Corporate Financial Distress Diagnosis in China

CorporateFinancialDistressDiagnosisinChinaLingZhang,CollegeofBusinessAdministrationHunanUniversity(SouthCampus)ChangshaHunan,P.R.China,410082E-mail:[e-mail]@hnu.cnShouChen,VicePresidentHunanUniversity(SouthCampus)ChangshaHunan,P.R.China,410082E-mail:[e-mail],Professor,CathayFinancialHoldings,Taipei,Taiwan,andDept.ofFinance,HongKongUniversityofScienceandTechnologyClearwaterBay,Kowloon,HongKongSARE-mail:[e-mail],MaxL.HeineProfessorofFinanceSalomoncenter,NewYorkUniversity44WestFourthStreet,Suit9-160NewYork,N.Y.10012-1126E-mail:[e-mail]acknowledgetheusefulcommentsofProfessorBilderbeekJanfromTwentyUniversityandalsothefinancialassistanceofNaturalScienceFoundationofChina(NSFC).DataassistancefromXiongweiWu,XinZhang,YanchunCaoandShenzhenGuoTai’AnInformationTechnology(GTA)isalsoacknowledged.CorporateFinancialDistressDiagnosisinChina*AbstractWiththeenforcementoftheremovalsystemfor“distressfirms”inChina’ssecuritiesmarketin2001,thedevelopmentofthebankruptcyprocessforfirmsinChinadidcreatehugeimpactstothecommunity.Therefore,identificationofpotentialbusinessfailuresandofferingearlywarningsfortheimpendingfinancialcrisesbecameveryimportanttoanalysts,practitionersandregulators.Thereareverydistinctdifferencesinthenatureofthefirms,theaccountingprocedures,thequalityortrustworthinessoffinancialdocuments,andcorporategovernancebetweenthefirmsinChinaandinthewesternworld.Therefore,itmaynotbepracticaltodirectlyapplythemodelsormethodologiesthatdevelopedinthewesternworldtosupporttheidentificationofsuchpotentialdistress.Inourresearch,wedevelopedamodelcalledZChinaScoretosupporttheidentificationofpotentialdistressfirms.WeappliedthemodeltoChina’ssecuritiesmarketfordistressdiagnosis.Thestudyachieveda98.8percentaccuracyinclassifyingdistressfirmsfortheoriginalsamplesand94percentaccuracyforholdoutsamples.Theearlyvalidationtestshowedthatthediscriminant-ratiomodelconstructedprovidedanearlywarningcapacityuptofouryearspriortofinancialdistress.Keywordfinancialdistress,discriminantanalysisChina’sstockmarket1.IntroductionOverthepasttwentyyears,ChinahasachievedgreatsuccessintheeconomicdevelopmentthattheannualGDPgrowthmaintainedaboveanastonishingaverageofeightpercent.Also,ChinahasbecometheNo.twocountryinattractingoverseasinvestmentandalsotheNo.twoinforeigncurrencyreservein2004.However,suchwonderfulachievementwasnotreflectedintheperformanceofthesecuritiesmarketthatShanghaiandShenzhenA-sharesplungedover40percentsince2001.Manyresearchersbelievedthatthesentimentofthemarketwassopessimisticwascausedbytheinadequatemarkettransparency,poormarketregulationfromgovernment,aswellaslackofsoundandreliablemodelstosupporttheassessmentoffirms’financialsituationandidentificationofpotentialdistress.ThesecuritymarketinChinaisquitedifferentfromthoseinthewesternworldduetohistoricalbackground.Forexample,manylistedfirmsareoriginallythestate-ownedenterprises(SOEs)andalsoacertainpercentageofsharesinsuchcompaniesarenottradable.Therefore,theactualfinancialsituationofthesefirmsmightnottotallybereflectedintheirstockprices.Toavoidinvestonsuchpotentialdistressfirmsisveryimportanttotheinvestors.Also,theinvestmentstrategiesofmajorityofinvestorsinChinaaremorefavoroflong-termholding,whichmight*ThispaperissupportedbyNaturalScienceFoundationofChina(NSFC)-Project(70172018).1coverseveralyears.Therefore,tohaveasoundandreliablemodeltopredictthefirms’survivabilitywithlongerhorizon,sayfewyears,hasbecomeextremelyimportant.Also,withtheBaselIInewEconomyAccordintroducedin2001,mostoftheactivebanksinthewesterncountrieswillusenewrulesinCapitalAdequacyRequirement(CAR)toestimatetheneededcapital.IftheyoptedtouseInternalRatingsBased(IRB)approaches,eitherfoundationoradvanced,theyhavetoprovethattheyhavethecapabilitytodevelopsoundandrobustcreditratinganddefaultpredictionmodels.Basedonthehistoricaldatacaptured,suchmodelscanbeusedtosupporttheestimationofprobabilityofdefault(PD),whichisthemostimportantinestimatingthepotentiallossesincreditrisk.AlthoughChinagovernmentindicatedthattheywillnotadoptPillarOne-minimumcapitalrequirement,theyindicatedthattheywillfollowPillarTwoandPillarThreetoimprovetheinternalmanagementandpublicdisclosureofbanksafterendof2006.However,inordertostimulatebankstoimprovetheircapabilityinmeasurementandmanagementofcreditrisks,Chinagovernmentstillencouragedbankstodeveloptheirowndefault(distress)predictionmodels.Overthepasttenyears,manyresearchersfromthewesterncountriesandChinatriedtodevelopmodelstoevaluatetheperformanceorpredictdistressofChinesefirms.SomeofsuchstudiesaresummarizedinSection2–LiteratureReview.However,wefoundsomeweaknessesinthosestudies.ThefirstweaknessisthelackofasolidtheoreticalbasisoradeepunderstandingoftheChinaaccountingproceduresandwhatfactorsthatreallyaffectedthefirmperformanceintheirselectionofvariablesformodeldevelopment.Mostresearchersselectedvariablesbasedonthepriorstudiesthatconductedinthewesterncountries.However,thesituationsofbothplaceswerequitedifferent,especiallytheaccountingrules,qualit