Making political connections work better: Information asymmetry and the development of private firms in China

• Published date: 01 November 2021
• Author: Guanchun Liu,Ge Xin,Jing Li
• Date: 01 November 2021
• DOI: http://doi.org/10.1111/corg.12390

ORIGINAL ARTICLE

Making political connections work better: Information

asymmetry and the development of private firms in China

Guanchun Liu

1

| Ge Xin

2

| Jing Li

3

1

Lingnan College, Sun Yat-sen University,

Guangzhou, China

2

School of Public Economics and

Administration, Shanghai University of Finance

and Economics, Shanghai, China

3

School of International Trade and Economics,

University of International Business and

Economics, Beijing, China

Correspondence

Ge Xin, School of Public Economics and

Administration, Shanghai University of Finance

and Economics, Shanghai, China.

Email: xin.ge@sufe.edu.cn

Funding information

National Natural Science Foundation of China,

Grant/Award Number: 72003116; Shanghai

Planning Office of Philosophy and Social

Science, Grant/Award Number: 2018EZZ003

Abstract

Research question/issue: Previous studies have documented the benefits for firms

of building political connections, yet there is a gap in the literature on the information

transmission effect of political connections. Our study examines the effect of political

connections in a highly asymmetric information environment—private firms in China.

Research findings/insights: Using quarterly data on listed private firms in China from

2004 to 2017, we find that political connections ensure such firms have access to

reliable political information, which mitigates the risks of policy uncertainty. Further,

firms connected to the government are better able to mitigate the negative effects of

policy uncertainty than those connected to the legislature, while firms tied to

high-level authorities are better able to do so than those tied to lower-level ones.

Specifically, political connections are more effective in lower-marketized and

peripheral regions, where information asymmetry is higher.

Theoretical/academic implications: Our study highlights the importance of political

connections in mitigating the negative relationship between policy uncertainty and

corporate investment via the information transmission channel. Specifically, officials

can more efficiently mitigate policy uncertainty than delegates, and high-level author-

ities are more effective than lower-level officials.

Practitioner/policy implications: We argue that building political connections helps

private firms offset the negative effects of policy uncertainty. Our findings provide

useful insights for understanding the impacts of Regulation No. 18 of October 2013,

which limits the employment of current and retired officials in private firms.

KEYWORDS

China, corporate governance, information asymmetry, political connections, policy

uncertainty, private firms

1|INTRODUCTION

Government and regulatory institutions often implement policies that

change the environment in which firms operate. Where a global or

bilateral event like the U.S.–China trade war and/or COVID-19

pandemic brings significant shocks to the global economy, authoritar-

ian regimes such as China's often make more frequent policy adjust-

ments, which generates a high degree of uncertainty in economic

policy. The associated policy information asymmetry between the

government decision-making bodies and firms poses challenges for

the latter. The failure to obtain accurate and timely government infor-

mation may create substantial transaction costs for private firms, such

as an increase in the cost of external financing and the equity risk pre-

mium (Bradley et al., 2016; Pastor & Veronesi, 2013). Considering the

damage that an unstable private sector can wreak on the overall

economy, economists have been very concerned about how private

investment is (and can be) made in an environment of policy uncer-

tainty (e.g., Dixit et al., 1994; Henisz, 2000; Henisz & Zelner, 2005).

Received: 3 July 2020 Revised: 12 May 2021 Accepted: 14 May 2021

DOI: 10.1111/corg.12390

Corp Govern Int Rev. 2021;29:593–611. wileyonlinelibrary.com/journal/corg © 2021 John Wiley & Sons Ltd 593

To cope with the political impacts on their development, private

firms have devised a series of ways to build connections with govern-

ment agents and officials, which have proved to be fairly beneficial. In

a cross-national study, Faccio (2006) finds that firm-level political con-

nections exist in 35 of the 47 countries. Although the true impacts of

political connections are theoretically ambiguous, they can, for

example, help firms obtain preferential bank loans (Cull et al., 2015;

Khwaja & Mian, 2005; Wu et al., 2012), legal protections

(Li et al., 2008), government contracts (Goldman et al., 2013), and

supportive policies and regulations (Al-Hadi et al., 2016).

Despite the abundant influence generated by political connec-

tions, the information transmission effect has not been fully explored.

Our study is one of the first to explore how political connections help

private firms amass government information in a changing and

uncertain environment. The recent global economic stagnancy and

the policy uncertainty it has engendered around the world have

begotten more frequent decision making from politicians and regula-

tory institutions in authoritarian regimes. It is therefore necessary to

examine the working mechanisms of political connections in a highly

asymmetric information environment.

In this paper, we analyze the case of China to study how

political connections generate an “information transmission effect”to

mitigate the negative impacts of information asymmetry. Since the

founding of the People's Republic of China, the authoritarian regime

has carefully balanced its relationship with private enterpreneurs: on

the one hand, burgeoning private firms largely drive China's economic

growth; on the other hand, the private sector is encroaching upon the

party's position in the market. Although Wank (2001) used the term

“symbolitic clientelism”to capture the exchange between the state

and the private sector, Tsai (2007) suggests that enterpreneurs are

diversified “capitalists without a class”: while some are closely

connected to the government to reap enormous benefits, others

choose to be “strategic”(Schubert & Heberer, 2017). We predict that

private firms with various kinds of political connections enjoy

disparate levels of access to political information, which can reduce

the negative effects of policy uncertainty on their investments.

To test this prediction, our empirical analysis employs quarterly

data for Chinese private firms listed on the Shanghai and Shenzhen

Stock Exchanges. We focus on private firms' political connections in

China primarily because abundant research has indicated that, due to

their sponsorship by the government, state-owned firms have much

stronger political connections and are therefore less likely than private

enterprises to suffer from information delay or distortion (Ding

et al., 2014). For private firms without direct insider information, one

feasible approach to making wise decisions amid economic policy

uncertainty seems to be exploiting political connections. We manually

classify the firms in our sample according to their connections with

political authorities and administrative levels and then estimate the

heterogenous effects of political connections on mitigating policy

uncertainty. To provide further evidence to evaluate our hypotheses,

we group and analyze firms according to the level of marketization in

the region in which their headquarters are based and their distance to

the political center—Beijing. More importantly, we exclude three

alternative explanations that may affect the validity of our explanation

of the “information transmission effect”of political connections. We

also use a difference-in-differences (DID) approach and propensity

score matching (PSM) to address potential endogeneity issues, and

our results remain robust.

Our analysis yields four major findings: (i) There is information

asymmetry between policymakers and firms in China; (ii) Politically

connected firms can offset the negative impacts of information asym-

metry, which proves that such firms benefit from an information

transmission effect; (iii) Firms with links to government can better mit-

igate the negative effects of economic policy uncertainty than those

connected to legislatures; (iv) Firms connected to higher-level authori-

ties (government or legislature) can better mitigate the negative

effects of policy uncertainty than those linked to lower-level officials.

Our findings contribute to the extant literature on four grounds.

First, we further the debate on the effects of policy uncertainty by

empirically examining how private firms in China can offset the

negative impacts of such uncertainty on corporate investment

through political connections. Julio and Yook (2012), Wang

et al. (2014), Gulen and Ion (2016), and Kim and Kung (2017) have all

documented a strong negative relationship between policy

uncertainty and corporate investments. In addition, we find that

political connections can moderate this relationship. In other words,

firms connected to political institutions can better mitigate the

adverse effects generated by policy uncertainty on firm investment.

Second, this article adds to the political connection literature,

particularly research that estimates the value of such connections. For

example, prior studies have demonstrated that politically connected

firms find it easier to access credit (Boubakri et al., 2012;

Faccio, 2006), experience fewer financing constraints (Chan

et al., 2012), and have abnormal positive returns (Acemoglu

et al., 2016; Civilize et al., 2015). We measure various levels of

government- and legislature-based political connections for Chinese

firms and show that disparate types of political connections function

differently to offset information asymmetry, which demonstrates that

political connections have a significant information transmission

effect.

Third, our findings about how political connections help firms

invest in a context of policy uncertainty enhance our understanding

of the real options literature. The real options theory emphasizes that

if investment projects are irreversible, uncertain information shocks

can delay firms' investments until new information arrives

(Bernanke, 1983; Dixit et al., 1994; Rodrik, 1991). However, some

studies have indicated that the real effects of uncertainty are unclear

and depend on the properties of the investment and the degree of

market competition (Atanassov et al., 2015). Our findings suggest that

politically connected firms have better performance to secure

investment projects in uncertain times, because they delay less due to

the access to policy information.

Finally, our results contest the resource dependency theory to

explain how a firm leader's capital may enhance firm performance. On

the one hand, this theory provides a conceptual tool to examine how

a firm's unique resources—such as the owner's experience,

594 LIU ET AL.