The Impact of Financing Constraints and Agency Costs on Corporate R&D Investment: Evidence from China

• Author: Shengqiang Liu,Z. Jun Lin,Fangcheng Sun
• Published date: 01 March 2017
• Date: 01 March 2017
• DOI: http://doi.org/10.1111/irfi.12108

The Impact of Financing Constraints

and Agency Costs on Corporate R&D

Investment: Evidence from China*

Z. JUN LIN

†

,SHENGQIANG LIU

‡

AND FANGCHENG SUN

‡

†

School of Business, Macau University of Science and Technology, Macau, China and

‡

Chongqing Technology and Business University, Chongqing, China

ABSTRACT

This study investigates the association between financing constraints/agency

problem (agency costs) and corporate R&D investment in China by using

the two-tier stochastic frontier model initially developed by Kumbhakar and

Parmeter (2009) in light of the Euler equation analysis framework. The results

show that there is a significantly negative association between financing con-

straints and firms’R&D investments and a significantly positive relationship

between agency costs and R&D investments. Thus, financing constraints lead

to R&D underinvestment, while agency costs cause R&D overinvestment by

the sample firms. However, government subsidies have a positive moderating

effect on the relationships. The impact of financing constraints and agency

costs on R&D investment varies slightly by firms in different geographical

regions, industries, business ownerships, and years.

JEL Codes: G31; M21; O32; M48

I. INTRODUCTION

In pace with the rapid progress of knowledge economy and the acceleration of

global economic integration, the importance of innovation for a firm or a

country has been overwhelmingly recognized (Aboody and Lev 2000; Coad

and Rao 2008; Aw et al. 2009; Brown et al. 2012; Barge-Gil and López 2014). As

a direct impeller to innovation and technology upgrading at firm level, research

and development (referred as R&D thereafter) investment is an important strate-

gic decision that determines a firm’s ability for survival and growth. Gordon and

Griliches (1997) contend that all production efficiency improvements, if being

properly measured, can be attributed to R&D investment. Porter (1990) also

argues that if a country, even with abundant resources, stays a long time in the

production-driven stage and does not transform itself into innovation-driven

stage, it will face severe challenges in economic development. These views are

* Authors are grateful to anonymous reviewers and Journal Editor for their valuable time and insight-

ful comments and suggestions to the previous version of the paper. The remaining errors are ours.

(Corresponding author,Dr S.Q. Liu). Financial support from China National Social Science Foundation

(Project #14BJY083) is acknowledged.

© 2016 International Review of Finance Ltd. 2016

International Review of Finance, 17:1, 2017: pp. 3–42

DOI: 10.1111/irfi.12108

shared by many scholars (Lev and Sougiannis 1996; Toivanen et al. 2002; Hall

and Oriani 2006; Manso 2011; Bronzini and Iachini 2014; Aghion et al. 2015).

After the global financial crisis in 2008, countries around the world have more

clearly recognized the importance of innovation and R&D investment (Brown

et al. 2009; Cohen 2010; Hall and Lerner 2010; Hsu et al. 2012; Paunov 2012;

Tongue and Allan 2013; Choi and Williams 2014; Lamperti et al. 2015). Recently

the “G8”group has explicitly contended that it is necessary to change the mode

of economic development and countries must vigorously promote strategic eco-

nomic restructuring and integrate both economic resources and new technolo-

gies, thus make the economic development relying more on the advancement

of sciences and technology (Aghion et al. 2012; Nunes et al. 2012; Bronzini

and Iachini 2014). Especially for China, the world’s largest developing country

with many economic growth problems such as production overcapacity and in-

vestment inefficiency,a transformation towards a market-based economy and in-

dustrial restructuring can only be achieved through increasing R&D activities

and technological innovation (Xu et al. 2008; Liu and Liu 2010; Zhen and Tang

2012; Chen 2013). It is now a general consensus in China that firms must en-

hance their competitiveness and maintain sustainable development by

expanding R&D investments and promoting technological innovation (Liu and

Liu 2011; Gu and Zhai 2012; Yang et al. 2012; Lu et al. 2013; Phillips 2013; Choi

and Williams 2014). The Chinese government has also significantly expanded

preferential policies and financial supports to firms’R&D investments in recent

years.

Similar to capital asset investments, R&D investment requires a large amount

of input, long investment cycle, and slow investment returns. For each firm,

although the demand for technology innovation is inherent, its R&D investment

behavior is confined by financing constraints from external capital market and

imperfect corporate governance with severe agency problems. The outcome of

R&D investment is mainly intangible assets that could not be the collaterals for

borrowing money from banks. The intangible outputs resulted from R&D

activities usually involve with business secrets or core technological knowhow

by specificfirms, so many firms are reluctant to disclose R&D-related informa-

tion. These characteristics make R&D investment facing more serious financing

constraints. In addition, R&D spending is a high-risk investment as its initial

input is usually a permanent sunk cost with high uncertainty or no returns can

be expected. Because a firm’s executives’compensations are more or less linked

to its financial performance, short-term managerial behavior to maximize mana-

gerial compensations at the expense of the firm’s long-term growing potential is

a typical agency problem derived from the conflicts between owners (share-

holders) and managers. A firm’s R&D investment is nevertheless affected by the

agency costs underlying the agency problem. Therefore, the association between

afirm’s R&D investment and its financing constraints or agency problem (agency

costs) is complicated. This leads to several questions such as how will financing

constraints and agency problem/costs impact a firm’s R&D investment behavior,

and what is the influencing magnitude of these two factors? There is a lack of

International Review of Finance

© 2016 International Review of Finance Ltd. 20164

convincing evidence in the literature, especially for a developing economy like

China. These issues are surely worthy of empirical investigation.

At the same time, it is an unsolved puzzle about what is the optimal level of

R&D investment. German scholar Dr. Von Braun (1999) argues that, when

R&D investment reaches a certain level, further investment might slow down

the growth of sales revenues and profits, so there is a possible R&D investment

“acceleration trap.”

1

In China, although some researchers believe that R&D in-

vestments by Chinese firms remain insufficient, others hold the opposite views.

For example, Zhang et al. (2008) find some evidence to support the existence of

such a R&D investment acceleration trap and Lu et al. (2013) query of whether

more R&D investments can result in better investment performance. Thus, a

series of questions remain unanswered, such as (i) whether the conclusion drawn

up by comparing R&D investment intensity in China and in the western

countries is valid?; (ii) what should be the optimal level of R&D investment by

firms in China?; (iii) have Chinese firms reached the optimal level of R&D

investment at present?; and (iv) how to measure the gap between the actual

and optimal levels of R&D investment by Chinese firms? These questions are

highly important and should be further explored theoretically and empirically.

Driven by such study motivations, we conduct a research to analyze the

association between corporate R&D investment and financing constraints or

agency costs by using a two-tier stochastic frontier model initially developed

by Kumbhakar and Parmeter (2009) with panel data of the annual reports of

Chinese listed firms from 2010 to 2012 and further measure the magnitude of

the deviation of the actual (real) R&D investment level from the optimal level

(i.e., R&D investment inefficiency) caused by financing constraints and agency

costs, respectively, even taking the impact of government subsidies into

consideration.

Compared with the literature, our study has the following originality and con-

tributions: (i) instead of using the traditional analysis model proposed by

Schiantarelli (1996), we adopt the two-tier stochastic frontier model proposed

by Kumbhakar and Parmeter (2009), which can not only overcome the subjectiv-

ity of artificially grouping sample firms but also mitigate the endogenous prob-

lem that is caused by using multiple financial indicator variables. Differing

from the analysis model proposed by Vogt (1994) that relies upon the direction

of the coefficients for the interaction terms of free cash flows and Tobin’sQ

(i.e., either positive or negative) to determine R&D underinvestment or overin-

vestment, we apply the two-tier stochastic frontier model to enhance the validity

of study findings by statistically simulating the inherent relationships among the

explained and explanatory variables; (ii) in order to make our study more in line

1 Dr.Brown firstly uses the concept of R&D investment “acceleration trap”in his book of The War

of Innovation. He examined R&D investments, sales revenues, and profits for 30 electrical and

electronic companies from America, Europe, and Japan and found that, during the period

1978 to 1990, the R&D expenditures of these high-tech companies increased three tofive times,

but their total sales rose only 10%. He therefore suggests that R&D investment “acceleration

trap”might produce high costs, great risk, and unpredictable investment results.

Financing Constraint/Agency Costs and R&D Investment

© 2016 International Review of Finance Ltd. 2016 5