Abstract
The study investigates the role of financial development in boosting the investment efficiency of firms’ investments in China. Using a large sample of firm-level financial data and country level economic data over the period 2004–2015, present study creates a link between financial and real economy. Firms are priori classified into under- or over-invested and effect of financial development is analyzed individually on each classification by using panel data estimations. The research concludes that firms suffering from under- (over-) investment problem due to financing constraints (agency problem), are more likely to increase (decrease) their investment` in the response of underlying financial development in the economy. This study has demonstrated a novel approach by concurrently incorporating the monitoring and financing issues that disturb the optimal level of investments. Moreover, the findings give strong implications by suggesting and empirically proving the remedy that has the potential to balance the investment distortions by rectifying monitoring and financing deficiencies.
Highlights
IntroductionThere is enough evidence suggesting the existence of cyclical effect of financial variables over real variables. Love and Zicchino (2006) advocates the prophecy that classical dichotomy of real and financial variables should no longer exist after emergence of information asymmetry
Since economists started to look at real phenomena abstracting from M-M model, a vast literature has been developed on the discussion of distortions in investment decisions in relation with real information asymmetry and agency cost; the former is likely to produce financing constraints and the latter is likely to produce monitoring issues
The first variable of financial development is commonly identified in the literature as Financial Development Activity (FDa) and it represents a measure of the overall activity or liquidity of financial sector
Summary
There is enough evidence suggesting the existence of cyclical effect of financial variables over real variables. Love and Zicchino (2006) advocates the prophecy that classical dichotomy of real and financial variables should no longer exist after emergence of information asymmetry. Comes the role of development in financial system, which is expected to help the firms in investment decisions by providing needed capital flow and monitoring. It helps the firms to boost their financial performance by strengthening their investment activity, which is achieved by making the flow of capital smooth and providing vigorous monitoring and corporate governance system. Even though Chinese stock market has grown tremendously beyond expectation, it is still relatively small compared with Chinese banking sector (Chen et al 2001) Due to these and other political economic issues, Chinese financial markets are not acting as an efficient platform for Chinese firms to reduce financing constraints and causing underinvestment resultantly. Our study fills this theoretical gap by providing empirical evidence
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