Corporate Investments, Liquidity and Bank Financing: Empirical Evidence from an Emerging Market

Abstract

A number of studies in the prior literature have found a link between cash flow and firm investment [Hubbard (1998) and cites therein]. Findings of most of these studies have the caveat that cash flow could simply be capturing expectations of future profitability because the empirical proxy (typically a version of average Q or market to book ratio) for marginal Q is imperfect. This study removes this caveat while retaining the Fazarri, Hubbard and Petersen’s (1988) a-priori sorting of firms into liquidity constrained and non-liquidity constrained regression framework. This study focuses on inventory investments of two sets of Indian manufacturing firms: issuers and non-issuers of short-term arm’s length debt during 1996-97, a time period of robust economic growth and simultaneously an inward shift in the supply of bank loans instituted by the Reserve Bank of India (RBI). Non-issuer firms have significantly higher investment-liquidity sensitivities vis-à-vis issuer firms for inventory investments in 1996-97. Issuer and non-issuer firms investing less than their internal funds have no differences in liquidity coefficients while firms investing more than their internal funds do. Issuer and non-issuer firms that do not face an increase in the cost of external debt (ergo not an increase in inferred external and internal cost of funds wedge) have no differences in liquidity coefficients while the two set of firms that face an increase do. Differences in investment-liquidity sensitivities between the two set of firms arise from their differences in bank dependence and hypotheses including pure bank dependence, priority lending and loans above banks’ rule for estimating a firm’s debt capacity find empirical support. Bank characteristics based hypotheses including single banking relationship and weak banks with below Basle capital standards cannot explain differences in liquidity constraints. Alternative explanations including agency problems, the flypaper effect, over-investment, legal regimes of parent companies and crony capitalism do not find empirical support. Debt overhang hypothesis is supported by the data. The findings are consistent with Almeida, Campello and Weisbach (2002) and represent differences in liquidity demand by firms explaining differences in liquidity constraints between issuers and non-issuers. Relatively pristine sub-sample of new short-term public debt issuers in 1996-97 (who were non-issuers till 1996), sub-sample of potentially ‘misclassified’ liquidity constrained non-issuers firms and a holdout sample of government owned firms that have access to state budgetary support provide results consistent with differences in liquidity constraints between issuers and non-issuers. Propensity score regressions match issuer and non-issuer firms on three dimensions: Q, net profit and age of the firm. In 4 out of 5 blocks the liquidity coefficient of non-issuer firms is higher than that of issuer firms. The results confirm that non-issuer firms face higher liquidity constraints and that the differences in liquidity coefficients are not subject to the caveat that firm characteristics, differences in mismeasurement of Q or differences in expectations of future firm profitability between issuers and non-issuers. In sum, relative differences in inventories investment-liquidity sensitivities represent differences in liquidity constraints. Empirical evidence is consistent with a causal link between differences in liquidity constraints and RBI’s regulatory fiat in 1996-97. The allocation of bank debt during 1996-97 is not consistent with maximizing economic efficiency measured by either ratio of value added to capital or ratio of operating profits to capital. Results from examining components of inventories: raw materials, work-in-process and finished goods are not supportive of differences in investment liquidity sensitivities between issuers and non-issuers. Differences in investment liquidity sensitivities between issuer and non-issuer firms in capital investments and total firm investments regressions provide support for the findings that the investment liquidity sensitivities documented earlier represent liquidity constraints driven by bank dependence. However, using propensity scores to match issuers and non-issuers on profitability, Q and age of the firm the results on capital investments and total firm investments are consistent with the differences in liquidity coefficients being potentially driven by differences in the mismeasurement of Q or that non-issuer firms are less liquidity constrained than issuer firms.