SMALL BUSINESSES AND LIQUIDITY CONSTRAINTS IN FINANCING BUSINESS INVESTMENT: EVIDENCE FROM SHANGHAI S MANUFACTURING SECTOR

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1 SMALL BUSINESSES AND LIQUIDITY CONSTRAINTS IN FINANCING BUSINESS INVESTMENT: EVIDENCE FROM SHANGHAI S MANUFACTURING SECTOR CLEMENT KONG-WING CHOW Lingnan College, Tuen Mun, N.T., Hong Kong MICHAEL KA YIU FUNG Chinese University of Hong Kong, Shatin, N.T., Hong Kong EXECUTIVE SUMMARY When firms experience financial hierarchy, external finance, if at all available, is substantially more expensive than internal finance. Factors such as transaction costs, agency problem, and asymmetric information have created such a hierarchy. Stiglitz and Weiss (1981) argue that asymmetric information between firms and potential suppliers of external finance creates adverse selection and moral hazard problems in the credit market in developed market economies. This problem of a higher cost of external finance is commonly thought to be more serious for small firms because they are more disadvantaged than their larger counterparts in accessing external finance due to several factors: (1) Public information on small firms is generally not available and leads to the even greater problem of asymmetric information, i.e., more severe adverse selection and moral hazard problems. These information problems have excluded small firms from bond and share markets. (2) Due to the lack of available means of external finance, small firms rely more heavily on bank loans than their larger counterparts. In addition, as small firms are more interested in cultivating stable relationships with a few banks in order to secure a stable supply of credit, these banks become virtual monopolies by lending to small businesses and exercise their market power in lending to small firms. Most of existing research considers only small firms in market economies; little research has been done to understand the relationship between firm size and investment financing in any economy in transition. This paper makes a contribution to the literature by studying the relationship between firm size and Address correspondence to Clement Chow, HKIBS, Faculty of Business, Lingnan College, Tuen Mun, N.T., Hong Kong. Tel: (852) ; Fax: (852) ; ckwchow@ln.edu.hk We would like to thank the comments from two anonymous referees. The remaining errors are, of course, ours. The financial support from the Lingnan College, the Chinese Management Group, the Faculty of Business Administration, the Chinese University of Hong Kong is gratefully acknowledged. Journal of Business Venturing 15, Elsevier Science Inc. All rights reserved /00/$ see front matter 655 Avenue of the Americas, New York, NY PII S (98)

2 364 D.K.-W. CHOW AND M.K. YIU liquidity constraints by using a firm level data of manufacturing enterprises in Shanghai during the period of We consider whether small manufacturing firms in Shanghai are constrained by the availability of liquidity compared with their larger counterparts when they are financing their fixed investment. In a transforming economy such as China (or other similar transition economies), external finance relies heavily on loans from banks that are fully owned by the state. Due to historical reasons, allocations of credit are always biased in favor of state-owned enterprises. Such a lending bias imposes an extra cost on small Chinese enterprises in financing investment as the majority of them are not state-owned. In such an environment, our empirical results show that small manufacturing firms in Shanghai are actually less liquidity-constrained than their larger counterparts in financing their fixed investment. This surprising result is rather different from what people normally predict based on the experience in market economies. We suggest three possible explanations for this peculiar finding: (1) The composition of various firm size classes plays an important role in explaining the result: Non-state enterprises which are fast growing and efficient dominate the small firm classes. Their successes in the markets helps them to generate enough internal funds to smooth their investment over time. (2) The presence of heavy indebtedness of large state-owned enterprises may deprive them of sufficient cash available for investment decision. Given that state-owned enterprises have been making heavy losses, the central and regional governments have a liquidity problem in satisfying their huge liquidity demands. (3) Small enterprises in non-state sectors can rely on the informal credit market to obtain funds for investment although they are excluded from the state banking system. However, the further trade liberalization in terms of eliminating tariffs and quotas caused by China s bid of joining the WTO will erode the profits of these small enterprises as imported goods will be supplied at lower prices. In addition, further reforms in financial sectors may also affect the supply of external finance to small enterprises in nonstate sectors. The consequence may lead to a tight liquidity constraint for small enterprises in China Elsevier Science Inc. INTRODUCTION In a perfect capital market, there would be no difference between internal and external funding of any investment project under Modigliani-Miller s theorem (1958). However, when capital market is no longer perfect (e.g., under the presence of asymmetric information and agency problems), the cost of external funds can be much higher than that of internal funds and can lead to under-investment. This is especially true for those small firms in which managers are accustomed to complaining that they cannot obtain enough external funds to exploit profitable investment opportunities. The economic theories such as credit rationing in Stiglitz and Weiss (1981) suggest that information asymmetries and agency costs are the major reasons for the lack of funds flowing to small enterprises, and therefore small enterprises are expected to rely more on internal finance. This firm-size effect on investment finance has been extensively studied by using company data in developed countries (see Fazzari, Hubbard, and Petersen 1988; Oliner and Rudebusch 1992; Himmelberg and Petersen 1994; Carpenter, Fazzari, and Petersen 1994). However, the nature of this firm-size effect in transition economies has been neglected in the literature. As economic conditions in transition economies are different from those in more advanced market economies, the role of internal finance in determining the level of investment can be different from results of existing studies on firms in developed economies. In terms of financing fixed investment, enterprises in transition economies are all heavily dependent on bank credit as this is probably the major source of external finance because capital markets in transition economies are either not available or underdeveloped. Banks are mainly owned and controlled by the state even though decentralization and devolution have been carried out rapidly in other sectors of these economies. The

3 SMALL BUSINESSES AND LIQUIDITY CONSTRAINTS 365 non-state sectors in these economies were much smaller than the state-owned sectors before the implementation of economic reforms, therefore, the allocation of credit was always biased in favor of state-owned enterprises. Perotti (1993) suggests that such a lending bias in favor of these large state firms will continue even when the reform is carried out in the state banking sector. On the other hand, small firms are not necessarily helpless. Even they have more difficulty in obtaining external finance compared with large and established firms. Using panel data in the People s Republic of China, Chow and Fung (1996 and 1997) show that small firms are relatively more efficient than their larger counterparts. Given their success in managerial efficiency, they may be able to generate large enough cash flow in financing their fixed investment. Moreover, these small enterprises in China can rely on borrowing from the informal credit market although they can only obtain very limited bank credit from the formal banking institutions (see Tam 1986; McKinnon 1994). The objective of this paper is to study whether firm size plays a role in determining the linkage between investment and internal funds in a transition economy such as the People s Republic of China. Most of existing research investigates only firms in market economies. Little research has been done to understand the relationship between firm size and investment financing in any economy in transition. This paper makes a contribution to the literature by studying the relationship between firm size and liquidity constraints by using a firm level data of manufacturing enterprises in Shanghai during the period of If small firms face a problem in obtaining external finance, they should rely more on their internal funds in financing their fixed investment, i.e., they have a tighter liquidity constraint than large firms. Recently, reforms in state sectors led to more unemployment in the People s Republic of China s economy. Results of this study provide relevant implications which can be important in solving the unemployment problem in China as small firms have been shown to be a major creator of jobs in developed economies (see Birch 1987; Davis and Haltiwanger 1992; Blanchflower and Burgess 1996). If findings in this study indicate that small firms are facing a tight constraint in liquidity, it limits not only their growth potential but also their contribution to job creation. In such a case, policy makers should pay attention to the provision of enough external funds for investment by small businesses when they formulate policy on financial reforms. The plan of the remainder of the paper is as follows. Section 2 provides a brief review of the existing theories on internal and external finance. Section 3 discusses the changing financial system in China. Section 4 presents the methodology. Section 5 discusses the empirical results. The last section provides the conclusion of this study. INVESTMENT AND INTERNAL FINANCE Although the importance of financial factors in business investment has received broad attention, Modigliani and Miller (1958) demonstrate the irrelevance of financial structure and financial policy for real investment in a perfect capital market: a firm s financial structure (such as internal liquidity, debt leverage, or dividend payments, etc.) will not affect its market value and then the firm can regard internal and external finance as perfect substitutes. However, when the capital market is no longer perfect, factors such as transaction costs, asymmetric information, and agency problems can create a financial hierarchy (Gertler 1988) in which internal finance may be less costly than equity and debt finance.

4 366 D.K.-W. CHOW AND M.K. YIU First, the transaction costs of issuing debt and equity can be significant. These costs include compensation for the underwriters, registration fees and taxes, and legal and accounting costs. Second, asymmetric information can generate significant cost disadvantages of external finance. Myers and Majluf (1984) analyze the case in which the firm s management has information about project returns that is unavailable to investors. Because investors cannot distinguish between good and bad projects, every issue is priced assuming the average project outcome, which implies that the securities backing good projects are undervalued. Given this undervaluation, the cost of financing such projects with external funds exceeds that of financing with internal funds. Stiglitz and Weiss (1981) further argue that asymmetric information between firms and potential suppliers of external finance creates adverse selection and moral hazard problems in the credit market. This inefficient outcome results from the fact that an increase in interest rate causes firms with good investment prospects to leave the applicant pool (adverse selection) or induces firms to switch to riskier projects (moral hazard). As a result, potential lenders may prefer to ration credit. All these studies suggest that external finance, in the presence of asymmetric information, is either rationed or available at a premium. Third, the presence of agency problems may imply a cost premium to the use of external finance. Under the asymmetry of information, the firm s managers may pursue their own interests at the expense of the firm s stockholders and bondholders. Jensen and Meckling (1976) show that this conflict of interests can boost the cost of obtaining external finance as outside shareholders attempt to control management behavior through the use of audits, budget control, and incentive systems designed to align manager and shareholder interests. These actions impart a cost premium to the use of outside equity finance, reflecting both the direct cost of monitoring management and the loss of profit opportunities due to reduced management flexibility (see Smith and Watts 1982). Debtors also face a similar risk as management actions may dissipate firm resources and management may erode the value of existing debt by undertaking excessively risky projects. In such a case, debtors may demand covenants that restrict management behavior in various ways (see Smith and Warner 1979). These restrictions, and the monitoring required for enforcement, constitute the agency costs of debt. As the external finance is more costly, Myers (1984) proposes a pecking order framework which suggests that firms finance their needs in a hierarchical fashion, using internally available funds before incurring debt and looking to external equity. When internal and external finance are no longer perfect substitutes in the presence of imperfection in capital market, a firm s investment decision will be constrained by the availability of internal funds (see Fazzari, Hubbard, and Petersen 1988; Hoshi, Kashyap, and Scharfstein 1991; Fazzari and Petersen 1993; Athey and Laumas 1994). However, financing constraints impact firms unequally. Small firms are expected to face an even higher cost in accessing external finance because of several factors: (1) According to the SEC (Securities and Exchange Commission) data, the transaction costs consumed nearly 19% of the gross proceeds of small stock issues and about 14% of the proceeds of small debt issues. These costs could have created a significant financing hierarchy for the smaller firms (see Oliner and Rudebusch 1992). (2) Public information on small firms is generally not available and leads to the even greater problem of asymmetric information, i.e., more severe adverse selection and moral hazard problems. These information problems can exclude small firms from bond and share markets (see Carpenter, Fazzari, and Petersen 1994). Due to the lack of available means of external finance, small firms rely more heavily on bank loans than their larger counterparts and

5 SMALL BUSINESSES AND LIQUIDITY CONSTRAINTS 367 they are more interested in cultivating stable relationship with a few banks in order to secure a stable supply of credit (Berger and Udell 1995; Ennew and Binks 1995; Petersen and Rajan 1994). When banks become virtual monopolies because of lending to small businesses, they can exercise their market power in lending to small firms, and then the borrowing costs of small firms may be higher than that of large firms (Binks and Ennew 1993; Cowling et al. 1991; Cowling and Sudgen 1995; Keasey and Watson 1993). Given these factors, one can expect that small firms would be more dependent on internal funds in financing their investment. Before we consider the data and methodology of this study, we need to explain the development of the financial system in the socialist China which is very different from the financial systems in any other market economy. THE CHANGING FINANCIAL SYSTEM IN CHINA In the past 19 years, while undergoing a fundamental transformation, China s real GDP grew at an average annual rate of about 10%. After the reform process began at the end of 1978, the formal central planning apparatus was gradually weakened. In the agricultural sector, the communes were abolished and the household responsibility system was established. Within the industrial sector, decentralization was implemented. In the early 1980s, the state-owned enterprises were given more discretion with respect to production and profit distribution. Moreover, the central government adopted the strategy of allowing economic activity outside the centrally planned system to develop, which effectively promoted rapid growth of the newly enfranchised non-state sector (collectives, private enterprises, and international joint ventures). However, reform of the financial system has been rather limited. Before 1978, the banking system in the People s Republic of China was part of the state s centrally planned economic system which organized and mobilized physical, human, and financial resources to attain certain government objectives. The main objective in the pre-reform period was to speed up the development of the industrial sector. The major role of the banking system was to direct funds from the government to enterprises and supervise the proper uses of funds by enterprises in accordance with the central plans (Tam 1986). The banking system was a mono-bank system before the economic reform that was implemented in 1978, in which the People s Bank of China served as both a central bank and a commercial bank. Aside from managing the currency issue, the banking system was responsible for the cashless settlements between enterprises, the accounting of the flows of funds among enterprises and government units under the national plans, and the collection and disbursement of funds under the budgetary process (Tam 1986; World Bank 1988; Yi 1994). Since 1978, industrial reforms have led to a rapid structural change in the Chinese economy. However, a sustained reform in the economy required corresponding reforms in the banking sector: First, the rapid emergence of non-state sectors generates increased demand for financial services, e.g., short-term commercial credits and long-term capital financing. Second, for better allocative efficiency, the sources of funds for capital investments in state enterprises should be changed from grants from the central government to interest-bearing loans from banks. Third, the open door policy caused the need for more financial services internationally, e.g., trade finance and foreign currency borrowing (Tam 1986). These suggested changes called for a new banking system. In January 1984, the People s Bank of China (PBC) was formally changed to a central bank. The mono-bank system was partially reformed, the functions of central

6 368 D.K.-W. CHOW AND M.K. YIU banking and commercial banking being separated. The PBC is both the monetary and prudential regulatory agency, which supervises the activities of all commercial banks and non-bank financial institutions. The commercial banking system consists of four specialized banks (the Agricultural Bank of China, the People s Construction Bank of China, the Industrial and Commercial Bank of China, and the Bank of China), comprehensive banks, regional development banks, a network of rural credit cooperatives, and cooperative banks in urban areas. Under the control of the PBC, the banking industry is dominated by the four specialized banks, which issued over 60% of China s total loans and controlled over 80% of the country s financial assets in 1994 (see Blanchard 1997). With such a concentrated structure in the banking system, the PBC has continued to use administrative measures for financial asset management. Most enterprises in China, like in other transition economies, rely heavily on bank credit because equity and bond markets are either not yet developed or only in the infant stage of development. However, banking institutions that emerged from the first wave of reforms are still characterized by large financial inefficiencies, lack of competition, and extensive government involvement in credit allocation (Miurin and Sommariva 1993). The state banking system assumes a dual role in the Chinese economy, functioning as a financial intermediary as well as a quasi-fiscal institution. All of the four major specialized banks are subject to extensive government regulations and control. They are required to make policy loans to the state-owned enterprises which generally operate under soft-budget constraints so that there is no risk associated with increased borrowing. In case of failure, they can get a bail-out by the government (Tam 1986). In order to avoid massive unemployment, central and local government officials force the state banks to keep lending to the state-owned enterprises, no matter how financially unsound these enterprises are (see Blanchard 1997). When state enterprises fail to generate profits to repay bank loans, they have to increase their lending to support the continuation of all affected projects (Tam 1986; Perotti 1993). As these state banks are forced to lend to the state sector, they are facing a severe constraint on their ability to fully perform their role as financial intermediaries. Because of the rapid expansion of the Chinese economy, the number of profitable investment projects seeking financing can be extremely large. However, firms, especially small ones and farm households in the non-state sector, can only obtain very limited bank lending from the formal banking institutions because the state banking system mainly supplies loans to the state sector (see McKinnon 1994). Consequently, other than self-financing, they must rely on borrowing from the informal credit market (see Chinese Academy of Social Sciences 1996). On the other hand, given that the real rate of return for deposits put into the state banking system is extremely low, those who are willing to take risks will attempt to put their deposits in other forms of financial intermediaries outside the formal system for a higher return. Naturally, similar to many other developing economies where financial sectors are repressed, a parallel and informal credit market has developed in China (see Goodstadt 1987; Tam 1991; Luk 1993). This informal credit market has become an important source of external finance for small nonstate firms albeit at a higher cost. DATA AND METHODOLOGY Data on individual manufacturing enterprises are obtained from industrial surveys conducted by the Shanghai Economic Commission. It covers 5,325 manufacturing enter-

7 SMALL BUSINESSES AND LIQUIDITY CONSTRAINTS 369 prises in 32 manufacturing industries of Shanghai and includes the input-output information of these enterprises from 1989 to This data set contains enterprises net industrial output values (measured at current prices in Chinese yuan), gross industrial output values (measured at current prices in Chinese yuan), original values of fixed assets (in Chinese yuan), net values of fixed assets (in Chinese yuan), depreciation (in Chinese yuan), types of ownership, and total profits (in Chinese yuan). There are four types of enterprises in this data set: state-owned enterprises (SOEs), collective-owned enterprises (COEs), joint ventures (JVs), and other enterprises (OEs) which include mainly private enterprises and state and collective jointly owned enterprises. The quality of data collected by Chinese officials may not be as good as that collected in developed countries. Chow (1986 and 1993) discusses the validity of official Chinese statistics and judges that official statistical reporting in China is by and large honest. Shanghai, a metropolitan city of fourteen million people is chosen because it has a large number of experienced engineers, a well-educated labor force and is the technological leader in many fields of manufacturing in China. The city has been one of the important commercial and industrial cities both before and after According to different issues of Shanghai s Statistical Yearbooks, the city s share in the national industrial output is very high with an average of 15% from 1949 to 1979 and about 7% in the post-reform period, even though Shanghai accounts for slightly more than 1% of the national population. To study the relationship between internal funds and investment, a traditional sales accelerator model is adopted in which fluctuations in sales motivate changes in capital spending. A commonly adopted alternative is to model fixed investment decisions based on Tobin s q theory (see Fazzari, Hubbard, and Petersen 1988). Unfortunately, it is impossible to compute Tobin s q for the Chinese enterprises because the market values of firms are not available. This is due to the fact that capital markets, like stock markets, are still at the experimental or infant stage. As a result, a sales accelerator model which is based on the accelerator principle is adopted. The principle holds that the rate of investment will be primarily determined by the rate of change of output (Case and Fair 1996; Samuelson and Nordhaus 1995). This implies that investment will be higher/lower when output is growing/falling. When output is growing, firms become more optimistic and increase their investment spending. Higher investment spending leads to an added increase in output, further accelerating the growth of output. Conversely, if output is falling, expectation is dampened, and investment spending will be cut even though the level of output may be high, thus accelerating the decline. The sales accelerator is widely used in studying the linkage between corporate investment and financing constraints in developed economies. Fazzari, Hubbard, and Peterson (1988) use a panel of U.S. manufacturing firms to test for the existence of a financing hierarchy. They find that cash flow and fixed investment were correlated and that the correlation is strongest for low-dividend firms: The strong correlation between cash flow and investment indicates that these firms do not regard internal and external finance as perfect substitutes. Hoshi, Kashyap, and Scharfstein (1991) use a panel data set of Japanese manufacturing firms to test how information problems in the capital market affect investment. They find that fixed investment by firms with a close relationship to a bank (through Keiretsu network) is much less sensitive to their liquidity than firms raising their capital through more arm-length transactions. Oliner and Rudebusch (1992) use a firm-level data set of U.S. firms and confirm the existence of a financial hierarchy in investment financing. Moreover, they provide some support for informa-

8 370 D.K.-W. CHOW AND M.K. YIU tion asymmetry as a source of the financing hierarchy but indicate no significant role for transaction costs. Carpenter, Fazzari, and Petersen (1994) show an economically important link between inventory investment and internal finance by using a panel data set of U.S. manufacturing firms. They find that small firms have larger internal finance effects than large firms. Using a similar methodology, the following fixed effect model, e.g., the firm-specific effect of firm i is captured by i, is assumed to study the linkage between fixed investment and internal finance: (I/K) it 0 i 1 (DS/K) it 2 (DS/K) i,t 1 3 (NP/K) it 4 (DEP/K) it e it (1) where I it is the gross investment of firm i at the end of year t. Capital Stock K is the beginning-of-the-period capital stock which is measured by gross (original) fixed assets deflated by a capital price index. Following McGuckin and Nguyen (1993), the capital price index is computed from the weighted average of product price indices of five capital goods manufacturing industries: machinery and equipment, automobile and transport equipment, electric appliances, electronics and communication equipment, and apparatus and instrument-making (using 1980 as the base year). 0 is the mean intercept while i is the firm-specific fixed effect. The time effect is not considered because of the short time horizon in this study. Effectively, there are only two years in the regression analysis. Therefore, the dynamic changes of investment are minimal. e it is independently and identically distributed over i and t with mean zero and variance 2 e. Accelerator variables: Changes of Sales DS it is the changes in sales of firm i at the end of year t measured by the gross output values of the firm. It is deflated by its product price index using 1980 as the base year. Current changes in sales DS and its lagged values, DS 1 are the sales accelerator variables in this model. Net Profits NP it is the net profits of firm i at the end of year t which is also deflated by its product price index using 1980 as the base year. This variable measures the internal funds of the firm. Depreciation DEP it is the depreciation of firm i at the end of year t which is also deflated by the capital price index. The depreciation variable is used to measure the replacement investment of the firm which can be another source of internal fund for fixed investment. This single-equation model has the simple interpretation that investment is a function of the sales accelerator, internal funds, and replacement investment. If the firm is financially constrained, current net profits are the available internal funds for capital expenditure. Therefore, if the firm suffers from liquidity constraints, (NP/K) it and (DEP/K) it should be statistically significant in explaining the investment behavior.

9 SMALL BUSINESSES AND LIQUIDITY CONSTRAINTS 371 TABLE 1 Variable Label Variable Definitions Description (I/K) it Gross investment per dollar value of capital stock of firm i measured in real term at the end of year t. (S/K) it Sales per dollar value of capital stock of firm i measured in real term at the end of year t. (DS/K) it Change of sales per dollar value of capital stock of firm i measured in real term from the end of year t 1 to the end of year t. (DS/K) it 1 Change of sales per dollar value of capital stock of firm I measured in real term from the end of year t 2 to the end of year t 1. (NP/K) it Net profits per dollar value of capital stock of firm i measured in real term at the end of year t. (DEP/K) it Depreciation expense per dollar value of capital stock of firm i measured in real term at the end of year t. (CF/K) it Value of cash flow (sum of net profits and depreciation) per dollar value of capital stock of firm i measured in real term at the end of year t. D1 Dummy variable: 1 for class of 0 99 workers; 0 otherwise. D2 Dummy variable: 1 for class of workers; 0 otherwise. D3 Dummy variable: 1 for class of workers; 0 otherwise. D4 Dummy variable: 1 for class of workers; 0 otherwise. DN5 Dummy variable: 1 for class of non-state firms of 1,000 workers or above; 0 otherwise. Depreciation is a provision, therefore, only book entries are made involving a deduction from profits. There are no cash outflows in any recorded depreciation. Some researchers such as Bilsborrow (1977), Fazzari et al. (1988), and Athey and Laumas (1994) include depreciation as a source of internal funds. As a result, the following model is also considered, (I/K) it 0 i 1 (DS/K) it 2 (DS/K) i,t 1 3 (CF/K) it e it (2) CF NP DEP, is cash flow. Similarly, as long as the firm is financially constrained, the cash flow, CF, is the only available internal fund for its capital investment. Consequently, CF should be statistically significant in accounting for the changes in investment. In order to test whether smaller enterprises are really facing liquidity constraints, we use the dummy variable approach. Two benchmark cases are considered: (1) all enterprises with 1,000 and more workers; (2) all state-owned enterprises with 1,000 and more workers. These categories are supposed to be less constrained by liquidity than those smaller enterprises in the presence of both lending bias and imperfection in the China s capital market. As a result, the following interaction terms are introduced: (1) a net profit term, NP/K times dummy variables of 0 99, , , workers and non-state firms of 1,000 and more workers (dummy of 0 99 workers equals one if the enterprises belong to the group of 0 99 workers); (2) a replacement investment term, DEP/K times this group of dummy variables; and (3) a cash flow term, CF/K also times this group of dummy variables. If the coefficients of these interaction variables are positive/negative, it implies that the corresponding size group of firms are/are not facing liquidity constraints compared with the benchmark case. These interaction variables are added to equation (1) to (2) so as to conduct our tests. A list of the definitions of variables used the regression analysis is summarized in Table 1. In addition, a simple F test is applied to each cash flow variable (F1 for NP/K, F2 for DEP/K, and F3 for CF/K) to examine whether the estimates of the particular cash

10 372 D.K.-W. CHOW AND M.K. YIU flow variable are constant across different firm size classes. There are too many fixed effects which are not our parameters of interest and estimating so many fixed effect coefficients complicates the estimation procedure, therefore, our estimation is done by the first difference method suggested in Hsiao (1986) so as to remove all fixed effects. As a result, all intercept terms are excluded in conducting the estimation and testing in this step. The method is briefly explained in the appendix. Our major hypothesis is summarized as follows: H 0 : Holding other things constant, small firms are more liquidity-constrained than their larger counterparts. EMPIRICAL RESULTS We first report the descriptive statistics of those relevant variables used in equations (1) and (2) in Table 2. We will focus on the mean values of the variables. One outstanding pattern is that the means of all variables are decreasing in firm size. For example, for gross investment per each dollar value of capital stock (I/K), the class of 0 99 workers (smallest class) is 72% larger than the class of 1,000 and more workers (largest class). In terms of changes of sales per dollar value of capital stock (DS/K), the smallest class is three times larger than the largest class. In terms of cash flow variables, the smallest class makes four times more net profit per dollar value of capital stock (NP/K) than the largest class. The cash flow per dollar value of capital stock, (CF/K) of the smallest class is nearly three times larger than that of the largest class. When we consider their standard deviations, an opposite pattern is observed: the standard deviations of all variables are increasing in firm size except variable I/K. As a whole, the financial strength of small firms in terms of availability of cash flow and turnovers is much stronger than their larger counterparts but individual performance among small firms varies substantially. However, small firms uniformly have larger gross investment per dollar value of capital stock (I/K) than large firms. The empirical results of estimating equations (1) and (2) are reported in Table 3a, b, and c. Overall, the high sensitivity of the investment of firms to cash flow suggests that the sales accelerator model is not an accurate indicator of the investment behavior of TABLE 2 Descriptive Statistics of Relevant Variables by Classes of Firm Size Variables ,000 All (I/K) (0.1038) a (0.7294) (0.7626) (0.8257) (0.6740) (0.7921) (DS/K) (6.9006) (4.3081) (3.0388) (1.5426) (0.7891) (3.9022) (NP/K) (1.8777) (1.7593) (0.4828) (0.3813) (0.2912) (1.2678) (DEP/K) (0.0921) (0.0619) (0.0616) (0.0399) (0.0332) (0.0621) (CF/K) (1.8929) (1.7675) (0.4939) (0.3963) (0.3013) (1.2775) Obs. No. 1,266 3,684 3,082 1, ,650 Notes: a Values in parentheses are the standard deviations of the corresponding means.

11 SMALL BUSINESSES AND LIQUIDITY CONSTRAINTS 373 TABLE 3a Investment Regression Equation (by Firm Size) All Firms b Regressor a Model 1 Model 2 DS/K ** ** (0.0023) c (0.0028) (DS/K) (0.0002) (0.0002) NP/K ** (0.0090) DEP/K ** (0.1600) CF/K ** (0.0108) R adj. R Firm No. 5,325 Obs No. 5,325 Class of workers DS/K * ** (0.0045) (0.0051) (DS/K) (0.0003) (0.0003) NP/K ** (0.0417) DEP/K ** (0.4090) CF/K ** (0.0465) R adj. R Firm No. 633 Obs No. 1,266 Notes: a Estimates of fixed effects are not presented because they are numerous; b The estimation using data of all firms are conducted by first difference method according to Hsiao (1986), pp so as to eliminate all fixed effects; c All values in parentheses are the standard errors of the corresponding coefficients. * and ** imply that the estimates are statistically significant at 5 and 1% level of significance, respectively. these firms. The sales accelerator principle can only explain the investment pattern of the class of 100 to 249 workers indicated by the statistically significant estimates of DS/K and (DS/K) 1. The overall picture in Table 3a, 3b, and 3c indicates that model 1 (using NP/K and DEP/K separately to measure the cash flows of enterprises) has a higher goodness of fit in comparison with the model 2 (using only CF/K to measure the cash flows of enterprises). Judging from the magnitude of the estimates, cash flow variables (NP/K, DEP/K, and CF/K) are more relevant in influencing the fixed investment than the sales accelerator (DS/K and (DS/K) 1 ). In Table 3a, the result of using all firm data shows that cash flow variables are all statistically significant. Similar results are obtained in Tables 3b, and 3c. This result indicates that fixed investments of enterprises are sensitive to cash flow. Across different panels of results, the estimates of cash flow variable coefficients are generally increasing in firm size. This result is different from what people commonly perceive: that small firms should be more liquidity-constrained than large firms in the presence of imperfection in capital market. In order to test whether there

12 374 D.K.-W. CHOW AND M.K. YIU TABLE 3b Investment Regression Equation (by Firm Size) Class of workers Regressor a Model 1 Model 2 DS/K * ** (0.0039) b (0.0049) (DS/K) ** (0.0025) (0.0032) NP/K (0.0083) DEP/K ** (0.2305) CF/K (0.0108) R adj. R Firm No. 1,842 Obs No. 3,684 Class of workers DS/K (0.0075) (0.0098) (DS/K) ** (0.0060) (0.0078) NP/K * (0.0601) DEP/K ** (0.2627) CF/K ** (0.0752) R adj. R Firm No. 1,541 Obs No. 3,082 Notes: a Estimates of fixed effects are not presented because they are numerous; b All values in parentheses are the standard errors of the corresponding coefficients. * and ** imply that the estimates are statistically significant at 5 and 1% level of significance, respectively. is any firm size effect in investment financing, we conduct the simple dummy variable tests discussed in the previous section. The results are reported in Table 4a and 4b. If small enterprises have more difficulty in accessing external finance at the margin, the coefficients of interactive terms, X*D i where X is cash flow variables (NP/K, DEP/K, and CF/K), D i is the dummy variable and i 1,...,4 or 5 should be positive. The benchmark case is the enterprises with more than 1,000 workers (reported in Table 4a) or state-owned enterprises with more than 1,000 workers (reported in Table 4b). In Table 4a, models 1ra and 1rb are the restricted model of equation (1) which impose the null hypotheses that the estimates of NP/K and DEP/K are constant across different size classes respectively, while model 1u is the unrestricted model of equation (1) which allows the estimates of NP/K and DEP/K to vary across different size classes. Similarly, model 2r is the restricted model of equation (2) which imposes the null hypothesis that the estimates of CF/K are constant across different size classes while model 2u is the unrestricted model of equation (2) which allows the estimates of CF/K to vary across different size classes.

13 SMALL BUSINESSES AND LIQUIDITY CONSTRAINTS 375 TABLE 3c Investment Regression Equation (by Firm Size) Class of workers Regressor a Model 1 Model 2 DS/K ** ** (0.0221) b (0.0237) (DS/K) (0.0121) (0.0131) NP/K ** (0.1155) DEP/K 10.08** (0.7644) CF/K ** (0.1198) R adj. R Firm No. 810 Obs No. 1,620 Class of 1,000 or above workers DS/K ** ** (0.0563) (0.0595) (DS/K) (0.0285) (0.0300) NP/K ** (0.1977) DEP/K ** (1.0053) CF/K ** (0.2023) R adj. R Firm No. 499 Obs No. 998 Notes: a Estimates of fixed effects are not presented because they are numerous; b All values in parentheses are the standard errors of the corresponding coefficients. * and ** imply that the estimates are statistically significant at 5 and 1% level of significance, respectively. First, all F tests (F1, F2, and F3) in Table 4a indicate that the null hypotheses of parameter constancy of cash flow variables across different size classes are unambiguously rejected. These suggest that the estimates of all cash flow variables vary across different firm size classes. Second, the estimates of the interaction variables (dummy variable tests) are generally negative and statistically significant. In Table 4a, the estimates of (NP/K)*D i, and (CF/K)*D i, I 1,2,3 (classes of firm size 0 99, , and ) are negative and statistically significant. These indicate that enterprises which employ less than 500 workers are less constrained at the margin by the availability of internal funds in financing their investment. This indicates that the opposite of our hypothesis, H 0, is accepted. In order to check the robustness of this result to the choice of the benchmark case, we separate the state-owned and non-state-owned enterprises within the class of 1,000 and more workers, and choose the state-owned enterprises with more than 1,000 workers as the benchmark case. In Table 5, the size distribution of different types of enterprises is reported: The state-owned enterprises dominate in the class of 1,000 workers

14 376 D.K.-W. CHOW AND M.K. YIU TABLE 4a Testing the Presence of Liquidity Constraints (by Firm Size, using Firm Size Class of 1,000 Workers as Benchmark) Regressor a Model 1ra Model 1rb Model 1u Model 2r Model 2u DS/K ** ** ** ** ** (0.0023) b (0.0024) (0.0023) (0.0028) (0.0028) (DS/K) (0.0002) (0.0002) (0.0002) (0.0002) (0.0002) NP/K ** ** ** (0.0089) (0.1898) (0.1888) (NP/K)*D1 c * * (0.1922) (0.1911) (NP/K)*D ** ** (0.1900) (0.1890) (NP/K)*D ** ** (0.1995) (0.1984) (NP/K)*D (0.2128) (0.2129) F ** DEP/K ** ** ** (1.0230) (0.1572) (1.0093) (DEP/K)*D ** ** (1.0656) (1.0510) (DEP/K)*D (1.0564) (1.0420) (DEP/K)*D (1.0631) (0.0488) (DEP/K)*D * (1.2314) (1.2256) F ** CF/K ** ** (0.0108) (0.2203) (CF/K)*D ** (0.2232) (CF/K)*D ** (0.2206) (CF/K)*D * (0.2314) (CF/K)*D (0.2464) F ** R adj. R Firm no. 5,325 Notes: a All models are estimated by first difference method according to Hsiao (1986), pp so as to eliminate all fixed effects; b, * and ** imply the corresponding estimates are statistically significant at 5 and 1% level; c D1, D2, D3, and D4 are dummy variables of firm size , , , and workers, respectively. Those interaction variables are actually measuring the difference between the corresponding firm size with our benchmark size group, 1,000 and above workers. or above while non-state enterprises including collectively-owned enterprises, joint ventures, and other enterprises, dominate in the smaller size classes. The results are reported in Table 4b. Similarly, all F tests (F1, F2, and F3) also reject the null hypotheses of parameter constancy of cash flow variables across different size classes unambiguously. Therefore, the estimates of all cash flow variables vary across different classes of firm size. Although the signs of estimates are relatively unchanged, some estimates of inter-

15 SMALL BUSINESSES AND LIQUIDITY CONSTRAINTS 377 TABLE 4b Testing the Presence of Liquidity Constraints (by Firm Size, using State-owned in the Class of 1,000 Workers as Benchmark) Regressor a Model 1ra Model 1rb Model 1u Model 2r Model 2u DS/K ** ** ** ** ** (0.0023) b (0.0024) (0.0023) (0.0028) (0.0028) (DS/K) (0.0002) (0.0002) (0.0002) (0.0002) (0.0002) NP/K ** (0.0089) (0.2637) (0.2633) (NP/K)*D1 c (0.2654) (0.2650) (NP/K)*D (0.2638) (0.2634) (NP/K)*D (0.2707) (0.2703) (NP/K)*D (0.2806) (0.2811) (NP/K)*DN (0.3798) (0.3778) F ** DEP/K ** ** ** (1.1061) (0.1572) (1.0953) (DEP/K)*D ** ** (1.1456) (1.1338) (DEP/K)*D (1.1370) (1.1255) (DEP/K)*D (1.1433) (1.1318) (DEP/K)*D * (1.3013) (1.2973) (DEP/K)*DN (2.9100) (2.8633) F ** CF/K ** ** (0.0108) (0.2993) (CF/K)*D * (0.3014) (CF/K)*D ** (0.2995) (CF/K)*D (0.3075) (CF/K)*D (0.3190) (CF/K)*DN (0.4421) F ** R adj. R Firm no. 5,325 Notes: a All models are estimated by first difference method according to Hsiao (1986) so as to eliminate all fixed effects; b, * and ** imply the corresponding estimates are statistically significant at 5 and 1% level; c D1, D2, D3, D4, and DN5 are dummy variables of firm size , , , and , and non-state of 1,000 and above workers, respectively. Those interaction variables are actually measuring the difference between the corresponding firm size with our benchmark size group: state-owned in group of 1,000 and above workers.

16 378 D.K.-W. CHOW AND M.K. YIU TABLE 5 Distribution of Enterprises by Their Size and Types of Ownership a Size State Collective Joint Other Total % % 51.2% 6.6% 16.6% 100% % % 64.0% 2.7% 14.9% 100% % % 46.9% 1.4% 17.9% 100% % % 25.8% 1.7% 15.5% 100% 1, % 5.4% 1.8% 7.2% 100% Notes: a Collective is collective-owned enterprises; joint is international joint ventures; other is other enterprises which include mainly private enterprises. action variables such as (NP/K)*D i, which are statistically significant in Table 4a, are now no longer statistically significant. Only the estimates of (CF/K)*D i, I 1,2 (classes of 0 99 and workers) are negative and statistically significant. The rest of firm size classes are basically facing the same levels of internal fund constraints as the stateowned enterprises with more than 1,000 workers. In order to explain this surprising result that smaller firms are less cash-constrained than larger firms, we suggest the following reasons: first, small firms which are better managed and more efficient may be smoothing their fixed investment by their working capital. Fazzari and Petersen (1993) suggest that working capital can be used to smooth fixed investment over time, even though the firm is financially constrained. For example, when a firm, which has ample working capital, is faced with a negative/positive cash flow shock, the firm can decumulate/accumulate its working capital and keep its fixed investment more or less intact. As a result, fluctuations in cash flow can have relatively little effect on fixed investment. Unfortunately, our data set does not have the detailed information on the working capital of sampled firms such as their short term assets and liabilities. Therefore, we cannot conduct an empirical test of the previous hypothesis of using working capital to smooth cash flow fluctuations when making investment decisions. However, this explanation is actually partially supported by the fact that small firms have much more cash flow than their larger counterparts as shown in Table 2. These cash flows are their working capital that they easily use to smooth their fixed investment given their better market performance in terms of rapid growth and higher profitability (Chow and Fung 1996 and 1997). Therefore, their investment is less sensitive to the availability of cash flow. Second, the composition of various firm size classes is also an important reason to explain our result. Due to collectively-owned enterprises domination in the classes of small firms, Chow and Fung (1996 and 1997) show that this type of firm is relatively more efficient and has been growing more rapidly than other types of ownership. Given their success in the market and managerial efficiency, they have greater capacity in generating a large enough cash flow to finance their fixed investment. Third, enterprises in the non-state sector can rely on borrowing from the informal credit market as they can only obtain very limited bank credits from the formal banking institutions (see McKinnon 1994). According to the Chinese Academy of Social Sciences (1996), private businesses are faced with the scarcity of financial resources and institutional support. The Academy s survey indicates that entrepreneurs in China got

17 SMALL BUSINESSES AND LIQUIDITY CONSTRAINTS 379 initial capital mainly from three sources: personal savings, loans from friends or relatives, and personal loans from other people. On the other hand, Blanchard (1997) mentions that the financial institutions in the formal banking system also participated in the underground loan market as the difference between the official and the black market interest rates was large in the era of high inflation (late 1980s and early 1990s). On the other hand, given that state-owned enterprises dominate in the classes of large firms (Table 5), their behavior should have a significant impact on the group of large firms. Large state-owned enterprises are usually heavily indebted from borrowing substantially from state-owned banks to keep them afloat. By 1994, the aggregate bank debt of the state industrial sector had further grown to 73% of aggregate book value (depreciated fixed capital plus all inventories). All these figures show that state-owned enterprises are increasingly in debt to the state-owned banking sector. During the central planning era, these large state-owned enterprises received substantial amounts of bank loans which were allocated to them automatically to supplement any shortfall of their working capital. This practice has not changed at all even after the implementation of economic reform in The Chinese economic reform emphasizes competition over privatization: The giant and inefficient state-owned enterprises are replaced not by extensive privatization in the short run, but by gradually being outcompeted and outgrown by non-state enterprises in the long run. Although the nonstate enterprises are thriving by gaining more and more market shares at the expenses of their state-owned counterparts, these state-owned enterprises are fighting a losing battle by accumulating heavy losses over time. A lot of bank loans received by them are actually subsidies in disguise. If so, these large state-owned enterprises actually need more cash to service their massive outstanding loans accumulated over the past three decades and less cash flow is available for fixed investment. Therefore, they can be effectively more constrained by the availability of cash flow in their investment decisions in the end since the central government has a limit in financing their insatiable appetite for cash flow. In addition, the central and regional government also have liquidity problem in satisfying all the liquidity demands of all state-owned enterprises. As the Chinese economy becomes more and more competitive and other non-state enterprises become more and more efficient, the problem of accumulating larger and larger losses by inefficient state-owned enterprises is growing larger day by day. The Chinese governments find it increasingly difficult to keep pumping cash into these enterprises to keep them afloat. Therefore, state-owned enterprises can be severely constrained by cash flow when they are contemplating their investment decision. DISCUSSION AND CONCLUSION The literature of asymmetric information, transaction costs, and agency problems suggests that small firms should face tighter liquidity constraints and rely more on internal funds to finance their investment projects. These theoretical arguments have been used to explain findings on how firm size affects investment finance of firms in developed economies (see Fazzari, Hubbard, and Peterson 1988; Oliner and Rudebusch 1992; Himmelberg and Petersen 1994; Carpenter, Fazzari, and Petersen 1994). However, the results of the study of firm-size effect on investment finance in developing economies are so mixed that these theoretical arguments developed for capital markets in more advanced market economies can hardly provide a satisfactory explanation. Mckinnon (1973) and Shaw (1973) argue that capital markets in developing econo-

18 380 D.K.-W. CHOW AND M.K. YIU mies are fragmented because of massive governmental interventions which can significantly affect how firms finance their investment. In the presence of a high degree of financial repression by government in Columbia during the mid and late 1970s, Tybout (1983), shows that, by using data from Colombian manufacturing firms, internal funds are important for small firms. Nabi (1989) uses data for manufacturing firms in Pakistan to test the relationship between internal funds and investment. He divides the sample into two groups: firms that have access to the formal subsidized capital markets and those firms that do not have access, and finds that the capital spending of excluded firms is constrained by the level of internal funds, while the favored firms (usually large firms) do not face the constraint. When the objective of the Indian government s industrial policy is the promotion of small industry, Athey and Laumas (1994) show that internal funds are relatively more important for large firms. This paper makes a contribution to the literature by studying the relationship between firm size and liquidity constraints in the Chinese economy in transition as little research has been done in this type of economy. Similar to other developing economies, the capital market in China is also fragmented, meaning that small enterprises in nonstate sectors are excluded from the formal credit markets which mainly provide loans to large state-owned enterprises because of political reasons. By using a firm level data of manufacturing enterprises in Shanghai during the period of , we show that the empirical relationship between firm size and liquidity constraints of Shanghai s manufacturing enterprises contradicts the expected results that smaller firms should be more cash-constrained than larger firms. In the manufacturing sector of Shanghai, larger enterprises actually are more cash-constrained than small enterprises. According to the structural characteristics of this transition economy, we suggest three possible explanations for this peculiar finding: (1) The composition of various firm size classes plays an important role in explaining the result: Collectively-owned enterprises which are fast growing and efficient dominate the small firm classes. Given their success in the market and managerial efficiency, they have greater capacity in generating large enough cash flow in financing their fixed investment. (2) The presence of heavy indebtedness of large state-owned enterprises may deprive them of sufficient cash available for investment decision. (3) Small firms in non-state sectors can rely on borrowing from the informal credit market although they can only obtain very limited bank credit from the formal banking institutions. As the PRC s top leaders, President Jiang Zemin and Prime Minister Zhu Rongji, call for a more accelerated reform of state enterprises. There will be more layoffs and dislocation of labor from the state sector. Given an underdeveloped welfare safety net, this wave of massive unemployment may be the one that will spin China into turmoil (Far Eastern Economic Review 1997). How to create enough jobs for the unemployed is one of the most important policy issues in China. Small businesses have been shown to be a major creator of jobs even if their access to capital market is costly and limited (see Birch 1987; Davis and Hartiwanger, 1992; Blanchflower and Burgess, 1996). Our findings may imply that small enterprises in China do not face such a tight constraint in liquidity that either their growth potential or contribution to job creation is restrained. Consequently, one may conclude that no active policy on small business development is required. However, two factors need careful consideration before any conclusion can be made. First, China s bid to join the World Trade Organization (WTO) will lead to a substantial elimination of trade barriers like tariffs and quotas which may erode the profits of these small enterprises in non-state sector

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