Academic journal article Journal of Politics and Law

Rule by Law, Government Control and Company Investment Efficiency: Empirical Evidence from China

Academic journal article Journal of Politics and Law

Rule by Law, Government Control and Company Investment Efficiency: Empirical Evidence from China

Article excerpt


Under the premise of considering the motives and actions of all levels of governments, this paper empirically studies the mechanism and economic consequences of the law and order regulating inefficient investments on a sample of 3201 firm-year observations of listed companies in Shanghai and Shenzhen Stock Exchange in China over the period from 2007 to 2009. Using investment-cash flow sensitivities to proxy for inefficient investment of a company, I provide evidence that the degree of inefficient investments of listed companies controlled by local governments is much higher than that of other companies controlled by central government or non-governments. Furthermore, I find that the level of law and order of a region with high quality can reduce significantly the sensitivity of investment of Chinese listed companies to cash flows, the effect of which is much stronger for listed companies controlled by local governments. According to the conventional interpretations, a lower investment cash flow sensitivity means less investment distortions. However, the improvement of investment efficiency aising from the law and order are not ultimately transferred to the increase in the company's future operating performances, suggesting that the roles of the level of law and order of a region across China playing in controlling company's inefficient investment are limited.

Keywords: law and order, government control, inefficient investment, investment-cash flow sensitivity

(ProQuest: ... denotes formulae omitted.)

1. Introduction

In a world where there are no tax and transaction costs and information is perfect, Modigliani and Miller (1958) have confirmed that a company's investment decisions are irrelevant to its financing decisions, the market value of a company will be determined only by the future profitability of investment projects and cost of capitals that a company uses, and the company will achieve the maximum market value at the optimal level of investment. However, there are no perfect capital markets in reality. Information asymmetries and transaction costs in the capital markets will give rise to two frictions: adverse selctions and moral hazards. Adverse selection problems in the capital markets will lead to a company to be credit rationed (Stiglitz & Weiss, 1981). Credit rationing causes the company to bear the additional cost premium for external financing, and makes uncollateralized external financing more costly than internal financing, which results in the company financially constrained and showing obvious preference to internal financing (Myers & Majluf, 1984), which leads to internal cash flows as an important determinant of investment of a company. When companies with many good investment opportunities are lack of enough internal funds, in view of the higher cost of external financing or capital rationing problem in the capital markets, companies facing financing constraints would be forced to give up some investment projects with positive net present values, which make the companies underinvest. On the other hand, moral hazard problems will aggravate agency conflicts of use of funds between managers and outsider shareholders, which make company's managers overinvest in unprofitable or even lost projects that will reduce shareholders wealth in order to obtain more monetary and non-monetary private benefits related to the large size of the company when managers are not monitored effectively and appropriate incentives are not given (Jensen, 1986). Since external financing will enable managers to face more monitors and constraints arising from the capital markets, managers tend to use internal funds of a company for overinvestment, making investments of a company also significantly positive correlated with internal cash flows. Therefore, in imperfect capital markets, though the true reasons of underinvestment as well as the resulting company's activities are completely different from those of overinvestment, both underinvestment and overinvestment will cause the investment expenditures of a company to increase with its internal cash flows, which make investment expenditures of a company very sensitive to its internal cash flows. …

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