Investor Protections, Financial Development and Corporate Investment Efficiency

This paper theoretically and empirically investigates the micro-mechanism and economic consequences of legal protections of investor rights and financial development regulating firm inefficient investment based on a broad cross-sectional sample of 8548 firm-year observations of companies listed on Shanghai and Shenzhen stock exchanges in China over the period 2003 to 2011. By following the creative approach to measure a firm’s underinvestment and overinvestment put forward by Richardson (2006), I find that the magnitude of underinvestment of the private enterprises is much higher than that of state-owned enterprises, however, there is no significant difference in overinvestment between private enterprises and state-owned enterprises. Further analysis reveals that firms with positive free cash flow are more likely to engage in overinvestment. In contrast, firms with negative free cash flow more easily suffer from underinvestment. The improvement in the level of the legal protection of investor rights of a region in China can significantly relax the underinvestment of private enterprises, yet further aggravates rather than mitigates state-owned enterprises’ underinvestment. Although financial development of a region in China can also reduce the underinvestment of private enterprises, it has no impact on the reduction in the magnitude of the underinvestment of state-owned enterprises. Furthermore, contrary to the theoretical expectation, there is no evidence indicating that the improvement in the level of the investor protections and financial development of a region in China could effectively restrain the possibility of overinvestment of private and state-owned enterprises, which suggests that the role of the rule of law and financial development in alleviating the enterprises’ inefficient investment is still relatively limited in China. These findings above together mean that unless the institutional environments of the lack of effective legal protection of private property rights as well as the underdeveloped formal financial system have been fundamentally improved, the inefficient problems of state-owned property rights and the resulting firm investment inefficiency and distortion may not automatically disappear with the reform of property rights of Chinese state-owned enterprises.