Institutional characteristics, investment sensitivity to cash flow and Tobin's q: Evidence from the Middle East and North Africa region

• DOI: http://doi.org/10.1111/infi.12366
• Published date: 01 August 2020
• Author: Abed Al‐Nasser Abdallah,Mohsen Saad,Wissam Abdallah
• Date: 01 August 2020

International Finance. 2020;23:324–339.wileyonlinelibrary.com/journal/infi324

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© 2020 John Wiley & Sons Ltd.

DOI: 10.1111/infi.12366

ORIGINAL ARTICLE

Institutional characteristics, investment

sensitivity to cash flow and Tobin’sq: Evidence

from the Middle East and North Africa region

Abed Al‐Nasser Abdallah

1

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Wissam Abdallah

2

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Mohsen Saad

1

1

Department of Accounting/Finance,

School of Business Administration,

American University of Sharjah, Sharjah,

UAE

2

Department of Finance and Accounting,

Adnan Kassar School of Business,

Lebanese American University, Beirut,

Lebanon

Correspondence

Abed Al‐Nasser Abdallah, School of

Business Administration, American

University of Sharjah, P.O. Box: 26666,

Sharjah, UAE.

Email: abedabdallah@aus.edu

Abstract

We examine the sensitivity of corporate investment to stock‐

market valuations (measured by Tobin’sq) and internal

funds (measured by cash flow) in a setting that captures the

unique country institutional characteristics of the Middle

East and North Africa region. We report a higher sensitivity

of investments to cash flow than Tobin’sq. However, both

sensitivities are unaffected by the country institutional

characteristics. By examining the sensitivity of investments

to cash flow and Tobin’sqbefore and after the 2008 global

financial crisis, we document that the investment‐cash flow

relation has weakened over time, while the investment‐

Tobin’sqrelation has significantly strengthened. Finally,

after dividing our country sample into resource‐rich and

resource‐poor countries, the importance of cash flow over

Tobin’sqin the determination of corporate investment

levels is asserted and the role of financial markets is found

to be restricted to resource‐rich countries only.

KEYWORDS

cash flow, crisis, institutional characteristics, investment, MENA

JEL CLASSIFICATION

G31; G32

1

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INTRODUCTION

The countries in the Middle East and North Africa (MENA) region have suffered from a

consistent decline in economic growth over the last few years. Similarly, private investment

levels are amongst the lowest worldwide.

1

In several of these countries, the environment, which

is characterized by economic stagnation and gloomy prospects, has fed social tensions and led

to further worsening of the original conditions, and many countries exhibit seemingly vicious

downward spirals. The recent 2019 IMF Regional Economic Outlook Report describes a sense of

urgency and presses policymakers in these countries to engage in immediate reforms before the

ability to do so passes. Enhancing the business environment to restore the ability of MENA

corporations to boost their investments in a way that creates jobs and promotes higher and

more inclusive growth in these societies is central to these reforms.

The novelty of this paper lies in the documentation of the first investigation of the behaviour

of corporate investments in the MENA region. We examine the sensitivity of corporate

investment to stock‐market valuations (i.e., Tobin’sq) and internal funds (herein, cash flow).

We also examine whether these sensitivities change over time. In a frictionless market, Tobin

(1969) shows that the marginal qpredicts investment levels, since firms with a high Tobin’sq

should be able to raise funds to undertake investments. Accordingly, investment is an

increasing function of q(Cao, Lorenzoni, & Walentin, 2019; Verona, 2019).

We perform our empirical investigation of the determinants of corporate investments in a

context that distinguishes among the varying institutional characteristics of 14 different MENA

countries using a sample of 802 industrial firms over the 2000–2018 period. First, we find that

corporate investments in the MENA region are positively associated with both Tobin’sqand cash

flow. However, the sensitivity of investments to cash flow is much higher than the sensitivity to

Tobin’sq. Thus, the limited access to capital markets renders firms in the MENA region more

reliant on internal savings as the predominant determinant of their investment decisions. Our

results persist regardless of whether the firms are financially constrained. We find that, compared

with the least financially constrained firms, the investments of highly financially constrained firms

are more sensitive to cash flow. This evidence contradicts Cleary (1999, 2006) and Kaplan and

Zingales (1997) but supports Baker, Stein, and Wurgler (2003); Gilchrist and Himmelberg (1995);

Oliner and Rudebusch (1992); and Scaller (1993). This finding is not surprising given that most

firms in the MENA region identify access to finance as a major impediment to their investments. A

typical MENA firm most likely finances its projects internally and through borrowing from banks,

which continue to be the main source of external finance. Stock markets play limited roles in

providing external finance. Most stock markets are subject to government control and often act as

public institutions or state‐owned companies (Amico, 2014). Second, we extend the work

performed by Francis, Hasan, Song, and Waisman (2013) and Mclean, Zhang, and Zhao (2012),

who examined the impact of investor protections and corporate governance on investment

sensitivity to cash flow and Tobin’sq, to the previously understudied MENA region. The authors

find a positive (negative) correlation between Tobin’sq(cash flow) and investments in countries

with strong investor protection. In contrast, we fail to find any effect of institutional characteristics

(investor protection and financial development) on corporate investment decisions. These findings

suggest that the institutional strength and financial‐market development in MENA countries are

below the thresholds needed to encourage private investments. Third, we account for the possibility

that some enacted reforms in MENA countries, especially during the period that proceeded the

global financial crisis, may affect the documented findings. We conduct a subsample analysis to re‐

estimate our empirical model during the following three separate periods: pre‐,during‐,andpost‐

financial crisis. We confirm our earlier finding by showing that the sensitivity of investments to

cash flow remains higher than that to Tobin’sq,evenintherecentyearsthatfollowedtheglobal

financial crisis. However, the investment‐cash flow relation has been significantly weakened over

time, while the investment‐Tobin’sqrelation has strengthened to become strongly significant.

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