Hong Kong and Shanghai rank among the top 10 global financial centres in 2023, according to the Global Financial Centres Index 33. By the end of 2022, the country's financial institutions had a total of 419.64 trillion yuan (around US$57.57 trillion) in assets, increasing 9.9 percent year on year.

Coinciding with the rapid capital market development, initial public offering (IPO) activity has also risen sharply. PwC's Global IPO Watch 2022 reported the total amount of funds raised through IPOs in China's domestic markets constituted about 39% of the global proceeds last year, replacing the U.S. as the world's number one in terms of IPO proceeds for the first time.

Vibrant as other developed markets may be, China's financial industry is shaped by one important factor that makes it unique like no others in the world. Guanxi, a Chinese social concept of interpersonal connections with implications for the exchange of favours, has long been dominating its socioeconomic landscape. Previous studies define that guanxi connections are characterised by trust in family-like relationships and instrumental exchanges that run alongside affective bonds. Business networking in the West carries no such elements.

In the realm of finance, guanxi often plays a considerable role in shaping the behaviours of economic agents. While this purposeful networking behaviour has potential benefits, it can also bring undesirable consequences.

In this Chinese University of Hong Kong (CUHK) Business School white paper, we conducted a series of studies into how the guanxi culture has led to the development of a unique financial sector in China and examined the impact of guanxi between different actors in China's financial sector.

Fund Managers and Analysts Reciprocate Benefits

First, we look at how social ties between fund managers and analysts affect their behaviours and business decisions, and how they reciprocate the benefits they receive from each other. Financial analysts are important information intermediaries who provide useful market information and insights into financial data for identifying opportunities, ultimately influencing investors' decisions. Fund managers rely particularly heavily on financial analysts for information.

We found that fund managers are more likely to obtain more support from analysts with whom they have guanxi ties, more likely to hold stocks covered by those analysts, and make higher abnormal returns from the connected holdings. To reciprocate the benefits received from their connected analysts, fund managers are more likely to vote in favour of the analysts in star analyst elections.

Does Guanxi Affect the IPO Process?

We then ask whether guanxi connections between investment bankers and auditors affect the IPO process and firms' post-IPO performance. When firms conduct IPOs, they appoint investment banks and audit firms to certify information disclosed to investors. During the process, bankers and auditors interact with each other. The need for close collaboration between the two could provide a fertile ground for social ties to deepen.

In 2004, China started to require IPO firms to hire investment banks as sponsors to assist with their IPO applications. We found that guanxi connections increase the likelihood that bankers and auditors participate in the same IPO deals. Such engagement can undermine IPO-audit quality and the interest of IPO investors. Nevertheless, guanxi ties work in the favour of auditors. Our study shows that through their social ties with bankers, auditors can command higher fee premiums and may later land more IPO-audit businesses from connected investment banks.

The Impact on Audit and Bad News Dissemination

The third type of guanxi ties we discuss are those between auditors and audit committees. Auditors play an important role as gatekeepers who ensure the quality of financial reports, which represent a key information source on which many economic decisions are based.

Overall, our studies show that the negative implications of guanxi between auditors and executives or audit committee members outweigh their benefits. Specifically, auditors' social ties with the client management or audit committee significantly reduce the likelihood that the auditors issue modified audit opinions (MAOs), a practice that implies an auditor is able to discover and report accounting irregularities. Even if connected auditors do issue MAOs, the modifications tend to be less severe.

Fourth, we look at how guanxi ties between financial analysts and firm management affect the acquisition and dissemination of bad news surrounding problematic firms. Sell-side financial analysts play a crucial role in discovering and disseminating bad news about firms, not least because managers have a proclivity to keep unfavourable news about their firms under wraps. We found that analysts with social ties to firm management have earlier access to bad news than unconnected analysts. After acquiring the negative information, connected analysts tend to share it with their clients privately while remaining silent in public.

While connected analysts play an important role in enhancing transparency and monitoring management, if they convey negative information privately, it may undermine investor confidence and hinder market growth.

Drawbacks Often Outweigh Benefits

For centuries, guanxi has been a building block of the Chinese business world. Guanxi ties do have the advantage of facilitating information sharing, but their costs to the market often exceed their benefits. Our findings have practical implications for various sides of the financial market, including investors, regulators, audit firms and audit committees.

Investors investing in IPO stocks should be wary of poor audit quality stemming from banker-auditor social ties. When formulating policies that touch on the independence of audit committees and outside auditors, it would be sensible for regulators to consider the role informal personal ties play. Given that investors do discount the earnings audited by engagement auditors who have guanxi connections with corporate executives or audit committee members, mandatory disclosure of such affiliation would be helpful.

Likewise, public accounting firms eager to improve their performance should take into account the guanxi factor when allocating scarce quality control resources and assigning individuals to audit engagements. Industry practitioners who want to strengthen corporate governance should also be aware of the impact of guanxi on external auditing when developing firm-level governance structures.

Learn more: https://cbk.bschool.cuhk.edu.hk/research-whitepapers/where-guanxi-matters-the-modern-chinese-financial-sector/

Hashtag: #CUHKBusinessSchool

The issuer is solely responsible for the content of this announcement.

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