Short selling has been viewed as a market mechanism that can potentially disincentivize firms’ opportunistic behaviors such as negative information suppression, as short sellers take actions when they detect the hidden bad news. Extant studies have provided evidence that short selling can help deter management from suppressing negative information in developed economies. However, in emerging markets, empirical evidence on how short selling affects firms’ information environment is very limited. One important difference is that the incentives of firms and short sellers are mainly economically motivated in developed economies but are influenced by both economic and political forces in emerging markets. Thus, it is unclear whether short selling can still play a disciplinary role in emerging markets when political forces are strong. Piotroski et al. (2015) suggest that political forces are powerful factors underlying firms’ negative information suppression in emerging markets. Specifically, negative information may reveal governments’ hidden political agendas, encourage unwanted scrutiny of private benefits enjoyed by politicians and executives, and impose significant costs on politicians and executives in terms of reputation and career prospects in emerging markets. Consequently, when political costs of revealing negative information are high, firms in emerging markets may have incentives to withhold bad news.
While we expect short sellers to be an important market force in reducing firms’ bad news hoarding, their activities may also be influenced by political forces. In emerging markets, institutional and large investors often have a close relationship with the government and politicians. If short sellers uncover that a firm is withholding bad news due to political pressure from the government, it is possible that this pressure also affects short sellers’ decisions/ability to short. From an empirical perspective then, it is unclear whether short selling is an effective market mechanism for reducing politically motivated negative information suppression in emerging markets. The aim of our study is to fill this research gap by providing empirical evidence.
Politically Motivated Bad News Hoarding
Piotroski et al. (2015) argue that the meetings of the National Congress of the Chinese Communist Party can raise the costs of releasing negative information for affiliated firms, and find evidence suggesting that listed Chinese firms suppress negative information before and during the meetings and release it after the meetings. Their findings clearly show the patterns of negative information suppression around these important political events. We consider a set of political meetings and other important national events as our main empirical setting. We use the meetings of the National Congress of the Chinese Communist Party (hereafter, party meetings), as these party meetings “outline central government policy, identify party leaders, highlight key developments, and set major party objectives for the next five years” (Piotroski et al. 2015). We also add the National People’s Congress and the Chinese People’s Political Consultative Conference (hereafter, Two-session meetings). Two sessions meetings are important in setting economic goals for the country, including China’s gross domestic product growth target for the year, along with other key targets for consumption, unemployment, and the fiscal deficit. The work report delivered by China’s premier at these meetings is closely watched globally. Other important events of significant national interest include Expo 2010, the Beijing Olympics, BRICS, and G20 meetings. As the success of these events is important for the Chinese government and many foreign media are in China to report on them, Chinese firms likely face political pressure to suppress negative information during these event periods.
Empirical Framework and Our Findings
Our strategy of empirically testing short selling as a mechanism in mitigating politically motivated bad news hoarding has several advantages. First, there have been multiple regulatory shocks to short selling within China. Since 2010, the China Securities Regulatory Commission (CSRC) has gradually included stocks that meet certain requirements in the short selling designated list, which creates both time-series and cross-sectional variations in short selling constraints. Every update of the short selling list can serve as a quasi-exogenous shock to the existing short selling constraints, so this setting enables us to identify the causality between short selling and suppression of negative information.
Second, the intertemporal change in the incentive to hoard bad news provides an ideal setting to perform a more powerful test to evaluate the short selling effect. While politically motivated bad news hoarding can be prevalent all the time, it is inherently difficult to do so indefinitely as it requires politicians to have full control over information production and dissemination. Without knowing in advance when the political pressure on bad news hoarding will shift, testing the mitigating effect of short selling can be difficult. Withholding bad news in our setting, triggered by heightened incentives induced by the government, has a widespread and simultaneous effect on all firms but only lasts for a limited time, as bad news will be released after the meetings. Short selling trades are usually short-term, as the downside risk is unlimited and a short-and-hold strategy can often result in large losses. Thus, politically motivated temporary shifts in managers’ incentives to hoard bad news is an ideal event for short sellers to focus on.
Third, short selling is particularly relevant in analyzing negative information suppression, as short selling focuses primarily on bad news. Short sellers’ in-depth investigations into bad news on firms provide a disciplinary force on managers; short sellers can quickly voice negative information uncovered through their trades, leading to sharp declines in prices. Therefore, managers may be less incentivized to engage in bad news hoarding given the presence of short sellers.
We use a Difference-in-Differences (hereafter, DiD) approach to investigate whether the change from non-shortable to shortable stocks significantly reduces the firm’s negative information suppression during the politically sensitive periods.
Using a sample from 2002 to 2018, we find that after short selling becomes eligible, negative information suppression around political meetings and other important national events becomes significantly lower for shortable stocks than for non-shortable stocks. These results suggest that although short sellers/brokerages are subject to political pressures from the government and politicians, their economic incentives dominate political ones (at least partially), and thus short selling is an effective mechanism for reducing negative information suppression in the Chinese business setting.
In addition, we find that the effect of short selling is more pronounced for political meetings and for firms with lower financial reporting quality, while it is similar between state-owned enterprises and non-state-owned enterprises. Finally, our additional analysis using output of news media also confirms that information environment is improved as the total production of news increases.
Overall, our empirical strategy aims at capturing the intertemporal shift in bad news hoarding in relation to political information using a China setting. Our results show the causal effects of removing short selling restrictions on negative information suppression. This in turn confirms the disciplinary effect of short selling on bad news hoarding in emerging markets.
Xiaohu Deng is an Assistant Professor (lecturer in Australia) in Tasmanian School of Business and Economics at the University of Tasmania.
Christine X. Jiang is a Professor in the Department of Finance at Fudan University School of Management.
Danqing Young is a Professor in the School of Accountancy and the Director of Executive Master of Professional Accountancy Programme at The Chinese University of Hong Kong (CUHK).
This post is adapted from their paper, “Short Selling Constraints and Politically Motivated Negative Information Suppression,” available on SSRN.