Corporate Liquidity and Monetary Union

Abstract

We investigate cash holdings of firms from 15 European Union (EU) countries [12 European Monetary Union (EMU) countries that adopted a common currency, euro, and 3 non-EMU countries] from 1993 to 2002 using a dynamic panel data model. Unlike previous studies, we formally consider endogeneity of explanatory variables and show that it matters. Contrary to these studies, we find that firms with greater investment opportunities hold less cash. We show that compared to shareholder rights, creditor rights play a more important role in determining corporate liquidity and should be included in international corporate liquidity research. Adoption of a common currency affects corporate liquidity in a variety of ways. Cash and debt become better inter-temporal substitutes while cash and net working capital become better contemporaneous substitutes for EMU firms after the euro's adoption. The agency theory view of cash holdings has better explanatory power for these firms, probably because of an enhanced capital market integration that weakens the transaction and precautionary motives of holding cash. We also obtain evidence consistent with the tradeoff theory. In our whole test period during which the EMU countries underwent a transition to a monetary union, the adjustment speed of corporate liquidity for EMU firms appears to be slower than for non-EMU firms. This suggests that for firms in a common currency area, cash management becomes relatively less important probably due to more integrated capital markets and thus lower cost of deviating from target cash holdings. Further, we obtain evidence that the introduction of the euro reduces corporate liquidity in the EMU firms.