Are Chinese Listed Firms Over-Investing‘

Abstract

We investigate how financial constraints and agency costs impact firms' investment in China. A generalized Q investment model is constructed. It implies that firms' investment depends mainly on three factors: investment opportunity which determines the optimal investment stochastic frontier, financial constraints and agency costs, both of which are one-sided distributed and tend to deflect the firm's investment from its optimal level. Our theory can be tested using the newly developed two-tier stochastic frontier analysis. The empirical results show that both financial constraints and agency costs have significant effects on Chinese listed firms' investment, while that of the former is dominant. The net effect of these two factors leads to a nearly 34% underinvestment. Thus, we severely cast doubt on a large body of previous studies which claim that Chinese listed firms are over-investing.

Keywords: Investment, Financial constraint, Agency cost, Fundamental Q, Two-tier stochastic

JEL Classification: E22, E32, G31