Title: Investment and the Soft Budget Constraint in China
Reference Number: 1188
Publication Date: February 2009
JEL Classifcation: E22, G32, P21

Clement K.W. Chow
Lingnan University

Frank M. Song
The University of Hong Kong

Kit Pong Wong
The University of Hong Kong

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.

Published in International Review of Economics and Finance 19 (April 2010), pp. 219-227.

Key words: Investment-cash flow sensitivities, Moral hazard, Soft budget constraints

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Last modified: 09/15/2010