Economics Letters 147 (2016) 90–92

Contents lists available at ScienceDirect

Economics Letters
journal homepage: www.elsevier.com/locate/ecolet

Political connections and stock price crash risk: Evidence from China
Jin-hui Luo ∗ , Manning Gong, Yilong Lin, Qifeng Fang
School of Management, Xiamen University, Fujian, China

highlights
• We examine the impact of corporate political connections on a firm’s future stock price crash risk.
• We explore to measure the strength of political connections and classify political connections into two distinct types.
• Political connections can reduce a firm’s future stock price crash risk in China.
• The effect of political connections is contingent to the strength and type of political connections.

article info abstract

Article history: We examine how political connections may influence a firm’s crash risk in China. We find that politically
Received 22 April 2016 connected firms have lower crash risk than their counterparts. Moreover, the effect of political connec-
Received in revised form tions varies according to their strength and types.
26 July 2016
© 2016 Elsevier B.V. All rights reserved.
Accepted 22 August 2016
Available online 26 August 2016

JEL classification:
G3
P2

Keywords:
China
Information environment
Political connections
Stock price crash risk

1. Introduction releasing of accumulated bad news to the market. Therefore,

The phenomenon of corporate political connections has drawn
numerous attention in the world, particularly with respect to
investigating their economic consequences. Most prior studies
have examined the effects of political connections on firms’
resource acquisitions and firm performance (e.g., Faccio, 2006;
Fan et al., 2007; Boubakri et al., 2008). Recently, one exception
is Piotroski et al. (2015), which finds that politically-connected
firms experience a significant increase in stock price crash risk
(hereafter, crash risk) after high-profile national political events
take place in China, because firms withhold bad news temporally
for the sake of their connected politicians’ careers. It is unclear,
however, whether and how political connections may affect firm
crash risk at normal times.
Stock price crash refers to the phenomenon that stock price
drops sharply over a short period of time because of the sudden
scholars have reached a consensus that managerial bad-news
hoarding is a major cause of firm crash risk (e.g., Jin and Myers,
2006; Hutton et al., 2009). We argue that political connections
may induce the connected firms to release but not to hoard bad
news at normal times and thus reduce those firms’ future crash
risk. Because price crash events would usually result in selective
regulatory scrutiny in China, and thus be costly to both politically-
affiliated firms and their connected politicians (Piotroski et al.,
2015). What is more, we try to classify political connections into
two distinct types, i.e., connections with government officials
and connections with members of People’s Congress and People’s
Political Consultation Conference, and contend that the effect of
political connections may vary according to the types of political
connections. We aim to indicate that political connections are a
specific channel through which the government exerts significant
influence on the stock market in China.

2. Data and methods

∗ Correspondence to: School of Management, Xiamen University, No. 422, Siming
South Road, Xiamen, Fujian, 361005, China. Fax: +86 592 2185870. We obtained detailed resumes of all managers for each China’s
E-mail address: jinhuiluo@xmu.edu.cn (J.-h. Luo). listed company in every fiscal year from the Wind database and
http://dx.doi.org/10.1016/j.econlet.2016.08.024
0165-1765/© 2016 Elsevier B.V. All rights reserved.
 J.-h. Luo et al. / Economics Letters 147 (2016) 90–92 91

manually identified each manager’s political experience. Other Table 1

data such as weekly stock return and financial information comes Political connections and stock price crash risk. This table reports OLS regression
results of political connections on future stock price crash risk and other
from the CSMAR database. Both Wind and CSMAR databases are
determinants. Both industry and year fixed effects are controlled by including
major providers of China data. We initially collected data on all industry and year indications. T -statistics, based on standard errors adjusted for
Chinese firms listed on the main board markets of Shanghai and Huber–White, are in parentheses.
Shenzhen during the period of 2006–2011. Then we excluded Dependent variable: NCSKEW t
cross-listed firms, firms under ST or *ST status, firms with debt
Model 1 Model 2 Model 3 Model 4
exceeding asset value, financial firms, firms with fewer than
30 weeks of stock return data, and firms with missing data to PCDUM t −1 −0.036**
minimize the influence of abnormal observations. Our final sample (−2.445)
PCMAX t −1 −0.002***
includes 5437 firm–year observations.
(−3.498)
We followed Hutton et al. (2009) and Kim et al. (2011) to GOVDUM t −1 −0.054***
measure a focal firm’s crash risk in a two-step procedure. We first (−3.242)
estimate firm-specific weekly returns for firm j in week t, denoted DBWYDUM t −1 −0.004
by Wj,t , as the natural log of one plus the residual return from the (−0.228)
GOVMAX t −1 −0.002***
expanded model regression for each firm and year in Eq. (1).
(−3.465)
Rj,t = αj + β1,j Rm,t −1 + β2,j Ri,t −1 + β3,j Rm,t DBWYMAX t −1 −0.001
(−0.244)
+ β4,j Ri,t + β5,j Rm,t +1 + β6,j Ri,t +1 + εj,t (1) NCSKEW t −1 0.011 0.011 0.011 0.011
(0.834) (0.783) (0.782) (0.780)
where Rj,t is the return on stock j in week t, Ri,t is the value-
RET t −1 0.591 0.570 0.561 0.568
weighted return on industry i in week t, and Rm,t is the return on (0.529) (0.511) (0.503) (0.509)
the value-weighted market index in week t. Then, we measured SIGMAt −1 −0.480 −0.448 −0.452 −0.446
crash risk as the negative skewness of firm-specific weekly returns (−0.876) (−0.818) (−0.826) (−0.815)
(NCSKEW ). Specifically, we calculate NCSKEW as follows in Eq. (2). ROAt −1 0.094 0.092 0.095 0.092
(0.691) (0.677) (0.702) (0.678)
A higher value for NCSKEW means a higher likelihood for a stock LEV t −1 0.020 0.018 0.022 0.018
to experience crash events. (0.432) (0.403) (0.486) (0.407)
   BM t −1 −0.151*** −0.154*** −0.153*** −0.154***
NCSKEW j,t = − n(n − 1)3/2

Wj3,t (n − 1)(n − 2) (−3.337) (−3.387) (−3.365) (−3.387)
SIZE t −1 0.010 0.012 0.010 0.012
 3/2  (1.154) (1.348) (1.175) (1.345)
ACCM t −1 0.051 0.054 0.056 0.054
× Wj2,t . (2)
(0.535) (0.572) (0.586) (0.572)
Intercept 0.098 0.047 0.076 0.046
Following Fan et al. (2007), we defined a focal firm’s political (0.474) (0.228) (0.370) (0.225)
connections as its CEO or board chairperson having political expe- Observations 5437 5437 5437 5437
rience, which includes serving in the government, the Party com- F -values 7.86*** 8.08*** 7.76*** 7.86***
mittee, the People’s Congress, the People’s Political Consultative Adjusted R2 0.040 0.041 0.040 0.041
Conference, the People’s Court, the People’s Procuratorate, or the **
Denote significance at the 5% level (two sided).
***
People’s Bank at both local and central levels. Specifically, we con- Denote significance at the 1% level (two sided).
structed a dummy variable, denoted by PCDUM, which equals one
if the CEO or board chairperson had political experience and zero 3. Empirical results
otherwise. In China, the political system has a strict hierarchy of
ranking, ranging from premier of the State Council to ministers Table 1 displays the OLS regression results. As Models 1
and administrative clerks. Therefore, we followed Du et al. (2014) and 2 show, thecoefficients of PCDUM and PCMAX are negative
to construct a strength variable, denoted by PCMAX, which equals and significant at the 5% and 1% levels. These results suggest
the highest official rank of the CEO or board chairperson’s polit- that political connections may reduce firm crash risk, and the
ical connections. Furthermore, we classified political connections reduction effect is positively associated with the strength of
into two types: connections with government officials (GOV ) and political connections. In China, major events such as price crash are
connections with members of People’s Congress and People’s Po- more likely to draw intense media coverage and public attention,
litical Consultation Conference (DBWY ). Then we constructed two
which would result in selective regulatory scrutiny (Piotroski et al.,
dummy variables, i.e., GOVDUM and DBWYDUM, to measure the ex-
2015). Meanwhile, firms usually build up political connections
istence of each type of political connections respectively, and two
for acquiring critical resources and preferential treatment from
continuous variables, i.e., GOVMAX and DBWYMAX, to measure the
the government. A poor-performed firm would have a better
strength of each type of political connections respectively.
legitimacy to leverage its government linkages to access valuable
To investigate the effect of political connections on crash risk,
resources and policies. As such, both politically-affiliated firms and
we constructed the regression estimation model in Eq. (3).
 their connected politicians would tend to release but not hoard bad
NCSKEW i,t = β0 + β1 Political Connectionsi,t −1 + Controli,t −1 news at normal times and thus lower crash risk. Therefore, political
  connections can deter firm crash risk at normal times in China.
+ Industry + Year + εi,t . (3) What is more, Models 3 and 4 show that both GOVDUM
Following Kim et al. (2011), we included a set of control variables and GOVMAX get negative and significant coefficients at the 1%
that may matter to crash risk. They include the lagged NCSKEW, level, while both DBWYDUM and DBWYMAX get negative but
RET (the mean of firm-specific weekly returns over the fiscal year), insignificant coefficients. These results indicate that the reduction
SIGMA (the standard deviation of firm-specific weekly returns over effect of political connections on firm crash risk is limited to
the fiscal year), ROA (return on assets), LEV (total liabilities divided connections with government officials. In China, only successful
by total assets), BM (ratio of total assets to market value of equity), big firms’ chairpersons or CEOs (e.g., Alibaba’s Jack Ma and Lenovo’s
SIZE (the natural log of total assets), ACCM (the absolute value of Chuanzhi Liu) and social celebrities (e.g., Ming Yao and Xiang
discretionary accruals), industry and year indicators. In addition, Liu) have opportunities to become members of People’s Congress
we winsorized the top and bottom 1% of each continuous variable. and/or People’s Political Consultation Conference. In other words,
92 J.-h. Luo et al. / Economics Letters 147 (2016) 90–92
most firms build up this type of political connections mainly for
the reason of their success. Therefore, these connected firms would
be prone to hoard but not to release their bad news to protect
their image of success and thus maintain their connections with
the government. On the contrary, it is usually a temporary thing
for a government official to become a firm’s chairperson or CEO
particularly for SOEs in China. These politically-affiliated managers
may pursue their future official careers at the expense of focal
firms’ performance. In this regard, these connected firms would
have the incentives to release bad news at normal times and avoid
crash risk events in the near future, thereby safeguarding their
connected politicians’ official career. In short, the reduction effect
of political connections on firm crash risk is contingent on the type
of political connections.
As to control variables in Table 1, only the variable BM gets
significant and negative coefficients at the 1% level in all regression
models, which is consistent with prior studies. In robustness
checks, we take the down-to-up volatility of stock price (DUVOL)
as an alternative measure of crash risk, conduct the two-way
clustering regression by firm and year to estimate Eq. (3) for
alleviating potential bias of standard errors, and investigate the
effect of political connections on future two-year crash risk. The
unreported results are quantitatively similar to those in Table 1,
suggesting that our findings are robust and have longer predictive
ability.
4. Conclusion
In China, there is a phenomenon that politicians would
rather give up the chance to distinguish themselves than make
big mistakes. Corroborating this case, we find that politically
connected firms have an incentive to release bad news at normal
times and thus experience lower crash risk in the future. The
reduction effect on firm crash risk is positively associated with
the strength of political connections and limited to firms having
connections with government officials but not to firms having
connections with members of People’s Congress and/or People’s
Political Consultation Conference, indicating the heterogeneity of
political connections. Our findings complement Piotroski et al.
(2015) to highlight the critical role that political factors play in
shaping listed firms’ information environment in China and other
government-led emerging economies.
Acknowledgment
We acknowledge the financial support from the Chinese
National Science Funds (Grant No. 71202061 and 71572160). All
remaining errors are our own.
References
Boubakri, N., Cosset, J.-C., Saffar, W., 2008. Political connections of newly privatized
firms. J. Corp. Finance 14, 654–673.
Du, X., Zeng, Q., Du, Y., 2014. Do politically connected independent directors
help Chinese listed private firms enter high-barrier industries? China Account.
Finance Rev. 16, 121–153.
Faccio, M., 2006. Politically connected firms. Amer. Econ. Rev. 96, 369–386.
Fan, J.P.H., Wong, T.J., Zhang, T., 2007. Politically connected CEOs, corporate
governance, and post-IPO performance of China’s newly partially privatized
firms. J. Financ. Econ. 84, 330–357.
Hutton, A., Marcus, A., Tehranian, H., 2009. Opaque financial reports, R2 , and the
distribution of crash risk. J. Financ. Econ. 94, 67–86.
Jin, L., Myers, S., 2006. R2 around the world: New theory and new tests. J. Financ.
Econ. 79, 257–292.
Kim, J.B., Li, Y., Zhang, L., 2011. CFOs versus CEOs: Equity incentives and crashes. J.
Financ. Econ. 101, 713–730.
Piotroski, J.D., Wong, T.J., Zhang, T., 2015. Political incentives to suppress negative
information: Evidence from Chinese listed firms. J. Account. Res. 53, 405–459.