The impacts of internal capital allocation efficiency on R&D investments: evidence from China

ABSTRACT

This research utilizes hand-collected data on business groups’ pyramidal equity structure to examine the impacts of internal capital markets on research and development (R&D) investments in China. Empirical findings show that the allocation efficiency of the internal capital market positively correlates with R&D investments. We further provide evidence of a U-shape relationship between pyramidal layers and R&D investments for state-owned business groups. For non-state-owned business groups, however, there is an opposite impact pattern on the relation between internal capital markets and R&D investments.

KEYWORDS:

• Internal capital markets
• research and development
• capital allocation
• emerging markets
• financing channel

JEL CLASSIFICATION:

• O32
• G32
• G14
• G30

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ For an overview of business groups, please refer to Khanna and Yafeh (2007).

² For example, Teng and Yi (2017) use China as a setting to document that firms owned by the central government are associated with increasing R&D activities. Lou et al. (2019) show that R&D is more intense when the firms are affiliated with a business group.

³ In China, solving financing difficulties is a major driving force for the formation of non-state-owned business groups. In the credit market, state-owned enterprises are favoured by banks and the government when providing R&D subsidies. The formation of state-owned business groups is not to solve financing problems, but mainly to cooperate with the reform of a streamlined administration and to delegate powers. Therefore, the financing function of the internal capital market of a state-owned business group is not prominent, and the pyramid level mainly affects capital allocation function of the internal capital market by impacting the relationship between the government and enterprises, thereby further influencing R&D investment. Existing literature finds that the internal capital market has been relegated into a tunnelling channel by controlling shareholders (e.g., Xu, Zhang, and Wen 2009; Sutherland, Ning, and Beatson 2011; He et al. 2013).

⁴ China’s reform in non-tradable shares began in 2005 and finished in 2013. The Third Plenary Session of the 18^th CPC Central Committee in 2013 proposed ‘actively developing a mixed-ownership economy’.

⁵ ‘Xi Zu’ business groups are ubiquitous in China’s capital market and play an increasingly important role in its economic society. The firms affiliated with Xi Zu have experienced a crisis due to inefficient internal capital allocation. These explosive events have spurred Chinese scholars to investigate the motivations and reasons that cause business groups to deviate from the principle of efficiency and distort resource allocation.

⁶ We obtain 8592 sample observations, 5624 of which are affiliated with business groups. From 2013 to 2018, each year there are 178, 181, 183, 198, 217, and 214 ‘Xi Zu’ business groups, respectively. The sample observations controlled by ‘Xi Zu’ business groups are 1853 in total.

⁷ There are several advantages to the internal capital market. First, it alleviates financing constraints through both the ‘more-money effect’ and ‘smarter-money effect’. Second, it utilizes the authority of group headquarters and the residual control advantage of fund providers so as to alleviate information asymmetry that widely exists in the external capital market, to supervise and control investment projects, to improve the efficiency of resource allocation, and to optimize resource allocation (Lamont 1997; Stein 1997; Castaneda 2002; Li and Jin 2007; Wang et al. 2011). Finally, the internal capital market is conducive to improving corporate governance and thus can be mainly reflected by its information superiority and the effectiveness of supervision and incentives (Gertner, Scharfstein, and Stein 1994; Liu, He, and Wei 2004).

⁸ In transition economies, state-owned companies undertake multiple policy tasks imposed by the government, such as employment, taxation, economic development strategies, social stability, and official performance goals. Excessive government intervention, however, brings serious negative effects to their business operations. The pyramidal shareholding structure within a state-owned business group keeps listed affiliations away from government control. The longer the pyramid layer is, the smaller is the probability and degree of government intervention in listed affiliations, the less political tasks that will be undertaken, and the greater is their independent decision-making power.

⁹ This study refers to the ‘cash flow sensitivity method based on asset return’ proposed by Wang and Xie (2010) to measure the allocation efficiency of the internal capital market.