Pacific-Basin Finance Journal 26 (2014) 227–243

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Pacific-Basin Finance Journal

journal homepage: www.elsevier.com/locate/pacfin

Economic policy uncertainty and corporate

investment: Evidence from China☆
Yizhong Wang a, Carl R. Chen b, Ying Sophie Huang a,⁎
a
College of Economics & Academy of Financial Research, Zhejiang University, Hangzhou, China
b
School of Business Administration, University of Dayton, Dayton, OH, United States

a r t i c l e i n f o a b s t r a c t

Article history: This paper studies how economic policy uncertainty influences
Received 4 November 2013 corporate investment for Chinese listed companies. We show that
Accepted 28 December 2013 when the degree of economic policy uncertainty is higher, firms stand
Available online 4 January 2014
to lower their investment and vice versa. However, firms that have
higher return on invested capital, use more internal finance and are
JEL classification:
not state-owned mitigate the negative effect of policy uncertainty on
G32
corporate investment. Moreover, firms in regions with higher degree
D80
E22
of marketization are more sensitive to the economic policy uncer-
E60 tainty. The evidence illustrates that keeping the transparency and
G18 stability of the implementation of economic policies can improve
corporate investment efficiency.
Keywords: © 2014 Elsevier B.V. All rights reserved.
Economic uncertainty
Policy uncertainty
Corporate investment
China

1. Introduction

This study examines the relationship between economic policy uncertainty and corporate investments at
the firm level. The impact of uncertainty on investments has been studied before, but the results are not
conclusive. Instead of idiosyncratic uncertainty, we are interested in the impact of economic policy
uncertainty. Economic or political shocks can be an important source of uncertainty for firms as their costs,
sales and profits will be greatly affected. In particular, corporate investment is usually costly and irreversible.
Policy changes would affect the environment in which firms operate and hence their investment behaviors.

☆ This paper has benefited from the comments of an anonymous reviewer. Yizhong Wang is grateful for financial supports from
the National Social Science Fund of China (10zd&034 and 12CJY115), the Foundation for the Author of National Excellent Doctoral
Dissertation of PR China (Grant No. 201102) and Zhejiang Provincial Natural Science Foundation of China (LY12G03027). Ying
Sophie Huang gratefully acknowledges the financial support provided by the Humanities and Social Sciences Foundation of the
Ministry of Education of China (12YJA790053), and the Zhejiang Provincial Natural Science Foundation of China (LQ12G03014).
⁎ Corresponding author at: College of Economics & Academy of Financial Research, Zhejiang University, Hangzhou 310027, China.
Tel.:+86 571 8795 1610; fax: +86 571 8788 3953.
E-mail address: sophiehuangying@zju.edu.cn (Y.S. Huang)

0927-538X/$ – see front matter © 2014 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.pacfin.2013.12.008
228 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243

Our study is mainly motivated by the importance of the influence of domestic policy uncertainty on
economic activities. Besides political reasons, more often than not, policy uncertainty is closely related to
unexpected changes that may alter the economic environment, which in turn will change the required
return that firms used to discount their further cash flows. Therefore, it is of great interest to examine the
impact of policy uncertainty on corporate investment decisions. We use Chinese data because China is still
regarded as a transition economy moving away from planned economy to market-based economy. It is
interesting to examine if the impact of economic policy uncertainty results in similar/different effect on
corporate investment from that of market-based developed economy. The results may provide
implications for other transition economies.
The extant literature documents empirical evidence that policy-related uncertainty can depress
economic growth through a decrease in corporate investment. Aizenman and Marion (1993) are among
the first to study the relationship between policy uncertainty and real per capita GDP for 46 developing
countries from 1970 to 1985. They document that policy uncertainty can influence economic growth by
investment. More recent studies find that the drop in corporate investment expenditures during the
recent global financial crisis is attributable to the increasing uncertainty in policies (Baker et al., 2013;
Gulen and Ion, 2013; Julio and Yook, 2012; Durnev, 2012).
To measure economic policy uncertainty, we resort to Baker et al. (2013), in which they develop a new
index of economic policy uncertainty (EPU) for the US. Their EPU index has been tested to be a good proxy
of real economic policy uncertainty. Following similar logic and methodologies, they then construct EPU
indexes for Europe, Canada, China and India.1 For our study, we adopt their China index to proxy the
economic policy uncertainty.
Using a panel of Chinese publicly listed firms from 2003 to 2012, we examine impacts of economic
policy uncertainty on corporate investment and find that such uncertainty indeed affects corporate
investment in China in important ways. First, as a key factor, policy-related economic uncertainty can
dampen corporate investment in general, which is consistent with prior evidence for developed
economies. Second, firms with heterogeneous characteristics are found to respond differently in the face
of policy uncertainty. Specifically, firms that enjoy higher return on invested capital, rely more on internal
finance and are non-state-owned, are better positioned to mitigate the negative impact of uncertainty on
corporate investments. Our results still hold when we apply a number of additional robustness tests. In
particular, we consider potential endogeneity problem, use differenced variables, consider longer-lag
effect in economic policy uncertainty, and an alternative proxy for economic policy uncertainty. To the
extent that no study has yet investigated the relation between economic policy uncertainty and corporate
investment for a transition economy, our findings contribute to the literature and offer meaningful
insights to policy makers in these economies.
The rest of the paper proceeds as follows. The second section provides the relevant theoretical
background in the literature and develops our main hypotheses. The third section describes our sample
and variables. The fourth section presents the empirical results. The fifth section conducts robustness tests.
We conclude in the last section.

2. Theoretical background and hypotheses development

The research on the relationship between corporate investment and uncertainty has been inconclusive.
The classical theory of Knight (1921) emphasizes that entrepreneurs have the ability to recognize and
seize investment opportunities in uncertainty and make profits through resource integration. Therefore,
uncertainty is the very source of corporate profits. Furthermore, under the assumption of perfect
competition, constant return to scale and symmetrical adjustment cost, economic models developed by
Hartman (1972) and Abel (1983) suggest that a higher level of uncertainty will boost the expected profit
margin of capital and thus increase investment. Abel and Blanchard (1986) provide empirical evidence for
this assertion.

1
For more details, refer to the policy uncertainty website developed by Baker, S.R., Bloom, N. and Davis, S.J. at www.
policyuncertainty.com.
 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243 229

On the other hand, Caballero (1991) argues that capital investments decrease when uncertainty increases
if the assumptions of Hartman (1972) and Abel (1983) are relaxed. The real options arguments reach the same
conclusions. The irreversibility nature of investment projects or the sunk cost makes firms to weigh the profit
difference between current and future investments. The higher the degree of uncertainty, the more the return
on waiting for future investment, hence a higher value on the option of waiting; consequently companies
reduce their current investment spending (Brenner and Schwartz, 1985; Titman, 1985; Bernanke, 1983;
McDonald and Siegel, 1986; Pindyck, 1988). Additional evidence supports this contention include Caballero
and Pindyck (1996) at the industry level, and Leahy and Whited (1996) and Bond and Cummins (2004) at the
firm level.
As one type of uncertainty, policy uncertainty has significant influence on corporate investment
behavior. Policy uncertainty can raise expected costs and cut down long-term investment and output
(Jeong, 2002). Especially in developing countries, where typical entrepreneurs react to policy changes, and
their rationality prevents them from increasing investment until the uncertainty associated with policy
reform has been eliminated (Rodrik, 1991). The theoretical model and empirical findings of Pastor and
Veronesi (2011) indicate that policy uncertainty decreases the value of protections provided by the
government for markets, thus leading to more fluctuations in stock prices. Julio and Yook (2012) find that
in election years corporate investment would decrease 4.8% on average as opposed to years without a
presidential election. Durnev (2012) documents that stock prices contain more noise in election years,
causing corporate investment to be insensitive to stock price changes. Additionally, the election
uncertainty leads to inefficient capital allocation and jeopardizes corporate performance. Using Baker et
al.'s (2013) Economic Policy Uncertainty Index, Gulen and Ion (2013) find that higher levels of economic
policy uncertainty will repress corporate investment. Based on the above analysis, we formulate our first
hypothesis as follows.

Hypothesis 1. Corporations reduce investment when economic policy uncertainty increases, and vice
versa.

It has been documented that a firm's financial characteristics affect the relationship between
uncertainty and corporate investment. Such firm characteristics include, but are not limited to financial
constraints, firm size, and managerial flexibility (e.g., Duchin et al., 2010; Xie, 2009). It should be noted
that compared to countries of mature market economy, the influence of economic policy uncertainty on
corporate investment in economic transition countries (e.g., China) may exhibit different patterns. First of
all, Bai et al. (2004) find that the return to capital in China is significantly higher than that in mature
market economies. Similarly, Sun et al. (2010) compare the return to capital in China, U.S. and Japan, and
suggest that the reason why China enjoys high investment rate is its considerable return to capital, which
is significantly higher than in other major economies. As a result, higher returns to invested capital may
motivate firms to continue investing instead of deferring investment in the face of greater policy
uncertainty. Accordingly, it is likely that higher expected return on invested capital moderates the adverse
impact of uncertainty on corporate investment. We postulate our second hypothesis as:

Hypothesis 2. Investments by corporations that have higher returns to invested capital are less
affected by economic policy uncertainty.

Second, Guariglia et al. (2011) argue that the financial system in China is not perfect. In the
state-owned bank dominated financing environment, corporate asset growth is mainly due to internal
finance. Hence, companies that are better at obtaining funding internally may be less adversely impacted
from policy uncertainty. Consequently, it can be the case that more internal financing entails less influence
of policy uncertainty on investment. We posit our third hypothesis as:

Hypothesis 3. Investments by corporations that use more internal financing are less affected by
economic policy uncertainty.

Third, government interventions are relatively common in countries during transition period. Deng
et al. (2011) document that there are close correlations between promotions of large state-owned
230 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243

enterprises (SOEs) managers who are loyal to the government and corporate performance. The “natural
relation” between state-owned enterprises and the government tends to make their investment behavior
“pro-policy”, namely, when policies aiming to stimulate (tighten) the economy are adopted, state-owned
enterprises would comply by increasing (curtailing) investments. What's more, given that the agency cost
of state-owned firms is higher than that of non state-owned firms (Huang et al., 2011), state-owned firms
are more willing to invest in accordance with policies. Morck et al. (2013) find that monetary policy is
more reliably transmitted by state-controlled banks and state bank lending is significantly more
responsive to monetary policy. Therefore, in China SOEs, which rely predominantly on bank lending, are
affected more by economic policy uncertainty, whereas the investment behavior of non-SOEs may be less
responsive to changes in the economic policy.2 Hence, our fourth hypothesis is postulated as follows.

Hypothesis 4. Investments by non-state-owned corporations are less affected by economic policy

uncertainty.

Finally, economic development and the degree of marketization seem to be uneven across regions/
provinces in China. To be sure, while Shanghai, Beijing, and Shenzhen are highly developed, many inland
provinces such as Gansu, Qinghai, and Quizhou fall behind significantly. Therefore, it is interesting to find
out if firms in regions with different marketizations are impacted differently by economic policy
uncertainty. The relationship, however, is not unambiguously clear. On the one hand, Pastor and Veronesi
(2011) argue that policy uncertainty decreases the value of protections provided by government for
markets, leading to more fluctuations in stock prices. This argument implies that the economy of
provinces/regions that are more planned (less marketized) reduces more value offered by the government
protection, hence is more negatively impacted by uncertainty. On the other hand, presumably higher
marketized provinces/regions are economically and financially more connected with global trade, credit
supply, and equity markets. As such, firms in these regions are more responsive to the economic shocks
and/or changes in uncertainty arising from economic/monetary policies. In fact, many countries that were
least impacted by the 2007 financial crisis are less developed/emerging economies, not well-developed
ones. Such countries include China, Brazil, Romania, North Korea, Iran, Armenia, and United Arab Emirates,
just to name a few. This interpretation is consistent with Calomiris et al. (2012) that credit supply shock
and liquidity shock during financial crisis periods have more significant impact on developed nations than
emerging economies. Therefore, we intend to empirically answer if economic policy uncertainty has
asymmetrical impacts on firm investment in different provinces/regions with various degrees of
marketization. In line with the above two views, we state our fifth hypothesis as:

Hypothesis 5. Investments by firms in more marketized provinces/regions are less affected by

economic policy uncertainty. Alternatively, investments by firms in more marketized provinces/regions
are more affected by economic policy uncertainty.

3. Sample selection and choice of variables

3.1. Sample

To better understand the short-term effects of economic policy uncertainty, we use a sample of Chinese
listed companies' quarterly financial statement data.3 Since 2003, all publicly listed companies have been
required by China Securities Regulatory Commission (CSRC) to publish quarterly reports. So, our sample
period goes from the first quarter of 2003 to the first quarter of 2012. In our robustness tests, we extend
the sample to the fourth quarter of 2012 to consider longer lagged effect of policy uncertainty. Excluding

2
The compliance with policies by state-owned enterprises may lead to more uncertainty and hence affect firm performance. For
example, Ng et al. (2009) find that ownership structure affects firm performance. Jiang et al. (2013) find that high volatility SOEs
optimally appoint outsiders as CEOs for firm-specific reasons, which non-SOE firms cannot do, and subsequent firm performance of
these SOEs is enhanced. Wei et al. (2005) also argue that SOEs have other important objectives than just maximizing firm value.
3
Many prior studies use quarterly statements. For example, Duchin et al. (2010) use quarterly data to analyze the impact financial
crisis on corporate investment in the US. Gulen and Ion (2013) use quarterly data to examine the impact of U.S. economic policy
uncertainty on corporate investment.
 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243 231

“special treatment” (ST) shares4 and financial companies, all data are winsorized to minimize the
influence of outliers, i.e. observed values lie outside 1% and 99% quantiles are replaced with values of 1%
and 99% quantiles. Our accounting data are retrieved from the Wind database, and the Chinese economic
policy uncertainty index is obtained from Baker et al. (2013).5

3.2. Variable definitions

In the baseline regressions, the dependent variable is corporate investment. Our explanatory variable
of primary interest is economic policy uncertainty, and the control variables include cash flow, Tobin's q,
company size, sales revenue and leverage ratio. In order to investigate the effect of firm heterogeneity on
the impact of economic policy uncertainty on corporate investment, we introduce three “firm
heterogeneity variables”, namely, return to invested capital, the extent of internal finance and corporate
ownership.
Corporate investment is measured as capital expenditures divided by total assets at the beginning of
the fiscal quarter (Duchin et al., 2010), and capital expenditures are calculated as the sum of cash paid for
the acquisition of fixed assets, intangible assets and other long-term assets in the quarterly statement of
cash flows.6 We adopt the Chinese monthly policy uncertainty index developed by Baker et al. (2013)7 to
measure the economic policy uncertainty in China, and use the geometric mean method to transform their
monthly data into quarterly data. In terms of control variables, we consider cash flow and Tobin's q from
the classic investment equation (Fazzari et al., 1988; Chen and Chen, 2012), company size, sales revenue
(Love, 2003), and leverage ratio (Chava and Roberts, 2008; Duchin et al., 2010). Specifically, cash flow is
computed as the net operating cash flow divided by total assets at the beginning of the fiscal quarter.
Tobin's q is measured as the market value of traded and non-traded shares plus total debt then divided by
total assets, lagged one period.8 Company size is expressed with the natural logarithm of current total
assets. Sales revenue is measured as cash received from sales of goods and services divided by total assets
at the beginning of the fiscal quarter. Leverage ratio is the ratio of total liabilities to total assets, lagged one
period.
To construct the “firm heterogeneity variables”, we define return on invested capital as net operating
profit before interest divided by invested capital. The invested capital is computed as shareholders' equity
(excluding minority interests) plus total liabilities minus non-interest-bearing current and long-term
liabilities. That is, our measurement of invested capital excludes cash, financial assets held-for-trading and
non-capitalized assets, such as receivables and payables. Following Guariglia et al. (2011), we compute
internal finance as the sum of net profit and depreciation normalized by total assets at the beginning of the

4
According to the stock listing rules that were implemented in 1998, the stocks of listed companies with abnormal financial
conditions would receive “Special Treatment”, hence the name “ST shares”.
5
www.policyuncertainty.com.
6
In 2001, the CSRC issued the Compiling Rules No. 13 for Information Disclosure by Companies Offering Public Securities — Special
Provisions on Content and Format of Quarterly Reports, mandating that from the first quarter of 2002, all listed companies must
prepare and disclose quarterly reports. On March 5, 2002 the Chinese Institute of Certified Public Accountants (CICPA) issued the No.
10 Bulletin on Independent Audit Practice — Accounting Statements Review, providing the industry standards on auditing financial
statements for accounting firms. In order to enhance the credibility of their financial statements, many listed companies require
accounting firms to audit the mid-year report. In 2003, the CSRC revised its Compiling Rules No. 13, requiring that all quarterly
reports must include the assurance from the board of directors on the truthfulness, accuracy, completeness, timeliness and fairness
of the disclosed information in the reports. To further mitigate the concern on the quality of quarterly financial statements, we also
conduct analyses using annual data. Results based upon annual data are consistent with those of quarterly data.
7
The method that Baker et al. (2013) use to estimate the Chinese economic policy uncertainty index is to construct a scaled
frequency count of articles about policy-related economic uncertainty in the South China Morning Post and it follows their news-
based indexes of economic policy uncertainty for the United States and other countries (see http://www.policyuncertainty.com/
china_monthly.html).Baker et al. (2013)'s economic policy uncertainty index has already been used in the literature (for example,
Gulen and Ion, 2013). The U.S. economic policy uncertainty index includes three components: news coverage, taxation, and
dispersion in economic forecasts. The findings in Gulen and Ion (2013) are consistent when using the overall policy uncertainty
index and only the news based component of the index.
8
We adopted the CSRC formula to calculate the total market capitalization of listed companies. Considering the fact that non-
tradable shares have less liquidity, we also follow Bai et al. (2004) and Jiang et al. (2013) by applying a 20% discount to calculate the
market value of these non-tradable shares. The results, not reported, show that the parameter size of Tobin's q becomes smaller, but
otherwise are all significant at the 1% level.
232 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243

Table 1
Descriptive statistics. Panel A summarizes the descriptive statistics of the main variables. Corporate investment is measured as capital
expenditures divided by total assets at the beginning of the fiscal quarter and capital expenditures are calculated as the sum of cash
paid for the acquisition of fixed assets, intangible assets and other long-term assets in the quarterly statement of cash flows.
Economic policy uncertainty is proxied by the Chinese monthly index of policy uncertainty calculated by Baker et al. (2013).We use
the geometric mean method to transform the original monthly data into quarterly data, then divide the numbers by 100 and lag
them by one period. Cash flow is computed as the net operating cash flow divided by total assets at the beginning of the fiscal
quarter. Tobin's q is measured as the market value of traded and non-traded shares plus total debt then divided by total assets,
lagged one period. Leverage is the ratio of total liabilities to total assets, lagged one period. Sales revenue is measured as cash
received from sales of goods and services divided by total assets at the beginning of the fiscal quarter. Size is expressed as the natural
logarithm of current total assets. Invested capital refers to shareholders' equity (excluding minority interests) plus total liabilities
minus non-interest-bearing current and long-term liabilities. Return on invested capital is equal to net operating profit before
interest divided by invested capital. Internal finance is measured as the sum of net profit and depreciation normalized by total assets
at the beginning of the fiscal quarter. Marketization index is taken from Fan et al. (2011). Panel B presents the t test and Wilcoxon
test on the difference in corporate investment between the high and the low economic policy uncertainty periods. The numbers in []
are p values.

Panel A: Descriptive statistics

Variable Mean St.dev. Min Median Max Obs.

Corporate investment 0.0184 0.0241 −0.0077 0.0098 0.1312 54,861

Economic policy uncertainty 1.1135 0.5678 0.5400 0.9667 3.232 84,348
Cash flow 0.0112 0.0497 −0.1521 0.0103 0.1770 56,123
Tobin's q 1.9525 1.5884 0.2542 1.4715 9.4517 57,523
Leverage 0.4904 0.2242 0.0456 0.4947 1.3652 57,332
Sales 0.1974 0.1635 0.0023 0.1544 0.9252 55,719
Size 2.8987 1.2411 0.0738 2.7860 6.6363 59,815
Return on invested capital 0.0452 0.0744 −0.1607 0.0250 0.3713 59,353
Internal finance 0.0191 0.0252 −0.0701 0.0153 0.1109 56,173
Ownership 0.6137 0.4869 0.0000 1.0000 1.0000 86,691
Marketization index 8.4772 2.0186 0.3800 8.780 11.80 65,548

Panel B: Corporate investment in high vs. low economic policy uncertainty periods

Diff(t-stat) Diff(z-score)
Difference(high–low) −8.113[0.0000] −5.610[0.0000]

fiscal quarter. For the ownership type dummy variable, if the actual owner is not the government or
State-owned Assets Supervision and Administration Commission, the company is categorized as a
non-SOE or 1, otherwise an SOE or 0 (Chen et al., 2011).9 Finally, marketization index for various
provinces/regions are taken from Fan et al. (2011) who construct an index on the degree of economic
development, government intervention, and legal system in their “NERI Index of marketization of China's
provinces”.

3.3. Summary statistics

Table 1 shows the descriptive statistics of the variables. It can be seen from Panel A that quarterly
capital expenditure is 1.8% of total assets on average, but can be as high as 13%. The average quarterly
operating cash flow is 1.1% of total assets, while the average quarterly sales revenue reaches 19.7% of total
assets in the sample period. The mean (median) value of Tobin's q is 1.95 (1.47). The average leverage
ratio is 49%, ranging widely from 4.6% to 137%. Our sample firms also experience diverse returns on
invested capital, with a minimum return of − 16% and a maximum of 37%. We can also see that the
internal finance to total assets ratio is quite low, averaging 1.9%. Ownership dummy has a mean of 0.6137,
implying that more firms are non-state owned in our sample. Marketization index has a mean of 8.4772,
standard deviation of 2.0186. The maximum is 11.8, while the minimum is 0.38.
In Panel B, we test whether there is a significant difference in corporate investment in the high/low
uncertainty regimes. We distinguish the high economic policy uncertainty period from the low economic

9
In the Wind database, it shows who the actual owner of the company is.
Table 2
Correlation matrix. This table reports correlation coefficients between the main variables. Corporate investment is measured as capital expenditures divided by total assets at the beginning of the
fiscal quarter and capital expenditures are calculated as the sum of cash paid for the acquisition of fixed assets, intangible assets and other long-term assets in the quarterly statement of cash flows.
Economic policy uncertainty is proxied by the Chinese monthly index of policy uncertainty calculated by Baker et al. (2013). Cash flow is computed as the net operating cash flow divided by total
assets at the beginning of the fiscal quarter. Tobin's q is measured as the market value of traded and non-traded shares plus total debt then divided by total assets, lagged one period. Leverage is the

Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243

ratio of total liabilities to total assets, lagged one period. Sales revenue is measured as cash received from sales of goods and services divided by total assets at the beginning of the fiscal quarter. Size
is expressed as the natural logarithm of current total assets. Invested capital refers to shareholders' equity (excluding minority interests) plus total liabilities minus non-interest-bearing current
and long-term liabilities. Return on invested capital is equal to net operating profit before interest divided by invested capital. Internal finance is measured as the sum of net profit and depreciation
normalized by total assets at the beginning of the fiscal quarter. Ownership is a dummy variable, which is equal to 1 for non-state-owned enterprises, 0 otherwise. Marketization index is taken
from Fan et al. (2011).

Corporate Economic policy Cash Tobin's q Leverage Sales Size Return on invested Internal Ownership Marketization
investment uncertainty flow capital finance index

Corporate investment 1.0000

Economic policy −0.0130 1.0000
uncertainty
Cash flow 0.1433 −0.0053 1.0000
Tobin's q 0.0223 0.0411 0.0265 1.0000
Leverage −0.1020 −0.0515 −0.0481 −0.1116 1.0000
Sales 0.0669 −0.0361 0.2131 −0.0115 0.1045 1.0000
Size 0.0611 0.0445 0.0460 −0.2558 0.1724 0.0967 1.0000
Return on invested 0.1784 0.0318 0.2194 0.1867 −0.2253 0.2460 −0.1410 1.0000
capital
Internal finance 0.2260 0.0085 0.2656 0.1150 −0.2185 0.2534 0.1101 0.7130 1.0000
Ownership 0.0246 0.0000 −0.0574 0.1131 −0.0882 −0.0375 −0.3610 0.1518 0.0158 1.0000
Marketization index −0.0372 0.0507 −0.0085 0.0466 −0.0184 0.1044 0.0282 0.1393 0.0613 0.1591 1.0000

233
234 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243

policy uncertainty period by using the median value of the uncertainty index, From the p values of t-test
(testing mean) and Wilcoxon z test (testing median), it is clear that there are distinctive differences in
corporate investment behavior in the high and low economic policy uncertainty regimes. The negative
sign indicates that corporate investment is generally lower during the high uncertainty period.

3.4. Correlation matrix

Table 2 reports correlation coefficients among relevant variables. It can be seen that except for the
relatively high correlation between internal financing and return on invested capital (0.713), the other
correlation coefficients are relatively small. Corporate investment exhibits negative correlations with
economic policy uncertainty leverage and marketization, while it is positively correlated with the other
variables.10

4. Empirical results

4.1. Baseline regression estimates

Our baseline regression equation is based on the literature about investment-cash flow sensitivity
(Fazzari et al., 1988;Chen and Chen, 2012). Following Gulen and Ion (2013) and Baum et al. (2010), we lag
the macroeconomic variable by one period.11 The main equation is specified as:


0
Capi;t =TAi;t−1 ¼ α i þ β1 EPU i;t−1 þ β2 Tobin qi;t−1 þ β3 Cashi;t þ β4 Firm Sizei;t
X X ð1Þ
þβ5 Levi;t−1 þ β6 ðSales=TAÞi;t þ Year þ Quar þ εi;t

where Capi,t is capital expenditures, TAi,t − 1 represents total assets at the beginning of the period, EPUi,t − 1
is economic policy uncertainty in the last period, Tobin ' qi,t − 1 is measured at the beginning of the
period, Cashi,t denotes the cash flow, Firm Sizei,t is the firm size, Levi,t − 1 is the leverage ratio in the prior
period, (Sales/TA)i,t is the sales revenue scaled by assets, Year is the year dummy, and Quar is the quarter
dummy. According to our Hypothesis 1, we expect the economic policy uncertainty coefficient β1 to be
negative.
Table 3 presents the estimation results for our baseline regression. Our estimations control for the firm
fixed effects, quarter/year effects, and the clustering of standard errors at the firm level.12 In Model (1) we
control for the firm fixed effects, but leave out other control variables. The main variable of interest,
namely the economic policy uncertainty, is found to have a significant and negative impact on corporate
investment. In other words, a higher degree of economic policy uncertainty is associated with less
corporate investment. The finding is consistent with the result predicted by the theory based on
investment irreversibility and option value of waiting to invest (e.g., Pindyck,1988). In Model (2) we add
other control variables, and the results reveal that cash flow, Tobin's q, sales/TA and firm size all have
significant and positive impacts on corporate investment, while the impacts of leverage and economic
policy uncertainty are significant and negative. Hence, our Hypothesis 1 is corroborated.

4.2. The impact of firm heterogeneity on the effect of economic policy uncertainty

The next question we address is the impact of firm heterogeneity on the effect of economic policy
uncertainty. The impact of uncertainty on firms with different financial strength and constraints may

10
We use Variance Inflation Factor (VIF) to test if multicollinearity is a problem in the regression analysis and VIF turns out to be
5.52 (which is b10), indicating that multicollinearity is not an issue in the model.
11
In our robustness tests, we also consider a longer time-lag effect from the economic policy uncertainty, where the dependent
variable is the future corporate investment.
12
Following Duchin et al. (2010), Chaney et al. (2012), and Gulen and Ion (2013), we have included firm fixed effects, hence no
industry effects in the models. However, we also re-run the main regressions with industry dummies added. After controlling for the
industry effect, the regression results remain unchanged.
 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243 235

Table 3
Analysis of the impact of economic policy uncertainty on corporate investment. This table presents estimates from the baseline model
using panel regressions, explaining firm-level quarterly investment between the 1st quarter, 2003 and the 1st quarter, 2012.
Economic Policy Uncertainty is one-period lagged Chinese economic policy uncertainty. Cash flow is computed as the net operating
cash flow divided by total assets at the beginning of the fiscal quarter. Tobin's q is measured as the market value of traded and
non-traded shares plus total debt then divided by total assets, lagged one period. Leverage is the ratio of total liabilities to total
assets, lagged one period. Sales revenue is measured as cash received from sales of goods and services divided by total assets at the
beginning of the fiscal quarter. Size is expressed as the natural logarithm of current total assets. Standard errors are clustered at the
quarter and firm levels following Petersen (2009). ⁎⁎⁎ and ⁎⁎ indicate statistical significance at the 1% and 5% levels, respectively.
The numbers in [] are p values.

(1) (2)

Economic policy uncertainty −0.0014⁎⁎⁎ −0.0013⁎⁎⁎

[0.000] [0.000]
Cash flow 0.0539⁎⁎⁎
[0.000]
Tobin's q 0.0005⁎⁎
[0.030]
Leverage −0.0123⁎⁎⁎
[0.000]
Sales 0.0058⁎⁎⁎
[0.000]
Size 0.0019⁎⁎⁎
[0.000]
Firm fixed effects Yes Yes
Quarter and year dummies Yes Yes
Cluster by firm and quarter Yes Yes
Number of observations 53,884 52,352
R-squared 0.020 0.051

differ. As discussed earlier, we expect firms with higher return on capital, more internal financing
resources and non-state ownership to be less sensitive in their investment in the face of greater
uncertainty in economic policy. Following Duchin et al. (2010) and Tong and Wei (2011) on the treatment
of interaction terms,13 we modify our baseline regression equation as follows:


0
Capi;t =TAi;t−1 ¼ α i þ β1 EPU i;t−1 þ β2 EPU i;t−1  HET i;t þ β3 Tobin qi;t−1 þ β4 Cashi;t
X X ð2Þ
þβ5 FirmSizei;t þ β6 Levi;t−1 þ β7 ðSales=TAÞi;t þ Year þ Quar þ ε i;t

Where HETi,t refers to return on capital, internal finance or the nature of ownership. According to
Hypotheses 2, 3 and 4, we expect the regression coefficient β2 N 0.
Table 4 reports the results. In Model (1), the coefficient on EPU is still significant and negative, but the
interaction term between EPU and return on capital fetches a statistically significant positive sign,
suggesting that the negative effect of EPU on corporate investment is mitigated for firms which enjoy
higher returns on invested capital. To be sure, the marginal negative effect of EPU on capital investment is
lower with the inclusion of return on capital variable. The stand alone impact of EPU is measured by the
13
In this model, we include the interaction terms between economic policy uncertainty and the three “firm heterogeneity
variables”, but not along with the three “firm heterogeneity variables” for two reasons. First, since the correlation coefficients
between these interaction terms and return on capital, internal finance and nature of ownership are 0.88, 0.80and 0.77, respectively,
multicollinearity is a serious problem if we put the three “heterogeneity variables” into the same regression equation. Second, we
follow the literature in the modeling of the interaction terms. Specifically, we follow Duchin et al. (2010) and Tong and Wei (2011)
on the treatment of the interaction terms. Similar treatments can also be found in other studies, such as Cavallo et al. (2013) and
Chaney et al. (2012). Duchin et al. (2010) document the impact of cash reserves on corporate investment before and after the
financial crisis. Tong and Wei (2011) study the importance of composition of capital flows in affecting the degree of credit crunch
during the financial crisis, while Cavallo et al. (2013) study the role of relative price volatility in the efficiency of investment
allocation.
236 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243

coefficient − 0.0014 (Column 1 of Table 3), while the same statistics is reduced to − 0.00127 with the
consideration of return on capital, which is about a 9% decrease.14 This result supports our Hypothesis 2.
Similarly, a statistically significant and positive coefficient for the variable (EPU × Internal Finance) in
Model (2) indicates that facing a higher degree of economic policy uncertainty, investment by companies
with more internal finance would be adversely affected to a lesser extent. The stand alone impact of
EPU is measured by the coefficient − 0.0014 (Column 1 of Table 3), while the same statistics is reduced
to − 0.00043 with the consideration of internal finance, which is about a 97% reduction.15 This result
supports Hypothesis 3. Comparing the moderating effect of return on capital vs. that of internal finance,
therefore, firms with more internal finance is more powerful in mitigating the negative effect of EPU on
capital investments.
Model (3) implies that compared to state-owned firms, capital investments of non-SOEs are
less sensitive to economic policy uncertainty. The stand alone impact of EPU is measured by the
coefficient − 0.0014 (Column 1 of Table 3), while the same statistics decreases to − 0.00108, which is
about a 22.9% reduction.16 This finding supports Hypothesis 4. The regression results are still consistent
when we include all three “firm heterogeneity variables” in Model (4).17 Except for the leverage ratio, cash
flow, Tobin's q, sales and firm size all exhibit positive associations with corporate investment.18

4.3. Impact of marketization

Since economic development and the degree of marketization seem to be uneven across regions/
provinces in China, it would be interesting to see if firms in provinces/regions with various degrees of
marketization respond differently to the uncertainty arising from economic policies. Fan et al. (2011)
construct an index on the degree of economic development, government intervention, and legal system in
their “NERI Index of marketization of China's provinces”.19 To this end, we first partition our sample based
on the level of the marketization index. If a company is in a province/region with an index reading equal to
or above the median value, the company falls into the high marketization group; otherwise, it belongs to
the low marketization group. The relevant results are reported in Columns 1 and 2 in Table 5. We see that
there appears to be minimal impact from marketization, as corporate investments for firms in the high and
low marketization groups exhibit no obvious difference and the coefficient on EPU is still significant and
negative. Crude sample partitioning based upon the median value, however, may not reveal much
information. Therefore, in Column 3 we create five marketization dummy variables, each representing a
different percentile of the marketization index, and interact them with the EPU variable. These five
dummies are based upon the 5, 25, 75, and 95 percentiles of the index value, with the highest group (≥95
percentile) excluded from the model.
Results in Column 3 suggest that firms in lower marketized regions are less sensitive to EPU as the
parameters of the interaction dummies are generally larger, and are significant and positive for lower

14
The mean of the rate of return on capital is 0.0452 (Table 1). The coefficient of the interaction term in Model (1) is 0.0271.
Multiplying the two, we have 0.0012. 0.0012 minus 0.0025 equals −0.00127. Obviously, with the introduction of the interaction
term, the direct impact of policy uncertainty on corporate investment becomes smaller.
15
The mean of internal finance is 0.0191 (Table 1). The coefficient of the interaction term in Model (2) is 0.0666. Multiplying the
two, we have 0.00127. 0.00127 minus 0.0017 equals −0.000428.
16
The mean of ownership is 0.6137 (Table 1). The coefficient of the interaction term in Model (3) is 0.0015. Multiplying the two,
we have 0.0009206. 0.0009206 minus 0.0020 equals −0.00108.
17
We also create dummy variables equaling to 1 when the values of return on capital and internal finance are above the median; 0
otherwise. Results based upon these new interaction dummies show that the interaction terms between these dummies and EPU
turn out to be positive and significant, implying that the negative impact of economic policy uncertainty on corporate investment is
mitigated in companies with higher level of return on capital and internal finance. The finding is in line with our prior results in
Table 4 using continuous measurement of return on capital and internal finance.
18
In Table 2, the correlation coefficient matrix shows that Cash Flow and Internal Finance have a correlation coefficient of 0.2656,
which is not that high. As indicated in Footnote 10, VIF test does not indicate serious multicollinearity problem. However, to alleviate
further concern on the positive correlation between the two variables, we exclude Cash Flow from the model and re-run the
regressions. The new results are consistent with those reported in the paper.
19
This marketization index is compiled by the National Economic Research Institute of China and intends to capture the regional
market development (including relationship between government and markets, development of non-state-owned sector in the
economy, development of product markets, development of factor markets, and development of market intermediaries and legal
environment). High scores of the index suggest good institutional development.
 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243 237

Table 4
The heterogeneous impact of economic policy uncertainty on corporate investment. Corporate investment is measured as capital
expenditures divided by total assets at the beginning of the fiscal quarter and capital expenditures are calculated as the sum of cash
paid for the acquisition of fixed assets, intangible assets and other long-term assets in the quarterly statement of cash flows.
Economic policy uncertainty is proxied by the Chinese monthly index of policy uncertainty calculated by Baker et al. (2013). We use
the geometric mean method to transform the original monthly data into quarterly data, then divide the numbers by 100 and lag
them by one period. Cash flow is computed as the net operating cash flow divided by total assets at the beginning of the fiscal
quarter. Tobin's q is measured as the market value of traded and non-traded shares plus total debt then divided by total assets,
lagged one period. Leverage is the ratio of total liabilities to total assets, lagged one period. Sales revenue is measured as cash
received from sales of goods and services divided by total assets at the beginning of the fiscal quarter. Size is expressed as the natural
logarithm of current total assets. Invested capital refers to shareholders' equity (excluding minority interests) plus total liabilities
minus non-interest-bearing current and long-term liabilities. Return on invested capital is equal to net operating profit before
interest divided by invested capital. Internal finance is measured as the sum of net profit and depreciation normalized by total assets
at the beginning of the fiscal quarter. Ownership is a dummy variable, which is equal to 1 for non-state-owned enterprises, 0
otherwise. ⁎⁎⁎, ⁎⁎ and ⁎ indicate statistical significance at the 1%, 5% and 10% levels, respectively. The numbers in [] are p values.

(1) (2) (3) (4)

Economic policy uncertainty −0.0025⁎⁎⁎ −0.0017⁎⁎⁎ −0.0020⁎⁎⁎ −0.0028⁎⁎⁎

[0.000] [0.000] [0.000] [0.000]
Economic policy uncertainty × return on invested capital 0.0271⁎⁎⁎ 0.0126⁎⁎⁎
[0.000] [0.005]
Economic policy uncertainty × internal finance 0.0666⁎⁎⁎ 0.0556⁎⁎⁎
[0.000] [0.001]
Economic policy uncertainty × ownership 0.0015⁎⁎⁎ 0.0011⁎⁎⁎
[0.001] [0.003]
Cash flow 0.0501⁎⁎⁎ 0.0524⁎⁎⁎ 0.0542⁎⁎⁎ 0.0515⁎⁎⁎
[0.000] [0.000] [0.000] [0.000]
Tobin's q 0.0003 0.0008⁎⁎⁎ 0.0005⁎⁎ 0.0007⁎⁎⁎
[0.162] [0.000] [0.030] [0.003]
Leverage −0.0110⁎⁎⁎ −0.0106⁎⁎⁎ −0.0128⁎⁎⁎ −0.0100⁎⁎⁎
[0.000] [0.000] [0.000] [0.000]
Sales 0.0035⁎⁎ 0.0033⁎⁎ 0.0058⁎⁎⁎ 0.0026⁎
[0.045] [0.049] [0.000] [0.137]
Size 0.0017⁎⁎⁎ 0.0021⁎⁎⁎ 0.0021⁎⁎⁎ 0.0022⁎⁎⁎
[0.000] [0.000] [0.000] [0.000]
Firm fixed effects Yes Yes Yes Yes
Quarter and year dummies Yes Yes Yes Yes
Cluster by firm and quarter Yes Yes Yes Yes
Number of observations 52,207 51,089 52,352 50,944
R-squared 0.056 0.064 0.053 0.065

quantile marketization dummies (i.e., firms in higher marketized regions are more sensitive to policy
uncertainty). This finding is in support of the second view we discuss earlier for Hypothesis 5. Being
consistent with the results in Calomiris et al. (2012) for the case of developed/developing countries, our
result on the firm level underscores the importance of policy transparency and stability as China moves
rapidly toward a market economy.

5. Robustness checks

5.1. Controlling for endogeneity

Due to the consideration that EPU may not be a strictly exogenous variable (for instance, it can be
affected by a country's political forces), we use the U.S. economic policy uncertainty lagged by two periods
as an instrumental variable for China's economic policy uncertainty (lagged by one period in the empirical
analysis) and apply the instrumental variable method as an alternative estimation method to mitigate
such concern. U.S. economic policy uncertainty is closely related with the uncertainty in China's economic
policy. For example, there is empirical evidence showing that external shocks are an important source of
macroeconomic fluctuations in emerging market countries, whose interest rates and exchange rates are
quickly affected by changes in U.S. monetary policy (Mackowiak, 2007). Furthermore, U.S. economic policy
238 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243

Table 5
The impact of marketization. We examine whether Fan et al. (2011)'s marketization index has any impact on the relationship
between corporate investment and economic policy uncertainty. In Columns 1 and 2, if the index reading is equal to or above the
median value, the company falls into the high marketization group; otherwise, it belongs to the low marketization group. In Column
3, interaction dummies are the product of EPU and marketization dummies, categorized based upon quantiles 5, 25, 75, and 95.
Economic Policy Uncertainty is one-period lagged Chinese economic policy uncertainty. Cash flow is computed as the net operating
cash flow divided by total assets at the beginning of the fiscal quarter. Tobin's q is measured as the market value of traded and
non-traded shares plus total debt then divided by total assets, lagged one period. Leverage is the ratio of total liabilities to total
assets, lagged one period. Sales revenue is measured as cash received from sales of goods and services divided by total assets at the
beginning of the fiscal quarter. Size is expressed as the natural logarithm of current total assets. ⁎⁎⁎, ⁎⁎ and ⁎ indicate statistical
significance at the 1%, 5% and 10% levels, respectively. The numbers in [] are p values.

(1) High (2) Low (3) Various degree of

marketization marketization marketization
≥Median ≤Median

Economic policy uncertainty −0.0011⁎⁎⁎ −0.0011⁎⁎⁎ −0.0028⁎⁎

[0.004] [0.000] [0.012]
Economic policy uncertainty × marketization dummy 0.0027*
(≤p5) [0.095]
Economic policy uncertainty × marketization dummy 0.0033⁎⁎
(p5 ≤ Market ≤ p25) [0.012]
Economic policy uncertainty × marketization dummy 0.0019⁎
(p25 ≤ Market ≤ p75) [0.079]
Economic policy uncertainty × marketization dummy 0.001
(p75 ≤ Market ≤ p95) [0.465]
Cash flow 0.0502⁎⁎⁎ 0.0658⁎⁎⁎ 0.0586⁎⁎⁎
[0.000] [0.000] [0.000]
Tobin's q 0.0011⁎⁎⁎ 0.0010⁎⁎⁎ 0.0010⁎⁎⁎
[0.001] [0.005] [0.000]
Leverage −0.0147⁎⁎⁎ −0.0102*** −0.0125***
[0.000] [0.000] [0.000]
Sales 0.0038* 0.0059⁎⁎ 0.0050
[0.089] [0.040] [0.009]
Size 0.0018⁎⁎⁎ 0.0040⁎⁎⁎ 0.0028⁎⁎⁎
[0.000] [0.000] [0.000]
Firm fixed effects Yes Yes Yes
Quarter and year dummies Yes Yes Yes
Cluster by firm and quarter Yes Yes Yes
Number of observations 15,197 18,603 34,252
R-squared 0.054 0.076 0.062

uncertainty is a suitable instrumental variable because it only affects the dependent variable (corporate
investment) through the independent variable of interest (economic policy uncertainty in China).20
Models (1) and (2) in Table 6 present the results from the instrumental variable method and the
results are very similar to those in Table 3. Wu–Hausman F tests indicate that the potential endogeneity
problem has been effectively controlled by adopting the U.S. economic policy uncertainty as an
instrumental variable. In short, considering the direct impact of economic policy uncertainty on corporate
investment and the possible endogeneity problem, we obtain consistent results that a rising level of
uncertainty in economic policy would cause a company to reduce capital investment, otherwise
investment would increase. This lends further support to Hypothesis 1.

5.2. Regression with first-differenced variables

Firm fixed-effects may capture the effect of time-invariant, firm-level omitted/unobservable variables.
However, it cannot capture time-varying unobserved factors that may also help explain the variation in
corporate investment. Therefore, we take the first difference in all variables (with the exception for
economic policy uncertainty and ownership) and re-run the regressions to check the robustness of our

20
The simple correlation between US EPU and China EPU is approximately 68%.
 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243 239

Table 6
Analysis of the impact of economic policy uncertainty on corporate investment (instrumental variable). This table presents estimates
from the IV estimator regressions, explaining firm-level quarterly investment between the 1st quarter, 2003 and the 1st quarter,
2012. Economic Policy Uncertainty is one-period lagged Chinese economic policy uncertainty. Cash flow is computed as the net
operating cash flow divided by total assets at the beginning of the fiscal quarter. Tobin's q is measured as the market value of traded
and non-traded shares plus total debt then divided by total assets, lagged one period. Leverage is the ratio of total liabilities to total
assets, lagged one period. Sales revenue is measured as cash received from sales of goods and services divided by total assets at the
beginning of the fiscal quarter. Size is expressed as the natural logarithm of current total assets Standard errors are clustered at the
quarter and firm levels following Petersen (2009). ⁎⁎⁎and⁎⁎ indicate statistical significance at the 1% and 5% levels, respectively. The
numbers in [] are p values.

(1) (2)

Economic policy uncertainty −0.0019⁎⁎⁎ −0.0018⁎⁎⁎

[0.000] [0.000]
Cash flow 0.0541⁎⁎⁎
[0.000]
Tobin's q 0.0005⁎⁎⁎
[0.000]
Leverage −0.0130⁎⁎⁎
[0.000]
Sales 0.0058⁎⁎⁎
[0.000]
Size 0.0019⁎⁎⁎
[0.000]
Wu–Hausman F test 0.144 0.144
Firm fixed effects Yes Yes
Quarter and year dummies Yes Yes
Cluster by firm and quarter No No
Number of observations 53,884 52,352
R-squared 0.017 0.051

findings. The corresponding results are presented in Table 7. Our dependent variable is corporate
investment variation. As shown in Model (1), although the significance level declines slightly compared to
the benchmark regression, economic policy uncertainty still negatively affects corporate investment
variation. In Models (2) and (3), the coefficients of the interaction terms between economic policy
uncertainty and the variations in rate of capital return and internal finance both remain positive,
indicating that firms with higher capital returns and more reliance on internal finance tend to experience a
lesser degree of investment decline given the uncertainty level in the country's economic policy.

5.3. A longer time-lag effect of policy uncertainty

In the above empirical analysis, we only examine how economic policy uncertainty affects corporate
investment in the next period. However, the uncertainty originating from economic policy might exert its
impact on corporate investment with a longer delay. To this end, we extend our sample period to the
fourth quarter of 2012 and analyze a longer time-lag effect of uncertainty on multi-period-ahead
corporate investment. Table 8 reports the impact that policy uncertainty has on two-period-ahead (i.e.
two-quarter-ahead) corporate investment. The regression results confirm that (1) economic policy
uncertainty has a significantly negative effect on corporate investment with or without control variables
and the interaction terms; (2) coefficients of the interaction terms between economic policy uncertainty
and the rate of capital return, internal finance and ownership are all positive, consistent with the results in
Table 4. Not unreported, the effects of economic policy uncertainty on three-period-ahead and
four-period-ahead corporate investment, however, are not statistically significant.

5.4. Financial crisis as a proxy for economic policy uncertainty

Since governments need to adjust their economic policies during a financial crisis, firms' expectations
and in turn their investment behavior would be altered. Therefore, one can view financial crisis as an
economic policy uncertainty event. Following Duchin et al. (2010) who find that the US subprime
240 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243

Table 7
Regression with first-differenced variables. The dependent variable is the incremental corporate investment. △ stands for the first
difference. Corporate investment is measured as capital expenditures divided by total assets at the beginning of the fiscal quarter and
capital expenditures are calculated as the sum of cash paid for the acquisition of fixed assets, intangible assets and other long-term
assets in the quarterly statement of cash flows. Economic policy uncertainty is proxied by the Chinese monthly index of policy
uncertainty calculated by Baker et al. (2013). We use the geometric mean method to transform the original monthly data into
quarterly data, then divide the numbers by 100 and lag them by one period. Cash flow is computed as the net operating cash flow
divided by total assets at the beginning of the fiscal quarter. Tobin's q is measured as the market value of traded and non-traded
shares plus total debt then divided by total assets, lagged one period. Leverage is the ratio of total liabilities to total assets, lagged one
period. Sales revenue is measured as cash received from sales of goods and services divided by total assets at the beginning of the
fiscal quarter. Size is expressed as the natural logarithm of current total assets. Invested capital refers to shareholders' equity
(excluding minority interests) plus total liabilities minus non-interest-bearing current and long-term liabilities. Return on invested
capital is equal to net operating profit before interest divided by invested capital. Internal finance is measured as the sum of net
profit and depreciation normalized by total assets at the beginning of the fiscal quarter. Ownership is a dummy variable, which is
equal to 1 for non-state-owned enterprises, 0 otherwise. ⁎⁎⁎, ⁎⁎ and ⁎ indicate statistical significance at the 1%, 5% and 10% levels,
respectively. The numbers in [] are p values.

Dependent variable:△Corporate investment (1) (2) (3) (4)

Economic policy uncertainty −0.0012⁎⁎ −0.0012⁎ −0.0015⁎⁎ −0.0011⁎

[0.045] [0.055] [0.044] [0.063]
Economic policy uncertainty × △return on invested capital 0.0077⁎⁎⁎
[0.006]
Economic policy uncertainty × △internal finance 0.0237⁎⁎⁎
[0.000]
Economic policy uncertainty × ownership −0.0002⁎⁎⁎
[0.000]
△Cash flow 0.0199⁎⁎⁎ 0.0197⁎⁎⁎ 0.0194⁎⁎⁎ 0.0200⁎⁎⁎
[0.000] [0.000] [0.000] [0.000]
△Tobin's q −0.0003 −0.0003 −0.0002 −0.0003
[0.127] [0.210] [0.311] [0.131]
△Leverage 0.0074⁎⁎ 0.0090⁎⁎⁎ 0.0092⁎⁎⁎ 0.0074⁎⁎⁎
[0.011] [0.003] [0.001] [0.012]
△Sales 0.0183⁎⁎⁎ 0.0177⁎⁎⁎ 0.0170⁎⁎⁎ 0.0183⁎⁎⁎
[0.000] [0.003] [0.000] [0.000]
△Size 0.0165⁎⁎⁎ 0.0168⁎⁎⁎ 0.0161⁎⁎⁎ 0.0166⁎⁎⁎
[0.000] [0.000] [0.000] [0.000]
Quarter and year dummies Yes Yes Yes Yes
Cluster by firm and quarter Yes Yes Yes Yes
Number of observations 50,455 50,332 50,443 50,455
R-squared 0.070 0.070 0.071 0.070

mortgage crisis triggers a decrease in corporate investment, with greater decline found in firms having
larger financial constraint and more external finance dependent; we examine the impact of financial crisis
on capital investments for Chinese firms in this subsection. Although this crisis started in August 2007, it is
the collapse of Lehman Brothers on September 15, 2008 that led the crisis spreading to the rest of the
world, evolving into a global financial crisis and jeopardizing the real economy. Taking Lehman Brothers'
bankruptcy as a demarcation point, we divide our sample period into two parts: before and after the
financial crisis. Specifically, the dummy variable for financial crisis is 1 if the sample period is after the 3rd
quarter of 2008, otherwise, it equals 0. We use this dummy variable as a proxy for economic policy
uncertainty and further test the robustness of our findings.
Table 9 reports the estimation results. Models (1)–(3) have the one-period-ahead corporate
investment as the dependent variable and the sample period is from the 1st quarter of 2003 to that of
2012. Then we repeat the regressions for the two-period-ahead corporate investment in Models (4)–(6)
and accordingly the sample period runs from the 2nd quarter of 2003 to that of 2012. The regression
coefficients of the financial crisis variable turn out to be negative and statistically significant at the
conventional levels across all six models, suggesting that there is a marked drop in corporate investment
for various kinds of firms after the outbreak of the crisis. This reconfirms our Hypothesis 1. In addition, as
predicted by Hypotheses 2–4, coefficients of the interaction terms between financial crisis and the rate of
capital return, internal finance and ownership are all statistically significant and positive, indicating that
during the financial crisis period the negative effect of policy uncertainty on corporate investment is
 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243 241

Table 8
A longer time-lag effect of policy uncertainty. The sample period is from the 2nd quarter, 2003 to the 2nd quarter, 2012. Corporate
investment is measured as capital expenditures divided by total assets at the beginning of the fiscal quarter and capital expenditures
are calculated as the sum of cash paid for the acquisition of fixed assets, intangible assets and other long-term assets in the quarterly
statement of cash flows. Economic policy uncertainty is proxied by the Chinese monthly index of policy uncertainty calculated by
Baker et al. (2013). We use the geometric mean method to transform the original monthly data into quarterly data, then divide the
numbers by 100 and lag them by one period. Cash flow is computed as the net operating cash flow divided by total assets at the
beginning of the fiscal quarter. Tobin's q is measured as the market value of traded and non-traded shares plus total debt then
divided by total assets, lagged one period. Leverage is the ratio of total liabilities to total assets, lagged one period. Sales revenue is
measured as cash received from sales of goods and services divided by total assets at the beginning of the fiscal quarter. Size is
expressed as the natural logarithm of current total assets. Invested capital refers to shareholders' equity (excluding minority
interests) plus total liabilities minus non-interest-bearing current and long-term liabilities. Return on invested capital is equal to net
operating profit before interest divided by invested capital. Internal finance is measured as the sum of net profit and depreciation
normalized by total assets at the beginning of the fiscal quarter. Ownership is a dummy variable, which is equal to 1 for
non-state-owned enterprises, 0 otherwise. ⁎⁎⁎, ⁎⁎ and ⁎ indicate statistical significance at the 1%, 5% and 10% levels, respectively. The
numbers in [] are p values.

(1) (2) (3) (4) (5) (6)

Economic policy uncertainty −0.0018⁎⁎⁎ −0.0011⁎⁎ −0.0023⁎⁎⁎ −0.0016⁎⁎⁎ −0.0016⁎⁎⁎ −0.0023⁎⁎⁎

[0.002] [0.034] [0.000] [0.000] [0.000] [0.000]
Economic policy uncertainty × return 0.0244⁎⁎⁎ 0.0076
on invested capital [0.000] [0.165]
Economic policy uncertainty × internal 0.0759⁎⁎⁎ 0.0698⁎⁎⁎
finance [0.000] [0.000]
Economic policy 0.0010⁎⁎ 0.0007⁎
uncertainty × ownership [0.015] [0.070]
Cash flow 0.0267⁎⁎⁎ 0.0231⁎⁎⁎ 0.0248⁎⁎⁎ 0.0269⁎⁎⁎ 0.0242⁎⁎⁎
[0.000] [0.000] [0.000] [0.000] [0.000]
Tobin's q 0.0005⁎⁎ 0.0003 0.0007⁎⁎⁎ 0.0005⁎⁎ 0.0006⁎⁎⁎
[0.038] [0.194] [0.002] [0.038] [0.006]
Leverage −0.0136⁎⁎⁎ −0.0119⁎⁎⁎ −0.0108⁎⁎⁎ −0.0134⁎⁎⁎ −0.0107⁎⁎⁎
[0.000] [0.000] [0.000] [0.000] [0.000]
Sales 0.0019 −0.0002 −0.0008 0.0019⁎⁎⁎ −0.0011
[0.206] [0.930] [0.583] [0.203] [0.428]
Size 0.0014⁎⁎⁎ 0.0013⁎⁎⁎ 0.0017⁎⁎⁎ 0.0016⁎⁎⁎ 0.0017⁎⁎⁎
[0.000] [0.000] [0.000] [0.000] [0.000]
Firm fixed effects Yes Yes Yes Yes Yes Yes
Quarter and year dummies Yes Yes Yes Yes Yes Yes
Cluster by firm and quarter Yes Yes Yes Yes Yes Yes
Number of observations 55,103 52,241 52,098 50,992 52,241 50,849
R-squared 0.020 0.039 0.043 0.051 0.039 0.052

smaller for firms with higher rates of capital return, are more dependence on internal finance, and are
non-state owned. The result is in line with the empirical findings reported earlier and is consistent with
the findings in Duchin et al. (2010).

6. Conclusions

From the perspectives of economic transition, this paper explores the impact of economic policy
uncertainty on corporate investment in Chinese listed companies using quarterly financial statements
from 2003 to 2012. Controlling for firm fixed effects and taking potential endogeneity problem into
consideration, we carry out empirical analysis based on the investment-cash flow sensitivity literature.
Our findings point out that economic policy uncertainty has a negative effect on corporate investment
behavior. However, such negative effect is greatly moderated by the heterogeneity in firm characteristics.
For firms that have high rates of return on invested capital, rely more on internal finance, and are
non-state-owned, the negative impact of economic policy uncertainty on corporate investment becomes
smaller. The greatest reduction in the negative effect of policy uncertainty is found for firms relying less on
external financing. Our main results remain robust when we consider potential endogeneity problems,
differenced variables, a longer-lag effect in economic policy uncertainty, and an alternative proxy for
economic policy uncertainty.
242 Y. Wang et al. / Pacific-Basin Finance Journal 26 (2014) 227–243

Table 9
Financial crisis as a proxy for economic policy uncertainty. Models (1)–(3) are for one-period-ahead while Models (4)–(6) are for
two-period-ahead regressions. Financial crisis is a dummy variable, which equals 1 after the 3rd quarter of 2008, 0 otherwise.
Corporate investment is measured as capital expenditures divided by total assets at the beginning of the fiscal quarter and capital
expenditures are calculated as the sum of cash paid for the acquisition of fixed assets, intangible assets and other long-term assets in
the quarterly statement of cash flows. Cash flow is computed as the net operating cash flow divided by total assets at the beginning
of the fiscal quarter. Tobin's q is measured as the market value of traded and non-traded shares plus total debt then divided by total
assets, lagged one period. Leverage is the ratio of total liabilities to total assets, lagged one period. Sales revenue is measured as cash
received from sales of goods and services divided by total assets at the beginning of the fiscal quarter. Size is expressed as the natural
logarithm of current total assets. Invested capital refers to shareholders' equity (excluding minority interests) plus total liabilities
minus non-interest-bearing current and long-term liabilities. Return on invested capital is equal to net operating profit before
interest divided by invested capital. Internal finance is measured as the sum of net profit and depreciation normalized by total assets
at the beginning of the fiscal quarter. Ownership is a dummy variable, which is equal to 1 for non-state-owned enterprises, 0
otherwise. ⁎⁎⁎, ⁎⁎ and ⁎ indicate statistical significance at the 1%, 5% and 10% levels, respectively. The numbers in [] are p values.

(1) (2) (3) (4) (5) (6)

Financial crisis −0.0018⁎⁎⁎ −0.0031⁎⁎⁎ −0.0013⁎⁎ −0.0018⁎⁎⁎ −0.0028⁎⁎⁎ −0.0010⁎⁎

[0.000] [0.000] [0.014] [0.000] [0.000] [0.042]
Financial crisis × return 0.0379⁎⁎⁎ 0.0371⁎⁎⁎
on invested capital [0.000] [0.000]
Financial crisis × internal finance 0.1366⁎⁎⁎ 0.1177⁎⁎⁎
[0.000] [0.000]
Financial crisis × ownership 0.0018⁎⁎ 0.0011⁎
[0.011] [0.095]
Cash flow 0.0520⁎⁎⁎ 0.0487⁎⁎⁎ 0.0539⁎⁎⁎ 0.0247⁎⁎⁎ 0.0223⁎⁎⁎ 0.0265⁎⁎⁎
[0.000] [0.000] [0.000] [0.000] [0.000] [0.000]
Tobin's q 0.0004⁎ 0.0004⁎⁎ 0.0005⁎⁎ 0.0004⁎ 0.0004⁎⁎ 0.0005⁎⁎
[0.056] [0.047] [0.022] [0.066] [0.041] [0.021]
Leverage −0.0120⁎⁎⁎ −0.0114⁎⁎⁎ −0.0130⁎⁎⁎ −0.0127⁎⁎⁎ −0.0122⁎⁎⁎ −0.0135⁎⁎⁎
[0.000] [0.000] [0.000] [0.000] [0.000] [0.000]
Sales 0.0046⁎⁎⁎ 0.0040⁎⁎ 0.0059⁎⁎⁎ 0.0008 0.0004 0.0020
[0.007] [0.015] [0.000] [0.586] [0.799] [0.180]
Size 0.0018⁎⁎⁎ 0.0017⁎⁎⁎ 0.0020⁎⁎⁎ 0.0014⁎⁎⁎ 0.0013⁎⁎⁎ 0.0015⁎⁎⁎
[0.000] [0.000] [0.000] [0.000] [0.000] [0.000]
Firm fixed effects Yes Yes Yes Yes Yes Yes
Quarter and year dummies Yes Yes Yes Yes Yes Yes
Cluster by firm and quarter Yes Yes Yes Yes Yes Yes
Number of observations 52,207 52,346 52,353 52,098 52,346 52,241
R-squared 0.054 0.059 0.052 0.041 0.059 0.039

The current study provides at least three important implications. First, the evidence on the negative
impact of economic policy uncertainty on corporate investment illustrates the importance for
policymakers to maintain the transparency, continuity and stability of macroeconomic policies. The
creation of a favorable corporate investment environment can be achieved by reducing policy uncertainty.
Second, for firms with high capital returns, reliance on internal financing and non-state ownership,
uncertainty has smaller negative impact on corporate investment. These firm characteristics provide
cushion for negative impact originating from unexpected policy uncertainty. Finally, as China moves
rapidly toward a market economy, economic policy transparency and stability have become more
important than ever, given that economic policy uncertainty has greater negative impact on firms in
provinces/regions that are more marketized.

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