Financial Slack and Inefficient Investment Decisions in China

Given the significant capital market imperfections and poor corporate governance mechanisms overinvestment and underinvestment coexist in China. This study provides a portrait of the nature of agency problems and financial constraints in China. Using a large panel of Chinese listed firms over the period from 2007 to 2018, we document strong evidence that firms with financial slack resources exhibit greater investment inefficiencies. Further analysis on firms with financial slacks shows that Chinese state‐owned enterprises (SOEs) are more likely to overinvest than non‐SOEs; firms with higher financing constraints show more overinvestment and less underinvestment; and firms facing more fierce market competitions are more likely to exhibit extra caution in making investment decisions and thus are less likely to overinvest. Our results are robust and consistent with the financial constraints and agency problem theories.