The Impact of Foreign Direct Investment on Firms' Cash Holdings: Evidence From China

ABSTRACT This paper investigates how foreign direct investment (FDI) affects firms' cash holdings in manufacturing sectors by taking the plausibly exogenous shock of FDI liberalization in 2002 as an instrumental variable. Using data from the Chinese annual survey of industrial firms from 1998 to 2007, it is found that a 1% increase in industry‐level FDI decreases firms' cash holdings by 7.10% on average. Two explanations of the effect of FDI, that is, investment squeezing and financial constraint alleviation, are explored. Both mechanisms lead to a decrease in firms' cash holdings. In contrast to the effect of horizontal FDI, vertical FDI sourced from upstream industries exerts a positive effect on firms' cash holdings. Furthermore, heterogeneity analyses suggest that the reduction in cash holdings caused by FDI inflows mainly affects smaller firms, privately owned firms, and firms belonging to competitive industries.