How do firms navigate the tightrope of R&D investments, cash flow sensitivity, and financial constraints? Evidence from China and India

In recent years, India and China have emerged as powerhouses of innovation in Asia, with significant research and development (R&D) investments. This study examines the sensitivity of R&D investments to a firm’s internal cash flow using firm-level panel data for two emerging economies, India and China, for the period 2011–2023. The research further explores how innovation efficiency influences this relationship in the face of financial constraints. Developing dynamic R&D models separately for these economies based on the Euler equation, our analysis reveals that while cash flow has a positive influence on R&D investments in both countries, the sensitivity is higher in India compared to China, indicative of binding financing constraints. Both countries exhibit a strategy of maintaining cash reserves to buffer R&D investments, aligning with the precautionary motive of holding cash. Indian firms predominantly rely on debt financing, whereas Chinese firms favour new stock issues as external financing sources. Notably, the sensitivity of R&D to cash flow becomes more pronounced when firms exhibit both higher innovation efficiency and financial constraints in both nations. These dynamics guide firms to strategize and optimize their R&D investments.