The Effect of Property Rights Protection on Capital Structure: Evidence from a Chinese Natural Experiment

Abstract: Little is known about how changes in property rights security impacts firm capital structure decisions. We examine this empirically by exploiting a natural experiment, the enactment of China’s Property Rights Law in 2007 (the Law). Using a large dataset of China’s non-listed firms, we document a significant decrease in leverage after the Law’s passage. This finding is consistent with the “reinvestment hypothesis” which stipulates that as property rights protection strengthens, firms are willing to reinvest more of their profits, thus leading to less use of external debts (Johnson, McMillan and Woodruff, American Economic Review, 2002). In subsample analyses, we find that financially constrained firms experience an increase in leverage relative to unconstrained ones following the Law’s enactment, as predicted by financial constraints theoretical models. Overall, our study finds that the Law has a significant impact on firm leverage decisions and that the Law is particularly important to financially constrained firms.