Capital for Chinese expansion : the effectof China’s capital market distortions on Chinese outbound mergers and acquisitions.

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Capital for Chinese expansion: the effect

of China’s capital market distortions on

Chinese outbound mergers and acquisitions

Master thesis

Thomas Daniël Hosman 0480770

Final version 21-11-2013

First supervisor: Tsvi Vinig Second supervisor: Zhe Sun MSc. in Business Studies

Entrepreneurship & Innovation Track University of Amsterdam

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This thesis is one the first studies that have looked at the effects of capital market distortions in China on Chinese outbound mergers and acquisitions. Because of discrimination and subsidization private owned enterprises have difficulties accessing the formal finance channels in the country, while the state-owned enterprises receive loans from the four state-owned banks with interest rates that are much lower than the market rates. These distortions are likely to affect the financing decisions of firm active in outbound M&A, and through the financing decisions also the performance of the outbound M&A. The analysis of a sample of 244 Chinese outbound mergers and acquisitions shows that because of the capital market distortions SOEs use more debt financing for outbound M&A than POEs. POEs on the other hand try to cope with the capital market distortions by looking for equity financing in an early phase of the outbound M&A process. These financing distortions result in smaller outbound M&A transactions for Chinese POEs. Moreover, the capital market distortions affect the performance of Chinese outbound M&A. Both the short-term and the long-run performance of POEs are much higher than the performance of SOEs. These differences in performance are created by the differences in the type debt between SOEs and POEs. For POEs debt has a disciplining effect, while for SOEs the low interest rate on their loans leads to risk-taking and investing in value-destroying prestige projects. With these results this thesis has added to the knowledge about the effect of capital market distortions on China’s outbound M&A, and more in general to the knowledge about the influence of the institutional environment of a country on the investment decisions of firms.

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1. Introduction

For a long time the label ‘Made in China’ was not seen as a positive indicator of product quality. During the twentieth century many Western companies outsourced their production processes to the People’s Republic of China to save on their production costs. Because of the cheap labor force, good infrastructure and high productivity companies invested heavily in production plants in China, making it the second-largest economy of the world and the largest foreign holder of U.S. debt. Production in China was seen as easy and cheap, and no competition for the high quality knowledge economy of the western world. Now things have started to change. Since the beginning of the twenty-first century China has been investing in its own multinational companies that are competing with the same companies that originally outsourced their processes to the country. But that was only the start. Chinese companies are now, fueled by the large stock of dollars in the country, buying Western firms to increase their competitiveness, technological capabilities and market penetration. These outbound mergers & acquisitions (M&A) have grown to a deal volume of almost 350 billion dollars in 2012.

The growth of China’s economy and the upcoming of Chinese outbound M&A have led to fearful reactions in the West. In the media China’s arrival on the international market is mostly characterized as a threat to the Western economic dominance. Even respected magazines as The Economist and Der Spiegel seem not be able to overcome the clichés and stereotypes when they refer to the Chinese as “dragons” and “the yellow danger” in their headings (“A ravenous dragon,” 2008; Obbema, 2013; “The Chinese are coming,” 2005; “The Dragon Tucks in,” 2005). These views are fed by the fears that China’s investments are driven by imperialistic motives, fueled by government subsidies and controlled by the Chinese state. Whether there is any truth to these claims will be the subject of debates for many years to come. While looking at Chinese outbound M&A from the Western viewpoint could lead to interesting insights, it is just as interesting to look at Chinese outbound M&A from the viewpoint of China. China’s political and economic system is very different from most Western economies. The country comes from a socialist background, but is now because of the fast changes often categorized as a planned economy in transition. The future of this transition is still uncertain, but what is certain is that China’s socialist background is still embedded in many aspects of society. One of the sectors in which China’s background is still an important force that not has to be underestimated is China’s financial system. China’s capital market is distorted in several ways, and this

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influences the economy in different directions. Among other things these distortions lead to discrimination and subsidization. Because four large state-owned banks dominate China’s financial market, state-owned enterprises receive preferential treatment over private-owned enterprises. The result is that state-owned enterprises receive larger amounts of debt with a subsidized low interest rate, while private enterprises have difficulties finding capital for their investments and are suffering from the high interest rates.

Previous research on China’s financial system has shown that the capital market distortions in China affect the performance of China’s economy at different levels. China’s banks have a large amount of non-performing loans that put a huge weight on their balances. State-owned enterprises have used these low-cost loans to invest in prestige projects that expand their empire but destroy value. Private enterprises have resorted to several informal finance channels to cope with the difficult access to formal finance channels. Because of this many value-creating investments have to be forgone by private owned enterprises, and capital is not allocated to the most profitable investments.

The capital market distortions in China are also likely to influence China’s outbound M&A. It is expected that these distortions affect the financing decisions of Chinese state-owned enterprises and private enterprises in different ways, resulting in non-optimal financing patterns. Moreover, the capital market distortions could possibly also affect the performance of China’s outbound M&A. The research on China’s internationalization process has discussed these possible effects of government subsidization and discrimination on China’s outbound investments but has never quantitatively tested them. This thesis tries to fill this gap in the literature by studying

what the effects are of the distortions in China’s capital market on Chinese outbound mergers and acquisitions.

To answer this question this thesis quantitatively analyzes a data set of 244 outbound M&A deals by Chinese firms between 2000 and 2012. This dataset allows this thesis not only to test the differences in financing decisions between state-owned firms and private firms, but also makes it possible to relate the capital market distortions and the financing decisions to the performance of China’s outbound M&A over different time periods. By comparing these results to the performance of Chinese firms that are listed on a foreign stock exchange it is possible to get a full understanding of the effects of the capital market distortions.

This thesis tries to complement the research on the financing and the performance of China’s foreign direct investment (FDI). Moreover, this thesis extends

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the general internationalization theories by testing how the specific institutional environment of a country influences the FDI from that country. Child et al. (2005, p. 404; 2005) appropriately emphasize that “the case of China strongly suggests that international business theory needs to take fuller account of the potential relevance of domestic institutional factors in developing and transitional countries”. This thesis is a first step in this direction.

In the next chapters first of all an overview is given of the relevant literature. Because the subject of this thesis requires that several theoretical lenses be combined to get a good understanding of the theory, the literature review focuses on both the literature about China’s internationalization process, classical finance theory and the financial theory on international mergers and acquisitions. This leads to the identification of a gap in the research and the formulation of the research question. After that the theoretical framework is presented that contains the hypotheses that are empirically tested with the collected data. This is followed by an overview of the research design and methodology, and an overview of the statistical results. The thesis is concluded with the theoretical discussion of the results.

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2. Literature review

In 2005 Child et al. (2005) noted that the research on the subject of Chinese outbound M&A is a relative new area of study that is largely based on case study evidence because more systematic firm-level data is absent. Since then more research has contributed to our understanding, both qualitative and quantitative. But although a subject like China’s outbound M&A requires a combination of resources lenses in order to be fully understood, it is still hard to find integrated studies that combine different areas of expertise. This thesis tries to fill this gap by looking at the subject of China’s outbound M&A from two different strands in the literature. This chapter will discuss these two research streams first individually before they will be combined. First the research on China’s internationalization is analyzed to get an understanding of the current knowledge on this subject. After that the research on China’s financial sector and the effect of distortions on the financing decision of Chinese companies is discussed. In the last part the literature that has merged these two research lenses will be discussed.

2.1 China’s Internationalization

2.1.1 Internationalization theories

According to Child et al. (2005, p. 382; 2005) internationalization can be defined as “the crossing of national boundaries in the process of growth”. The authors describe three different levels of engagement in which internationalization can happen. The first level is exporting, in which a country exports its natural resources or products to foreign countries. The second level has the form of original equipment manufacturing (OEM), in which foreign companies subcontract their production to the country. This is the level of activity that China’s economy has become known for in the last two decades. The third and last level of engagement is about the expansion of Chinese firms into foreign locations, which is called Foreign Direct Investment (FDI) (Child & Rodrigues, 2005). Although the use of the word levels suggests that the three levels are following each other over time, this doesn’t necessarily have to be the case. Better it is to think of the three stages in terms of engagement and presence abroad (Child & Rodrigues, 2005). While the first two levels form still the most important part of China’s international business in term of economic value, exporting and OEM don’t require any active organizational presence outside of China. FDI on the other hand requires Chinese firms to physically expand the reach of their firms outside of China,

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and to manage and organize their operations there. Foreign Direct Investment of Chinese firms is the focus of this thesis. There are many definitions to what FDI exactly entails. Most studies use the definition of the United Nations Conference on Trade and Development (UNCTAD), which says that FDI is “an investment involving a long-term relationship and reflecting a lasting interest and control by a resident entity in one economy in an enterprise resident in an economy other than that of the foreign direct investor” (UNCTAD, 2005, p. 289; 2005).

Before the specific situation in China is discussed it is helpful to discuss some general theories on FDI to see how they apply to China. The mainstream theory in international business says that “firms will internationalize on the basis of a definable competitive advantage that allows them to secure enough return to cover the additional costs and risks associated with operating abroad” (Child & Rodrigues, 2005, p. 383; 2005). Dunning’s eclectic paradigm has specified three types of advantages that motivate FDI: ownership, location and internalization (OLI) (Buckley et al., 2007; Child & Rodrigues, 2005; Dunning, 1988; Erdener & Shapiro, 2005). Ownership (O) advantages are firm-specific factors developed in the home market that can give a firm a competitive advantage in foreign markets. Examples are resources, knowledge or management experience. Location (L) advantages are country-specific advantages that influence where a firm decides to internationalize. These advantages can be superior market opportunities but can also be close cultural distances. Lastly, firms have internalization (I) advantages when they can internalize the advantages of FDI effectively. This happens when firms are successful in managing their international operations and interdependencies in knowledge, value chain management or reputation (Child & Rodrigues, 2005).

Based on the L-advantages in the model three dominant motives for FDI appeared in the 1970’s: resource-seeking FDI (firms in search for natural resources), market-seeking FDI (firms in search of new markets to exploit current capabilities) and efficiency-seeking FDI (firms in search of lower costs) (Buckley et al., 2007; Erdener & Shapiro, 2005). These three types of FDI are all based on the mainstream perspective that firms have competitive ownership advantages that they wish to exploit in foreign countries. This can easily be explained: in the 1970’s and 1980’s it almost only were multinationals from developed countries that were active in FDI to compete with each other on the world market. At the end of the 1990’s firms from developing countries entered the international competition, some for the same reasons described above. But with the emergence of this new source of FDI also came a new motivation that wasn’t addressed by the mainstream theory until then (Buckley & Casson, 1998;

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Erdener & Shapiro, 2005). The idea that some firms were not investing abroad to exploit their home country advantages, but were looking across their borders to address a home country disadvantage was new (Child & Rodrigues, 2005). One stream of research that does address this viewpoint is the ‘late development’ thesis, that shows how firms from emerging economies like Taiwan, South Korea and more recently China are relatively new to the international market (Child & Rodrigues, 2005). Besides that these “late-comers” had the disadvantage of entering the international stage later than others, the most significant difference was that these firms did not come from a position of strength but from a position of relative disadvantages. These disadvantages included outdated technology and knowledge, and a lack of internationally known brand names. Outward FDI allowed these firms to “close the gap that separated them from leading companies through acquiring appropriate assets and resources” (Child & Rodrigues, 2005, p. 384; 2005). As will be shown later in this thesis, this asset-seeking FDI is one of the main reasons of the Chinese outbound mergers and acquisitions.

With these general mainstream theories in mind the next section takes a look at the specific Chinese situation. First of all an overview is given of the several stages that China’s FDI has went through. After that the motives and routes of China’s firms are explored. The last part will discuss the special role of mergers and acquisitions in China’s internationalization process.

2.1.2 Overview of China’s internationalization in different stages

This section will give an overview of the most important characteristics of China’s FDI by looking at the several stages that China’s FDI has went through over time. The last phase will receive the most attention as this thesis focuses on the present-day FDI. Although most studies differ a bit in the amount of phases and the timing of the phases they identify in the history of China’s FDI, generally speaking it is accepted that that China has went through four large periods (Buckley et al., 2007; Voss, Buckley, & Cross, 2008; J. Wong & Chan, 2003; Wu & Chen, 2001). What is also non-controversial is that the first stage of China’s FDI started in 1979, the year that the ‘Open Door’ policies were initiated. In these policies the Chinese government identified FDI as a means of opening up China to the world (Buckley et al., 2007). The goal of the FDI in this period was therefore to expand the collaboration with foreign governments and to improve China’s political influence in the world, rather than to create economic value (Wu & Chen, 2001). Only authorized and selected state-owned companies directly under control of the Ministry of Commerce

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(MOFCOM) were allowed to establish foreign branches (Voss et al., 2008). All foreign currencies that were earned by these foreign affiliates were legally owned by the Chinese government and could not be used to invest without further approval. From 1979 to 1985 only 189 projects were approved with a total value of around 197 US dollar (Buckley et al., 2007).

In the second stage (1986 – 1991) the restrictive policies were liberalized and government approval was somewhat relaxed (Wu & Chen, 2001). The reason for this policy shift was that China’s economy was growing because of the increasing exports. At the same time, it needed to get foreign resources to fuel that export because of a shortage in China (Wu & Chen, 2001). With this increased importance of economic FDI also came an increased emphasis on profit maximization, and the foreign plans of state-owned enterprises were now also reviewed on their financial performance. In this period the amount of projects that were approved increased from 189 to 891, with an estimated value of 1.2 billion US dollar (Buckley et al., 2007).

The third phase (1992 – 1998) was characterized by a tightening of government control. Initially, Deng Xiaoping’s tour to the South in 1992 initiated economic reform and increased liberalization (Buckley et al., 2007). Encouraged by the new élan of liberalization in China’s politics, state owned enterprises, private firms and even local and provincial governments were increasingly engaged in overseas business (Voss et al., 2008). China’s FDI increased to encompassing 6.4% of all FDI from developing countries (Cai, 1999). While the focus in the previous phase was on industrialized countries, the focus was now amended with a heightened investment in other developing countries (Voss et al., 2008). But the overheating economy combined with rising prices in 1993 and the subsequent Asian crisis in 1997 threw a spanner in the works. Driven by a fear of both a loss in government control on state assets and the flight of national reserves to foreign countries, the government tightened the approval procedures. Because of the increased bureaucratic control the amount of projects declined in the latter phase of this period, while the value of FDI remained around 1.2 billion US dollars (Buckley et al., 2007; J. Wong & Chan, 2003).

The fourth stage (2001 – present) was initiated by China’s accession to the World Trade Organization (WTO) in 2001 (Buckley et al., 2007; Voss et al., 2008). The main results of this important step was that, because of WTO rules, the domestic market was opened to foreign competitors (Buckley et al., 2007). This increased competition forced Chinese firms to improve their business in the domestic market but also to seek new markets abroad. The importance of going abroad was underlined by the Chinese government in their “Go Global” policies that identified 512

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companies that were of key importance in China’s international business aspirations (Voss et al., 2008). These companies have received special attention from the Chinese government. But the regulations and procedures were also relaxed for other firms (Voss et al., 2008). The approval process was simplified and decentralized to provincial governments. Besides that, companies were now allowed to raise capital on international financial markets. The effects of this new government policies and increased competition on the motives, directions and forms of FDI will be studied in the next sections that focus on China’s FDI since 2000.

2.1.3 Motives

Previous sections have shown that China’s FDI has went through several stages, and that each stage had its own rationales, directions and routes for FDI. This section will focus on the motives of China’s FDI since 2001, when China became a member of the WTO. Since the entrance to the WTO an economic rationale is the driver of the largest part of China’s FDI. While there is still government support on many levels, the political role of China’s FDI is taken over by a focus of profit maximization. Therefore the motives of China’s FDI are now comparable to the motives of FDI from other market economies (Cai, 1999). Generally speaking four main motives of China’s current FDI are identified in the literature: natural resources, new markets, strategic assets and financial capital (Cai, 1999; Cheng & Ma, 2010; Child & Rodrigues, 2005; Wu & Chen, 2001). These four motives will now be described.

Historically the main economic motive for China’s FDI was resource appropriation. The rising levels of exports led to enormous economic growth in the 1980’s. But for these exports the Chinese government and Chinese firms needed resources, which had become scarce in the country (Cai, 1999; Wu & Chen, 2001). While China is well endowed with many national resources there is still a shortage because of the many people in the country (Deng, 2004). The three main sectors in which Chinese firms are looking for resources are fishery, forestry and mining (Cai, 1999). Outward FDI has become an important method for China’s firms to keep a steady supply of resources in these sectors. That Chinese firms have bought mines in many African countries to insure their supply of iron has received much media attention in Western countries. It is estimated that China will also ship 200 million tons of iron from Australia in the next twenty years (Deng, 2004). Other examples are the oil deals that China has made with Sudan, Venezuela, Kazakhstan and countries in the Mid-East (Cai, 1999). Resource-seeking investments are often very large scale projects, in which the government is involved (Deng, 2004; Lunding, Lanzeni, Trinh,

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& Walter, 2006). While the relative importance is likely to drop, the continuing urbanization in China will make sure that resources will remain an important component of China’s FDI in the future (Rosen & Hanemann, 2009).

The second motive of China’s FDI is the development of overseas markets. China’s ascension into the WTO had as an effect that domestic competition suddenly increased because of WTO’s open markets rule. One reaction of Chinese firms to this increased domestic competition was to go abroad to find new export markets (Buckley et al., 2007; Cai, 1999). Increased protectionism and imports barriers in some countries have forced many Chinese firms to establish factories outside of China to circumvent trade barriers (Cai, 1999; Deng, 2004). Examples of these are Chinese subsidiaries in Mexico and Jamaica for the US market, factories in Turkey for the European market and affiliates in Fiji for the Australian market. The investments with a market-seeking motive are often relatively small-scale compared to resource-seeking investments, and are characterized by labor-intensive manufacturing and the production of low-value added goods (Deng, 2004). All these factories abroad has led some to believe that in the future the label made in china will be replaced by “made by

China – abroad” (Rosen & Hanemann, 2009, p. 96; 2009).

The third motive that can be identified in China’s FDI is strategic asset seeking (Cai, 1999; Lunding et al., 2006). Compared to the first two motives this one is relatively new and not well explained by the mainstream theory of international business. As has been shown above, China’s accession to the WTO has increased the competition for Chinese firms both within China and outside of China. In this competition many Chinese firms have found out they lack many of the strategic assets that foreign firms have. In order to catch up with these foreign leaders Chinese enterprises are using FDI. That this type of FDI is different from the FDI from developed countries was already shwn. The mainstream internationalization theory says that firms use FDI to exploit a competitive advantage. Chinese firms on the other hand are using FDI because they have a relative disadvantage compared to other firms (Child & Rodrigues, 2005; Rui & Yip, 2008). This disadvantage originates from the fact that for a long time China was closed off from the world economy. As will be shown in the next chapter, during this period most enterprises were state-owned, competition was minimal and the institutional environment didn’t foster innovation. As a result, Chinese firms found themselves on the lower end of the international value chain (Lunding et al., 2006; Rosen & Hanemann, 2009). For many of the products that are manufactured in China Chinese firms only receive 20 percent of the final profit. The rest is captured by Western firms that do the production design,

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research & development and branding (Rosen & Hanemann, 2009). These elements are hard to replicate and cannot be developed overnight. Therefore these strategic assets need to be acquired in the international markets, and this is now one of the main motives for China’s FDI. The new focus on strategic asset-seeking has been regarded by some scholars as being “the significant change in the motives for FDI over the last two decades” (Dunning, 1999).

Three main focuses of strategic asset seeking are identified in the academic literature. First of all Chinese firms are looking for technology to replace their own outdated (manufacturing-) technology (Cai, 1999; Deng, 2004). Secondly, firms use FDI to acquire intellectual property, like patents or research departments (Rosen & Hanemann, 2009). A third focus of Chinese firms is getting international brand names. In order to compete on a global level an internationally recognized brand name is required, and for many Chinese firms building such a brand name is the main reason to invest abroad (Deng, 2004). For some firms this process is taking too long and therefore they take over firms that have already established such brand value (Deng, 2004; 2007; Wu & Chen, 2001). Lastly, Chinese firm are looking for international management skills that cannot be found in China (Cai, 1999; Deng, 2007).

The fourth motive of Chinese FDI that has emerged in the last decade is that Chinese firms have started using FDI as a means of raising capital for domestic use (Cai, 1999; Wu & Chen, 2001). Because of the inefficient capital markets at home (see next chapter), many firms don’t have access to capital to fund their investments and have to look abroad. The main target of this FDI is Hong Kong where many firms are seeking public listing of their shares on the Hong Kong Stock Exchange (HKSE) (Cai, 1999). Because many of the Chinese firms do not meet the accounting requirements of the HKSE they have bought non-listed but accounting standard compliant companies in Hong Kong that they use as a vehicle to get enlisted. Because these capital gains are mainly used to fund mainland investments, this last motive connects inward FDI and outward FDI in a novel way. The size of capital seeking FDI is relatively small compared to the other three motives.

As there are multiple motives to use FDI there are also multiple routes to FDI. With the growing importance of strategic asset seeking has also grown the use of mergers and acquisitions in Chinese FDI. The next chapter will take a closer look at the different routes that exist in FDI and will show why mergers and acquisitions have become so important.

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2.1.4 Different routes in FDI and the role of mergers and acquisitions

Previous section has discussed the four main motives of Chinese FDI. But FDI can take several forms, each with its own advantages and disadvantages. Child et al. (2005) describe three important routes that are taken by Chinese firms in internationalization: greenfield investment, joint-ventures and mergers & acquisitions. This section will discuss these different routes in FDI and will show why of the three routes mergers and acquisitions have become the main route in China’s FDI.

The organic route toward FDI is the greenfield establishment of local branches and facilities in foreign markets (Child & Rodrigues, 2005). The main goal of these greenfield investments is often securing differentiation advantages. Examples are local branches that adapt to local tastes and needs (Child & Rodrigues, 2005). Greenfield FDI has therefore mainly an asset exploitation and less an asset-seeking motive (Schüller & Turner, 2005). The main focus of greenfield FDI is market-seeking: using a home-advantage to get access to new markets (Child & Rodrigues, 2005; Deng, 2007). In the case of China these home-advantages include a large labor workforce and low production costs. Haier is a good example of a Chinese firm that has used greenfield FDI to expand its operations over the world. Fueled by its success in China’s market it has established several departments outside of China that connect the advantage of have low-cost production facilities in China with the goal of securing a global brand name (Child & Rodrigues, 2005).

A second route in FDI is joint-venturing with a foreign enterprise (Child & Rodrigues, 2005). In a joint-venture two companies agree to collaborate in one a specific area. Both companies bring a competitive asset to the table that the other party does not have, so that both parties can profit from the combination of these assets. An important goal of joint-venturing is asset-seeking: starting a partnership with a foreign enterprise can be an effective means of transferring knowledge or management skill to the Chinese firm. This differentiates joint ventures from greenfield FDI, in which the goal is often asset-exploitation. The joint venture route is also different from mergers and acquisitions in terms of direction. Joint ventures often amount to a kind of inward internationalization, in which the goal is not directly to internationalize as a firm but to transfer international knowledge and technology to a firm (Child & Rodrigues, 2005).

Mergers and acquisitions (M&A) combine features of both greenfield FDI and international joint ventures. Outbound M&A can be defined as “a corporate action of purchasing the shares or assets of another company in a foreign country” (Changqi & Ningling, 2010). The terms merger and acquisition are often used interchangeably (J.

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Ma, Pagan, & Chu, 2009). While there technically is a difference between the two terms (this has to do with the relative size of the acquiring firm to the acquired firm), this difference does not matter for studying M&A because the outcome of the two is the same. The motive of M&A is asset seeking, and the goal is to become a competitive player in the international markets. M&A have proven to be a very effective means in acquiring foreign technologies, research & development and international brand names (Child & Rodrigues, 2005; Deng, 2009). By acquiring a firm with a world-known brand name and up-to-date technologies Chinese firms can update their competitive assets without the hassles of partnering with a foreign enterprise. In this regard M&A fits perfectly in the late-coming theory: Chinese firms are trying to become internationally competitive players but lack certain technologies, skills or branding power (Rui & Yip, 2008). Developing these assets is both difficult and time-consuming. Therefore M&A can be seen as a fast-route in closing the gap between Chinese firms and Western multinationals (Deng, 2007). Another reason that M&A has become a popular route for Chinese firms is that strategic assets are often sold individually. The only option therefore is to “acquire entire businesses to extract the resources owned by the acquired firm” (Rui & Yip, 2008, p. 215; 2008). To acquire these firms aggressive M&A is often the only option (Deng, 2009). A good example of a Chinese firm acquiring a multinational enterprise is Lenovo, that bought IBM’s PC division in 2003. Lenovo was forced to look at foreign markets because of increased competition at home, while at the same time it was attracted by the possibility of becoming an international player (Child & Rodrigues, 2005). The acquisition meant a huge step forward for Lenovo in terms of brand recognition and technology, and has put it in the list of the top ten computer manufacturers in the world. Because of its characteristics M&A has become the number one mode of entry for Chinese firms (Deng, 2007; Lunding et al., 2006). Between 1990 and 2002 the value of cross-border M&A had increased 27-fold to almost 1,65 billion US dollar, while other Asian countries saw a decrease in M&A activity in this period (Hong & Sun, 2006). Although the figures differ in many studies, M&A accounted for 55 to 80 percent of total Chinese outward FDI in 2005 (Deng, 2007; Lunding et al., 2006). This increasing use of M&A as the route of entry led many researchers to the conclusion that asset-seeking is now the main focus of China’s FDI (Deng, 2007; Hong & Sun, 2006; Schüller & Turner, 2005). Of course Chinese M&A deals are not only a success story, and there are many problems that Chinese firms face after they have bought foreign firms. In general, M&A are very difficult to perform and in many cases lead to losses for the acquiring firm (Schüller & Turner, 2005). Reasons for these

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failures are overvaluation of the future synergies, too optimistic market expectations and poor after-acquisitions management (Schüller & Turner, 2005). These difficulties are often enlarged for Chinese outbound mergers and acquisitions where clashes in language, culture and management styles can be expected (Child & Rodrigues, 2005; Schüller & Turner, 2005). The capital market distortions that are the focus of this thesis could be another reason for the high-level of M&A failures. This has led some scholars to believe that as much as 70% of M&A fail to deliver shareholder value (Lunding et al., 2006).

This section has shown that M&A have become a popular route for Chinese firms in their internationalization process. Chinese firms are facing increased competition both in Mainland China and on the international markets and they find themselves having a large competitive disadvantage compared to other firms. To close the gap as quickly as possible these firms have employed asset-seeking FDI. The characteristics of M&A have made them the preferred route of entry for Chinese firms.

An aspect that is not well captured by the mainstream theory is that firms from developing or transition countries are embedded in an institutional environment that is different from most western economies (Child & Rodrigues, 2005). This environment can both hinder and support the development of FDI and M&A from these countries. This seems especially to be the case in China, where the institutional environment is very different from most Western countries (Deng, 2009). Buckley et al. (2007) describe three institutional factors that could influence China’s FDI: capital market imperfections, ownership-advantages and state-support. In order to get an idea if these and other factors influence China’s outbound mergers and acquisitions one of the most important parts of China’s institutional environment is the focus of the next chapter: China’s financial markets.

2.2 China’s financial markets

2.2.1 China’s institutional environment: a planned economy in transition

China’s political system and economy are so different from most Western systems that it is necessary to give a larger view of China’s institutional environment in order to let the reader understand what the origins are of the current financial system. Maybe Peng (1996, p. 493; 1996) gives the best description of why such insight into China’s history is necessary to understand todays business environment: ”The socialist legacy as well as the recent transformations in these countries present an institutional

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environment that is immensely different from what a typical Western firm would encounter“. Morck et al. (2008) emphasize this point and state that because of China’s institutional environment any analysis of FDI from China on the micro-level is not complete without an analysis of factors on a macro-level. This section will therefore take a closer look at China’s institutional environment.

Before the transformation China’s economy was characterized by central economic planning by the state (Peng & Heath, 1996). All economic decisions were formulated by the state in a national plan that was decomposed into smaller plans and targets for the state owned firms. In a way, the whole country was run like a multidivisional firm with a corporate headquarters and several divisions (Peng & Heath, 1996). The central planning system was characterized by paternalism and soft budget constraints for state owned firms (Hoskisson, Eden, Lau, & Wright, 2000). State-owned firms didn’t have any motivation to produce in an optimal way and the state curbed all enthusiasm to innovate (Hoskisson et al., 2000).

China’s transformation from a socialist central planning economy to a more open and market-based economy has had its effects on many levels of society. It should be noted that this transformation is still ongoing. Where China will end is unknown. Because China in between a planned economy and a market-based economy a better term would be to describe China as a planned economy in transition (Peng & Heath, 1996) or transition economy (Hoskisson et al., 2000). Because China is not the only country that has started such a transformation in the last part of the twentieth century some studies have compared China to other transition economies that come from a communist ideology, such as countries in Eastern Europe and the former Soviet republics. While these countries differ in many aspects, they share three important characteristics (Peng & Heath, 1996). These three characteristics will be described in more detail below.

The first result of the transformation from a central planning economy to a market-based economy is an institutional environment that is characterized by a mix of strong, but unstable, government control, lack of property rights-based legal systems and lack of strategic factor markets (Hoskisson et al., 2000; Peng & Heath, 1996). While China’s economy is moving away from the central planning system toward a more marked-based economic exchange, the power of the government can still be felt on many levels. In a survey under Chinese managers it was shown that these managers perceive the regulatory regime of the state as the most influential but also most unpredictable of several institutional factors (Justin Tan & Litsschert, 1994). Since then the control of the state has went up and down, with periods of increased

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liberalization that are followed by setbacks and heightened control. Because the state ruled the country before the transition trough bureaucratic control and regulations there was no need to for formal laws to regulate exchange in the economy (Peng & Heath, 1996). Therefore a second problematic aspect of the institutional environment of these countries is the lack of a proper legal framework. Without proper legal frameworks it is very difficult for markets to function properly, and opportunistic behavior by the participants of the markets can be expected (Boisot & Child, 1988). This leads to a third aspect of the institutional environment of transition economies such as China: the lack of strategic factor markets (Barney, 1986; Peng & Heath, 1996). In strategic factor markets “the resources that are necessary to implement a strategy” are acquired (Barney, 1986, p. 1231; 1986). When strategic factor markets function properly the cost of acquiring strategic resources will roughly equal the value of those resources. When these markets do not function properly the cost of acquiring new resources exceeds the value of those resources, leading to high transaction costs for the acquiring and selling firms. One of the most important strategic factor markets, the financial market, is the focus of this thesis.

The second important characteristic of transition economies is the mix of both state owned enterprises (SOEs) and private owned enterprises (POEs). After the People’s Republic of China was founded in 1949 all POEs were transformed into SOEs according to the social ideals of the Communist Party (H. Li, Meng, Wang, & Zhou, 2008). For more than 25 years, until 1977, all POEs were banned in China. The Constitution of 1978 for the first time allowed POES to emerge, although the document noted that this was only ”temporarily and tightly controlled” (S. Young, 1995). It was Deng Xiaoping’s Southern Tour in 1992 that truly unleashed the growth of private firms in China (Voss et al., 2008). Since then the amount and the size of private firms has grown enormously: together they provide up to 60% of the industrial output and 50% of total employment (H. Li et al., 2008). With the legal status of private ownership the government decided to privatize many of its SOEs. This privatization process of SOEs is going very slow: in the nineties only one firm a week was being privatized leading some researches to conclude that it would take centuries for the process to be completed (Peng & Heath, 1996). While private ownership nowadays is allowed in all of China distinct differences between POEs and SOEs still exist. According to Li et al. (2008) POEs still experience political and social discrimination at many levels. The discrimination in the financial sector is the focus of this thesis.

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To survive in such an uncertain environment, in which the government controls much of the recourses that SOEs and POEs are competing for, in which legal frameworks are lacking and strategic factor markets are almost nonexistent, firms have to rely on other measures to survive: personal relationships and trust (Peng & Heath, 1996). This is the third and last characteristic of transition economies. In China there is a special name for these networks of personal connections: Guanxi (X.-P. Chen & Chen, 2004). The term guanxi is made up of two words in Chinese, guan and xi, which together have the meaning of connection. The term Guanxi can be traced back to the philosophical works of Confucius but nowadays can be best defined as “an informal, particularistic personal connection between two individuals who are bounded by an implicit psychological contract to follow the social norm of guanxi such as maintaining a long-term relationship, mutual commitment, loyalty, and obligation” (X.-P. Chen & Chen, 2004, p. 306; 2004). Allen et al. (2005) show that these beliefs have for a large formed as an replacement for the nonexistence of formal governance mechanisms in China.

In this section it was shown that China’s economic background could be compared to that of other transition economies. Its institutional environment is characterized by a government with strong bureaucratic control, lacking legal frameworks and non-functioning strategic factor markets. One of the most important strategic factor markets, and the focus of this thesis, is the financial market. The next sections take a closer look at the research on China’s financial sector. The focus will be on the research on the two most important sources of finance for firms that want to cross borders: the banking sector and the listed sector. After that the financial sector is described from the viewpoint of the firm by looking at the capital structure of Chinese firms.

2.2.2 Banking sector

China’s financial system is dominated by a large banking sector, which in turn is dominated by four large state-owned banks (Allen, Qian, & Qian, 2007; Ayyagari, Demirgü textbackslash cc-Kunt, & Maksimovic, 2010; A. N. Berger, Hasan, & Zhou, 2009). The “Big Four” banks own around three-fourths of all industry assets (A. N. Berger et al., 2009). One of the reasons the banking sector is so large in China is the high level of savings in the country. Powered by the rising incomes residents of large Chinese cities put between 50% and 75% of their income in domestic banks (Cull & Xu, 2003; Morck et al., 2008). Although the household savings rate has dropped slightly in the last few years, corporate savings are still increasing. This trend can be

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explained by two factors. First of all, most SOEs are dividend-averse and have very high retained earnings (Morck et al., 2008). Half of the listed SOEs pay no dividend at al. Secondly, as will be shown later, private owned enterprises are having troubles accessing the formal financial markets. The POEs are relying on their own internal funds for investments and growth (Morck et al., 2008). Both the private and corporate savings are among the highest in the world.

Despite the fast growth and evolution of China’s banking sector in the last decades the sector is still under-developed in comparison to the banking sectors of other emerging economies (Allen et al., 2005; 2007; Ayyagari et al., 2010; A. N. Berger et al., 2009). One of the most important signals of this under-development is the non-performing loans (NPLs) of the four state-owned banks (Allen et al., 2005). Although data on the amount and size of these NPLs is limited (which most likely is a strategic non-disclosure decision of the government) most researchers assume that the problem is severe (Allen et al., 2005; 2007). The limited data that is available show that between 2000 and 2002 China had the highest level of all the NPLs among the seven largest Asian economies (Allen et al., 2005). Two main causes can be found for this high level of NPLs (Ayyagari et al., 2010; A. N. Berger et al., 2009). First of all, the very high savings rate of the country has created a surplus of funding. This surplus of funding has led many researchers to believe that efficient allocation of funding was not that necessary because of the abundance of funds (A. N. Berger et al., 2009). A second important cause of the high level of NPLs could be found in the fact that for long the four largest state-owned banks made most of their loans to SOEs (Ayyagari et al., 2010; A. N. Berger et al., 2009). These SOEs had almost no incentives to pay back their loans. The banks on other hand believed that the government would bail them out in case of financial trouble. When the government stopped doing that in 1999 it became clear that the Chinese banks had some serious problems (A. N. Berger et al., 2009). In order to resolve the problem of NPLs the Chinese government has taken several measures (Allen et al., 2005; A. N. Berger et al., 2009). But despite these measures, many researchers shows that government ownership is still negatively related to bank performance. Berger et al. (2009) find that the Big Four banks are by far the least efficient.

Although funds are supposed to be widely available and the four commercial banks have stopped functioning as policy banks much research has been done to show that discrimination between SOEs and POEs is still prominent on all levels of formal finance. For example, Hale et al (2011) show that, despite the many reforms in the last centuries, SOEs continue to have better access to formal finance in the form of bank

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loans than POEs. Many researchers show that this is caused by the political objectives of state-owned banks: instead of maximizing return state-owned banks follow the objectives of politicians to serve political and personal objectives (Brandt & Li, 2003; Firth, Lin, & Wong, 2008; Ruan & Xiang, 2013; Sapienza, 2004). Sapienza (2004) has studied the effects of government ownership on banks from three different theoretical perspectives: social, political and agency. According to the social view SOEs are created to address market failures in which the social benefits outweigh the costs. The political view sees SOEs as a means of pursuing the individual goals of politicians. Lastly, agency theory combines parts of these two views: SOEs are created to maximize social welfare but corruption and weak managerial incentives can disrupt the process. The author finds that in Italy the political view best explains the preferred loans from state-owned banks to state-owned enterprises (Sapienza, 2004). Brant et al. (2003) were one of the first to show that also in China private firms are being discriminated against, and that they are less equal to obtain loans and receive smaller loans than SOEs from state-owned banks. Cull et al. (Cull & XU, 2005) show that SOEs continue to receive a disproportionately large share of credit extended by the state owned banks, although their statistical evidence is thin. Ruan et al. (2013) find that state-owned listed companies have more access to state-owned bank loans compared to their private counterparts. Firth et al. (Firth et al., 2008) and Firth et al. (2009) show that the state-owned banks not only take firm-specific economic and financial factors into account but also politically motivated factors and state-ownership of firms. Lastly, Ruan et al. (2013) use a dataset on the loans of the four large state-owned banks to show that for SOEs it is much easier to receive loans from these banks than it is for POEs.

Despite the development and structural changes in the banking sector policy lending also remains to be an important source of funding in China’s financial system. Cull et al. (2003, p. 539; 2003) define policy loans as “loans from the central bank to financial institutions that are used to finance specific projects identified by the State Planning Commission”. In 1985 one-third of total loans outstanding were policy loans, but this number has declined in the last few years (Cull & Xu, 2003). Most of these policy loans pass trough special departments of the four large state-owned banks. Ruan et al. (2013) show that SOEs receive significantly more policy loans than POEs , showing that even between 2002 and 2009 these policy banks are active and lending to SOEs.

This section has shown that the high household and corporate savings rate have fueled the banking sector to become the most important part of China’s financial

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markets. Despite the fast evolution in the last thirty years the sector is still under-developed. This led to one of the highest levels of non-performing loans in the world, which poses a serious problem for the future. If the financial sector is not professionalized in the near future this might seriously hammer growth in the next decades. One step in the right direction is the growth of the two national stock markets that are described in the next section.

2.2.3 Stock markets

China has two mainland stock exchanges. Both the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE) were established in the 1990’s. Many scholars see this as an example of the professionalization of the financial markets in China (Allen et al., 2007). Still, the scale and the importance of finance from this source is still not comparable to other channels of finance when looked at from an macro-level (Ruan & Xiang, 2013). The two stock markets on China’s mainland, with their combined market capitalization, rank eleventh on the largest stock exchanges of the world, while the Hong Kong stock exchange ranks tenth (Allen et al., 2007). These figures are also heavily distorted by the large amount of non-tradable shares that add to the total market capitalization of the stock markets but do not lead to liquidity. Allen et al. (Allen et al., 2005, p. 73; 2005) show that China’s stock markets “are not efficient and that prices and investor behavior do not reflect fundamental values of listed firms”. Still, many of the companies that are active in outbound M&A are listed on China’s stock markets. In this section a closer look is taken at how the two stock markets function, what kind of enterprises are listed in China and how being listed is related to growth en performance.

From the establishment of the two stock exchanges in 1990 until the reforms in 2005, firms that were listed on China’s two stock exchanges issued two different types of shares: tradable shares and non-tradable shares. The non-tradable shares were mostly held by the state or government, while a smaller part was held by other legal entities like or firms or organizations (Allen et al., 2005). These shares originated from the privatization process in which firms were converted into a limited liability corporation while the government held a large part of the shares. The tradable shares were newly issued shares as part of the corporization process. The tradable shares were either A-shares that were sold to Chinese investors, or B-shares that were sold to foreign investors. Firms that are listed on the Hong Kong exchange, the “Red Chip” companies, issued H-shares that could be held by anyone. Many researchers show that nontradable shares constituted the largest part of all the shares of these stock

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exchanges with a percentage circling around 65% in the last few years (Allen et al., 2005; 2007). Between 50% and 55% of these nontradable shares were held by the state, while legal entities or employees held the rest. Around 75% to 80% of the tradable shares (35% of total shares) were A-shares issued to Chinese investors. When the legal entity shares are traced back to their final owners it becomes clear that the central government was the dominant owner of 60% of the listed firms (Allen et al., 2007). In 2005 the government took a second step in the privatization process of Chinese listed firms by reforming the spilt share structure so that all non-tradable shares would be converted to tradable shares. In 2008 97% of the firms had completed this reform (K. Li, Wang, Cheung, & Jiang, 2011). Although the share structure of the Chinese stock markets was reformed during this period, the ownership often did not change. Because of that the state has remained the largest shareholder (H. Li et al., 2008).

Most research on the listed sector in China shows that stock markets in China are among the least efficient financial markets in the world. One indicator of this inefficiency is that in 2003 only about one-third of the listed firms were marginally profitable, another third barely broke even while the remaining one-third were constant loss-makers (Bai, Liu, Lu, Song, & Zhang, 2004). This is surprising when one takes in mind that the Chinese economy is one of the fastest growing economies in the world. Morck et al. (2000) and Lou (2012) show that China’s stock prices are synchronous, e.g. that they move up and down together. This means that the performance of many Chinese firms can only be attributed to the growth of China’s economy at a whole and not to individual company performance. Another indicator of the inefficiency of China’s stock markets is that the leverage of listed firms is much higher compared to listed firms in other countries (Allen et al., 2005). Apparently listed firms choose to take on more debt instead of selling equity, even though corporate finance theory suggests that selling equity would be preferable for these listed firms.

There are three reasons for the inefficiency in raising capital for Chinese firms on the stock markets. First of all corporate governance is limited and weak in the listed sector (Allen et al., 2005; Bai et al., 2004). The members of the boards are often not elected by the shareholders but by the firm’s parent companies and the government. As a result many of the supervisors are government officials that have limited incentives for performance (Allen et al., 2007). External corporate governance mechanisms are also weak because the government is both the regulator of the stock exchanges and the dominant owner of a large part of the listed firms. A second

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problem of the stock exchanges originates in the fact that a large part of the shares are concentrated at one large owner, the Chinese government. Bai et al. (2004, p. 603; 2004) show that ownership concentration leads to tunneling, e.g. “the transfer of resources out of firms for the benefits of controlling shareholders”. A third problem is that the non-controlling shareholders have limited influence and protection because of the underdeveloped legal systems in the country (Allen et al., 2007). A result is that there are not so many institutional investors in China as it is more attractive to invest in the Hong Kong exchange.

Because of these problems the money raised through the stock exchanges is very small compared to the total size of the economy. While in most other economies the stock markets function as a efficient mediator between funds and investments, Ayyagari et al (2010, p. 3053; 2010) show that the Chinese equity markets are “largely a vehicle for privatization by the government rather than a market for capital raising by firms with growth opportunities”. Because of the privatization process these firms are now partly owned by private investors, while the government, despite the reforms, still owns the majority of the shares in many cases. These two different types of ownership lead to differences in company objectives and motivations that decrease the efficiency of these firms. Another problem is that for a long time there were not many listed firms that originated in the private or hybrid sector. While it was always legally possible for these firms to become listed the process of becoming publicly traded was very long and bureaucratic so that many firms choose to become listed elsewhere (Allen et al., 2005). Since the reforms in 2005 this process has become much easier and the percentage of private firms has grown.

In summary it can be seen that, although the reforms and changes have improved many things, the Chinese mainland stock exchanges are not the most efficient in allocating resources to support the growth of firms. This can be attributed to the weak internal and external corporate governance mechanisms of the listed sector, a strong concentration of shares at one owner, an abundance of former SOEs and a lack of firms from the hybrid and private sector

2.2.4 Capital structure of Chinese firms

Now that the institutional environment and the two main official channels of capital of China have been discussed in the previous two sections, this section will take a closer at the capital structure of Chinese firms. It can be expected that the unordinary environment in which these firms operate will influence their capital structure. This can be best seen in the large financing differences between SOEs and POEs. In order

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to better understand these differences the next section will discuss general finance theory and the theory on capital structures of firms.

Modigliani and Miller (1958), the founders of modern finance theory, demonstrated that in perfect capital markets a firm’s financing decision between debt and equity does not affect the value of a firm or investment. In other words: finance and capital structure doesn’t matter in investment decisions, as long as the cost of capital reflects the risk associated with the investment. Of course, many researchers were quick to show that in reality perfect capital markets don’t exist, and that imperfections like tax and financial distress influence the capital choices of firms. Two strands of research have tried to connect Modigliani and Miller’s model to the theory of the firm: the pecking order theory and the trade-off theory.

The pecking order theory demonstrates that financing decisions are influenced by information asymmetries between managers and investors (Myers & Majluf, 1984). Because managers have the best knowledge of the firm and investments they can make well-informed decisions about the risk and rewards of an investment. Outside investors cannot adequately inform themselves about the risk of a firm or project, and thus they will always require a premium on the return of the investment. This premium becomes higher as the distance between the firm and the source of finance, and by that the risk, becomes larger. Equity financing also requires a higher premium than debt because debt takes precedence over equity in terms of repayment. Managers therefore have a pecking order of preferences on how to finance new investments, which follows the cost of capital for the firm: first comes internal funds with a low cost of capital, followed by low-risk debt which has a medium cost of capital and lastly riskier external equity which has the highest cost of capital. As a result there is, according to this theory, no optimal capital structure or target-debt ratio, as managers purely make their financing choices based on the costs of capital and the pecking order (J. Chen & Strange, 2005; G. Huang & Song, 2006).

Trade-off theory, on the other hand, demonstrates that an optimal capital

structure does exist. It was Modigliani and Miller (1963) themselves that added the effects of two imperfections in the capital market to their theory of capital structure: the role of tax and financial distress. Both these factors are linked to debt and combined they form a trade-off between the benefits of a tax shield of debt on the one hand and the financial distress costs of debt on the other. Because the interest payments of debt are tax-deductible they add value to the firm. A firm should therefore maximize its leverage, as long the tax shield of debt is not higher than the profit of the company. But this poses a risk for the company: when the debt-levels of a

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firm become too high the risk of defaulting on the debt increases, adding bankruptcy costs to the company. A firm should therefore find a balance in this trade-off between the upside and the downside of debt. This leads to an optimal capital structure for every individual firm based on the performance, size and asset-structure of the firm (J. Chen & Strange, 2005; G. Huang & Song, 2006). More imperfections were later added to the trade-off theory based on agency theory and corporate control (J. Chen & Strange, 2005). The most important aspect of these additions for this thesis is that changing the capital structure changes the allocation of power between different parties: between the managers and the equity holders, or between the debt holders and equity holders.

Since the introduction of both theories many researchers have tried to test which theory has more explanation power for firms’ financing decisions. Unfortunately, the question to that answer to this question is not clear, as both theories seem to be able to offer similar predictions of a firm’s capital structure that only differ in the strength of the predictions (J. Chen & Strange, 2005). Therefore, most research on capital structure use both theories to help them explain how different factors affect capital structure. The next section will discuss whether the two theories are applicable to the Chinese situation and how they explain the capital structures of firms.

Chen et al. (2005) were one of the firsts to use a large sample of listed companies to test whether the mainstream finance theories were applicable to China. They found that the profitability of a Chinese firm is the best (negative) predictor of the height of its’ debt. This is in line with the pecking order theory that states that profitable firms use more internal funds than debt, and with the results of various studies around the world. What is surprising though is that they found that business risk in China is positively related to debt. This is different from other stock exchanges, but can be explained by the idea that state-owned banks lend money based on political motives instead of profit motives. Contrary to the research on discrimination by state-owned banks they could not find any proof for SOEs receiving more loans, although they do show that the length of being listed is positively related to debt. Because the earliest listed enterprise were all state owned enterprises this might either show a problem in the authors’ variable definition or that the political connectedness is not easily measured along formal lines. Huang & Song (2006) used a dataset with market and accounting data from 1994 to 2003 and found that Chinese firms follow capital structure theory and that state ownership has no significant impact on capital structure. But while they have nine years of data their analysis is only cross-sectional,

Capital for Chinese expansion : the effectof China’s capital market distortions on Chinese outbound mergers and acquisitions.