The Relationship between debt and Nontradable Shares in China

This paper investigates the relationship between corporate leverage of Chinese listed firms and the level of non-tradable shares held by the state or state controlled institutions. We document that conflicts of interest arise between holders of nontradable and tradable shares, whereby holders of non-tradable shares focus on the book value of their investment as opposed to the listed market value. The significant level of non-tradable shareholding in the Chinese stock market leads to a reversed pecking order theory whereby equity is preferred before debt. Our findings add a new dimension to the 'twin agency problem' involving the coexistence of the state, corporate insiders and minority investors to explain a firm's capital structure decision. We also find that leverage is positively related with size and asset tangibility and negatively related to non-debt tax shield, supporting the static or trade-off theory of capital structure; leverage is negatively related with profitability as predicted by the pecking order theory; and leverage is negatively related with TOBIN'S Q, providing support for an agency theory of capital structure.