A balancing act: Managing financial constraints and agency costs to minimize investment inefficiency in the Chinese market

Using a large panel of Chinese listed firms over the period 1998–2014, we document strong evidence of investment inefficiency, which we explain through a combination of financing constraints and agency problems. Specifically, we argue that firms with cash flow below (above) their optimal level tend to under- (over-)invest as a consequence of financial constraints (agency costs). Furthermore, focusing on under-investing firms, we highlight that the sensitivities of abnormal investment to free cash flow rise with traditionally used measures of financing constraints, while for over-investing firms, the sensitivities increase with a wide range of firm-specific measures of agency costs. •We document strong evidence of investment inefficiency among Chinese listed firms.•We explain it through a combination of financing constraints and agency problems.•We focus on the sensitivities of abnormal investment to free cash flow.•For under-investing firms, these sensitivities rise with financing constraints.•For over-investing firms, the sensitivities increase with agency costs.