Banking System Reform and Investment–Cash Flow Relation: The Case of Vietnam

2014 found an evidence that bank sector reform had a significant impact on Chinese companies’ investment – cash flow relation in general and in both state-controlled listed and non-state

Banking System Reform and Investment–Cash Flow

Relation: The Case of Vietnam

NGUYEN THI UYEN UYEN University of Economics HCMC - uyentcdn@ueh.edu.vn

TU THI KIM THOA University of Economics HCMC - tkthoa@ueh.edu.vn

PHAM THIEN BACH University of Economics HCMC - bachphamthien@gmail.com

Abstract

Becoming the 150 th member of the World Trade Organization (WTO) in Jan 2007, Vietnam has step by step opened the door of its financial system to the world The banking industry, which was dominated by state- controlled banks, was the main source of financing for inefficient state-owned enterprises while non-state- controlled enterprises found it difficult to access bank loans The growing presence of foreign banks in Vietnam has resulted in decreasing in dependence on local banks and changed investment behavior Using a sample of listed companies in both stock exchanges in Vietnam, HOSE and HNZ, this research investigates the effect of banking system reform which is measured by foreign bank’s presence on investment-cash flow sensitivity for the period of 2009–14 We found evidence that banking system reform had certain effects on investment behavior of listed firms After the reform, they are less dependent on their internal cash flow for investments Underinvestment issues of non-state-controlled listed firms were also mitigated due to better accessibility to bank loans

Keywords: banking system reform; investment-cash flow sensitivity; state-controlled listed firms; state-controlled listed firms; Vietnam

non-1 Introduction

Bank loans together with internal cash flow have been two main financing sources of funds for firm’s investments in Vietnam However, credit market is not a fair play ground for state – owned enterprises and private companies due to some historical reasons1 although Vietnam has done a lot

of effort to improve the situation Vietnam has conducted several reforms in banking sector in order

to improve its efficiency as well as competitiveness since it started the Doi Moi policy2 in 1986 The biggest reform in banking sector was the separation the role of central bank and commercial bank Prior to 1990, banking system in Vietnam was a 1-tier system in which state bank functioned as both central bank and commercial bank After 1990, State Bank of Vietnam (SBV) only played the central banking role, while its former commercial functions were separated and delegated to 4 newly-established major state-owned commercial banks (SOCBs): Bank for Foreign Trade of Vietnam (Vietcombank), Vietnam Bank for Industry and Trade (Vietinbank), Vietnam Bank for Agriculture and Rural Development (Agribank) and Bank for Investment and Development of Vietnam (BIDV) The only four banks dominated the whole credit market with more than 70% market share Traditional customers of these banks are state-owned enterprises, which were favorable in getting loans at lower cost The entry into international trade and investment agreements such as US-Vietnam Bilateral Trade Agreement (2001), WTO (2007) of the country… allowed presence of foreign banks with the hope that domestic banks would benefit from management technology, business operating skills, professional knowledge and additional capital provided by foreign banks Equitisation (privatization) of state-owned commercial banks was also another effort to reform the sector by the government, etc However, after many reforms, companies have still not been easy to access the bank’s capital while local banks are still struggling with restructuring programs to solve non-performance loans (NPLs) as well as other structural problems Tsai et al (2014) found an evidence that bank sector reform had a significant impact on Chinese companies’ investment – cash flow relation in general and in both state-controlled listed and non-state controlled listed firms, which reliance on internal cash flows were reduce after the reform Although Vietnam has similar political, cultural, social and economic conditions with China, Viet nam was just a very small country

in comparison with China that just opened the economy for about 30 years Therefore we conduct this research to examine the effect banking system reform on investment – cash flow relation in a context of small transitional economy Presence of foreign banks is considered additional credit channel to companies for financing their investment opportunities, helping to mitigate firm’s financial constraints It also create reform pressures on local banks that they have to improve their

1 Vietnam used to be a centrally-planned economy in which state – owned banks mainly served for state-owned enterprises

2 Doi Moi Policy is the policy on tranforming the economy from centrally-planned to market-oriented one

corporate governance to compete with foreign banks who have stronger capital, more advanced technologies, better business operating skills, etc

In this study, we use a sample of Vietnamese listed firms from 2009 – 2014 to examine impact of banking system reform, which is defined by presence of foreign banks, on firm’s investment – cash flow relation The impact was also investigated for the two sub samples: state-controlled listed firms and nonstate-controlled firms due to their different ownership characteristics as Tsai et al (2014)

As other transforming countries, state-owned enterprises in Vietnam also had to do some political responsibilities and they got some favorable privileges in terms of capital, investment opportunities, etc than other form of businesses, especially private ones

Our main findings are as follows: First, we found a U-shape relation between investment – cash flow on listed companies in Vietnam Second, banking system reform changed firm’s investment behavior in the way they were less dependent on internal cash flow, implying that reducing politically-oriented investment problem in state-controlled listed companies and also overinvestment problem Underinvestment problem in non state-controlled listed companies seemed to be alleviated because the companies have more channels to raise funds

Investment and debt relation is also investigated because bank loans are main source of funds for Vietnamese companies

Contribution of this study to enrich the literature, providing empirical evidence on the impact of banking sector reform on investment – cash flow relation in a small transitional country It also provides some policy implications at both govermental and firm levels to improve investments The remainder of this research is organized as follows Section 2 presents literature review Section 3 describes research methodology Section 4 reports research results and Section 5 concludes the research

2 Literature review

2.1 Investment – cash flow relation

In financial theory, a company can use two sources of funds to finance its potential positive NPV projects: internal funds which is the cash flow generated by company’s operation and external funds which is newly – issued debt/equity In a perfect capital market where transaction cost does not exist, funds are available for all firms, so they do not need to rely on availability of internal cash flows for financing their investments (Modigliani and Miller, 1958) However, in an imperfect capital market, external funds are more costly than internal funds, so internal funds becomes main source of financing

The topic of investment – cash flow relation has been studied by many researcher for many decades and this still is a controversial one so far Fazzari et al (1988) and (Allayannis and Mozumdar, 2004; Cleary, 1999; Kaplan and Zingales, 1997) are representatives for the two opposite

opinions Fazzari et al (1988) used a sample of US manufacturing firm in the period of 1970 – 1984

to study firm’s investment and cash flow relation under financial constrain The authors used payout ratio as measure for financial constrain, in which firm paying decreasing dividend considered as more financially constrained and vice versa The authors found that financially constrained firms had more sensitive relation between investment and cash flow, and the relation was less sensitive for non-financially constrained firms Hoshi et al (1991) supported Fazzari et al (1988) findings with their research on relation between capital structure and investment Hoshi et al (1991) found that individual company who did not have good relation with banks, meaning facing financial constraint have higher investment – cash flow sensitivity than Keiretsu – a type of Japanese group

The opposite opinion was represented by Kaplan and Zingales (1997) These authors built up KZ index to measure financial constrain and examined investment – cash flow relation with KZ index They found that cash flow had positive relation with investment Besides, less financially constrained firms had more sensitive investment – cash flow relation which was opposite to Fazzari et al (1988) Sean Cleary (1999) used 2 samples, one US firms and the other Canadian firms to test both Fazarri

et (1988) and Kaplan and Zingales (1997) findings The US sample results supported Kaplan and Zingales (1997) that less financially constrained firms had more sensitive investment – cash flow relation However, the Canadian sample supported Fazzari et al (1988) Sheshinski and Lopez-Calva (1999) documented that state–controlled companies had soft budget constrain because they could access external funds easier than private companies, so are less financially constrained

Hubbards (1998); and Cleary et al (2007) demonstrated that financial constrain would make the U-shape curve of investment flatter, meaning that firm’s investment would be less dependent on its internal cash flow Cleary et al (2007) found a U-shape for relation between investment and cash flow with a large sample of 88,599 observations for the period of 1980 – 1999, causing by cost and revenue effects The cost effect arises because the more investment the firm takes, the more borrowing cost incurred Accordingly, higher level of investment, more revenue is expected to generate Guariglia (2008) supported Cleary et al (2007) that there was a monotonical relation between investment – cash flow and degree of internal or external financial constraints “Internal” financial constraints are measured by firms’ cash flow and coverage ratio, and “external” financial constraint is measured by firm size, and age Firth et al (2012) also confirmed the U-shape curve but further argue that the curve may vary with politically – oriented investment or soft budget constraint Tsai et al (2014) also support Cleary et al (2007) and Firth et al (2012) with their findings that banking system reform would reduce financial constrain for firms, especially non-state controlled listed firms, leading flatter U-shape It means that lesser investment- relation sensitivity would reduce underinvestment problem of non-state controlled listed firms Banking system reform also reduced political- oriented overinvestment problem at state – controlled listed firms

2.2 Effect of banking system reform on investment – cash flow relation:

A study of Liu and Lu (2007) on China reported that government officials at state – controlled listed firms often had incentives to achieve social and political objectives to serve for their own promotion, therefore politically-oriented investments were the main cause of overinvestment situation in these firms Firth et al (2012) found similar evidence supporting that point of view Detragiache et al (2008) found evidence that foreign banks were less sensitive to political pressure, and they had less pressure of lending relation partners, who were capable of breaking relation barriers Political and non-economic motivations were not top priorities of domestic banks now Therefore, state-owned commercial banks were transformed from politically – incentive organization to modern corporate governance – oriented ones Therefore, reforming bank system by allowing foreign banks holding ownership at domestic state-owned banks could reduce policies favoring to politically – oriented investments of state – controlled companies With presence of foreign investors, credit granting would be more careful, that careless loans as well as politically-oriented loans could be reduced With this research, Detagiache et al (2008) used foreign ownership

in domestic bank as proxy for banking system reform This research was supported by Beger et al (2008) Beger et al (2008) reported that after reform, foreign ownership in domestic banks, especially state-controlled banks could change their lending practice, from politically – oriented to commercially-oriented banks Nonstate-controlled listed companies are considered more transparent, more commercially-oriented and more efficient than state-controlled listed companies Therefore, after reform, nonstate-controlled listed companies had more channels to access bank loan and underinvestment problem of nonstate- controlled listed companies were reduced

Different with Detagiache et al (2008), Tsai et al (2014) in their study on effect of bank system reform on investment – cash flow sensitivity defines presence of foreign bank at region where company had headquartered or branches as measure of bank system reform The research found evidence that politically-oriented investments at state controlled listed companies were reduced after the reform due to more commercially – oriented operations Problem of underinvestment at non state – controlled listed companies seemed to be reduced due to an increase in bank loans The similar results of effect of banking system reform on relation of financial leverage and investment were found, meaning a reduction of distortion of investment in state controlled listed companies as well

as reduction on financial constraints at non state – controlled listed companies

3 Research design

3.1 Hypothesis development and model specification

3.1.1 Investment – cash flow relation

Some recent researches (Cleary et al (2007) and Firth et al (2012) shows evidence of non-linear shape for investment – cash flow relation (U-shape), meaning that there is a difference in the relation when company has positive or negative cash flow For positive cash flow companies, they are willing

to finance many investments for growth, therefore they are more dependent on their internal cash flows Meanwhile, negative cash flow companies face investment constrain due to lack of capital If they still want to take new investment projects, they need to use external funds which has higher cost

H1: There is a non linear investment – cash flow relation (U-shape) at Vietnamese companies

The hypothesis is tested by the following model which was developed by Fazzari et al (1988), then applied by Cleary et al (2007) and Firth (2012):

IKi,t = α0 + α1CFKi,t + α2CFKSQRi,t+ α3(SaleGrowthi,t−1) + α4SIZEi,t+ α5LEVi,t+

Where IKi, t is investment ratio, measured by Ii, t divided by Ki, t-1 I is the investment in fixed assets

in year t, measured by book value of net fixed assets at the end of year t minus book value of net fixed asset at beginning of year t, and plus depreciation in year t Kit-s is total fixed asset of firm i at the beginning of year t CFKi,t is annual cash flow ratio, measured by earnings before interest, tax,

depreciation and amortization (EBITDA) of firm i in year t divided by total fixed asset of firm i at beginning of year t (Ki,t-1) CFKSQR is square of CFK is included in the model If CFKSQR significantly takes positive sign, the relation will have U-shape If it has negative sign significantly, the relation is inverse U-shape. SaleGrowthi, 1-1 is proportion of change in sales from year t–2 to year t–1 Like

Tobin’Q, SaleGrowthi, t-1 is also a common proxy to control the effect of a firm’s growth potential (Firth et al., 2012) Vietnam’s stock market is still very young and immature which is much affected

by “herd effect” Fluctuation of stock price in many cases does not reflect the true potential of the company Meanwhile, companies normally increase investments to meet their increasing potential sale growth, therefore we believe SaleGrowth is more appropriate than Tobin’s Q to measure investment opportunity in Vietnam’s context SIZEi,t is firm size This variable is a proxy for the degree of financial constraint experienced by firms (Guariglia, 2008), measured by logarithm of beginning book value of total assets for firm in in year t LEVi, t-1 is the beginning-of-period financial

leverage, measured by total liabilities to total assets for firm i in year t AGEi, t is the number of years since the company listed This variable is used to measure information asymmetry (Myers and Majluf, 1984) BETAi, t is the slope coefficient from the market model estimated using daily stock and market returns: RI, t =  + Rm, t + i, t where Ri, t is the daily stock return of firm i, Rm, t is the daily

market return for day t The estimation period is one year BETA reflects the relation between

uncertainty and investment

3.1.2 Effect of banking system reform on investment – cash flow relation

It is common to have problem of “flexible budget constrain in the centrally-planned economy, which refers to the favorable policies for state-controlled organizations Due to being owned by government, these organizations are often bailed out if they are in trouble, normally in form of subsidy, tax deduction or exemption, set low input cost, set high output price, low cost financing, etc Therefore, state – owned enterprises in Vietnam normally can access bank credit much easier and

normally at lower cost than private forms, that leads to the situation of overinvestment Moreover, like China, overinvestment problem in state-controlled companies are mainly caused by politically- oriented investments (Firth et al., 2012) because officials in these companies also have incentives to achieve social and political objectives for their promotion (Liu and Lu, 2007) Meanwhile, nonstate-controlled companies are not favored with these privileges, so they have to rely on their own internal cash flow to finance their investment opportunities (Tsai et al., 2014)

H2: Banking system reform mitigates overinvestment problem at state – controlled listed companies

With the presence of foreign bank, credit market become more competitive and transparent State-owned banks may have to change its lending practices from politically-oriented to commercially-oriented, so non-state controlled companies have more chance to access bank financing, so underinvestment problem of these company could be reduced

H3: Banking system reform mitigates underinvestment problem at non state – controlled listed companies

We applied the following model which was developed by Tsai et al (2014) to test the hypothesises H2 and H3:

𝐼𝐾𝑖,𝑡 = α0+ α1CFKPOS𝐼,𝑡+ α2CFKNEG𝐼,𝑡+ α3CFKPOSBANK𝐼,𝑡+

α4CFKNEGBANK𝐼,𝑡+ α5BANK𝐼,𝑡+ α6SalesGrowthi,t−1+ α7BANKi,t+ α8SIZEi,t+

α9LEVi,t+ α10AGEi,t+ α11BETAi,t+ vi+ vt+ εi,t (2)

In this model, CFK is separated into positive CFK and negative CFK by using dummy variables POS and NEG POS takes the value 1 if CFKi,t is greater than 0, and 0 if otherwise NEG takes the value 1 if CFKi, t is less than 0, and 0 if otherwise The relation between investment and cash flow will have U-shape if CFKPOS (= CFK*POS) has positive sign and CFKNEG (= CFK*NEG) has negative sign at conventional significances BANKi,t is a dummy variable that takes the value 1 for firms located

in a region where foreign banks are allowed to do business in year t and afterwards, and 0 otherwise

CFKPOSBANK (=CFK*POS*BANK) and CFKNEGBANK (=CFK*NEG*BANK) reflect effect of banking system reform on firm’s investment behavior when it has positive or negative cash flow Definitions

of other variables are as those of the model (1)

3.1.3 Effect of banking system reform on investment and debt relation:

As many other transitional economies, bank loans are still main source of external funds in Vietnam where stock market is still young and immature To see if banking system reform have any impact on investment –debt relation, we develop following hypothesis:

H4: Banking system reform has a positive impact on firm’s investment – debt relation:

We applied the following model which was developed by Tsai et al (2014) to test the hypothesis H4:

IKi,t = β0+ β1CFKi,t+ β2LEVi,t−1+ β3BANKi,t+ β4BANKi,t∗ LEVi,t−1+

Definitions of other variables are as those of the model (1)

3.2 Data

We use an unbalanced panel data from the period 2009 to 2014 for non-financial companies listed

on Ho Chi Minh City Stock Exchange (HOSE) and Hanoi Stock Exchange (HNX) Financial firms are excluded because they have different investment behavior with non-financial firms The firm’s financial data is extracted from the Stockplus database Market data is downloaded from the websites www.vietstock.com.vn Missing value observations are also excluded Outliers that may influence the results are excluded by winsorizing 1% for two tails for each variable

4 Empirical results

4.1 Descriptive statistics

Table 1 describes the research sample This sample is unbalanced panel of 3.124 observations of non-financial companies listed on HOSE and HNX in Vietnam for the period of 2009 – 2014 Each firm in the sample is classified as state – controlled listed company or nonstate-controlled company for each year by proportion of state ownership of the company in that year A shareholder or a group

of shareholders is defined as controlling one if it holds 50% or more of the voting shares The number of state – controlled listed firm is about a half of nonstate controlled firms

Notes: The sample includes non-financial firms listed on HOSE and HNX of Vietnam over the period of 2009 – 2014

State controlled firms are those that the government held at least 50% of voting shares The rest are nonstate –controlled firms

Table 2 presents a summary of the descriptive statistics for all variables in the regression models

In average, mean and median of investment ratio (IK) for the whole sample is 17% and 3% respectively State–controlled listed firms in average invest more than non-state – controlled listed firms (21% and 15% respectively) Although having higher growth potential as indicated by mean of SaleGrowth (59%), non state – controlled listed firms has lower average internal cash flows (CFK 15%) and higher negative cash flows (NEG 39%), meaning that underinvestment exists in this group

and they seem to have to rely more on external funds to finance their investment than state – controlled listed firms In average, state – controlled listed firms have higher leverage (54%), implying their higher accessibility to bank loans to non-state – controlled listed firms (49%)

Table 2

Variable descriptive statistic

Full sample State-controlled listed firms Non state – controlled listed firms

4.2 Correlations

Table 3 below presents correlations among the variables The bottom left triangle reports Spearman correlations and the upper right triangle reports Pearson correlations IK has positive correlation coefficient with CFKPOS at high level of significance (1%), and negative correlation with CFKNEG but insignificant at conventional levels It suggests the U-shape curve for investment and cash flow relation Besides, IK also has negative correlation with AGE and positive correlations with SaleGrowth, LEV, and BETA at high significance

Table 3

Pearson and Spearman correlation matrix

Notes: IK is investment ratio CFKis annual cash flow ratio CFKPOS is the positive cash flows CFKNEG is the negative

cash flows SaleGrowth is proportion of change in sales from year t–2 to year t –1 LEV is the beginning-of-period

financial leverage, measured by total liabilities to total assets AGE is the number of years since the company listed BETA

is the slope coefficient from the market model estimated using daily stock and market returns: R i,t =  + R m,t +  i,t where

R i,t is the daily stock return of firm i, R m,t is the daily market return for day t *, **, *** respectively indicate significance

at 10%, 5% and 1%

4.3 Regression results

4.3.1 Examining investment – cash flow relation

As explained in section 3 above, we used the model (1) in Section 3 which was developed by Fazzari

et al (1988) and then applied by Cleary et al (2007) and Firth (2012) The Table 4 below reports the regression results Coefficient of variable CFKSQR of the full sample is significantly positive at 0.0000298** This confirms a U-shape investment - cash flow relation Due to mean of both cash flow (CFK) and investment (IK) are equal 0.17, a 10% increase in cash flow would lead to 0.0358% increase in investment3 This number is rather small as compared with 1.12% as reported by Guariglia (2008) in his study on British companies or 1.3% as reported by Firth et al (2012) for Chinese companies There is similar relation for nonstate-controlled listed companies, but insignificantly For Vietnamese state – controlled listed companies, relation between IK and CFK is inverse U-shape curve, represented by highly significantly negative coefficient (-0.00361***) For state – controlled companies, regression coefficient of investment on SaleGrowth is significantly negative at -0.00770, implying that in average these companies still invest even though their growth potential decrease This confirms overinvestment problem of this group of companies Will this problem exist after bank reform? We will further examine this problem in the section 4.3.2 below

For non-state-controlled companies, coefficient of SaleGrowth is also negative but insignificant

So we cannot confirm overinvestment problem in this group of companies yet

In conclusion, we found a U-shape curve for investment – cash flow relation on a full sample of Vietnam’s listed companies and inverse U-shape for state – controlled listed companies while U-shape for non-state – controlled listed companies are not confirmed yet We also confirm overinvestment problem at state – controlled listed companies

3 According to Guariglia (2008, p.1802), the number 0.0358% is calculated by 0.17*10%*0.00358/0.17