How To Model The Relationship Between Earnings And Capital Investment In A Business

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1 Eurasian Economic Review, 1(2), 2011, CAPITAL INVESTMENT, EARNINGS, AND ANNUAL STOCK RETURNS: CAUSALITY RELATIONSHIPS IN CHINA Ahmet Can Inci * Abstract: The Granger-causality effects between earnings, cash flow, and capital investment as well as on subsequent annual stock returns are examined for China in an international framework. Overall, there is a Granger causality relationship from earnings to capital investment. Furthermore, there is strong causality in the reverse direction as well. Capital investment causes positive subsequent stock returns while earnings have a more direct and contemporaneous impact on stock prices. Regulatory mechanisms, managerial monitoring, state capitalism controls work best during expansions and non-crisis periods. The causality relationships diminish during recessions and crisis periods, such as the Asian Crisis. The results observed in China are different from the results for G7 countries, or the results for other non-g7 countries. Using cash flows instead of earnings confirms the conclusions. Insider ownership is not necessarily as effective as other control mechanisms in China. Keywords: China, Earnings, Capital Investment, Annual Stock Returns JEL Classification: G30, G31, G34 1. Introduction China s economy has changed from a centrally planned economy, which was introduced in 1949, to a market orientated economy since 1978 and it is currently one of the most important participants in the global economy. China s economy is growing at an annualized rate of 9-10 percent while the US economy is growing at 3-5 percent on average. Even though the stock market in China is relatively new (in existence since the early 1990s) and has a total market capitalization of less than $2 trillion, the prospects for growth and profits cannot be overstated. The development of China s stock market has been healthy due to the improved legal environment, regulation, and supervision of capital markets. Efforts to further develop and expand on the reforms have resulted in major shifts in 2006, where for example, foreigners have more freedom to invest in Chinese stocks. Managers in China as well as elsewhere are supposed to make investment decisions to maximize the firm value. The dynamic relation between earnings and capital investment can be utilized to draw implications with regard to these managerial investment decisions. If capital * Bryant University, College of Business, USA. ainci@bryant.edu I would like to thank Josh Coval, Bong Soo Lee, Kongli Liu, Shinichi Sakata, Nejat Seyhun, Jungwon Suh, Hong Yang, and seminar participants at Bryant University, Eurasian Business and Economics Society 2011 Conference - Istanbul and the 2011 Multinational Finance Society Conference for their suggestions and comments.

2 investment leads to positive earnings, this would be indicative of good managerial skills and effective monitoring mechanisms which mitigate the principal-agent problem. On the other hand, if earnings lead to capital investment, that would imply the higher pecking order of internal funding as opposed to external funding in financing investment projects. The relationship between earnings and capital investment has been examined around the world with mixed conclusions. In this study, this issue is investigated in the context of the dynamic Chinese economy. Using firmlevel data, Granger causality is employed to determine how earnings influence capital investment and how capital investment influences earnings. The dynamic linkage may depend on corporate governance mechanisms. For example, Xu et al. (2011) document various unique corporate governance tools in China, such as the regional tax enforcement by the state government, which leads to unique outcomes in China. I find that earnings Granger-cause capital investment and that the net (cumulative) effect of earnings on subsequent investments is positive. Earnings to capital investment causality is consistent with Kung et al. (2010) who find that companies with state and concentrated ownership structures are more likely to depend on private communication to reduce information asymmetry and to resolve agency problems internally, thereby creating a low demand for earnings conservatism. I also find that capital investment leads to significant positive earnings. The Granger causality indicates that corporate managers in China, with tough and strong corporate governance or monitoring mechanisms, tend to make better capital investment decisions. The results change with business cycles, recessions / expansions, and up / down markets. The Granger-causality diminishes during recession times in both directions. This is consistent with Chen et al. (2011) and Wang and Di Iorio (2007), who also find evidence of structural differences in Chinese stock returns during up- and down-markets. The Granger-causality relations of earnings and of capital investment on stock returns are also investigated. With time varying discount rates, earnings should positively co-vary with current stock returns and negatively co-vary with future stock returns (Lamont, 2000). Indeed, there is a strong contemporaneous relationship between earnings and stock returns. Subsequent returns are negative as a result of the immediate increase in the discount rate. One interpretation may be the evidence of efficiency in the Chinese Stock Market, although Ma (2004) provides contradictory evidence to this interpretation. A more likely explanation to the results is that the regulatory systems and corporate governance seem to work well. 1 Capital investment leads to significant and positive subsequent stock returns. Given that the outcome of capital investments is unclear in general, stock price reaction is not immediate. However, the 1 China Securities Regulatory Commission (CSRC) was established in Securities Laws were set up and updated during with further adjustments in 1994 and Green (2004) provides a detailed account of the evolution of the regulatory mechanisms for the Chinese Stock Market. 96

3 positive subsequent reaction is indicative of good quality capital investment projects in China. Insider ownership does not seem to be a very important corporate governance mechanism. The results are not dramatically different for firms with high insider ownership versus for firms with low insider ownership. Lin et al. (2009) use bank ownership as a proxy for ownership in Chinese firms and also find that higher bank ownership does not necessarily indicate higher efficiency or the reduction of the principal-agent problem. The results are robust to the use of cash flow from operations or the use of cash flow from investments instead of earnings. Introducing year dummies as additional explanatory variables makes little difference. Using changes in earnings and changes in capital investment instead of level values does not alter the conclusions either. The rest of the paper is organized as follows. The theoretical model is presented next. Section 3 describes the data. Section 4 presents the empirical methodology and Section 5 discusses the empirical results. Conclusion follows. 2. Theoretical Framework The dynamic causal relation between earnings and capital investment is related to several areas of the literature in finance in a general context and in the specific Chinese context. The direction and strength of the causality between earnings and capital investment may be affected by corporate governance environments and by the maturity of financial markets. A simple comprehensive theoretical model is developed here for the testable empirical hypotheses. The investment decision problem of the firm can be modeled as a present value problem in continuous time (similar results can be obtained using a discrete time version): t [ w1 ( s ) rint ( s ) w2 max ( ) ( s ) rext ( s )] PV C CF s e ds g,,,, (1) s0 where the integral is the continuous time expression of the present value of future cash flows (CF) discounted using the weighted average cost of capital, which is a combination of internal and external costs of financing denoted by r int (s) and r ext (s), respectively. Similar models have been proposed by Sannikov (2008) and Martins-da-Rocha and Riedel (2010), among others. C denotes the initial capital investment. To reflect the higher cost associated with external financing, the external cost is modeled as int r ( s) r ( s) f,,, r ( s), (2) ext int where f( ) is the risk premium function with as the external financing risk, as the financing constraint and financial non-development, γ as the scarcity of insider ownership, and ζ as the deficiency of monitoring mechanisms and legal environment. These parameters make it more costly 97

4 for the firm to get external financing, and thus make it more difficult for the firm to finance a project. The risk premium expression has the standard functional properties with f / x i > 0, 2 f / x 2 i < 0, and the initial condition that f ( ) 0 0 for x i = α, β, γ, and ζ, respectively. The expression x i g(,,, ) is a quality function, where represents managerial quality, υ the corporate governance mechanism, μ the shareholder protection, and the level of financial development following DeMarzo and Fishman (2007). 2 I examine the dynamic causal relation between earnings and capital investment with testable hypotheses based on the choice of external or internal financing alternatives (i.e., the risk premium f( )), and based on the quality function g( ) determined by the ability of managers, maturity of financial markets, and the legal system. The first hypothesis is that according to the free cash flow theory of Jensen et al. (1992), managers have incentives to grow their firms beyond optimal size because growth increases the amount of resources under their control. In weak corporate governance environments, firms with large earnings may be more likely to engage in many investment projects that benefit managers or controlling stakeholders privately but that are not in shareholders best interests. 3 Thus, in weak corporate governance environments, capital investment will display relatively high sensitivity to earnings. This corresponds to a higher deficiency in monitoring, ζ, in (2), leading to a higher external financing cost and making internal financing more attractive. The general legal system of a country may also be a factor. Li and Filer (2007) study the mode of investment and governance environment and find that in countries with poor rule of law, investors prefer foreign direct investment to indirect (portfolio) investment. Therefore, their study also implies that the earnings-capital investment relation is positive and stronger in countries with weak legal protection. The second hypothesis is that the causal relation from earnings to capital investment may be stronger for firms with financial constraints. Based on the pecking order theory, Fazzari et al. (1988) argue that capital investment is more sensitive to internal funds such as earnings, if these firms are financially constrained. Many empirical studies tend to use the sensitivity of capital investment to the availability of internal funds as a measure of financial constraints (see, for example, Fee et al., 2009). These studies suggest that the causality from earnings/cash flow to investment may reflect the relative difficulty of raising external funds. Firms in countries without financially developed markets will have higher financing constraint 2 The characteristics of the quality function are g/y i>0 and 2 g/y i 2 <0, and the initial condition that g( ) 0 0 for y i = δ, υ, μ, and, respectively. y i 3 Investors may be worried that managers might waste funds through unprofitable projects in weak governance firms. Thus, investors may prefer to keep the cash flows under their own control when it comes to investing in weak governance countries. This notion is supported in a recent study by Li and Filer (2007). They document that countries with poor corporate governance attract larger direct investment as opposed to portfolio investment. 98

5 () values in (2), and therefore, a higher external risk premium, making it difficult to raise external funds. Finally, if internal financing represented by earnings does not affect capital investment, this implies that other means of external financing are available and are less costly, i.e., the risk premium function, f( ), in (2) is immaterial. That is, external financing risk, financing constraints, and financial non-development are negligible. High insider ownership and effective monitoring mechanisms prevent managers from misusing earnings for unproductive capital investment projects. These causality relationships will be examined for China and for developed country firms. If earnings Granger cause capital investment in both China and developed countries, this would support that free cash flow is common everywhere and that internal financing is cheaper regardless of financial development. A reverse causal relation from investment to earnings is also related to several areas in finance. Law and finance studies such as La Porta et al. (2003) argue that shareholder protection is strong in common law countries compared to civil law countries. Firms in common law countries will display a stronger and positive causality from investment to earnings. Moreover, the causality will be more pronounced in countries with better regulatory mechanisms, manager monitoring systems, and more talented managers who can pick profitable investments leading to positive earnings. Finally, in a country with abundant profitable projects like China, causality from capital investment to earnings should be strong. If investments do not lead to earnings, a causal relation from capital investment to earnings does not follow. This can be due to low managerial quality and Jensen s empire building hypothesis, lack of corporate governance mechanisms, lack of shareholder protection, or lack of financial development in the country. 3. Data and Issues The data in the study are from the FactSet database, formerly Worldscope. Annual earnings, capital investment, cash flow, cash flow from investments, and annual stock returns of individual firms from China and 39 other countries from 1990 to 2005 are used. When a firm-year observation has a missing value in any of these variables, the observation is removed from the sample construction procedure. The explanatory variables are normalized with assets. Taking ratios of the variables with assets achieves stationarity, eliminates the need to use co-integration and the need to normalize the variables using inflation rates, and finally, takes care of the potential size effect of firms. When the samples are created for each country, firm data are stacked similar to panel data analysis following Vuolteenaho (2002). Furthermore, the data are winsorized following Cleary (1999) in order to deal with extreme observations and possible misreports. 4 Because 4 For each firm, the data of a variable are arranged as a column; each row representing the 99

6 observations from different firms and years in China are stacked, one potential complication is year effects. To control for possible business cycle effects, dummy variables for each year are introduced as additional explanatory variables. Further tests are conducted based on fixed effects regressions with year dummies. The relationship between returns and earnings and capital investment may be different due to the legal system. For example, La Porta et al. (2003) argue that corporate ownership concentration varies in countries. High corporate ownership may be a result of corporate insiders responding to poor shareholder rights in the country. Investor protection is strong in common-law countries relative to civil-law countries. 5 Thus one can conjecture that the explanatory power of firm-level factors may be stronger in common-law than in civil-law countries. If investor protection affects managerial performance, then the explanatory power of capital investment and earnings on returns may differ between common-law and civil-law countries. The data from individual countries are classified into civil law and common law countries, G7 and non-g7 countries, financially developed and undeveloped countries according to the classification system designed in Li and Filer (2007). Regressions using these subsamples are conducted to examine the earnings and capital investment causality in subsequent sections. A fundamental preliminary test when using times series data is the unit root test. If a series is non-stationary and therefore has unit roots, then this means a possible relationship with another time series variable may not be a direct relationship but that it may be because of another unrelated factor that is not considered in the study. Generally, the proper course of action is to use first differences, or to normalize the series in some other way, or to conduct co-integrating regressions. In this study, earnings (cash flows from operations, cash flow from investments) and capital investment are normalized to eliminate unit roots. Additionally, the returns data will be shown to have no unit roots. Table 1 reports the augmented Dickey-Fuller unit root tests and other descriptive information for China and the pooled data. None of the pooled sample data or the Chinese data are non-stationary. The variables do not contain unit roots when normalized with assets. The stock return data do not contain unit roots either. value in a particular year. Then three new columns are created representing lags of one to three years. This process is repeated for each firm. As a result, the first column has the original data of the firms stacked on top of each other. The second column is the first lag, the third column is the second lag, and the fourth column is the third lag. The observations of the first column are ranked from highest to lowest. The top (bottom) 1 percent of the values are redefined to be equal to the value just below (above) them. This is winsorization at 1%, since 1% of the largest and smallest values are updated. This eliminates extreme observations and helps obtain streamlined results. 5 A civil law country is one with commercial law based on the French, German, or Scandinavian Commercial Code. A common law country is one with commercial law based on the English Common Law. These classifications are presented in La Porta et al. (2003) and Dittmar et al. (2003). 100

7 Table 1. Descriptive Data on Each Country with Unit Root Tests Country Nobs Mean Statistics As Percentage of Assets E C CF CFI China 2095 %1.8 %5.8 %5.6 %6.0 G %1.8 %4.9 %4.2 %6.6 non-g %1.7 %4.7 %6.4 %5.2 Civil Law %1.3 %4.7 %5.5 %5.1 Com.Law %1.9 %4.9 %3.5 %6.7 Country Nobs Unit Root Tests Fin.Dev.Ind. E C R CF CFI Li and Filer China G non-g Civil Law Com.Law Notes: E (Earnings), C (Capital investment), CF (Cash flow), and CFI (Cash flow directly from investment activities) are all normalized by A, Assets of the firm corresponding to the same year and country. R is the return in that year. The null hypothesis is H 0: ρ = 0 (non-stationarity). The rule is to reject the null if ρ > Critical value. Critical values -2.60, -2.93, and for 10%, 5%, and 1% significance, respectively (Fuller, 1996). The Dickey-Fuller regression is of the form Δx t = α + ρx t-1 + γ 1Δx t-1 + γ 2Δx t-2 + γ 3Δx t-3, for R, E, C, CF, and CFI, respectively. The lag order is determined by the Akaike information criterion. Financial development index values are from Li and Filer (2007). The index measures the level of development of the financial system in a country. The averages are reported for pooled countries. 4. Empirical Methodology Granger-causality tests between earnings and capital investments of Chinese firms are carried out in the empirical tests. Furthermore, Grangercausality tests between Chinese company stock returns and earnings and between stock returns and capital investments are carried out rather than the usual regressions. The purpose was to see the impact of earnings (capital investment) on the dependent variable independently. Another goal was to see the impact of earnings (capital investment) on the stock return independently and to avoid potential multicollinearity complications. Two sets of null hypotheses are conducted for the independent variables: Hypothesis 1: Lagged coefficient are jointly zero (causality test), and Hypothesis 2: Sum of lagged coefficients is zero (net cumulative effect test). If all the lag coefficients of earnings (capital investment) are jointly zero in explaining stock returns or capital investment (earnings), then there is no causality effect from earnings (capital investment) to stock returns or capital investment (earnings) according to first hypothesis. If the sum of the lag coefficients of earnings (capital investment) is statistically zero, then the cumulative effect of earnings (capital investment) on annual returns or 101

8 capital investment (earnings) is statistically insignificant in China according to second hypothesis Earnings and Capital Investment in China To test the hypothesis from earnings to capital investment described in the theoretical development, the following regression model is used: i3 j3 C t c i, c Et i j, cct j c, t, (3) i1 j1 where C t is capital investment in year t divided by total assets in year t, and E t is earnings in year t divided by total assets in year t. Considering both the Akaike information criterion (AIC) and the Schwarz information criterion (SIC), three lags of the explanatory variables are included in the regressions throughout the analyses. Based on the above discussion, the causal relation from earnings to capital investment is tested with: Hypothesis 1: If internal financing is a significant constraint for capital investment, earnings Granger-cause capital investment. If earnings Granger-cause capital investment, each coefficient of lagged earnings in (3) is jointly different from zero (i.e., i, c 0, for i = 1, 2, and 3). In the theoretical model, this corroborates r ext ( ) > r int ( ), where managers use internal funds for investment opportunities. Hypothesis 2: When internal financing is a significant constraint for capital investment, the net (cumulative) effect of earnings on capital investment, which is measured by the sum of the coefficients of lagged i 3 earnings, is positive (i.e., i,c > 0). A stronger causality from earnings to i1 investment is anticipated in weak corporate governance countries (and/or in financially undeveloped countries), since external financing is not easily available in these countries. In the theoretical models (1) - (2), this corresponds to comparable costs of financing, r ext ( ) r int ( ), or f( )0 in countries with mature financial markets; and to r ext ( )>>r int ( ), or f( )>>0 in countries without established financial markets. But if little difference is found in the causality results between countries with different legal systems or financial markets, this would imply that the pecking order theory dominates alternative explanations and that external financing would be prohibitively costly whether it is available or not. From capital investment to earnings, the following regression model is used: i3 j3 Et e i,e Eti j,ect j e,t, (4) i1 j1 where lagged values of capital investments are explanatory variables along with lagged earnings, all normalized by the total assets of the matching year. 102

9 Hypothesis 3: If capital investment leads earnings, then capital investment Granger-causes earnings, and each coefficient of lagged capital investments in (4) is jointly different from zero (i.e., 0, for j = 1, 2, and 3). Hypothesis 4: When capital investment leads earnings, the net (cumulative) effect of capital investment on earnings measured by the sum j of the coefficients of lagged capital investments is positive (i.e., 3 j,e > j1 0). Stronger causality from capital investment to earnings in countries with strong corporate governance is anticipated (i.e., higher ) as suggested by La Porta et al. (2003) and Wurgler (2000). In such countries, corporate governance rules are well established (i.e., higher υ), along with state (in the case of China) or independent monitoring and auditing agencies (i.e., higher μ). Therefore, managers are under close scrutiny to make good capital investment decisions, which would lead to positive earnings Returns vs. Earnings, Capital Investment (and Past Returns) The impact of earnings and capital investment on annual stock returns is examined with two different regression systems. The first uses past earnings and past capital investment j, e i3 j3 R t r i, r Et i j, rct j r, t i1 j1, (5) where C t is formally defined as capital investment in year t divided by total assets in year t, and E t stands for earnings in year t divided by total assets in year t, with three lagged earnings and three lagged capital investment variables to explain subsequent returns. Because observations from different firms and years are stacked, one potential complication is year effects. To control for possible business cycle effects, dummy variables are introduced as additional explanatory variables. This fixed effects regression is i3 j3 R t r i, r Et i j, rct j D D1994 r2, t i1 j1 (6) where D i is 1 if the observation is in year i and 0 if the observation is not in year i. The second regression system uses past returns, earnings, and capital investment to explain future returns as i3 j3 k 3 R t r i, r Et i j, rct j k, r Rtk r, t i1 j1 k 1 (7) where R t stands for the return in year t. To control for possible business 103

10 cycle effects, dummy variables are introduced for each year as additional explanatory variables. This fixed effects regression is R t r i3 i1 j3 k3 i, re C R D... D t i j, r t j k, r tk r1, t (8) j1 k1 Causality of the earnings and capital investment on stock returns is formally tested with two hypotheses: Hypothesis 5: Earnings do not Granger-cause stock returns. If each coefficient of earnings lags are not all jointly zero statistically, then the hypothesis is rejected, which means earnings influence future dividends which in turn influence contemporary and subsequent stock returns. Therefore, earnings Granger-cause subsequent stock returns. Hypothesis 6: The net cumulative effect of earnings on subsequent stock returns is not significantly nonzero. If the sum of the coefficients of earnings lags is not statistically zero in explaining future stock returns, then the hypothesis is rejected and earnings increase leads to future returns. 6 In a similar manner, causality of the capital investment on stock returns is formally tested with two hypotheses: Hypothesis 7: Capital investment does not Granger-cause future stock returns. If each coefficient of capital investment lags are not all jointly zero statistically, then the hypothesis is rejected: Capital investment influences future earnings and indirectly future dividends; which in turn influence returns. Therefore, capital investment Granger-causes returns. Hypothesis 8: The net cumulative effect of capital investment on stock returns is not significantly nonzero. If the sum of the coefficients of capital investment lags is not statistically equal to zero in explaining returns, then the hypothesis is rejected and an increase in capital investment leads to stock returns. This indicates good managerial choices and abundance of profitable projects Financial Development and Earnings vs. Capital Investment Another perspective on the information content of the earnings-capital investment relation is the level of financial development of a country. Several indicators have been developed to measure the level of financial development in a country such as that by Khurana et al. (2006). In this paper, a more recent governance environment index from Li and Filer (2007) is used, which considers political rights, rule of law, free press, 6 The sign of the cumulative impact is conjectured from previous research. According to Lamont (2000), high earnings increase contemporaneous returns. This leads to high discount rates induced by high expectations for future cash flows. This in turn leads to negative subsequent stock returns with the mean reversion in stock price movements in equilibrium. While Kerstein and Kim (1995) empirically document that capital investment independently affects future stock returns; Titman et al. (2004) specifically present that capital investment leads to negative subsequent returns in the US. I investigate if this is prevalent in other countries, or in China. 104

11 quality of accounting standards, and the level of general trust. China, according to this classification index is considered to be a financially developing country. A higher value of the financial development index indicates that the financial structure relies more on market-oriented financing and financial intermediaries in the country. Table 1 reports the financial development index averages for each pooled data. are divided into financially developed and financially developing groups using the median value of the index from Li and Filer (2007). The causality relations between earnings and capital investment for financially developed countries and financially developing countries are examined. The earnings-capital expense relationship in financially developing China is compared to other financially developing countries, and also to countries with fully developed financial markets Business Cycles and China The causal relation between earnings and capital investment in China may be affected by the business cycles. If earnings-to-capital investment causality is weak during expansions, this may be because of easy access to external capital. On the other hand, if causality is strong, this may indicate that the pecking order in financing continues to work. Another explanation may be Jensen s free cash flow hypothesis of empire building by managers. If Granger causality from capital investment to earnings is weak, that may be because managers may become overconfident during expansions (Malmendier and Tate, 2005) and may not necessarily analyze their investment decisions carefully ex-ante because of the availability of many projects and ample financing alternatives. Managerial decisions may not be scrutinized by monitoring mechanisms and corporate governance tools since the firm is already operating profitably. Empirical results below will support this conjecture for countries other than China. Rejection of this conjecture would imply either high quality managers or efficient corporate governance mechanisms. The third possibility is wide availability of profitable projects during expansions. This is what the empirical tests will suggest for China. During recessions, lack of investment opportunities may diminish causality relationships from earnings to capital investment and from capital investment to earnings. Managerial decisions are much more crucial because bad decisions could very well lead to the demise of the firm. The overwhelming scrutiny may prevent managers from making any investments and thus may break down any potential causality The above discussion is summarized with two hypotheses: Hypothesis 9: During recessions, earnings do not Granger-cause capital investment and the cumulative effect of earnings is not significant because of lack of capital investment projects. Suffocating regulatory oversight prevents managers from making any investment decisions even 105

12 when earnings are available. However, during expansions, the abundance of good investment projects leads managers to use earnings as their first financing resort. Hypothesis 10: During recessions, capital investment does not Granger-cause earnings because of lack of good projects which would lead to positive earnings. The causality is stronger during expansions and the cumulative effect is positive because corporate governance and monitoring mechanisms may be fully enforced nudging managers to select investments that would lead to positive earnings. To examine the effect of business cycles on the earnings-capital investment causality relations, three tests are conducted: (1) Dummy variables for each year are used as additional explanatory variables in the following empirical models, C E t t c e i3 i1 i3 i1 i,c i,e E E j 3 C D... D t i j,c t j j1 j 3 C D... D t i j,e t j j1 c,t e,t (9), (10) where D i is 1 if the observation is in year i and 0 if the observation is not in year i. (2) A business cycle dummy is introduced into the regression model instead of year dummies. Observations for recession years 1990 through 1992 and 2001 through 2003 in the entire pooled sample are assigned D rec =1 as an additional variable. The rest of the observations are assigned D rec =0. 7 (3) The entire pooled sample is separated into the recession sub-sample, which includes observations for the years 1990 through 1992 and 2001 through 2003, and the expansion sub-sample, which includes the rest of the observations Asian Crisis and China An important event that has had a large impact on the Asia-Pacific region is the Asian Crisis. The effect of the crisis on the earnings investment causality in China and in the region is examined. Using the causality models in equations (1) and (2), the sample period is divided into subsamples. The first sub-sample covers the non-crisis periods from 1988 through 1996 and from 2000 to The second sub-sample represents 7 NBER (2010) defines 1990 and 2001 as business cycle recessions for the US. Since the US is the largest economy in the world, its economic conditions may have a ripple effect on other economies. China and the US have close trade relationships. Furthermore, Wang and Wang (2010) find evidence of volatility and recession/expansion spillovers from the US to China. Therefore, even though the business cycles in the two countries may not necessarily match, 1990 through 1992 and 2001 through 2003 are chosen as the two potential recession periods in this study, considering the potential negative impact of a slowdown in the US on China. Wider recession periods are used in order to take into account the lag time in the ripple effects. Alternative recession periods lead to similar overall findings. 106

13 the Asian crisis from 1997 through The results of the earnings investment relationship are reported and discussed for both sub-samples Robustness: Cash Flow vs. Capital Investment in China For robustness, earnings are replaced by cash flow from operations. One can make the argument that actual cash flows are more relevant for a company than earnings. Accounting rules vary across countries; therefore, cash flows from operations may be more appropriate. Fazzari et al. (1988) argue that firms facing financial constraints will rely more on internal funds and thus will display higher investment sensitivity to cash flows. Fee et al. (2009) find a strong relation between cash flows and intangible investment even for geographically dispersed multinational corporations. On the other hand, evidence from Alti (2003) and Cleary (1999) suggest that capital investment-cash flow sensitivity may not be related to the financial constraints in US firms. Malmendier and Tate (2005) establish a link between cash flows and overconfident managerial investment decisions. I contribute to the literature by looking at the causal relation between capital investment and cash flows in China using the regression models of (1) and (2) by replacing earnings (E t ) with cash flows (CF t ). Cash flow is defined as the sum of net income, depreciation or amortization expense, and change in deferred tax, divided by total assets in year t Robustness: Cash Flow from Investments vs. Capital Investment As further robustness check, cash flow generated specifically from investing activities (CFI) is used instead of earnings to examine the causality relationships. The cash flow from investing activities might more clearly reveal the causality links in Chinese firms and in other firms. In the regression models of (1) and (2), earnings (E t ) are replaced with cash flow from investments divided by total assets in year t (CFI t ). Finally, in addition to the relationships between the levels of cash flow from investment and capital investment, the causality relationships between the changes in these variables are examined. The Granger-causality tests from the change in past investments to the change in cash flow from investments are followed by the investigation of reverse causality using the regression models of (1) and (2) with appropriate replacements Insider Ownership and Corporate Governance in Chinese Firms Agency conflicts can influence the causality between earnings and capital investment. Jensen et al. (1992) suggest that managers allocate resources to activities that benefit themselves at the expense of shareholders best interests. Furthermore, Jensen et al. (1992) point out that managers have an incentive to expand their firms beyond optimal size because growth increases the amount of resources under their control. If the level of agency conflicts is high that is, if managers pursue their own interests rather than 107

14 shareholders interests the earnings-to-capital investment causality can be strongly positive because an increase in earnings (i.e., free cash flows) allows managers to freely engage in investments that will increase the size of the firm. This will be common in firms with lower insider ownership because manager and shareholder interests will not be well aligned. The causality from capital investment to earnings is also related to insider ownership of firm shares. If the level of agency conflicts is high, the capital investment to earnings causality can be weak because managers may be willing to invest in low profitability projects as well as high profitability projects since doing so increases the size of the firm and thus serves managers personal interests. But in higher insider ownership firms, capital investment is expected to lead to positive and significant earnings because agency problems are expected to be less and managers and owners should have similar interests (see, for example, Jensen et al., 1992). The following hypotheses are tested using the sub-samples: Hypothesis 11: If insider ownership, which is part of corporate governance, is low, earnings will Granger-cause capital investment because managers will focus on empire building rather than being selective on good quality investment opportunities. If inside ownership is high, the causality will be weaker. Hypothesis 12: Capital investment will Granger-cause earnings and will have a positive cumulative effect if insider ownership is high. Since manager-shareholder interests are aligned, the projects chosen by the managers will lead to profits and earnings. Therefore, insider ownership again functions as a part of corporate governance. Insider ownership impact on causality relations is examined by splitting the data on Chinese firms based on low, medium, and high ownership levels. If no difference is detected in the causality relationships between low and high ownership samples, this would indicate that insider ownership is not a primary regulatory mechanism in China. Furthermore, the significant causality relationships in both low and high ownership samples would indicate that managers work in the best interest of shareholders regardless of insider ownership. 5. Empirical Results and Discussion 5.1. Earnings Capital Investment Causality in China Table 2 reports the earnings capital investment causality results. For China, the lagged earnings coefficients are significant from Test 1 especially the first lag. Furthermore, Test 2 shows that earnings lead to capital investment in majority of the tests. Earnings increase subsequent capital investment in China. This is consistently the case around the world for G7, non-g7, civil law, and common law countries. In Panel B, causality tests from capital investment to earnings are reported and there is an important difference in the results. For Chinese companies, capital investment leads to significant and positive earnings in the future. This is not the case around the world. Capital investment does not necessarily 108

15 cause future earnings in G7 or in non-g7 countries in general. There is no causality in Common Law countries either. There is some weak evidence of causality in Civil Law countries. China is a Civil Law country but the causality is much more pronounced for Chinese firms compared to other countries. It seems that in China state regulatory mechanisms may be more intense and may force managers to scrutinize for superior investment choices. Thus capital investment leads to higher earnings. The results imply that strict rules and regulations in China serve as effective corporate governance tools. To further examine the net (cumulative) effect in China and in other pooled data, bootstrapping regression tests are conducted by generating 10,000 random samples with replacement. The comparison using the distribution of the sum of the three estimated capital investment coefficients shows that China results and other sample results are different at 1% significance. The net (cumulative) effect is larger in China. 8 8 I conducted similar bootstrapping tests throughout the analyses to complement the regression tests. The bootstrapping tests are consistent with the regression results. I report and discuss the results of the tests, especially when comparing the statistical similarities/differences between sub-samples of data. 109

16 Table 2. Earnings vs. Capital Investment Panel A. Causality from Earnings to Capital Investment Country Int. E t-1 E t-2 E t-3 C t-1 C t-2 C t-3 adjr 2 Test1 Test2 China 0.02 *** 0.09 *** *** 0.06 *** 0.09 *** G *** 0.01 *** 0.00 *** *** 0.11 *** 0.12 *** non-g *** 0.04 *** 0.01 *** *** 0.09 *** 0.09 *** Civil Law 0.01 *** 0.04 *** 0.01 *** -.01 *** 0.43 *** 0.12 *** 0.11 *** Com. Law 0.01 *** 0.01 *** 0.00 *** *** 0.10 *** 0.11 *** Panel B. Causality from Capital Investment to Earnings Country Int. E t-1 E t-2 E t-3 C t-1 C t-2 C t-3 adjr 2 Test1 Test2 China ** 0.40 *** *** G *** 0.48 *** 0.15 *** 0.15 *** * non-g *** 0.13 *** 0.14 *** * Civil Law *** 0.11 *** 0.11 *** * -.03 *** Com. Law -.02 *** 0.48 *** 0.15 *** 0.15 *** * i3 j3 Notes: In Panel A, the regression is: C t c i, cet i j, cct j c, t, where E t is earnings, i1 j1 C t is capital investment. ***, **, * represent 1%, 5%, and 10% significance levels, respectively. Test 1 reports the p-values of the F test (with three degrees of freedom for the numerator) that examines whether all coefficients of lagged earnings are different from zero. Test 2 reports the p-value of the F- test (with 1 degree of freedom for the numerator) for the net (cumulative) effect of earnings on capital investment and examines whether the sum of the three lagged earnings estimates is positive. In Panel B, Test 1 is about whether all coefficients of lagged capital investment estimates are different from zero. Test 2 is the F-test for the net (cumulative) effect of capital investment on earnings and examines whether the sum of the three lagged capital investment estimates is positive. The regression is i 3 j 3 E t e i, e E t i j, e C t j e, t i 1 j Returns vs. Earnings, Capital Investment, and Lagged Returns The causality results of earnings and capital investment on subsequent stock returns are presented in Table 3 and Table 4. In China, there is clear and strong evidence that capital investment leads to strong positive subsequent returns for Chinese companies. This is also the case for G7 countries but the cumulative effect of capital investment on stock returns, though positive, is insignificant. For non-g7, common law and civil law country groups, the causality of capital investment to stock returns is negative and insignificant. The unique positive and significant causality from capital investment to subsequent stock returns in China can be explained in several different ways. Managers of firms in China seem to pick better investment opportunities, and capital investment leads to more profitable outcomes; in other words, managers in China seem to be more talented. Similarly managers of firms in G7 countries also show evidence of talent compared 110

17 to other developing countries. Another interpretation of Chinese capital investment producing positive and significant stock returns is that the corporate governance mechanisms are better established and more efficient in China. State capitalism, coupled with a careful and determined move towards capitalism may have properly established these regulatory mechanisms. The monitoring regulations force managers to make more informed investment decisions. The third, more likely explanation is that there are better investment opportunities in China. Clearly, the explosive growth over the last two decades, huge government outlays in transportation, space, technology, construction, real estate, industrial, and manufacturing sectors indicate that the third explanation is the probable one, although these interpretations are not mutually exclusive. Earnings also have a causality impact on stock returns but the impact seems to be negative. It seems the earnings announcements lead to positive contemporaneous stock price reactions and returns. This leads to an increase in the equity discount rate since expectations for higher stock returns increase for the future. The high discount rates induced by high expectations for future cash flows seem to lead to negative subsequent stock returns as explained in detail in Lamont (2000). In equilibrium there seems to be a mean reversion in stock price movements. The particular causality pattern from earnings to stock returns is an indication of efficiency. This conclusion holds for Panel B results which controls for fixed year effects, and also holds in Table 4 where lagged stock returns are also used as explanatory variables. However, for China, the causality from earnings to subsequent stock returns is negative and insignificant in Panel B of Table 3 and in Table 4. This is different from other countries. Apparently, there is no mean reversion in equilibrium in stock prices. In China the contemporaneous positive reaction to earnings seems to be permanent Financial Development and Earnings Capital Investment Causality A higher value of financial development index indicates that financial systems rely more on financial intermediaries and market-oriented financing. The causality relations between earnings and capital investment for China, for financially developed countries, and for financially developing countries are presented in Table 5. First, there is strong evidence that earnings Granger-cause and increase capital investment. This seems to be the case for China and for other pooled data. The results hold after accounting for fixed year effects as well. 111

18 Table 3. Returns vs. Earnings and Investments Panel A. Returns regressed on Earnings and Investments Country Int. E t-1 E t-2 E t-3 C t-1 C t-2 C t-3 Test1 Test2 Test3 Test4 China 0.23 *** *** G7 non-g ***.04 *** -.22 *** -.04 *** -.62 ***.46 *** 0.17 ** *** ** Civil Law 0.15 *** *** * Com. Law 0.22 *** 0.03 ** -.21 *** * -.59 *** 0.37 *** Panel B. Returns regressed on Earnings and Investments with Year Dummies Country Int. E t-1 E t-2 E t-3 C t-1 C t-2 C t-3 Test1 Test2 Test3 Test4 China * ** G *** 0.03 ** -.20 *** -.04 *** -.54 *** 0.45 *** 0.20 *** non-g *** ** ** Civil Law Com. Law 1.25 *** *** * 0.33 * *** 0.03 ** -.17 *** ** -.46 ***.33 *** i3 j3 Notes: Panel A regression is R t r i, r Et i j, rct j r, t. ***, **, * represent 1%, 5%, i1 j1 and 10% significance, respectively. Panel B regression adds year dummies to the Panel A regression. Test 1 is about each coefficient of earnings lag estimates. The null is that all the coefficients are jointly zero. Test 2 is the F-test for the cumulative impact of earnings on returns. The null hypothesis is that the sum of the three earnings lag estimates is zero. Test 3 is whether the coefficients of capital investment are jointly zero. Test 4 is about whether the cumulative impact of capital investment (the sum of the three coefficients) is zero. P-values are reported for all tests. On the causality from capital investment to earnings in Panel B, we observe interesting results. There is weak evidence of Granger-causality in financially developing countries; and the net (cumulative) effect of capital investment is reduced earnings. This implies that in developing countries, the managers of firms may not be monitored effectively and investment decisions of managers are not always value-increasing. There may not be useful and preventive corporate governance tools. Independent auditors and financial analysts may not have the means to observe managers talents and to force them make good managerial decisions. In financially developed countries, there is no strong evidence for capital investment Granger-causing earnings. However, the net (cumulative) effect is positive. 112

19 Country Int. E t-1 E t-2 E t-3 C t-1 C t-2 C t-3 R t-1 R t-2 R t-3 adjr 2 Test1 Test2 Test3 Test4 A. C. Inci / Eurasian Economic Review, 1(2), 2011, Table 4. Returns vs. Earnings, Investments, and Past Returns Panel A. Returns Regressed on Earnings, Investment, and Past Returns 113 China 0.47 *** *** * 0.07 * -.25 *** -.32 *** G7 non-g7 Civil Law 0.19 *** 0.06 *** -.21 *** -.05 *** -.44 *** 0.51 *** *** -.04 *** -.11 *** *** -.53 *** *** ***.05 *** -.02 *** *** -.52 *** ** 0.27 ** ***.31 ***.05 *** -.02 *** Com. Law 0.27 *** 0.08 *** -.19 *** -.05 *** -.37 *** 0.39 *** ** -.11 *** -.08 *** -.11 *** Panel B. Returns Regressed on Earnings, Investment, and Past Returns with Year Dummies Country Int. E t-1 E t-2 E t-3 C t-1 C t-2 C t-3 R t-1 R t-2 R t-3 adjr 2 Test1 Test2 Test3 Test4 China * 1.01 ** * *** G *** 0.04 *** -.18 *** -.05 *** -.40 *** 0.49 *** *** -.04 *** -.09 *** non-g *** -.43 *** ** * *** 0.06 *** -.02 *** Civil Law 1.14 *** -.48 *** -.29 *** 0.23 ** * *** 0.31 *** 0.06 *** -.03 *** Com. Law 0.39 *** 0.06 *** -.15 *** -.05 *** -.27 *** 0.34 *** * *** -.07 *** -.09 *** i3 j3 k3 The regression in Panel A is R t r i, r Et i j, rct j k, r Rtk r, t. ***, **, * represent 1%, 5%, and 10% significance, respectively. Test 1 is about each i1 j1 k1 coefficient of earnings lag estimates. The null is that all coefficients are equal to zero. Test 2 is the F-test for the cumulative impact of earnings on returns. The null hypothesis is that the sum of the three earnings lag estimates is equal to zero. Test 3 is whether the coefficients of capital investment are jointly equal to zero. Test 4 is about whether the cumulative impact of capital investment (the sum of the three coefficients) is equal to zero. P-values are reported for all tests. In Panel B, the regressions are augmented with year dummies.

20 Although not significant, capital investment leads to increased earnings. In such countries, external financing is easier to access and thus, managers are not faced with stringent financing constraints (Wurgler, 2000). As a result, capital investment may have inconsequential causality impact on earnings. In China, we see a completely different picture. Capital investment leads to significant and positive earnings, which is seen neither in financially developed nor in financially developing countries. Chinese financial markets are not fully developed, but they are growing fast. Moreover, the regulatory mechanisms are well established, enabling proper capital investment on good projects leading to significant and positive earnings. 114