Debt enforcement, financial leverage, and product failures: Evidence from China and the United States

• Published date: 01 September 2023
• Author: Yaopan Yang,Songsong Li,Hengqin Wu
• Date: 01 September 2023
• DOI: http://doi.org/10.1111/jfir.12331

Received: 16 April 2022

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Accepted: 19 April 2023

DOI: 10.1111/jfir.12331

ORIGINAL ARTICLE

Debt enforcement, financial leverage, and

product failures: Evidence from China and the

United States

Yaopan Yang

1,2

|Songsong Li

1

|Hengqin Wu

3

1

School of Economics and Management,

Harbin Institute of Technology, Harbin, China

2

Faculty of Economics and Business,

KU Leuven, Leuven, Belgium

3

Department of Building and Real Estate,

The Hong Kong Polytechnic University,

Hong Kong, China

Correspondence

Songsong Li, School of Economics and

Management, Harbin Institute of Technology,

Harbin, China.

Email: lisongsong@hit.edu.cn

Funding information

Natural Science Foundation of Heilongjiang

Province (China), Grant/Award Number:

G2018006; Heilongjiang Provincial

Postdoctoral Science Foundation (China),

Grant/Award Number: LBH‐Q18064; Natural

Science Foundation of China (China),

Grant/Award Number: 71773024

Abstract

Building on capital structure and product market interac-

tions, and the role of debt enforcement in leveraged firms'

investments, we examine whether cross‐country debt

enforcement can produce different associations between

financial leverage and product failures. Results show that

different debt enforcement systems can generate oppo-

site leverage effects. In countries with weak/nearly

ineffective debt e nforcement,financialleverageshows

an incentive investment effect due to low default costs,

and thus highly leveraged firms tend to invest more and

arelesslikelytohaveproductfailures.Conversely,in

countries with strict/effectivedebtenforcement,dis-

tressed companies tend to have an underinvestment

effect and more product failures.

JEL CLASSIFICATION

G32, G34

1|INTRODUCTION

Looking around the world nowadays, product failures such as food safety, automobile recalls, and toy issues are

omnipresent, triggering public concerns about product quality (Bollerslev et al., 2018; Cleeren et al., 2017;

Khamitov et al., 2020; Kini et al., 2017; Ni et al., 2016; Seo et al., 2013; Zhao et al., 2013). The underlying causes

may be a shortage of capital resources, insufficient production lines, the product development process, or industrial

market threats (Kini et al., 2017; Thirumalai & Sinha, 2011), which can be determined by the corporate capital

structure and subsequent underinvestment (Kini et al., 2017). Simultaneously, nonfinancial companies in many

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© 2023 The Southern Finance Association and the Southwestern Finance Association.

countries, including civil and common law countries, or transition and advanced economies, have increased debt

financing in the past 30 years, which influences their capital structure and investment policies (Jordà et al., 2022)

and ultimately may induce product failures.

Most studies have explored this subject—relation between capital structure and product market—within an

individual country. Some academics find that during crisis periods, internal or external financing, such as cash

reserves or debt financing, can play relevant and different roles in product market performance (Byoun & Xu, 2016;

Fresard, 2010; Kale et al., 2013). Campello and Fluck (2004) pay attention to interactions between high debt and

product market in the industry context and distinguish the interactions between crisis and boom periods. Kini et al.

(2017) document that high financial leverage can induce corporate underinvestment and hurt product market

performance during a financial crisis period, increasing the incidence and frequency of US product failures.

Moreover, one strand of literature (El Ghoul et al., 2020; Favara et al., 2017; Oeztekin, 2015) has emphasized

the importance of legal origins and/or institutions attached to affecting the investment decisions and product

market of leveraged firms. Another strand has proposed that civil law countries, such as China, have weak/nearly

ineffective debt enforcement system, and common law countries, such as the United States, have strict/effective

debt enforcement (Allen et al., 2005; Favara et al., 2017; La Porta et al., 2008). Hence, recent literature investigates

the capital structure and corporate investment interplays by considering country‐level differences across legal

origins and/or legal institutions. Favara et al. (2017) claim that financially distressed companies tend to invest more

in weak debt enforcement countries than in strict debt enforcement countries because default costs are low and

risks are shifted to creditors in weak debt enforcement countries.

Building on the literature about capital structure and product market interplays (Byoun & Xu, 2016; Kini

et al., 2017), as well as the literature about the role of debt enforcement in investment decisions of leveraged firms

(Acharya et al., 2011; El Ghoul et al., 2020; Qi et al., 2017), we employ weak/nearly ineffective and strict/effective

debt enforcement systems/scenarios to empirically analyze the effect of financial leverage on product failures. Such

different debt enforcement systems may lead to diverse effects of financial leverage on product failures.

Consequently, we demonstrate a significant negative effect of financial leverage on product failures for Chinese

manufacturers amid a weak/nearly ineffective debt enforcement scenario, but a significant positive effect of

financial leverage on product failures for US manufacturers amid a strict debt enforcement scenario.

Our contributions are as follows. First, the literature pays limited attention to the role of debt enforcement in

corporate structureand product market interplays (Cho et al., 2014;Keister,2004; Wu & Yue, 2009). We extendthe

theoreticalframework of capital structureand product market interplays by considering the roles ofnearly ineffective

and effective debt enforcement systems in leveraged firms' investments. Second, a few studies look closely at

the capital structure and product market interplays in weak/nearly ineffective debt enforcement countries. Studies

looking at the capital structure and product market interplays have always been conducted in the United States, a

common law countrywith strict/effective debt enforcement (Campello & Fluck,2004; Chevali er & Scharfstein, 1996;

Chevalier,1995; Kini et al., 2017). Thus, we give a closer look at the effectof financial leverage on product marketin a

weak/nearlyineffective debt enforcementcountry and identify financial leverage'sincentive investmenteffect and its

positive effect on product market performance amid the transition economy. Finally, we echo the constraint

investment effect of financial leverage argued in Kini et al. (2017) by assuming a prediction in a strict debt

enforcement scenario and using US product failures during normal times to test the prediction. In doing so, we

suggest a powerful prediction of debt enforcement for the impact of financial leverage on the product market.

2|THEORETICAL FOUNDATION AND PROPOSED HYPOTHESES

In this section, we predict how financial leverage affects firms' investment decisions and product failures under

different debt enforcement scenarios. We first describe the theoretical background of product failures and their

underlying underinvestment, as well as capital structure and product market interplays and the role of legal

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