Product Market Competition and Financial Flexibility: Evidence from China

Abstract

This paper discusses the effects of product market competition on the value and level of corporate financial flexibility of Chinese listed firms for the period 2001-2014. We use three different measures of product market competition: predation risk, natural hedge and price-cost margin. Predation risk is used to measure how firms’ growth opportunities covary with those of their industry rivals. We thus calculate the correlation of firm stock returns with industry stock returns. The regression coefficient on the industry return is then used as the proxy for predation risk. Greater values of this measure indicate a greater predation risk, more interdependence of investment opportunities and therefore fiercer competition. Natural hedge is calculated as the absolute value of the difference between a firm’s ratio of net fixed assets per employee and the median ratio in the industry. To make this difference comparable across industries, the difference is then scaled by the industry range of the capital-to-labor ratio. Smaller values of this measure indicate greater similarity of a firm’s operations with industry counterparts and therefore signal fierce competition. The results show that when the other conditions remain unchanged, the predation risk weakens the spare debt capacity and excessive cash holdings and ultimately decreases corporate financial flexibility. Except for the natural hedge used to measure the degree of product market competition, which does not significantly affect spare debt capacity, the other results show that natural hedge reduces excessive cash holdings and corporate financial flexibility. On the one hand, product market competition increases the demand for financing; because Chinese listed firms are subjected to China Securities Regulatory Commission (CSRC) supervision for issuing securities, they must increase debt and reduce their spare debt capacity. On the other hand, product market competition increases investment expenditure, consumes cash, and reduces excessive cash holdings. In the end, product market competition reduces corporate financial flexibility.