Firm-Level Policy Risk in China: The Effects on Corporate Leverage Target Following Behaviour

Abstract

This study proposes a new approach that bridges the asset pricing implications of economic policy uncertainty (EPU) and the dynamic debt-financing decisions of Chinese firms. The approach introduces a new variable, firm-level policy risk (FLPR), in empirical tests. FLPR embraces two elements, the exposure of a firm’s stocks to EPU shocks and the change of EPU as economy-wide policy risk. Our approach rectifies the defect that all firms respond homogeneously to EPU innovations and underpins the connection between EPU and capital structure with established theories. We show firms with positive (negative) EPU betas have their FLPRs impact negatively (positively) the leverage target, supporting the prediction derived from trade-off theory that rising economy-wide risk leads to falling optimum debt ratios. We also find that over-levered firms adjust towards the leverage target faster than under-levered firms.