Capital market internationalization and equity financing costs: firm-level evidence from China^*

* Accepted by Yue Ma upon recommendation by Junbo Wang.

Abstract

In recent years, the Chinese capital market has been increasingly integrated into the international capital market, although the level of integration remains low. We exploit the unique variations in China’s capital market integration to study the effect of capital market internationalization on the cost of equity financing. Using firm-level panel data from China, we measure capital market integration at the corporate level using the degree of co-movement between a company’s share price and the international capital market. After controlling for year effects and industry effects, we find that the growing integration of the capital market is significantly increasing Chinese companies’ equity financing costs. This surprising result still holds after controlling for the endogeneity problem. One possible explanation is the asymmetric approach of China’s capital market internationalization, i.e. while the Chinese capital market is increasingly open to international investors, it remains difficult for Chinese investors to invest abroad. Consequently, while international investors bring more risk into the Chinese market, domestic investors in China lack effective ways to diversify the risk in the global market. This additional source of non-diversifiable risk demands a higher return to capital, which raises the equity financing costs in China.

Keywords:

• Capital market integration
• equity financing cost
• non-diversifiable risk
• China

Acknowledgments

We appreciate the helpful comments and suggestions from the anonymous reviewer. We also thank Qiang Chen at Shandong University for his help and econometric suggestions. All errors are our own.

Notes

* Accepted by Yue Ma upon recommendation by Junbo Wang.

1. There are four variations of GB_i,t measuring the dynamic time-varying correlation between the RET of listed Chinese companies and the returns on international capital index Mscik: GB_BEKK-AR (estimated by the BEKK model with AR (1)), GB_BEKK (estimated by the BEKK model), GB_DCC (estimated by the DCC model), and GB_DCC-AR (estimated by the DCC model with AR (1)).

2. We use stock market value by the end of June and future earnings prediction matching to calculate composite equity financing costs. First, we estimate future earnings for the next one to five years through the cross-sectional regression model (Hou, Van Dijk, and Zhang 2012), and then, we calculate four different types of equity financing indexes (R_GLS_1, R_CT_1, R_OJ_1, R_MPEG_1). Next, we calculate the average of four indices without missing values to obtain compound equity financing cost R_cp_1. To guarantee the robustness of our calculation, we also use data by the end of October and obtain R_cp_1_10. The results using R_cp_1_10 and R_cp_1 are essentially the same, and to save space, we do not report the results using R_cp_1_10.

3. Home bias refers to clear international capital flow obstacles, the motives for hedging, deviation from purchasing power parity theory, information asymmetry, behavioral biases, and accounting standards.

4. On 5 November 2002, China's QFII system was formally implemented. Prior to this date, China was considered a closed market.