCON firms. By contrast, using publically listed firms (2001–2004), BG find that Malaysian PCON firms incur a higher cost of debt compared to non-PCON firms. In this study, we investigate the association between cost of debt and PCON firms in Hong Kong to provide insights into the mixed findings between the U.S. (HJLM) and Malaysian (BG) papers. Hong Kong provides a good setting to test these mixed findings given that it shares some degree of culture and location with Malaysia as being within the Asian region, whilst in economic terms it is comparatively wealthy as is the U.S.

On 1 July 1997, the British following their 151 years of control returned Hong Kong sovereignty to the People’s Republic of China (PRC). The Chief Executive of Hong Kong (CE) replaced the previous position of Governor of Hong Kong that existed under British rule. The CE occupies the most powerful position in Hong Kong having almost unfetted powers. Members of the Electoral Committee (EC) elect the CE. This study focuses on the 800 members of the EC formed in 2006 with the task of selecting the next CE. We identify a firm as politically connected if the firm has at least one of its directors being one of the 800 members on the 2006 EC¹. Our sample firms consist of all publicly listed Hong Kong firms over the period 2007–2011. This six-year period coincides with the term of office of the CE.

The results from this study provide evidence that interest rates charged by lenders to PCON firms in Hong Kong are significantly lower than charged to other firms. Interestingly, whilst this finding is in line with the result reported by HJLM in their U.S. study, this result contrasts with the Malaysian results reported by BG. Our finding of a negative association between cost of debt and Hong Kong PCON firms may suggest that political connection in a wealthy economy reflects cronyism, and the self-serving maximization of benefits that can arise through the building and supporting of relationships with high levels of power and influence. It is also arguable that given that lower risk firms attract the reputed leaders as directors, they also pay lower interest. To address this potential concern, we use matched propensity scoring which provides qualitatively similar results to our main tests.²

Our finding of a negative association between cost of debt and Hong Kong PCON firms suggests that political connection in a wealthy economy reflects that lower risk firm types are more likely to attract as directors high-level individuals, such as those with EC membership, compared to more risky firm types. This is because in a transparent environment with freedom of the press, as exists in Hong Kong and the U.S., such directors are concerned about their reputation. As such, they are less likely to be prepared to risk being associated with more risky type firms where even a small risk to their financial health could have a serious impact on their reputation. In contrast, in an opaque environment, such as exists in Malaysia or China, the opacity itself provides protection and comparatively diminishes concerns such directors would have against loss of reputational capital.³

We consider that Hong Kong offers an excellent environment for testing benefits from political connection given the limited few that select the CE and the power that rests with the person occupying that position.⁴ Those elected, or to a smaller extent appointed, to EC membership represent various Sectors including a political sector (Sector 4). We performed further analysis on EC membership within this Sector and find that firms with directorships comprising EC members from the (1) National People’s Congress, and (2) Legislative Council are significantly associated with lower interest rate pricing. These results suggest that some political members may be able to use their influence to extract lower interest rates for firms of which they are associated, or potentially lenders may perceive lower risk for these associated firm types.

The growing literature on political connections has largely focused on the Asian region. The BG paper is, to the best of our knowledge, the only paper that has considered the relationship between cost of debt and political connections outside of the HJLM study of the cost of bank loans of U.S. PCON firms. Our major contribution is extending the understanding of cost of debt and PCON firms by identifying and investigating Hong Kong as a location in which to test this association. The choice of Hong Kong was not a random but instead was strategically chosen given that it is part of Asia, and as such is culturally similar to Malaysia, whilst economically being similar to the U.S. Our results provide evidence that PCON firms in that region are associated with significantly lower rates of interest consistent with the findings of the HJLM U.S. study, and in contrast to the BG Malaysian study. The differing results across different locations suggests the possibility that economic factors may outweigh cultural factors in this association. It is hoped that this study stimulates future research of this association in different locations to determine if this is the case. In the conclusion section, we discuss three identified factors that may potentially affect this association: (1) the economic wealth, (2) the extent of political power, and (3) the pervasiveness of firms having political connection. Additionally, it is possible that the stage of economic development of a country will affect the level of sophistication of its lending institutions.

The remainder of this study is organized as follows. The second section contains the literature review and the hypotheses. The third section discusses the research methodology, followed by a discussion of the results. The final section contains the conclusions that summarize the main findings paper and a discussion on identified limitations and the implications of our findings.