Remedial role of financial development in corporate investment amid financing constraints and agency costs

    Muhammad Kaleem Khan Affiliation
    ; Ying He Affiliation
    ; Ahmad Kaleem Affiliation
    ; Umair Akram Affiliation
    ; Zahid Hussain Affiliation


The study investigates the role of financial development in boosting the investment efficiency of firms’ investments in China. Using a large sample of firm-level financial data and country level economic data over the period 2004–2015, present study creates a link between financial and real economy. Firms are priori classified into under- or over-invested and effect of financial development is analyzed individually on each classification by using panel data estimations. The research concludes that firms suffering from under- (over-) investment problem due to financing constraints (agency problem), are more likely to increase (decrease) their investment` in the response of underlying financial development in the economy. This study has demonstrated a novel approach by concurrently incorporating the monitoring and financing issues that disturb the optimal level of investments. Moreover, the findings give strong implications by suggesting and empirically proving the remedy that has the potential to balance the investment distortions by rectifying monitoring and financing deficiencies.

Keyword : financial constraints, agency problem, under investment, over investment, financial development, information asymmetry, China

How to Cite
Khan, M. K., He, Y., Kaleem, A., Akram, U., & Hussain, Z. (2018). Remedial role of financial development in corporate investment amid financing constraints and agency costs. Journal of Business Economics and Management, 19(1), 176-191.
Published in Issue
May 4, 2018
Abstract Views
PDF Downloads
Creative Commons License

This work is licensed under a Creative Commons Attribution 4.0 International License.


Allen, F.; Qian, J.; Qian, M. 2005. Law, finance, and economic growth in China, Journal of Financial Economics 77(1): 57–116.

Bates, T. W. 2005. Asset sales, investment opportunities, and the use of proceeds, The Journal of Finance 60(1): 105–135.

Beck, T.; Demirgüç-Kunt, A.; Levine, R.; Maksimovic, V. 2001. Financial structure and economic development: firm, industry, and country evidence, in A. Demirgüç-Kunt; R. Levine (Eds.). Financial structure and economic growth: a cross-country comparison of banks, markets, and development. Cambridge: The MIT Press, 189–242.

Bergstresser, D. 2006. Discussion of “Overinvestment of free cash flow”, Review of Accounting Studies 11(2–3): 191–202.

Blundell, R.; Bond, S. 1998. Initial conditions and moment restrictions in dynamic panel data models, Journal of Econometrics 87(1): 115–143.

Castro, F.; Kalatzis, A. E.; Martins-Filho, C. 2015. Financing in an emerging economy: does financial development or financial structure matter?, Emerging Markets Review 23: 96–123.

Chen, S. S.; Chung, T. Y.; Chung, L. I. 2001. Investment opportunities, free cash flow and stock valuation effects of corporate investments: the case of Taiwanese investments in China, Review of Quantitative Finance and Accounting 16(4): 299–310.

Chen, X.; Sun, Y.; Xu, X. 2016. Free cash flow, over-investment and corporate governance in China, Pacific-Basin Finance Journal 37: 81–103.

Duchin, R.; Ozbas, O.; Sensoy, B. A. 2010. Costly external finance, corporate investment, and the subprime mortgage credit crisis, Journal of Financial Economics 97(3): 418–435.

Fazzari, S. M.; Hubbard, R. G.; Petersen, B. C.; Blinder, A. S.; Poterba, J. M. 1988. Financing constraints and corporate investment, Brookings Papers on Economic Activity 1: 141–206.

Firth, M.; Malatesta, P. H.; Xin, Q.; Xu, L. 2012. Corporate investment, government control, and financing channels: evidence from China’s listed companies, Journal of Corporate Finance 18(3): 433–450.

Guariglia, A.; Liu, P. 2014. To what extent do financing constraints affect Chinese firms’ innovation activities?, International Review of Financial Analysis 36: 223–240.

Guariglia, A.; Yang, J. 2016. A balancing act: managing financial constraints and agency costs to minimize investment inefficiency in the Chinese market, Journal of Corporate Finance 36: 111–130.

Gurley, J. G.; Shaw, E. S. 1955. Financial aspects of economic development, The American Economic Review 45(4): 515–538.

Hubbard, R. 1998. Capital-market imperfections and investment, Journal of Economic Literature 36(1): 193–239.

Jensen, M. C. 1986. Agency costs of free cash flow, corporate finance, and takeovers, The American Economic Review 76(2): 323–329.

Jensen, M. C.; Meckling, W. H. 1976. Theory of the firm: managerial behavior, agency costs and ownership structure, Journal of Financial Economics 3(4): 305–360.

Khan, M. K.; He, Y.; Akram, U.; Sarwar, S. 2017. Financing and monitoring in an emerging economy: can investment efficiency be increased?, China Economic Review 45: 62–77.

Kim, J. B.; Ma, M. L.; Wang, H. 2015. Financial development and the cost of equity capital: evidence from China, China Journal of Accounting Research 8(4): 243–277.

Levine, R. 1996. Foreign banks, financial development, and economic growth, in C. E. Barfield (Ed.). International financial markets: harmonization versus competition. Washington, DC: AEI Press, 7: 224–254.

Levine, R. 2005. Finance and growth: theory and evidence. Chapter 12, in A. Philippe, N. D. Steven (Eds.). Handbook of economic growth. Amsterdam: Elsevier BV 1, p. 865–934.

Lin, C.; Su, D. 2009. Does state control affect managerial incentives? Evidence from China’s publicly listed firms, Journal of Business Economics and Management 10(4): 291–311.

Love, I. 2003. Financial development and financing constraints: international evidence from the structural investment model, Review of Financial Studies 16(3): 765–765.

Love, I.; Zicchino, L. 2006. Financial development and dynamic investment behavior: evidence from panel VAR, The Quarterly Review of Economics and Finance 46(2): 190–210.

Malmendier, U.; Tate, G. 2005. CEO overconfidence and corporate investment, The Journal of Finance 60(6): 2661–2700.

Modigliani, F.; Miller, M. H. 1958. The cost of capital, corporation finance and the theory of investment, The American Economic Review 48(3): 261–297.

Myers, S. C.; Majluf, N. S. 1984. Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics 13(2): 187–221.

Polk, C.; Sapienza, P. 2008. The stock market and corporate investment: a test of catering theory, The Review of Financial Studies 22(1): 187–217.

Richardson, S. 2006. Over-investment of free cash flow, Review of Accounting Studies 11(2–3): 159–189.

Stulz, R. 1990. Managerial discretion and optimal financing policies, Journal of Financial Economics 26(1): 3–27.

Whited, T. M.; Wu, G. 2006. Financial constraints risk, The Review of Financial Studies 19(2): 531–559.

Xie, S.; Mo, T. 2015. Differences in corporate saving rates in China: ownership, monopoly, and financial development, China Economic Review 33: 25–34.