Fast or slow: Unveiling the speed of market leverage adjustment in China

Abstract

In the capital structure literature, the practice of using market leverage to estimate the speed of adjustment (SOA) to target capital structure is debated. We empirically examine the capital structure adjustment behavior of Chinese firms using the SOA decomposition model proposed in Yin and Ritter (2020). Our findings suggest an overestimation of SOA towards the target market capital structure in Chinese firms, with a pre-correction speed of around 19.6% and a post-decomposition active adjustment speed of merely 7.4%. This overestimation is attributed to significant price fluctuations in the stock market. We further explore the cross-sectional differences and time-series variation in SOA to confirm our findings, advising caution in the use of market leverage for robustness tests. Our results imply that the trade-off and pecking order theories have limited explanatory power for the capital structure decisions of Chinese firms, while market timing theory appears to be more applicable.