The Impact of Government Intervention on Corporate Investment Allocations and Efficiency: Evidence from China

• Author: Jing Lu,Ying Hao
• Date: 01 June 2018
• DOI: http://doi.org/10.1111/fima.12188
• Published date: 01 June 2018

The Impact of Government Intervention

on Corporate Investment Allocations

and Efficiency: Evidence from China

Ying Hao and Jing Lu∗

We examine whether government intervention plays an important role in determining corporate

investment allocations and efficiency in China. We find the government tends to intervene to

promote corporateinvestment in fixed assets, equity in other state-owned enterprises (SOEs), and

natural resources including oil, natural gas, and mines, but reduces research and development

(R&D) investment.However, the effectsof government intervention on these investment allocations

areprimarily found in local SOEs rather than in central SOEs or in private enterprise. Government

intervention also induces a crowding-out effect in natural resource investments of private firms,

suggesting that government intervention distorts investment allocations and reduces investment

efficiency.

The role of government in promoting and regulating economic development has long been

recognized as an extremely important issue. One way in which government can significantly

influence corporate financial strategy is by directly intervening in firm investment decision

making (Chen et al., 2011a; Cohen, Coval, and Malloy, 2011; Julio and Yook, 2012; Lin and

Wong,2013). Government intervention has been identified in almost all developed and developing

economies (La Porta et al., 1999; Stiglitz, 2000, 2010) and it is plausible that it substitutes for

the effects of a private market. Government intervention, viewed as a response to market failures,

arises from the existence of externalities and the optimized design of social security policies.

Compared to developed economies, transitional and developing economies are more likely to

experience market deficiencies and breakdowns. Thus, government intervention can serve to

increase the allocative efficiency of economic resources. However, since government objectives

tend to deviate from market-oriented goals in a transitional economy, government intervention

can instead trigger the misallocation of economic resources, not only at the market level, but

also at the firm level (Che and Qian, 1998a; Allen, Qian, and Qian, 2005). Although government

intervention clearly has important implications for firm-level resource distribution and different

types of investment allocations (essentiallythrough changes in government policy or direct effects

on the institutional environment), there is little research as to howgovernment intervention affects

firms’ investment allocation.

We appreciate helpful comments from Raghu Rau (Editor), an anonymous referee,Stephen H. Penman, Robin K. Chou,

Xiao Chen, Qinglu Jin, Qingquan Xin, Yanyan Wang, Lisheng Yu, Keng-Yu Ho, and seminar participants at Xiamen

University, Shanghai University of Finance and Economics, the 2015 FMA Annual Meeting in Orlando, and the 2016

European Finance Management Association (EFMA) Annual Conference in Basel. Ying Hao gratefully acknowledges

financial support from the National Natural Science Foundation of China (Grant No. 71372137), and fromthe National

Science Foundationof China (Grant No. 71232004 and Grant No. 71572153). Jing Lu gratefullyacknowledges financial

support from the National NaturalScience Foundation of China (Grant No.71373296). All remaining errors are our own.

∗Ying Hao (CorrespondingAuthor) is a Professor at the Business School at Beijing Normal University in Beijing, China.

Jing Lu is a Professor in the School of Economics and Business Administrationat Chongqing University in Chongqing,

China.

Financial Management •Summer 2018 •pages 383 – 419

384 Financial Management rSummer 2018

In this study, we examine the effects of government intervention on the investment allocations

of firms in China. Although numerous studies have focused on the effects of government inter-

vention, particularly the effect of inducing overinvestment in fixed assets among the country’s

“state-owned enterprises” (SOEs), to the best of our knowledge, very few empirical studies have

focused on the impact of government intervention on corporate investment allocation and asset

structure (Cull and Xu, 2005; Dollar and Wei, 2007; Chen et al., 2011a). The economic conse-

quences of such intervention on corporate investment allocation is largely dependent upon the

socioeconomic objectives of the government, with different types of investment (such as fixed

assets, natural resources, equity and research and development [R&D] investment) serving to

meet a range of government goals and interests (De Long and Summers, 1991; Corrado, Hulten,

and Sichel, 2009; Daniele, 2011).

While government intervention in business is not unique to China, the Chinese economy

is particularly well suited for examining the impact of government intervention on corporate

investment allocation for three reasons. First, the Chinese government plays an essential role

in business activities through its significant ownership and control of SOEs. Although private

enterprises (PROEs, non-SOEs) are growing in numbers, the enormous influence of government

on the private sector during ongoing reforms is a distinctive feature in China (Allen et al., 2005).

SOEs still play a dominant role in almost all important economic resources, especiallyin industries

such as natural resources, utility,transpor tation, and infrastructure. In addition, since the political

promotion of local government officials is closely tied to local economic performance, local

government officials clearly have strong incentives to influence local enterprises to invest in

assets that make a direct and immediate impact toward achieving economic goals (Li and Zhou,

2005; Qian, Roland, and Xu, 2006). The managers of these local SOEs (LSOEs), who play

a semiofficial role within the bureaucratic hierarchy, are appointed by local governments (Bai

et al., 2000; Jin, Qian, and Weingast, 2005). Consequently, the government’s majority ownership

in SOEs, combined with the almost absolute power to appoint top executives, provides us an

excellent setting to examine how government intervention affects firms’ investment allocation.

Finally, as the world’s largest transitional economy, China’s reforms from a centrally planned

economy to a market economy are already well documented (Allen et al., 2005; Prasad and

Rajan, 2006). To encourage ownership reform, the government allows a controlling ownership

stake to transfer from one state entity to another and from a state entity to a private one.1Using a

setting of changes in ownership, wecan avoid potential endogeneity issues in the relation between

government intervention and government ownership in SOEs and better delineate the impact of

government intervention on the corporate investment allocation.

Our measure of government intervention is based on two alternative proxies: the ratio of

government expenditures to gross domestic product (GDP) and the ratio of public officers to total

employment. Using data for Chinese listed firms from 2005 to 2012, we find that the government

tends to intervene to promote corporate investment in fixed assets, equity, and natural resources,

while correspondingly reducing R&D investment. These results are more pronounced in regions

with higher government intervention. Investments in fixed assets, equity, and natural resources

are more visible, are easier to measure in terms of their contribution to the GDP, and provide

a quick strategy to meet short-term economic evaluation criteria. Conversely, R&D investments

are riskier and take much longer to be realized.

1The ownership and control structures of listed firms in China can be broadly classified into three forms: central

government-controlled state-owned enterprises (central SOEs or CSOEs), local government-controlled state-owned en-

terprises (local SOEs or LSOEs), and privately owned enterprises (PROEs).

Hao & Lu rImpact of Government Intervention on Corporate Investment Allocations and Efficiency 385

Further, we examine the effects of government intervention on firm investment allocation

under different types of ownership. Since the ownership of LSOEs is completely controlled by

the local government and the managers of LSOEs are appointed by local government, the effects

of government intervention on such investment allocations are primarily found in LSOEs. In

contrast, we find that government intervention has little impact on the investment allocation of

central SOEs (CSOEs) and PROEs. As the ownership of both CSOEs and PROEs is not within

the scope of local government control, the goals and incentives of local government cannot

directly affect these enterprises. We also find that government intervention tends to crowd out

private sector investment activities in natural resources suggesting that state-owned economic

sectors enjoy a dominant position within the natural resource allocation system. Overall, our

empirical results indicate that government intervention distorts investment allocation and reduces

investment efficiency.

Investigating the impact of the institutional environment on the economic outcomes of various

types of firms remains a challenging task, largely due to the potential endogeneity between the

institutional environment and the economic outcomes. To mitigate endogeneity concerns, we

conduct numerous robustness tests, the most important of which is a difference-in-differences

framework to compare investment activity before and after a transition (ownership change)

from an LSOE to a PROE or a transition from a PROE to an LSOE. In our difference-in-

differences regressions, the coefficients on the interaction term between the transition and LSOE

variables are typically statistically significant, particularly in the high government intervention

group. Furthermore, our results are robust to the use of different specifications of government

intervention, the use of separate tests for industry classifications, and the exclusion of politically

connected firms.

Our study differs from prior research in two ways. First, we focus on the effects of gov-

ernment intervention on corporate investment allocations and the resultant effects on in-

vestment efficiency. Although many prior studies have highlighted the negative impact of

government intervention on investment efficiency (Chen et al., 2011a; Firth et al., 2012;

Lin and Wong, 2013), the channels through which such investment inefficiency is gener-

ated are unclear. In addition, our study links the investment inefficiency of firms directly

to their investment allocation, which, in turn, is further linked to the incentives and goals

of local governments across different geographical regions and the strength of government

intervention.

We make several contributions to the extant literature. We provide direct evidence on the

link between government intervention and corporate investment allocation. The effects of

such intervention are largely dependent upon government incentives, different forms of gov-

ernment control, and the geographical strength of government intervention. Moreover, the

performance-centered promotion system for local officials in China results in suboptimal as-

set structures within LSOEs, which, in turn, reduces investment efficiency. Thus, in addition to

the problem of overinvestment documented within the extant literature (Chen et al., 2011b;

Firth et al., 2012; Ghoul et al., 2016), we demonstrate another important channel through

which government intervention has a significantly negative impact on corporate investment

allocation.

The remainder of this paper is organized as follows. We derive empirical predictions

linking government intervention to corporate investment allocation in Section I. Section II

presents our data sources and the research methodology. The empirical results are sub-

sequently presented and discussed in Section III. The robustness tests and extensions are

provided in Section IV, while the conclusions drawn from this study are presented in

Section V.