The effects of government quality on corporate cash holdings

Abstract

While Stulz (2005) highlights the importance of the state expropriation agency problem and its interaction with the insider agency problem, there is limited research on how state policies shape firm policies. We test the effects of government quality on corporate cash holdings using a unique World Bank survey containing data on local government quality in China. Using single-country data enables us to have a cleaner test of the effects of law enforcement on cash holdings by effectively holding shareholder rights conferred by law constant (shareholder rights are a focus of prior international studies). We hypothesize that on the one hand, a good government refrains from expropriating firms and enables firms to hold more cash. On the other hand, a good government may help relieve financial constraints and enable firms to hold less cash – a new channel that has been neglected by the prior literature. In addition, a good government may indirectly affect cash holdings through limiting insiders’ private consumption of firm resources. We find that firms hold less cash when there is a better local government, and the effect is more pronounced in private firms than in state-owned enterprises (SOEs). Our evidence suggests that the financial constraint relieving argument dominates the expropriation argument in China. Increasing external sources of finance such as bank loans, trade credit, and inward foreign direct investment are among the ways through which local governments help relieve firms’ financial constraints. Our study is also the first to find evidence that supports Stulz’s (2005) argument on the interaction between the twin agency problems.