Abstract
This paper examines the incentive effects of the soft budget constraint on the investment behavior of firms in general and on the investment-cash flow sensitivity in particular. To this end, we develop a simple model of moral hazard that takes the soft budget constraint into account. Within this moral hazard environment, we show that investment is positively related to the amount of internal funds. We further show that the presence of the soft budget constraint deteriorates the moral hazard problem, thereby making the investment level less sensitive to the amount of internal funds. This is the case irrespective of whether the soft budget constraint renders the firm more or less liquidity constrained. To test the model's empirical implications, we employ data of China's listed companies for the period from 1997 to 2003. We use the share of state ownership as a proxy for the severity of the soft budget constraint. We find strong evidence that firms with larger shares of state ownership exhibit lower investment-cash flow sensitivities than firms with smaller shares of state ownership.
| Original language | English |
|---|---|
| Pages (from-to) | 219-227 |
| Number of pages | 9 |
| Journal | International Review of Economics and Finance |
| Volume | 19 |
| Issue number | 2 |
| DOIs | |
| Publication status | Published - 1 Apr 2010 |
Funding
sWe would like to thank Philippe Aghion, Chong-En Bai, Ron Giammarino, Donald Lien (the guest editor), Albert Schweinberger, Neal Stoughton, an anonymous referee, and seminar participants at the University of Hong Kong, the University of Konstanz, and the Conference on China's Security Market and Financial System Reform at the Peking University for helpful comments and suggestions, and Chuntao Li for excellent research assistance. Chow acknowledges the Lingnan University, and Song and Wong are
Keywords
- Investment-cash flow sensitivities
- Moral hazard
- Soft budget constraints