Financial liberalization and the investment-cash flow sensitivity

Abstract

The decline and diminishment of investment-cash flow sensitivity remains a puzzle in literature. This paper attempts to address this puzzle by examining the heterogeneous effects of domestic financial liberalization and international financial integration on corporate investment-cash flow sensitivity. Using a large firm level data for 69 developed and emerging economies over the period 1995–2019, we provide robust evidence that firms in countries with more liberalized domestic financial markets exhibit lower sensitivity of investment to the availability of cash flows. Reducing financial constraints and then promoting external finance are possible mechanisms through which domestic financial liberalization affects investment-cash flow sensitivity. While the effect of international financial integration, on average, is less clear, our results show that increases in international financial integration promote investment more for firms with higher cash flows in high income economics but more for firms with lower cash flows in non-high income economies. Our paper provides new insights into the real effects of financial institutional arrangements on the economy.