1. Tunneling or Propping: Evidence from Connected Transactions in China By Winnie Peng, K.C. John Wei and Zhishu Yang Presenter: Winnie Peng, HKUST NTUICF, December, 2006

2. 1. Research motivation 2. Hypotheses development 3. Data and methodology 4. Empirical results 5. Conclusion OutlineOutline 1

3. Research Motivation A model in Friedman et al. (2003) The controlling shareholder’s optimal choice: –A moderate adverse shock => Propping –No shock or shock is too small => Tunneling Empirical results of Friedman et al. (2003) –Propping exists during the Asian financial crisis –Issuing debt commits propping easily in pyramid groups This paper provides direct evidence of propping and tunneling, by studying connected transactions in China 2

4. Why China? –Unique ownership structure of Chinese firms Large number of Listed firms are “carve outs” from SOEs => Connected transactions are common (84.6% of listed firms in 1997, 93.2% in 2000) –Unique stock market regulations in China Risk of delisting (ST, PT, *ST) and losing rights to issue new equity => Enable us to differentiate firms in sound financial conditions from poor financial conditions Research Motivation (cont’d) 3

5. Connected transactions in China –A connected transaction is defined as any transaction between a firm (or any of its subsidiaries) and a connected person. A listed firm’s major connected persons include its shareholders, its shareholders’ affiliates and its own affiliates. –CSRC: Connected transactions of a total value greater than RMB1 million (US$121,000) or 0.5% of net assets, whichever is higher, must be reported to the exchange within two working days following the signing of the contract. Research Motivation (cont’d) 4

6. Hypotheses development Tunneling: to extract cash from listed firms, transfer assets from the listed firm to other firms under the same controlling shareholder, buy low/sell high, etc. –Jian and Wong (2003): a group-controlled firm within the raw material industry in China is more likely to use connected transactions to tunnel firm value. –Liu and Lu (2004): earnings management in Chinese listed firms is mainly induced by controlling owner’s tunneling activity. Hypothesis 1: When a listed firm is in sound financial conditions, the market will react negatively to the announcements of connected transactions. 5

7. Propping: to inject cash to listed firms, inject good asset with bad asset in return, buy high/sell low etc. –Bai, Liu and Song (2004): ST firms in China have generated 31.8 percentage points of abnormal stock market performance over the two years after being designated. Hypothesis 2: When a listed firm is in poor financial conditions, the market will react positively to announcements of connected transactions. Hypotheses development (cont’d) 6

8. Sample: 1,311 connected transactions and 669 non- connected transactions from 787 non-financial firms listed on the SHSE and SZSE during the1998-2004 period Transaction information from Shenzhen GTA Information Technology Corporation, Beijing Sinofin Information Service, and Shenzhen Bloomberg Database Corporation Accounting information from the Genius database Stock information from the CSMAR Database Data and methodology 7

9. Three different periods reflecting firm’s financial conditions: –The “Rights” period: the year during which the firm successfully obtains the rights to issue new shares. –The “STPT” period: The period during which the firm is designated as ST, PT or *ST –The “Others” period Types of transactions: asset acquisitions, asset sales, asset displacements, cash payments and equity transfer Data and methodology (cont’d) 8

11. Cumulative abnormal returns (CAR), the standard event study methodology Regression model and variables Data and methodology (cont’d) 10

12. Data and methodology (cont’d) 11

14. Empirical results Six groups: Connected & STPT, Non-connected & STPT, Connected & Rights, Non-connected & Rights, Connected & Others and Non-connected & Others In nearly all the CAR windows, we find: –Significant positive results in the Connected & STPT group => Propping –Significant negative results the Connected & Rights group => Tunneling Average CARs from day –10 to day +10 around the event date for the six groups 13

18. Cross-sectional regression analysis –Full sample regression Without or with interaction terms Robustness check: replace STPT, Rights with ROE Test Friedman et al., (2003)’s theory –Subset regression 1: STPT, Rights, Others, Connected and Non-Connected –Subset regression 2: asset acquisitions, asset sales, asset displacements and equity transfer Hypotheses supported Empirical results (cont’d) 17

23. ConclusionConclusion A negative market reaction is found towards the connected transactions when a listed firm is in sound financial conditions, which indicates the tunneling view. A positive market reaction is found towards the connected transactions when a listed firm is in poor financial conditions, which indicates the propping view. The non-connected transactions don’t show quite different results during the two different conditions. No significant difference among the four types of transactions. 22

24. Thank You!