William Megginson, Kedi Wang, and Junjie Xia find in new research that the Chinese Communist Party’s anti-corruption campaign produced worse firm performance by reducing managers’ risk tolerance.

Existing management and finance studies have identified managerial incentives that can induce managers to act against the best interest of shareholders. Empire-building models (Williamson, 1964; Lilienfeld-Toal and Ruenzi 2014; Gantchev, Sevilir and Shivdasani 2020) suggest that managers have an incentive to undertake value-destroying activities and increase firm size. However, avoiding empire-building may lead managers to exert less effort and to pursue a quiet life (Bertrand and Mullainathan 2003 and Shi, Hoskisson, and Zhang 2017) or play it safe (Gormley and Matsa 2016). Our recent study highlights an important, yet understudied, negative influence of Chinese regulators’ disciplinary inspections by documenting that a regulatory enforcement shock can generate managerial anxiety and fear that will dramatically reduce value-enhancing investment, leading to a significant decline in firm performance.

Using the event of discipline inspections to state-owned enterprises (SOEs) during the ongoing anti-corruption campaign in China as an external shock, we find that the principal economic impact of these inspections has been for firms that were targeted by the discipline inspections to significantly cut capital investment, leading to a major decline in profitability, innovation and Tobin’s Q, which is the ratio of the total market value of equity to the total book value of equity at every year end. These inspections primarily involved reviewing internal documents. More importantly, the campaign generates fear in managers, leading expenditures on R&D— as well as managerial perks like entertainment and travel— to decline significantly. SOE managers, who have limited risk-promoting equity holdings or incentive compensation and few external employment options, were deterred from taking risky but value-enhancing investments after the inspections.

Where did these disciplinary inspections come from? To crack down on corruption and reinforce the leadership of the Communist Party of China (CPC), the CPC announced in December 2012 “eight points” of regulation. Any person or organization violating the regulation would be disciplined. This marked the beginning of the anti-corruption campaign in China. According to an official government website, 187,409 officials were indicted for corruption from 2013 to 2016.

From 2013 onwards, in addition to local government officials, CPC officials initiated discipline inspections of the largest state-owned enterprises SOEs. Whole organizations and administration leaders, including chairmen and managers, were also investigated. The main purpose of the inspections was to institutionalize strong leadership by the CPC and improve internal supervision and accountability in SOEs. According to the CPC’s Central Discipline Inspection Commission (CCDI) official website, the CPC had reviewed more than 110,000 documents during the inspections. Sixty four top leaders and more than 100 general managers were indicted for corruption after the inspections. Among all attributions for indictment summarized by the CCDI, issues related to over-investment in R&D contributed 56% of cases of corruption.

We took this political event as an external shock and employed a staggered difference-in-difference approach in our empirical analysis. Our data sample consists of quarterly data on publicly traded firms from the first quarter of 2007 to the fourth quarter of 2017, obtained from the China Stock Market and Accounting Research (CSMAR) database. All these firms are controlled by either the inspected SOEs or their subsidiaries.

We demonstrate that in response to this regulatory enforcement shock, managers appear to care much more about investment than they did before the shock. After discipline inspections, managers reduced their investment by 26.7%. This is related to the fact that a significant number of shareholders were indicted for corruption and 56% of these cases were related to investment. Investment became symbolic of over-usage of resources and likely drew the government’s attention. In addition, R&D expenditures declined significantly, indicating that managers were reluctant to make difficult decisions about investing in long-term and risky projects. Expenditures on travel and entertainment also sharply decreased. These findings suggest that this political event generated strong pressures on managers and made them nervous about being accused of graft.

Second, we show that the fearful managerial responses substantially worsened firm performance. Firm profitability, measured by return on asset (ROA), return on equity (ROE) and return on debt (ROD) decline significantly. The market-based performance, measured by Tobin’s Q, also decreased dramatically. In addition, innovation activities, including R&D expenditures and authorized patents for invention, declined dramatically. These findings suggest that managers tended to act tentatively and avoided costly efforts to improve firm performance. This is consistent with the post-traumatic growth (PTG) theory that anxiety and psychological tension reduce individuals’ motivation to achieve extrinsic goals, such as accumulating individual wealth (Tedeschi and Calhoun 2004) and making business acquisitions (Shi, Hoskisson, and Zhang 2017).

Meanwhile, we find that managers do not adjust employment, which is consistent with the view that Chinese SOEs face policy burdens and tend to employ excess labor to maintain social stability (e.g., Boycko, Shleifer, and Vishny 1996; Lin, Cai, and Li 1998; Cao et al. 2019). This is also consistent with the hypothesis that the inspections generated anxiety and fear for managers, since downsizing might trigger social tensions and draw the government’s attention. Therefore, avoiding downsizing became another way for managers to “buy peace” with the government, even though downsizing might improve the firm’s private market value.

In sum, our research reveals an unintended consequence of the anti-corruption campaign in China. On the one hand, the campaign effectively reduced corruption and enhanced CPC leadership and accountability. On the other hand, the campaign seemingly imposed strong pressure on leaders, including local government officials and SOEs managers, who adjusted their behavior to minimize the risks of being accused of abusive attitudes. Managers became reluctant to take risks and, as a result, delivered worse results.

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