Investor Protection and Its Effects on Investment, Finance, and Growth

The following post comes to us from David McLean of the Department of Finance at the University of Alberta, Tianyu Zhang of the Accounting Department at the Chinese University of Hong Kong, and Mengxin Zhao of the Department of Finance at the University of Alberta.

In the paper, Why Does the Law Matter? Investor Protection and its Effects on Investment, Finance, and Growth, forthcoming in the Journal of Finance, we study how investor protection affects firm-level resource allocations. We test for these effects using both ex-ante and ex-post measures of efficiency. We conduct our analyses in a large sample of firms from 44 countries during the period 1990 to 2007. We show that the relations between q and investment and q and external finance are stronger in countries with stronger investor protection laws. These findings are consistent with the notion that investor protection laws encourage accurate share prices, efficient investment, and better access to external finance.

We find that investment is less sensitive to cash flow in countries with stronger investor protection laws. We further find that both share issuance and debt issuance tend to have negative sensitivity to cash flow in countries with strong investor protections, but positive sensitivities in countries with weak investor protections. Taken together, these cash flow-sensitivity findings suggest that investment is less sensitive to cash flow in countries with strong investor protections because low cash flow firms issue more shares and debt in these countries, thereby overcoming financing shortfalls.

Our q-sensitivity and cash flow-sensitivity measures are associated with ex-post economic outcomes. In countries with high investment-sensitivity to q and low investment-sensitivity to cash flow, investment predicts faster growth and higher profits. We get the similar results with external finance. In countries where share issuance and debt issuance have strong sensitivity to q and negative sensitivity to cash flow, share issuance and debt issuance predict faster growth and higher profits.

Our paper sheds light on how investment-sensitivity to cash flow ought to be interpreted. Our findings cast doubt on the idea that it measures investment in response to growth opportunities. Across countries, the relation between investment and subsequent growth weakens with investment-sensitivity to cash flow; if cash flow was correlated with growth opportunities, then we should find the opposite. Moreover, in countries with strong investor protection both share issuance and debt issuance have negative sensitivity to cash flow. If cash flow measures growth opportunities, then this result shows that firms with the weakest growth opportunities raise the most capital, which seems unlikely. The more plausible explanation for our findings is that low cash flow firms are in need of external finance and, in countries with strong investor protection, raise capital to fund their projects, which explains why investment-sensitivity to cash flow is lower in countries with greater investor protections.

With respect to q-sensitivity, our findings suggest that cross-country differences in investment-sensitivity to q are associated with more efficient investment. We find that in countries with high investment-sensitivity q investment predicts growth, but in countries with weak investment-sensitivity to q investment does not predict growth. These findings do not rule out the possibility that q is correlated with mispricing and that some firms raise capital and invest in response to mispricing. However, even if these sentiment effects are present, our results do show that higher levels of investment-sensitivity to q are associated with stronger relations between investment and subsequent growth.

The full paper is available for download here.

Both comments and trackbacks are currently closed.