This paper studies the relationship between market frictions and political connections in determining financial constraints. We develop a novel index to measure the depth of political connections (PC) at the firm level and provide robust empirical evidence that firms in China actively build PC to alleviate the costs of market frictions. Specifically, we find that firms facing severe market frictions are not as financially constrained as expected. This is because these firms also possess strong PC, which alleviate the costs of market frictions. We find that market frictions can significantly affect financial constraints in Chinese firms, but only for those firms with modest levels of PC.

No abstract

No abstract

Literature streams disagree about the capacity of investment-cash flow sensitivity (ICFS) to measure both investment thirst and financial constraint. We argue that ICFS measures the former but not the latter. Therefore, we use Fazzari et al. 's study (1988) to develop a model to test the relationship between ICFS and financial constraint, but extend that model using Kornai (1979) to include investment thirst. We demonstrate: because the ICFS-financial constraint relationship varies, ICFS cannot measure financial constraint. Conversely, using a natural experiment of China's Four Trillion Stimulus policy, we show ICFS significantly and positively correlates with investment thirst after controlling for financial constraint.

No abstract