Prof. Wu Donghui and Prof. George Yang, School of Accountancy at CUHK Business School

HONG KONG SAR - Media OutReach - 29 November 2023 - China's financial services sector has experienced burgeoning growth in the past two decades. 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...