Economic policy uncertainty, financial development, and financial constraints: Evidence from China

Financial frictions are important transmission mechanism of the adverse effect of policy uncertainty on economic output. We use Chinese listed firms' data to verify the mechanism directly by empirically examining whether economic policy uncertainty (EPU) exacerbates corporate financial constraints and whether financial development can mitigate the impact of policy uncertainty on financial constraints. We find that economic policy uncertainty causes a significant increase in the firm financial constraints level. We further find that financial development mitigates the adverse impact of EPU on financial constraints. Financial development also relieves the increase in cost of capital and the significant decrease in cash flow caused by rising EPU through which EPU affects financial constraints. Further analysis shows that the moderating effect is much stronger when the firm is credit constrained, (e.g., small firms and non-state-owned enterprises).