Abstract
This paper uses a dataset of more than 100,000 firms over the period of 2000–2007 to assess whether and why Chinese firms overinvest. We find that corporate investment is more efficient in the non-state sector. Within all ownership categories, we uncover evidence indicating a degree of overinvestment among firms that invest more than their industry median or more than their predicted optimal investment. The free cash flow hypothesis provides a good explanation for China’s overinvestment in the non-state sectors, whereas in the state sector, overinvestment is attributable to the poor screening and monitoring of enterprises by banks.
Highlights
In the regression, we find that the cash flow ratio has a positive and significant coefficient, suggesting a positive relationship between investment efficiency and the abundance of internal funds
We devise and analyze an alternative measure of overinvestment, which enables us to test for Jensen‟s (1986) free cash flow hypothesis of overinvestment, and to give a thorough assessment of whether debt plays a disciplinary role in curbing managerial discretion (Jensen, 1986; Stulz, 1990)
We believe that a significant part of the difference observed in our dataset is likely to represent overinvestment because of the influences of free cash flow and leverage that we find in subsequent sections
Summary
China has experienced an investment boom in recent years. Gross fixed capital formation has averaged 33 percent of GDP since economic reform commenced in 1978, and 39 percent over the last decade (World Development Indicators, December 2010). The use of such a comprehensive dataset enables us to move the literature forward, by taking into account the vast heterogeneity characterizing Chinese firms in analyzing their overinvestment behavior We first look at overinvestment indirectly, constructing firmlevel measures of investment efficiency, and provide descriptive statistics so as to shed light on the linkages between investment efficiency and firm ownership, industry, time, geographic location, and political affiliation. Despite significant differences across ownership groups, industries, regions, and levels of political affiliation, the general investment efficiency of Chinese firms has increased over time. This suggests that overinvestment has been declining.
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