The Effects of Government Quality on Corporate Cash Holdings

Abstract

We use China as a laboratory to test the effect of government quality on cash holdings. We build on, and extend, the existing literature on government expropriation and its interaction with firm-level agency problems by proposing a financial constraint mitigation argument. Wefind that firms hold less cash when local government quality is high, which is not consistent with the state expropriation argument, but supports the financial constraint mitigation argument. A good government lowers the investment sensitivity to cash flows and cash sensitivity to cash flows, decreases cash holdings more significantly in private firms, and improves access to bankand trade credit financing. We also test and find support for Stulz’s (2005) model on theinteraction between government and firm agency problems.

Keywords: Cash holding, Government quality, Institutions, Property rights, Twin agency problems, China

JEL Classification: G32, G38