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The Effect of Economic Policy Uncertainty on Innovation. A Case Study of Listed Firms in

China

Name

Course

Professor
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Abstract

This research evaluates the impacts of economic policy uncertainty (EPU) on firm-level

innovation of Chinese trading firms between 2000 to 2019. To measure EPU, the study

utilizes Steven et al. (2020) news-based EPU index for China. The level of innovation is

gauged in terms of patent applications by each firm. The findings revealed that EPU is

positively correlated to innovation of a firm with a regression coefficient of 2.459. However,

this connection is contingent on the level of EPU. Before 2008, the EPU was lower but rose

significantly past 2008. The samples of study were divided into two to reflect the two

periods. Regression results with the full period of 2000 to 2007 showed that at 1%

significance level, EPU has a positive influence on a firm's innovation with a regression

coefficient of 4.516. In the period 2008-2019, the regression coefficient was -9.69.

Furthermore, the regression coefficient of the interaction measure of the influence of cash

flows on the connection between EPU and innovation is -0.00054 at 1% level significance.

This is an indication that the bigger the ratio of cash flows, the smaller the influence of EPU

on the innovation level of a firm. Overall, this research adds to the current literature on the

connection between uncertainties of economic policies and firm level innovation in China as

well as the impact of a firm’s cash flows on the relation between EPU and firm’s innovation.

Keywords: Economic Policy Uncertainty; Firm Level Innovation; Cash-Flows;

Economic Regimes
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Table of Contents

Abstract......................................................................................................................................2

Introduction................................................................................................................................4

Literature review........................................................................................................................5

Data and Methodology...............................................................................................................9

Results and Analysis................................................................................................................12

Descriptive statistics................................................................................................................12

Effect of cash flows on the connection between firm level innovation and EPU......................14

Conclusions..............................................................................................................................18
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List of Tables

Table 1: Description of variables.............................................................................................12

Table 2:Descriptive Statistics...................................................................................................13
Table 3:Impact of EPU on Innovation-regression...................................................................14
Table 4: Effect of cash flows...................................................................................................15
Table 5: Economic policy uncertainty and firm level innovation...........................................16

List of Figures

Figure 1: China EPU index trends...........................................................................................17

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Introduction

Economic policy uncertainty refers to the likelihood of change in economic policies

which is not accurately predictable by players in the market. This results in a change in the

economic conditions. As policy influences the economic conditions where a company

operates, the general risks that result in economic policy influence firm level conduct either

straightforwardly or by implication. This study aims at providing experimental proof of the

linkage between EPU and firm innovation. The study further looks at the behavior of firm

level activities during diverse economic seasons. Gulen et al. (2016) indicate that policy

uncertainty alludes to the challenges market players or firms encounter in anticipating

changes to present policies, and it frequently results in fluctuations in the financial and

economic environments. After the 2007 and 2008 financial crises, the world's economy

plummeted. To prevent economic downturns, the Chinese government like many others

intervened, which increased EPU, resulting in fluctuations in macroeconomic conditions.

Consequently, since the financial crises, EPU has seen increased focus researchers

who seek to examine its effect on developing of economies. A key factor of global

competition is technological competitiveness, which is borne through invention and

innovation. China's spending on research and development in 2018 was approximately 2.2%

of the gross domestic product, measured in terms of patents applied and authorized to rank

top in the world(Ni, 2020). The country is still considered an emerging economy compared to

the United States, for instance. Presently,China's ability to innovate is not as robust due to

limited fundamental technology. However, the economy has gone through tremendous

changes, with uncertainties increasing from the recent trade war with the US as well as the

outbreak of COVID-19. The economy is set for a considerable change, with innovation being

the key driver. The country continues to enhance innovation by deepening entrepreneurship.

As such, comprehending the importance and connection between EPU and a firm's
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innovation is essential to researchers and policymakers. This research therefore, seeks to

answer two research questions. First, what is the influence of EPU on a firm’s innovation.

Second, what is the impact of a firm’s cashflows on the connection between economic

policy uncertainty and innovation?

This research adds to the extant literary works in various . Given the contradictory

findings of the positive effect of EPU on a firm’s innovation by Gu (2018) and a negative

impact by Wang (2017), this research finds that there is a positive connection between EPU

and a firm's innovation supporting findings of Gu (2018). Nevertheless, the influence of EPU

on innovation depends on the prevailing market conditions. During seasons of low EPU

before 2008, there was a positive effect on firms' innovation. This, however, turned negative

during the period after 2008 when the EPU was higher. It can, therefore, be concluded that

although there is a positive connection between EPU and firm's innovation, it is reliant on the

level of EPU. This research also sheds light on the influence of a company’s cash flows on

the connection between EPU and innovation. EPU impacts a firm’s innovation through its

cash holdings. Positive net cash flow from investing activities implies that inflows from investing

activities are higher than the outflows, or the firm has disposed of some of the assets or long-term

investment. This may also be reflective of poor operations state of the firms hence focusing more on

operations as opposed to innovation. This research reviews extant literature on the connection

between EPU and a firm’s level of innovation and proposes the hypothesis. The data and

methodology are also discussed. The results and analyses of data are presented and conclusions are

drawn.

Literature Review

This part looks at the growing literature on the influence of policy uncertainty on the

different aspects of firms’ decisions. The empirical evidential material from the above studies

reveals that the uncertainty-investment connection is somewhat inconsistent. Some studies

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conducted decades back indicate that it is optimum for companies that are facing doubt to

postpone investments as reversal of investments is cost-intensive, and doubt raises the value

of waiting (Bernanke, 1983; McDonald & Siegel, 1986). Alternatively, the waiting option is

not valuable when companies are facing competition or when investment lead to valued

growth prospects. Uncertainty leads to a rise in investments if companies can dispose the

asset at a later date(Abel et al., 1996)

There are different studies that have been conducted on EPU and the impact of

various firm-level decisions. Hangyong (2005), using firm level data from the manufacturing

sector in Korea, studied the connection between uncertainty and investment. To measure

uncertainty, the study utilized the volatility of daily returns of the individual firm selected. To

determine if there was a change in uncertainty since the financial crisis, the study utilized two

samples. One sample focused on the period between 1991 to 1997, which was the pre-crisis

sample. The other sample, post-crisis sample, focused on the period between 1999 to 2004.

The study obtained results using an estimation of the error correction model of stocks

adjustment utilizing firm-level data for the 1985-2010 period, of 2700 firms in the

manufacturing sector. The results demonstrated that uncertainty and firm level investment

were negatively correlated but only past the crisis period. Their findings are in line with the

claim that corporations have a tendency to avoid risk in periods of doubt, such as during a

financial crisis. Hangyong (2005) concluded that uncertainty leads to firms to delay

investments. Furthermore, the study linked the depressing impact of uncertainty on

investment with the business cycles. Alternatively, extrinsic or economic policy uncertainty,

combined with intrinsic or firm-level uncertainty, works via news-based policy channels and

federal spending policy shocks.

Gulen et al. (2013), using the Baker, Bloom, and Davis (2012) uncertainty index

(news-based policy uncertainty index), investigated the impact of uncertainty linked to

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regulatory results and future policy on a firm’s capital investments at both the firm and

industry levels. The empirical data was generated from Compustat files from January 1987 to

December 2013. The policy uncertainty index data chosen covered a similar period, and

regression analysis of the variables was run. The results showed that there is a robust negative

connection between firm-level capital investments and the degree of doubt linked with

regulatory outcomes and future policy. Evidence from the study indicated the connection

between economic policy uncertainty and capital investments by firms was non-uniform

cross-sectionally. However, the connection was more robust for corporations with a higher

investment irreversibility degree as well as those that were more dependent on federal

expenditure. Gulen et al. (2013) concluded that uncertainty in policy could lead to depressed

firm-level investments through the induction of delays of precautionary nature because of the

irreversibility of investments.

Xu (2019) examined the effect of uncertainty in government policies on firm level

innovation and the cost of capital. The study utilized the Baker, Bloom, and Davis (2016)

EPU index to capture the US government's future policy uncertainty. Consequently,

innovation was measured using both inputs and outputs. The inputs were R&D investment,

and the outcomes were patent and debt costs, equity costs, and the wacc. Data on patents

were acquired from Kogan, Papanikolaou, Seru, and Stoffman (2017), while research and

development investments on technology data was acquired from the US Patent and

Trademark Office available until 2010. The results indicated that there was a rise in a firm's

capital cost with increased uncertainty in government economic policy. The rise in the cost of

initial investment translates to reduced innovation. The study indicated that as the

government economic policy doubt increased, the corporations were exposed to a higher

weighted average cost of capital on external borrowing hence less innovation. Xu (2019)

concluded that innovations of firms that are constrained financially and those that are heavily
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contingent on external borrowing were more affected. Alternatively, the findings of Stein and

Stone (2013) on stock volatility and firm-specific volatility, indicated that implied volatility

leads to a drop in capital investments but leads to a rise in research and

development(R&D)investments.

Bhattacharya et al. (2017) studied 43 countries to determine, which, between policy

and policy uncertainty impacts technological innovation the most. They measured innovation

using a patent-based proxy. Results indicated that implemented policies did not impact the

innovation activities on average. However, innovation activities reduced tremendously in

seasons of policy uncertainty, such as during national elections. The reduction was especially

significant in exploratory innovations as opposed to exploitative innovations as well as for

innovation-intensive sectors. They indicated that the number of patents applicants reducing

with a rise in policy uncertainty. They concluded that political compromise boosts innovation

and vice versa

According to Nia (2020), local policy uncertainty can inspire firm level innovation.

They found a positive connection between uncertainties in local policy and innovation in

government-owned enterprises due to the competitive advantage they possess from innate

government links and hence a better comprehension of future regulations and policy changes.

The study concluded that increased local policy uncertainty creates prospects of growth for

firms that are superior in terms of information to exploit competitive advantages resulting

from innovative activities tactically.

Kang (2014), on the other hand, scrutinized the influence of economic policies

uncertainties and its constituents on investments by firms. The result revealed that macro

uncertainty linked with micro uncertainty dampens companies' investment choices. When

companies are unsure about ease of doing business because of regulation changes, they limit

the investment plans. The level of impact on investments is, however, greater during a
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recession. Kang, however, concluded that policy uncertainty did not appear to affect the

investments plans and choices of the very large firms. Wang et al. (2014) looked at how

policy uncertainty impacts firm level investment by looking at publicly trading firms in

China. Their results showed that when the level of uncertainty in government economic

policies are high, firms lower the investment and vice versa. Nevertheless, firms with a

higher return on investments employed, used more internal capital, and are privately held,

lessen the negative impact of policy uncertainties on firm level investments.

There is extensive evidence indicating that firms postpone capital expenditure,

acquisition, and merger activities, and finance raising during seasons of increased policy

uncertainty (Gulen & Ion 2016; Çolak, Durnev, & Qian 2017; Jens 2017; Bonaime, Gullen,

& Ion 2018). Contrariwise, Atanassov et al. (2018) demonstrated that policy uncertainty, such

as during gubernatorial election years, can result in some firms boosting long-run investment

activities such as R&D. This contradicts the extant literature (Çolak, Durnev, and Qian 2017;

Jens 2017; Chen et al. 2018) linking gubernatorial elections to a reduction in real activities,

for instance, investment, capital raising, and acquisitions. From the above studies, there is no

consensus in terms of the connection between economic policy uncertainties and innovation.

As such, this study will use the foundation laid by these studies to examine the influence of

economic policy uncertainties ; a case study of listed firms in China.

Data and Methodology

The data for the study is collected from trading firms on the Shanghai security

exchange from 2000 to 2019. The relevant company and financial infor are from the

CSMAR and RESSET websites. The patents applications information is derived from the

CSMAR website, while the EPU index will be from the EPU website. The data on listed

firms will exclude firms in the financial and insurance firms as well as firms missing

financial data
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Selection of Variables

Dependent Variable

Innovation

Innovation is the study’s dependent variable. In comparison to patents

applications, patent authorizations, comprise of various human elements. Patent applications

Alternatively are more linked with an organization’s choice-making. As such, innovation is

measured in terms of patent applications. Patents comprise of invention patents; appearance

designs as well as utility models. In this study, invention patents are utilized as they are more

linked to a firm’s innovation. To measure innovation, therefore, the natural log of the number

of invention patents application by a firm are computed.

Independent variable

Economic Policy Uncertainty

To determine EPU, the study utilizes Baker et al. (2020) news-based EPU index for

China, which is based on the South China Morning Post newspaper. To develop the index,

the numbers of newspaper articles having at least each of these terms, “economic,” “policy,”

term and “uncertainty” are counted through an automatic search of the newspaper’s digital

archives monthly. The quantity of the articles linked to EPU are measured by the numbers of

articles comprising the term “today.” The time-series data is normalized to a standard

deviation unit. The normalized series is summed across each month.

Given that the index is on a monthly frequency, it is transformed into annual data to

match the frequency of the innovation data provided by the listed firms. To transform into

annual frequency, the data’s arithmetic mean value for each year is computed as a natural log.
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EPU is on a macro-level, that is, it is out of an individual firm’s control, thus regarded as

exogenous to a specific firm. This fact, therefore, alleviates the concern on the endogeneity

problem in regression analysis.

Control variables

The main control variables in this study are the age of the firm (years since

founding), size of the firm (net assets), leverage(debt) ratios, return on assets, book market

ratios, and tangible assets ratio. Additionally, the dummy variables, years, and industries is

utilized in the regression analysis.

Model specification

To test the effect of EPU on level of innovation, two hypotheses are

tested. The value of patents is taken as the natural log of one plus the number

of patents applied per firm.

The following hypotheses tested are:

H1: Economic policy uncertainties has a positive influence on firm level innovation.

H2: Economic policy uncertainties affects firm level innovation more positively in

companies with less cash flows

To verify Hypothesis 1,2 and 3, the following regression models is applied

Patent1i,t = a0 + a1EPUi ,t -1 + a 2-ln age + a3 Sizei,t -1 + a 4 Levi,t -1 + a5 ROA-

1+ a TQ+ a MB + a Tangibility + year + industry + e

Patent1i ,t = a0 + a1EPUi ,t -1 + a 2Xi ,t -1 * EPUi,t -1 + a3 ln age + a 4 Sizei ,t -1

+ a5 Levi,t -1

+αROA+αMB+αTangibility +year + industry+ e

All the independent and control variables, in exception of the year and the industry, are one

lag to the independent variable. i is the individual firm, t denotes the year, α characterizes
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the regression coefficients of the variables, ɛ is the error term, while years and industries

are dummy variables for the year and the industry in which the firms operate.

Results and Analysis

Description of Variable

Table 1 shows the definitions of variables used in the models and their calculations.

Table 1: Explanation of Variables

Variable Description
Patent Natural log (patent applications + 1)
EPU EPU index developed by Steve et al (2019)
Cash flow (net operation cash flow + net investment cash flow) ÷net assets
Cash Cash plus cash equivalents/net assets
Age Natural log (age of the firm)
Size Natural log (Net assets)
Leverage liabilities ÷assets
Return on Assets Net profit÷total assets
Book to market Market capitalization ÷ shareholder equity
ratio
Tangibility Tangible asset ÷ total assets
Table 2 presents the descriptive statistics for the main variables. Patents have a least value of

0 while the highest value is 7.762. This shows that innovation varies greatly among the listed

firms. On the other hand, the patent has an average value of 1.219, while the standard

deviations is 1.387. EPU, on the other hand, has a minimum of 1.951 and a maximum of

7.262. The mean value is 4.297, while the standard deviation is 1.096. This reveals the fact

that EPU has varied greatly during the 2000-2019 period. From table 2, there is a substantial
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difference in variables in the above period of observation. Therefore, this research is

significant and feasible.

Table 1:Descriptive Statistics

Standard
Variable Sample sizes Average Lowest value Highest value
Deviations
Patent 21697 1.219 1.387 0 7.762
EPU 21697 4.297 1.096 1.951 7.262
Cashflow 21697 -1.727 10.075 -31.497 26.553
Cash 21697 13.321 14.03 0 63.217
age 21697 2.482 0.49 0 3.721
Size 21697 20.543 1.35 18.523 24.576
Leverage 21697 0.426 0.231 0.0453 0.877
ROA 21697 0.0435 0.0612 -0.223 0.187
Book to
21697 0.87 0.817 0.0213 4.432
market
Tangibility 21697 0.934 0.0695 0.545 1.2

Regression Analysis

EPU and Innovation

Table 2 shows the regression results of EPU in connection to innovation. The control

variables are year and industry. The model is tested at 1% significance level. EPU has a

positive regression coefficient of 2.459. The regression model shows that EPU has a

significant impact on firm-level innovation in terms of the number of patent applications

made by the listed firms. These findings are similar to those of Atanassov (2016). The
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regression models. The regression factor of the firm’s age is negative (-0.2) at a 1%

significance level. This means that the older the company, the lower its level of innovation.

The results also show that younger firms in China are more innovative. This is similar to the

results of Fassioa et al. (2019). On the other hand, the results reveal that at1% significance

level, tangibility has a negative connection coefficient of (-0.111).

Furthermore, innovation level is higher for listed firms that are more solvent. These

results are similar to Hall et al. (2015) research findings. Book to market ratio has a negative

coefficient of -0.519 at 1% significance level, hence negatively correlated to firm level

innovation. Overall, the regression analysis reveals that EPU impacts innovation positively.

Innovation rises with a rise in EPU. This, therefore, verifies hypothesis 1 of this research

study.

Table 2:Impact of EPU on Innovation-regression

Year 2000-2019
Dependent variable Patent
EPU 2.459
Age -0.2
Size 0.816
Tangibility -0.111
Leverage -0.271
ROA 2.767
Book to market ratio -0.159
Constant -29.01
Year Effect
Industry Effect
Observations 21697
Adjusted R2 0.2728
Chi-sqrd 0

Effect of cash flows on the connection between firm level innovation and EPU
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Table 4 presents the regression analysis of EPU on Patents and cash flow respectively, at 1%

level of significance. To determine the influence of cash holding on the connection between firm

level innovation and EPU, an interaction measure between cash flows and EPU was introduced. As

per the regression model, the EPU regression coefficient is positive at 1% level of significance. The

coefficient is 20.617. On the other hand, the regression factor of the interactive measure is -0.00054

at 1% level of significance. This implies that the high the ratios of cash flows, the low the impact of

EPU on the innovation level of a firm. The positive effect of EPU on innovations is robust on

organizations with a low ratio of cash flows due to the fact that the higher the net cash holding level,

the high the net cash flow created from operations and investments. Positive net cash flow from

investments implies that inflows from investing activities are higher than the outflows, or the firm

has disposed of some of the assets or long term investment. This may also be reflective of poor

operations state of the firms hence focusing more on operations as opposed to innovation. This

finding validates Hypothesis 2 of the research study.

Table 3: Effect of cash flows

Dependent variables Patent Cash

Independent variable    
EPU 2.459 20.617
age -0.2
Size 0.816 -0.691
Tangibility -0.111 -0.136
Lev 2.767 0.899
ROA -0.159 -14.817
MB -29.01 20.361
Constant Effect -0.287
Industry Effect -43.6
No. of observations 21697 21697
Adjusted R2 0.2728 0.3737
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Chi sqrd 0 0

EPU in Different Periods

Table 5 shows t h e regression of EPU on innovation. The control variables are year and

industry across the different periods. There is a positive effect of EPU on firm’s innovation.

However, this impacts changes or varies with the level of EPU. Figure 1 presents China’s

Uncertainty index between January 2000 and January 2020. As per the analysis of the results,

there is a clear difference before and after 2008. Before 2008, the EPU was lower but rose

significantly past 2008. As per table 4, the samples were divided into two to reflect the two

periods. Regression results with the full period of 2000 to 2019 show that at 1% significance

level, EPU has a positive influence on a firm’s innovation. The regression factor for this

period is 2.459. This implies that 1% rise in EPU leads to a 2.459% rise in a firm’s

innovation.

On the other hand, during the 2000 to 2007 period, the regression coefficient is 4.516 at 1%

significance level. This implies that a 1% rise in EPU leads to a 4.516% rise in innovation. In

the period 2008-2019, the regression coefficient was -9.69, implying that there exists a

negative impact of EPU on firm level innovations. The results indicate that during regimes of

low EPU, there is increased firm level innovations. When EPU is higher, it has there is a huge

constraining impact on innovation.

Table 4: Economic policy uncertainties and firm level innovations

Year 2000-2019 2000-2007 2008-2019

Dependent
Patent Patent Patent
variables
EPU 2.459 4.516 -9.69
age -0.2 0.00801 -0.253
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Size 0.816 0.878 0.823

Tangibility -0.111 -0.956 0.0102
Leverage -0.271 -0.662 -0.131
ROA 2.767 3.23 2.893
MB -0.159 -0.14 -0.195
Constant -29.01 -32.94 23.64
Year effect Effect effect
Industry effect Effect effect
Observations 21697 21697 21697
Adjusted R2 0.2728 0.1267 0.1649
Chi-sqrd 0 0 0

Figure 1: China EPU Index Trends

Conclusions

By analyzing information of the listed firms in China between 2000 to 2019 and the EPU

index developed by Steven et al. (2019), the research has evaluated the effect of EPU on

firm innovations. EPU has a positive effect on firm innovation, which implies that as EPU

rises, firm-level innovations rises. EPU impacts f i r m - l e v e l innovation through cash

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flows. Additionally, when EPU is lower, it has a positive effect on firm-level innovation;

when EPU is higher, it constrains firm level innovation.

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