Political Connections, Financing Friction, and Corporate Investment: Evidence from Chinese Listed Family Firms

Date01 September 2013
AuthorXinzhong Xu,Nianhang Xu,Qingbo Yuan
Published date01 September 2013
DOIhttp://doi.org/10.1111/j.1468-036X.2011.00591.x
European Financial Management, Vol. 19, No. 4, 2013, 675–702
doi: 10.1111/j.1468-036X.2011.00591.x
© 2011 John Wiley & Sons Ltd
Political Connections, Financing
Friction, and Corporate Investment:
Evidence from Chinese Listed Family
Firms
Nianhang Xu
School of Business, Renmin University of China, Beijing, 100872, China
E-mail: nhxu@ruc.edu.cn
Xinzhong Xu
Guanghua School of Management, PekingUniversity, Beijing, 100871, China
Lingnan College, Sun Yat-senUniversity, Guangzhou, 510275, China
E-mail: xuxz@gsm.pku.edu.cn
Qingbo Yuan
Department of Accounting and Business Information Systems, University of Melbourne, Melbourne,
VIC 3010, Australia
E-mail: yuanq@unimelb.edu.au
Abstract
Using a sample of Chinese family firms from 2000 to 2007, we investigate the
investment behaviour of family firms and the effects of these firms’ political
connectedness on their investments in a relationship-based economy. Consistent
with previous evidence that Chinese family firms have difficulty in financing,
our results demonstrate that underinvestment due to problems with asymmetric
information rather than overinvestment resulting from problems of free cash flow
prevails in such firms. We further find that the political connectedness of family
We acknowledge the helpful comments from an anonymous referee, John Doukas (editor),
Gary Tian, Zhen Wang,Mingui Yu, seminar participants at WuhanUniversity, and conference
participants at the European Financial Management (Asian Finance) Symposium 2010
and the AsianFA 2010 Annual Conference. Financial supports from the National Natural
Science Foundation of China (Nos. 70802002 and 71021001), the Social Science Research
Project supported by the China Ministry of Education (No. 08JC630001), the Foundation
for the Author of National Excellent Doctoral Dissertation of PR China (No. 201085),
and the Fundamental Research Funds for the Central Universities and the Research Funds of
Renmin Universityof China (No. 10XNK089) are also g ratefullyacknowledged. Professional
editing service provided by Joelma Nascimento is greatly appreciated. All errors remain our
responsibility.
© 2011 John Wiley & Sons Ltd
Nianhang Xu, Xinzhong Xu and Qingbo Yuan
676
firms can help mitigate the underinvestment problem, with the mitigation effect
being more pronounced in financially constrained firms.
Keywords: political connection,corporate investment,family firm,China
JEL classification: G32, G34
1. Introduction
In a world of perfect and complete capital markets, a firm’s financial status is irrelevant
for investment decisions, as has been demonstrated by Modigliani and Miller (1958).
However, in the real world, a variety of distortionary forces exist. The most pervasive and
important factors influencing the efficiency of corporate investment are those arising
from informational asymmetries and agency problems (Stein, 2003). The empirical
literature, starting with Fazzari et al. (1988), confirms the existence and robustness of
investment-cash flow sensitivity after controlling for investment opportunities. The two
traditional explanations for these investment distortions are the information asymmetry
between corporate insiders and the capital market (Myers and Majluf, 1984) and the
misalignment of managerial and shareholders’ interests (Jensen, 1986). Although the
two theories are observationally equivalent with respect to the sensitivity of investment
to cash flow, their policy implications are obviously different, with the former leading
to underinvestment and the latter to overinvestment.
In China, the government still controls most resources, and state-owned enterprises
(SOEs) enjoypreferential status in obtaining bank loans and other key inputs (Chow et al.,
2010; Li et al., 2008; Poncet et al., 2010). Moreover,f amilyf irms in China are generally
smaller and younger than their state-owned counterparts and are therefore of higher risk
in the eyes of financing institutions. For these reasons, financing becomes a critical
problem for the development of family firms, which sometimes leads to suboptimal
investment level. However, some family firms mitigate this financial constraint problem
by fostering connections with the government. There is wide evidence that political
connectedness can help firms obtain less costly resources from banks and other state
institutions (Johnson and Mitton, 2003; Khwaja and Mian, 2005; Faccio et al., 2006; Li
et al., 2008; Wu et al., 2010).
This paper aims to investigate the investmentbehaviour of Chinese listed family firms,
which are presumably facing severe financing constraints problem because of their non-
state status and China’s socialist ideology. Specifically, which of the abovementioned
distortions prevails is of particular interest to us. Based on the findings in the first
step, we further investigate whether political connection status can help mitigate this
distortion.
Our first set of tests f inds that Chinese listed familyf irms’ investments highlydepend
on internally generated funds. To differentiate between the asymmetric information
hypothesis (underinvestment) and the agency cost hypothesis (overinvestment), we
further investigate whether the investment-cash flow sensitivity varies according to
two dimensions of financial constraints and corporate governance. If the sensitivity is
positively related to a priori measures of financial constraints, we can interpret this
finding to mean the f irm is below its optimal level of investment (underinvestment).
In contrast, if the sensitivity is inversely related to the quality of corporate governance
perceived to monitor any firm behaviour of distorting resources to engage in empire
2012).

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