Loan Guarantee, Management Earnings Forecasts and Cost of Debt: Evidence from Chinese Firms

Abstract

One of the most pressing issues facing developing economies is how to provide expansion capital for existing businesses. But in China, where private enterprises suffer significant financial constraints from capital market limitations, this issue is more pressing. Therefore, the significance of obtaining third-party loan guarantees (LGs) rises among private firms in the secondary loan market. This study investigates the between the LGs and the firm’s Cost of Debt (COD) as well as the substitution effect of Management Earnings Forecasts (MEFs). We find that LGs have a significant negative relationship with the firm’s COD. However, a positive relationship between information asymmetry measures and LGs is more pronounced, suggesting that LGs reduce the significance of information asymmetry issues which impair borrowing firm re-payment ability and increase the credit risk of guarantors and banks. In contrast, frequent and quality MEFs help firms’ to build their reputation in the market by reducing the concerns of information asymmetry, information risk, agency problems, and loan repayment with banks, which, in turn, benefit firms in reducing their COD. Our study results are robust to the use of difference-in-difference (DID) and Placebo (falsification) analysis, a two-stage least square (2SLS), Heckman two-stage treatment effect model, and alternate proxies. This work offers the latest contribution to the recent understanding of the effects of LGs, in reducing COD and the vital role of MEFs in firms’ growth.

Keywords: Management Earnings Forecast, Loan Guarantee, Cost of Debt, information asymmetry