Introduction

The choice between debt vs equity is one of the major corporate finance decisions, as it directly impacts on a corporation’s cost of capital and, therefore, its value. While generally providing the lower cost of capital, the benefit of debt financing is also linked to its ability to reduce the adverse impact of equity issuances. According to the pecking order theory Myers (1984) and Myers and Majluf (1984) assert that, since management are presumably equipped with better information about the firm’s prospects, they face difficulty in convincing outside investors that they will not be paying for overpriced stocks. This forces firms to issue equity at a price lower than its intrinsic value. Firms with higher degrees of information asymmetry (e.g. lower corporate governance quality) will be more harshly penalized through deeper discounting of their equity issuances. Thus, the pecking order theory predicts that firms with a higher degree of information asymmetry are associated with higher levels of debt usage, all other things being equal. While the pecking order theory has proven to explain capital structure choices among corporations worldwide, it is at odds with the findings of Chen (2004). The author reports the new pecking order of which firms prefer the use of retained earnings, new equity issuances, and long-term debt accordingly. We conjecture that the unconventional preference of equity issuance over long-term debt may stem from the fact that Chen (2004) study period is during the time when non-tradable shares (NTS) (predominantly owned by the state). Since these NTS investors are less subject to information asymmetry problem, firms are generally less adversely impacted by new equity issuances. This gives rise to the finding that information asymmetry may not lead to higher debt financing in China (and thus less needs to use debt financing to reduce the adverse selection problem faced by equity investors). Our paper aims to empirically investigate whether Chinese corporations conform to the pecking order theory once NTS are revoked during the 2005-2007 NTS Reform period. With the NTS Reform, NTS (which contribute to a big proportion in Chinese capital market) are converted into tradable shares and become subject to information asymmetry problem. In this new environment, the role of information asymmetry on debt financing choices should become more prominent. In other words, we should detect a positive relation between information asymmetry and net debt issuances, as predicted by the traditional pecking order theory. Having mentioned that, directly testing the information aspect of a firm’s capital structure decisions is challenging due to the lack of a direct measure on information asymmetry. Recent developments in microstructure research have, however, provided new tools for researchers to detect the degree of information asymmetry faced by stock investors. Bharath et al. (2009) are the first to apply such techniques to test the pecking order theory. In their study, the positive relation between asymmetric information and leverage use is confirmed among US firms. We apply Bharath et al. (2009) techniques to investigate how information asymmetry affects the new debt issuances of Chinese listed firms in the years 2005 to 2007 NTS Reform transition period[1]. The ability of the pecking order theory to explain firms’ financing choices depends heavily on the stock market’s ability or incentive to produce information. The latter should be systematically promoted with the lifting of NTS. There is another reason why a study in the Chinese market is particularly interesting. First, it has been argued that share manipulation and insider trading are rampant in Chinese capital markets, while investor protection rights are not legally codified (see, e.g. Chakravarty et al., 1998; Chan et al., 2008).