Institutional Determinants of Vertical Integration: Evidence from China

Abstract

In a world with no transaction costs, vertical integration is intrinsically inefficient because it reduces specialization and thus the exercise of comparative advantage among firm units. However, in reality transactions between separate units carrying out vertically related activities have transaction difficulties stemming from weak property rights protection, information asymmetry, or agency behavior, all of which lead to anticipated opportunistic behavior and ex ante distortions in investment. If these transaction difficulties cannot be overcome by contracting, because of weak institutions or insufficient market disciplinary forces, vertical integration can be a solution. At the same time, in such environments, local corporate insiders with political connections can use vertical integration to enhance their rent-seeking returns and yet it is doubtful if outside shareholder can capture any of the gains. Empirical validation of these hypotheses is most likely in emerging economies, where legal and market institutions are often weak despite substantial variation across sub-regions. Using Chinese data, we find that vertical integration is indeed importantly affected by institutional factors - it is more common in Chinese regions with weaker property rights protection, poorer local government quality, and stricter local regulation of market trades (which hampers market forces). Moreover, companies led by insiders with political connections are more likely to be vertically integrated. Vertical integration has a varying relationship with share value. Vertical integration is negatively associated with share value if the top corporate insider is politically connected. Vertical integration is positive associated with share value if the firm is independently audited. If firm has a politically connected insider and is independently audited, the combined effect is large and positive.