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Investment and the soft budget constraint in China

Author

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  • Chow, Clement K.W.
  • Song, Frank M.
  • Wong, Kit Pong

Abstract

This paper examines the incentive effects of the soft budget constraint on the investment behavior of firms in general and on the investment-cash flow sensitivity in particular. To this end, we develop a simple model of moral hazard that takes the soft budget constraint into account. Within this moral hazard environment, we show that investment is positively related to the amount of internal funds. We further show that the presence of the soft budget constraint deteriorates the moral hazard problem, thereby making the investment level less sensitive to the amount of internal funds. This is the case irrespective of whether the soft budget constraint renders the firm more or less liquidity constrained. To test the model's empirical implications, we employ data of China's listed companies for the period from 1997 to 2003. We use the share of state ownership as a proxy for the severity of the soft budget constraint. We find strong evidence that firms with larger shares of state ownership exhibit lower investment-cash flow sensitivities than firms with smaller shares of state ownership.

Suggested Citation

  • Chow, Clement K.W. & Song, Frank M. & Wong, Kit Pong, 2010. "Investment and the soft budget constraint in China," International Review of Economics & Finance, Elsevier, vol. 19(2), pages 219-227, April.
  • Handle: RePEc:eee:reveco:v:19:y:2010:i:2:p:219-227
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Lin, Tsung-Te & Chou, Jian-Hsin, 2015. "Trade credit and bank loan: Evidence from Chinese firms," International Review of Economics & Finance, Elsevier, vol. 36(C), pages 17-29.
    2. Nagano, Mamoru, 2016. "The bank–firm relationship during economic transition: The impacts on bank performance in emerging economies," Emerging Markets Review, Elsevier, vol. 28(C), pages 117-139.
    3. Guariglia, Alessandra & Yang, Junhong, 2016. "A balancing act: Managing financial constraints and agency costs to minimize investment inefficiency in the Chinese market," Journal of Corporate Finance, Elsevier, vol. 36(C), pages 111-130.
    4. Jiang, Wei & Zeng, Yeqin, 2014. "State ownership, bank loans, and corporate investment," International Review of Economics & Finance, Elsevier, vol. 32(C), pages 92-116.
    5. János Kornai, 2014. "The soft budget constraint," Acta Oeconomica, Akadémiai Kiadó, Hungary, vol. 64(supplemen), pages 25-79, November.
    6. Kornai, János, 2014. "Bevezetés A puha költségvetési korlát című kötethez
      [Introduction to the author s volume entitled Soft Budget Constraint]
      ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(7), pages 845-897.
    7. Bradford, William & Chen, Chao & Zhu, Song, 2013. "Cash dividend policy, corporate pyramids, and ownership structure: Evidence from China," International Review of Economics & Finance, Elsevier, vol. 27(C), pages 445-464.
    8. Kang, Fei & Hauge, Janice A. & Lu, Ting-Jie, 2012. "Competition and mobile network investment in China’s telecommunications industry," Telecommunications Policy, Elsevier, vol. 36(10), pages 901-913.
    9. Deng, Lu & Li, Sifei & Liao, Mingqing & Wu, Weixing, 2013. "Dividends, investment and cash flow uncertainty: Evidence from China," International Review of Economics & Finance, Elsevier, vol. 27(C), pages 112-124.
    10. Fonseka, M.M. & Colombage, Sisira R.N. & Tian, Gao-Liang, 2014. "Effects of regulator's announcements, information asymmetry and ownership changes on private equity placements: Evidence from China," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 29(C), pages 126-149.

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