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Authors:

• Keith K. P. WONG
  University of Hong Kong

• Kong Wing CHOW

• Frank M. SONG
  University of Hong Kong

This paper examines the incentive effects of the soft budget constraint on the investment behavior of firms in general and on the investment-cash flow sensitivity in particular. We develop a simple model of moral hazard which takes the soft budget constraint into account. We show that in such a moral hazard environment investment is positively related to the amount of internal funds. We further show that the presence of the soft budget constraint reduces the commitment value of internal funds, thereby lowering the investment-cash flow sensitivity. We test these theoretical predictions with data of China's listed companies for the period from 1995 to 2000. We find that firms in China are by and large liquidity constrained. We further find that firms with larger shares of state ownership appear to be less liquidity constrained than firms with lower shares of state ownership. Since it is reasonable to treat the share of state ownership as a proxy for the severity of the soft budget constraint, our empirical findings seem to support the theoretical predictions.