Credit constraints and investment-cash flow sensitivity in declining economic conditions: The role of reliance on bank debt

Tayem, Ghada Article Credit constraints and investment-cash flow sensitivity in declining economic conditions: The role of reliance on bank debt Economies Provided in Cooperation with: MDPI – Multidisciplinary Digital Publishing Institute, Basel Suggested Citation: Tayem, Ghada (2022) : Credit constraints and investment-cash flow sensitivity in declining economic conditions: The role of reliance on bank debt, Economies, ISSN 2227-7099, MDPI, Basel, Vol. 10, Iss. 11, pp. 1-15, https://doi.org/10.3390/economies10110288 This Version is available at: https://hdl.handle.net/10419/328588 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Citation: Tayem, Ghada. 2022. Credit Constraints and Investment-Cash Flow Sensitivity in Declining Economic Conditions: The Role of Reliance on Bank Debt. Economies 10: 288. https://doi.org/10.3390/ economies10110288 Academic Editor: Robert Czudaj Received: 2 September 2022 Accepted: 7 November 2022 Published: 17 November 2022 Publisher’s Note: MDPI stays neutral with regard to jurisdictional claims in published maps and institutional affiliations. Copyright: © 2022 by the author. Licensee MDPI, Basel, Switzerland. This article is an open access article distributed under the terms and conditions of the Creative Commons Attribution (CC BY) license (https:// creativecommons.org/licenses/by/ 4.0/). economies Article Credit Constraints and Investment-Cash Flow Sensitivity in Declining Economic Conditions: The Role of Reliance on Bank Debt Ghada Tayem The Department of Finance, The University of Jordan, Amman 11942, Jordan; [email protected] Abstract: This paper examines the sensitivity of investment to cash flow in declining economic conditions, focusing on the impact of a firm’s reliance on bank debt. Using the context of Jordan, a developing Middle East and North Africa (MENA) country, the study utilizes the standard Q theory of investment augmented by cash flow, leverage, and liquidity. Then, it allows for differential loading on the cash flow coefficient pre- and post-2008, the year that marks the beginning of declining conditions, and by categorizing companies based on their reliance on bank debt, measured by having access to a bank line of credit. Using alternative estimation specifications, the findings indicate that firms’ investments decreased significantly in episodes of declining conditions. In addition, the findings indicate that firms’ investments exhibited more sensitivity to cash flow during declining conditions, especially for firms with access to lines of credit. The latter finding suggests that firms reliant on bank debt could not compensate for the credit shortages by switching to other sources of external funding and therefore they were compelled to use more of their internally generated funds to finance their investments. Keywords: investment-cash flow sensitivity; credit constraints; lines of credit; economic policy uncertainty; developing markets; MENA 1. Introduction The role of financial sector development in improving the efficiency of investment allocation has been the subject of important research (Aghion et al. 2018;Allen et al. 2018; Tirole 2010). Indeed, the empirical evidence documents a positive impact of financial development on economic growth and gross capital formation (Beck et al. 2014;Cama and Emara 2022;Hunjra et al. 2022;Nguyen 2022;Popov 2018). In addition, firm-level based evidence shows that firms facing credit constraints, i.e., when external finance provided by the financial sector is costly or unavailable, are forced to rely on their internal sources of finance, causing a larger degree of sensitivity of investment to cash flow (A˘gca and Mozumdar 2017;Chiu et al. 2022;Ek and Wu 2018;Fazzari et al. 1988,2000;Lewellen and Lewellen 2016;Tayem 2015b). The present article builds on this literature by examining the impact of declining economic conditions on the sensitivity of investment to cash flow using the context of Jordan, a developing market from the Middle East and North Africa (MENA) region, with a focus on the role of a firm’s reliance on bank debt on attenuating (or exacerbating) the impact of these conditions on investment-cash flow sensitivity. The literature on investment-cash flow sensitivity focuses mainly on firm-specific factors that influence the investment-cash flow relationship (A˘gca and Mozumdar 2017; Chiu et al. 2022;Ek and Wu 2018;Fazzari et al. 1988;Lewellen and Lewellen 2016;Tayem 2015b), with little research on the impact of macro conditions on this relationship. Although there is important literature on the relationship between macro conditions and firms’ investments, the focus of this literature is on the impact of those conditions on firm investment behaviour, not on investment-cash flow sensitivity. For example, several studies examine the impact of weaknesses caused by the 2008 crisis on corporate investment (Bucăand Economies 2022,10, 288. https://doi.org/10.3390/economies10110288 https://www.mdpi.com/journal/economies Economies 2022,10, 288 2 of 15 Vermeulen 2017;Campello et al. 2010,2011). Other studies examine the impact of economic conditions on corporate investments, with a focus on conditions of financial nature such as monetary policy, interest and exchange rates, credit demand and financial development (Masuda 2015;Tang et al. 2022). In addition, there is emerging research that examines firm-level investment behaviour over the business cycle (Jeon and Nishihara 2014;Schoder 2013) and the impact of economic uncertainty on firm investment (Azimli 2022;Chen et al. 2020;Gulen and Ion 2016;Wang et al. 2014). The premise of this research is that economic uncertainty discourages corporate investments because of the presence of adjustment costs or the irreversibility of investment costs (Gulen and Ion 2016;Wang et al. 2014). The focus of the above-mentioned strand of literature is on the impact of economic shocks and uncertainty on firms’ investment behaviour, not on the investment-cash flow relationship. Although some studies do examine the impact of macro shocks on investmentcash flow sensitivity, most of these studies focus on the impact of shocks of financial nature not on shocks that originate in the real sector. For example, Zubair et al. (2020) examine the impact of the financial crisis, Gül and Ta¸stan (2020) and Guizani and Ajmi (2020) examine the impact of monetary policy and financial development, while Gupta et al. (2022) examine the impact of economic policy uncertainty. Furthermore, studies on economic conditions and firm investment behaviour focus on cases of developed and transition economies, with little research on small and developing economies. However, the study of firms’ investment behaviour in small developing economies is important because of the pivotal role played by private investments in driving economic growth and employment (Beck et al. 2014) . In addition, there is little research on firms’ investments in the MENA region, with some exceptions such as Guizani and Ajmi (2020), which examine the case of Saudi Arabia. MENA represents an integral part of the world economy, and Jordan, with its characteristics shared with other MENA countries, is a useful study of the region. Therefore, this study addresses this gap in the literature by examining the impact of declining economic conditions on firms’ investment-cash flow sensitivity using the context of Jordan. Specifically, this study attempts to answer the following questions: Do declining economic conditions have a negative impact on firms’ investments and growth? Do declining economic conditions strengthen the reliance of firms on their internal sources of finance and the degree of investment to cash flow sensitivity? How do these conditions affect the investment-cash flow sensitivity of firms reliant on bank debt? To answer these questions, the study utilizes the standard Q theory of investment (Hayashi 1982;Tobin 1969), augmented with cash flow to capture investment sensitivity to the availability of internal finance (A˘gca and Mozumdar 2017;Chiu et al. 2022;Ek and Wu 2018; Fazzari et al. 1988 ;Lewellen and Lewellen 2016;Tayem 2015b). This study follows the literature by subdividing listed Jordanian firms into two clusters based on their access to lines of credit, a measure of a firm’s reliance on bank debt. The choice of lines of credit as a clustering criterion is motivated by the fact that Jordan is a bank-based economy where banks are the main providers of external finance (Tayem 2022) and that the issuance of stocks and bonds on the stock exchange is rare (Tayeh et al. 2015;Tayem 2017). Further, line-of-credit facilities are the main lending vehicle employed by the banking sector (Tayem 2022). These facilities have the advantage of providing liquidity when firms face uncertainty about new investment opportunities (Sufi 2009). The study, then, examines the sensitivity of investment to cash flow for the two firm clusters during the full sample period and in the pre- and post-2008 periods, with the year 2008 marking the start of declining conditions in Jordan. This study chooses the context of Jordan because of the growing evidence indicating that investment-cash flow sensitivity is diminishing in developed countries, but is still present in emerging and developing markets (Brown and Petersen 2009;Larkin et al. 2018; Machokoto et al. 2021;Moshirian et al. 2017;Verona 2020). In addition, Jordan is a small, developing economy, indicating that firms tend to face higher uncertainty in investment decisions (Bloom 2017) and greater credit constraints (Tayem 2017) than those in large, developed economies. Also, external financing of corporate Jordan is dominated by bank Economies 2022,10, 288 3 of 15 debt, with lines of credit being the main lending vehicle (Tayem 2022). Furthermore, the context of the Jordanian market offers an appropriate setting to examine the hypotheses of this study. This is because the real sector in Jordan showed signs of decline post- 2008, while the banking sector, which is the main supplier of external finance, showed strong performance and stability measures pre- and post-2008, hence the weaknesses of the real sector in Jordan did not translate into weaknesses in the financial sector (see Section 2). Nonetheless, Jordanian banks have shifted their loan portfolio structures away from business lending, which has led to tightening the supply of bank credit and an increase in the cost of funds to businesses. Hence, this study identifies a new channel for tightening bank credit, i.e., changes in the structure of bank loan portfolio, and examines how firms, especially the ones reliant on bank debt, responded to shortages of credit supply. The findings of this study contribute to the literature in several ways. First, this study contributes to the literature on the impact of economic conditions and uncertainty on investment behaviour, as it supports the evidence that worsening economic conditions affect firm investment negatively (Schoder 2013;Jeon and Nishihara 2014;Wang et al. 2014;Gulen and Ion 2016;Chen et al. 2020;Azimli 2022), using a new context that has not been examined before which can be viewed as out-of-sample evidence to test whether this outcome only pertains to developed and transition economies. In addition, this study contributes to the literature on investment-cash flow sensitivity in documenting that firms in Jordan, a developing market, still exhibit investment-cash flow sensitivity, unlike firms in many developed markets (Brown and Petersen 2009;Larkin et al. 2018;Machokoto et al. 2021;Moshirian et al. 2017). This finding is important in shaping our understanding of the role of financial development in easing firms’ financial constraints. Furthermore, this study contributes to the literature on the adverse impact of worsening financial conditions on the imposition of further financial constraints on businesses (Campello et al. 2010; Zubair et al. 2020 ). Unlike previous literature, this study examines the case of a small developing country with a bank-based economy. In addition, this study examines a context under which banks have healthy balance sheets, nonetheless, bank credit was tightened because of changes in bank loan portfolio choices. Consequently, firms were compelled to use more of their internally-generated resources to finance their investments, especially firms reliant on bank debt, because they were not able to compensate for the credit shortages by switching to other sources of external funding. Furthermore, this study contributes to the growing number of articles that examine the investment behaviour of firms operating in developing economies, especially in MENA countries (Guizani and Ajmi 2020). The remainder of this article is organized as follows. The next section presents an overview of the Jordanian economy with a focus on the past decade. Section 3discusses the methodology and research design while Section 4presents the data, sample, and descriptive statistics. Section 5presents the results and Section 6discusses the findings. Section 7 concludes the paper. 2. Jordanian Economy: A Background The Jordanian economy has exhibited declining economic conditions during the past decade. The start of the declining conditions coincided with the financial crisis of 2008; however, Jordan suffered an extended aftermath of the financial crisis, followed by multiple crises detailed below. During this study’s sample period of 2002–2019, Jordan’s economy was stagnant from 2008 to 2019. Figure 1shows a sharp decline in GDP growth between 2008 and 2009 and a prolonged period of slow economic growth thereafter. Several reasons contributed to the declining economic conditions post-2008 including (i) the global recession caused by the crisis of 2007/2008, (ii) the Arab Spring, as Jordan received a large number of refugees during that period and lost a significant share of trade with Syria, (iii) the weaknesses of the Jordanian energy sector, and (iv) the nationalization movements in the Gulf countries which led to the termination of existing contracts of a large number of Jordanian workers in those countries and fewer new job opportunities abroad. The above-mentioned factors, alongside the contractionary fiscal and monetary policies run by Economies 2022,10, 288 4 of 15 consecutive Jordanian governments during that period, exposed the structural weaknesses of private investments. Economies 2022, 10, x FOR PEER REVIEW 4 of 16 Syria, (iii) the weaknesses of the Jordanian energy sector, and (iv) the nationalization movements in the Gulf countries which led to the termination of existing contracts of a large number of Jordanian workers in those countries and fewer new job opportunities abroad. The above-mentioned factors, alongside the contractionary fiscal and monetary policies run by consecutive Jordanian governments during that period, exposed the structural weaknesses of private investments. −4.00 −2.00 0.00 2.00 4.00 6.00 8.00 10.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 GDP Growth Figure 1. GDP growth over the period 2000–2020. Source: World Bank Development Indicators. The declining economic conditions over the past decade are reflected in the stock exchange’s performance in terms of the number of listed firms and the valuation of listed firms to book values and GDP. The number of companies listed on the Amman Stock Exchange (ASE) has decreased over time from 245 in 2007 to 179 in 2020 (ASE’s Key Statistics, various issues) and the size of the market has been shrinking; as of 2020, the size of the market was less than 41% of GDP, down from about 240% of GDP in 2007 (World Bank Development Indicators). In addition, corporations are unable to grow or even survive with a continuous pattern of de-investing that has been going on for at least the past decade. The declining conditions of the ASE are especially troubling given the significant investment in reforms and plans aimed at strengthening the private sector and the Jordanian stock market put forward in the 2000s (Tayem 2015a). However, the banking sector in Jordan, which is the main provider of external funds, has shown few signs of instability, and has been steadily performing well during the past decade. For example, bank assets grew by more than 4% throughout the declining conditions, with a book value of assets equal to 63 billion in 2020 compared to 40 billion in 2007 (See Figure 2). In addition, bank performance in terms of accounting numbers registered remarkably stable interest margins, with an average of 2.8% (ASE Companies Guide, various issues). Therefore, one could argue that banks’ ability to supply credit has not been adversely affected by the economic conditions post the 2008 period. However, it is important to note that during the same period, bank asset structure shifted towards more investment in government securities, with an average investment of 1.7 billion before 2008 and 9.5 billion post-2008 (See Figure 2). Furthermore, credit to the industrial sector as a proportion of bank loan portfolio has been declining from a reported 18.5% in 2008 to only 13.1% in 2020 (Central Bank Annual Report, various issues). Additionally, the cost of bank finance has been increasing steadily, as illustrated in Figure 3. Figure 1. GDP growth over the period 2000–2020. Source: World Bank Development Indicators. The declining economic conditions over the past decade are reflected in the stock exchange’s performance in terms of the number of listed firms and the valuation of listed firms to book values and GDP. The number of companies listed on the Amman Stock Exchange (ASE) has decreased over time from 245 in 2007 to 179 in 2020 (ASE’s Key Statistics, various issues) and the size of the market has been shrinking; as of 2020, the size of the market was less than 41% of GDP, down from about 240% of GDP in 2007 (World Bank Development Indicators). In addition, corporations are unable to grow or even survive with a continuous pattern of de-investing that has been going on for at least the past decade. The declining conditions of the ASE are especially troubling given the significant investment in reforms and plans aimed at strengthening the private sector and the Jordanian stock market put forward in the 2000s (Tayem 2015a). However, the banking sector in Jordan, which is the main provider of external funds, has shown few signs of instability, and has been steadily performing well during the past decade. For example, bank assets grew by more than 4% throughout the declining conditions, with a book value of assets equal to 63 billion in 2020 compared to 40 billion in 2007 (See Figure 2). In addition, bank performance in terms of accounting numbers registered remarkably stable interest margins, with an average of 2.8% (ASE Companies Guide, various issues). Therefore, one could argue that banks’ ability to supply credit has not been adversely affected by the economic conditions post the 2008 period. However, it is important to note that during the same period, bank asset structure shifted towards more investment in government securities, with an average investment of 1.7 billion before 2008 and 9.5 billion post-2008 (See Figure 2). Furthermore, credit to the industrial sector as a proportion of bank loan portfolio has been declining from a reported 18.5% in 2008 to only 13.1% in 2020 (Central Bank Annual Report, various issues). Additionally, the cost of bank finance has been increasing steadily, as illustrated in Figure 3. Economies 2022,10, 288 5 of 15 Economies 2022, 10, x FOR PEER REVIEW 5 of 16 0.00 10.00 20.00 30.00 40.00 50.00 60.00 70.00 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Assets Investments Loans, Net Figure 2. Listed banks’ assets, government bond investment and loans over the period 2001–2020. Source: ASE’s Companies Guide (various issues). 0% 2% 4% 6% 8% 10% 12% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Figure 3. Prime rate over the period 2001–2020. Source: Central Bank Statistics Database. 3. Methodology and Research Design 3.1. Hypotheses Motivation A growing literature examines the impact of uncertainty related to economic, political and policy shocks on firm-level investment decisions with the assumption that uncertainty has a negative impact on firm-level investment (Azimli 2022; Chen et al. 2020; Gulen and Ion 2016; Wang et al. 2014). The rationale behind this assumption originates from the real-option theory, which shows that because capital investments are costly and irreversible, the higher the degree of uncertainty the larger the value of the option of waiting for uncertainty to resolve (Gulen and Ion 2016; Wang et al. 2014) and therefore firms reduce their current investment spending as uncertainty increases. Several studies show that firm investment and disinvestment decisions depend on the state of the economy (Jeon and Nishihara 2014; Schoder 2013), while other studies focus on economic policy uncertainty and show that it has a significant negative impact on corporate investment in the US (Gulen and Ion 2016), China (Wang et al. 2014), Japan (Morikawa 2016) and Australia (Chen et al. 2020). Therefore, this study predicts that in episodes of declining economic conditions firm investments will decrease as stated in H1: H1. Corporate investments decrease significantly in episodes of declining economic conditions. However, the impact of economic conditions on investment-cash flow sensitivity is less clear. On one hand, if the financial sector is affected negatively by the declining economic conditions, we would expect external financing to become less available and investment-cash flow sensitivity to become larger (Guizani and Ajmi 2020; Verona 2020). For example, research on the financial crisis of 2008 shows that firms became more Figure 2. Listed banks’ assets, government bond investment and loans over the period 2001–2020. Source: ASE’s Companies Guide (various issues). Economies 2022, 10, x FOR PEER REVIEW 5 of 16 0.00 10.00 20.00 30.00 40.00 50.00 60.00 70.00 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Assets Investments Loans, Net Figure 2. Listed banks’ assets, government bond investment and loans over the period 2001–2020. Source: ASE’s Companies Guide (various issues). 0% 2% 4% 6% 8% 10% 12% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Figure 3. Prime rate over the period 2001–2020. Source: Central Bank Statistics Database. 3. Methodology and Research Design 3.1. Hypotheses Motivation A growing literature examines the impact of uncertainty related to economic, political and policy shocks on firm-level investment decisions with the assumption that uncertainty has a negative impact on firm-level investment (Azimli 2022; Chen et al. 2020; Gulen and Ion 2016; Wang et al. 2014). The rationale behind this assumption originates from the real-option theory, which shows that because capital investments are costly and irreversible, the higher the degree of uncertainty the larger the value of the option of waiting for uncertainty to resolve (Gulen and Ion 2016; Wang et al. 2014) and therefore firms reduce their current investment spending as uncertainty increases. Several studies show that firm investment and disinvestment decisions depend on the state of the economy (Jeon and Nishihara 2014; Schoder 2013), while other studies focus on economic policy uncertainty and show that it has a significant negative impact on corporate investment in the US (Gulen and Ion 2016), China (Wang et al. 2014), Japan (Morikawa 2016) and Australia (Chen et al. 2020). Therefore, this study predicts that in episodes of declining economic conditions firm investments will decrease as stated in H1: H1. Corporate investments decrease significantly in episodes of declining economic conditions. However, the impact of economic conditions on investment-cash flow sensitivity is less clear. On one hand, if the financial sector is affected negatively by the declining economic conditions, we would expect external financing to become less available and investment-cash flow sensitivity to become larger (Guizani and Ajmi 2020; Verona 2020). For example, research on the financial crisis of 2008 shows that firms became more Figure 3. Prime rate over the period 2001–2020. Source: Central Bank Statistics Database. 3. Methodology and Research Design 3.1. Hypotheses Motivation A growing literature examines the impact of uncertainty related to economic, political and policy shocks on firm-level investment decisions with the assumption that uncertainty has a negative impact on firm-level investment (Azimli 2022;Chen et al. 2020;Gulen and Ion 2016;Wang et al. 2014). The rationale behind this assumption originates from the realoption theory, which shows that because capital investments are costly and irreversible, the higher the degree of uncertainty the larger the value of the option of waiting for uncertainty to resolve (Gulen and Ion 2016;Wang et al. 2014) and therefore firms reduce their current investment spending as uncertainty increases. Several studies show that firm investment and disinvestment decisions depend on the state of the economy (Jeon and Nishihara 2014; Schoder 2013), while other studies focus on economic policy uncertainty and show that it has a significant negative impact on corporate investment in the US (Gulen and Ion 2016), China (Wang et al. 2014), Japan (Morikawa 2016) and Australia (Chen et al. 2020). Therefore, this study predicts that in episodes of declining economic conditions firm investments will decrease as stated in H1: H1. Corporate investments decrease significantly in episodes of declining economic conditions. However, the impact of economic conditions on investment-cash flow sensitivity is less clear. On one hand, if the financial sector is affected negatively by the declining economic conditions, we would expect external financing to become less available and investmentcash flow sensitivity to become larger (Guizani and Ajmi 2020;Verona 2020). For example, research on the financial crisis of 2008 shows that firms became more constrained during the crisis and relied more on their internal resources of funds (Bucăand Vermeulen 2017; Campello et al. 2010;Zubair et al. 2020). However, if the financial sector is not affected by Economies 2022,10, 288 6 of 15 these conditions and the supply of funds is made available to businesses, the investmentcash flow sensitivity will not differ significantly across economic conditions. Nonetheless, the weaknesses in the real sector can affect the motives of the financial sector, as in the case of Jordanian banks, to supply credit to businesses and induce banks to shift their loan portfolios to more profitable segments. This can result in a decrease in the supply of funds to businesses and strengthen the reliance of businesses on internal sources of funds which in turn can strengthen investment-cash flow sensitivity. The second hypothesis of this study is stated as follows: H2. Investment-cash flow sensitivity increases significantly in episodes of declining economic conditions. The third hypothesis focuses on the impact of a firm’s reliance on bank debt on the firm’s investment, and employs lines of credit as a clustering criterion. Early evidence by Fazzari et al. (1988) finds significantly higher sensitivity of investment to internally generated funds in constrained compared to unconstrained firms. Supporting evidence from the US includes Lewellen and Lewellen (2016), A˘gca and Mozumdar (2017) and Ek and Wu (2018). In addition, evidence from other markets, such as Gupta et al. (2022) from India, Guizani and Ajmi (2020) from Saudi Arabia and Tayem (2015b) from Jordan, finds that constrained firms display the highest investment-cash flow sensitivity. However, it is important to note that the premise of investment-cash flow sensitivity is challenged by several authors, most notably Kaplan and Zingales (1997). Sufi (2009) shows that firms with lines of credit are financially less constrained than the ones without lines of credit. Firms with line-of-credit facilities rely on bank debt to provide financial flexibility to meet their unexpected financial needs (Sufi 2009). Banks, on the other hand, use these facilities to produce private information that enables them to refine the contract terms offered to the borrower (Berger and Udell 1995), which can alleviate financial constraints and increase credit availability (Zhao 2021). In addition, Jordan is a bank-based economy and lines of credit are the main lending vehicle (Tayem 2022). Therefore, this study hypothesizes that firms with lines of credit rely less on internally generated cash flows, hence their investment to cash flow sensitivity will be weaker compared to their counterparts without lines of credit. The third hypothesis of this study states: H3. Firms with lines of credit have smaller investment-cash flow sensitivities compared to the ones without lines of credit. However, H3 does not consider the impact of shrinking bank debt supply on investmentcash flow sensitivity for firms reliant on bank debt. Previous research shows that banks in countries affected by the financial crisis of 2008 faced deteriorating balance sheets, hence they reduced the amount of credit supplied, which increased its cost (Zubair et al. 2020). Research also shows that due to the reduction of bank credit supply, firms dependent on bank debt reduced their investment (Campello et al. 2011) and employment (Chodorow- Reich 2014). This is because these firms were not able to compensate for the credit shortages by switching to other sources of external funding (Cingano et al. 2016;Iyer et al. 2014). This study proposes that firms reliant on bank debt (firms with lines of credit) should not exhibit differential investment cash flow sensitivity across economic conditions if the financial sector is not affected by these conditions. However, if the banking sector responds to weaknesses in the real sector by tightening credit to the real sector and supplying it at higher costs, firms with lines of credit are likely to reduce their dependence on external finance during the declining conditions (Zubair et al. 2020). This, in turn, leads to increased reliance on internal resources for firms with lines of credit in episodes of declining economic conditions to compensate for credit shortages. Hence, this study expects that firms with lines of credit will exhibit differential investment-cash flow sensitivity in the two economic conditions, with greater sensitivity during the declining conditions period. The fourth hypothesis of this study states: Economies 2022,10, 288 7 of 15 H4. Firms reliant on bank debt (firms with lines of credit) have larger investment-cash flow sensitivities in episodes of declining economic conditions. 3.2. Model, Variables and Empirical Procedure This study employs the framework of Tobin’s (1969)qwhere firm investment is a function of forward-expected profits expressed in terms of market valuation. Stock prices serve as a useful signal that aids insiders in mobilizing capital toward the most valueadding investment opportunities (Dessaint et al. 2019;Edmans et al. 2017). Under this theory, qis defined as the marginal increase in market value due to the increase of one unit of capital. However, since marginal qis not observed, Hayashi (1982) shows that under certain assumptions average Q can be used as a proxy of marginal q, where average Q is the current market value of the firm divided by the replacement cost of the firm’s capital. However, the empirical evidence shows that Q alone fails to fully explain the behaviour of a firm’s investment. One main shortcoming of the classical Tobin’s qand its average Q extension theory of investment is that it assumes perfect capital markets where firms have ready and costless access to external financing and therefore finance is irrelevant to firm investment decisions. Fazzari et al. (1988) build on the work of Myers and Majluf (1984) and show that once market frictions are introduced, external financing becomes costlier than internal financing, resulting in firms passing up profitable investment opportunities that are becoming unprofitable due to those frictions. Therefore, they suggest that the investment model should contain internally generated funds expressed in terms of firm cash flow, as a firm investment is expected to be sensitive to those funds, especially if firms face financial constraints. Therefore, this study includes firms’ cash flows to capture firms’ reliance on internal funds (Fazzari et al. 1988;Hoshi et al. 1991). In addition, empirical studies document evidence that a firm’s financial leverage determines in part its investment through the channel of underinvestment problem (Bikas and Glinskyt ˙ e 2021;Chiu et al. 2022;Lewellen and Lewellen 2016). The model also includes a cash ratio, as previous evidence indicates that liquidity affects investment positively (Bucăand Vermeulen 2017; Campello et al. 2010,2011). Finally, the model includes an indicator variable to capture the impact of the deteriorating economic conditions (Guizani and Ajmi 2020). The final model of this study is specified as follows: Iit/Kit−1=β1Qit +β2CashFlowit +β3DebtRatioit−1+β4CashRatioit−1+β52008-Indicator +εit (1) where (I/K) is firm investment and is measured by the change in net fixed assets plus depreciation divided by the beginning period total capital. Since the focus of this study is on firm capital expenditures, the variable (I/K) is coded zero in case the change in net fixed assets is nonpositive. Qis the average Qand is measured by the market to book value (MBV) which is the sum of the market value of a firm’s equity and the book value of its liabilities divided by the book value of a firm’s assets. CashFlow is defined as earnings before interest, taxes and depreciation divided by total assets to capture credit constraints faced by firms. DebtRatio is equal to total debt over total assets and CashRatio is equal to cash over total assets. 2008-Indicator is an indicator variable that equals one if the year is post-2008 and zero otherwise. To test H1, the study estimates Equation (1) and expects β 5 to be negative and significant. To test H2, the study estimates two specifications for the pre- and post-2008 periods (without including the 2008-Indicator) and expects β2 to be larger in the post-2008 period. In addition, the study adds an interaction term as specified in Equation (2) and expects λ to be positive and significant: Iit/Kit−1=β1Qit +β2CashFlowit +β3DebtRatioit−1+β4CashRatioit−1+β52008-Indicator +λ2008-Indicator ×CashFlowit +εit (2) Compared to estimating separate regressions for each sub-sample, the use of an interaction term has the added advantage of computing a significance level for the interaction term coefficient. To test H3, the sample is subdivided into two groups based on a priori Economies 2022,10, 288 8 of 15 considerations, then the regressions are estimated separately for each group and the signs and sizes of the coefficients of the cash flow variable across the predetermined groups are compared (Ek and Wu 2018;Lewellen and Lewellen 2016). The a priori consideration of this study is access to lines of credit. In addition, the estimation includes an indicator variable, LineCredit, which takes the value of one if the firm has access to a line of credit and zero otherwise and it interacts this indicator variable with CashFlow as specified in Equation (3) and expects δto be negative and significant: Iit/Kit−1=β1Qit +β2CashFlowit +β3DebtRatioit−1+β4CashRatioit−1+β6LineCreditit + δLineCreditit×CashFlowit +εit (3) Finally, to test H4, the study estimates Equation (2) separately for the sample of firms with and without lines of credit and expects λto be positive and significant only for firms with lines of credit. 3.3. Estimation Methods Previous studies, such as Lewellen and Lewellen (2016) and Chiu et al. (2022), have employed OLS to estimate the investment equation. However, this study employs panel data; hence, there are firm-specific characteristics that are invariant over time which may not be captured by other independent variables. Therefore, this study follows Zubair et al. (2020) and applies the fixed effects model to eliminate the firm-specific effect across firms with regard to investment expenditures, which reduces the omitted variable bias. For robustness, the estimation corrects standard errors for heteroscedasticity using robust standard errors and clusters them by firm. Also, the specification uses one period lag for balance-sheet control variables, since an investment decision at time tis likely to be influenced by information available at the beginning of the period of balance sheet accounts (Ek and Wu 2018; Lewellen and Lewellen 2016). Using lagged explanatory variables has the added benefit of alleviating endogeneity. 4. Sample, Data and Summary Statistics This study utilizes firm-level data of industrial companies listed on the ASE during the period 2002–2019. Financial firms are excluded from the sample because the nature of their investments is different from nonfinancial firms. Furthermore, service companies are excluded because they rely heavily on labour and have small incremental changes in their fixed assets base. Financial data used in this study is collected from the annual Companies Guide published by the ASE. The required data on lines of credit used is hand-collected from firms’ annual reports. The final sample is unbalanced and consists of 1116 firm-year observations representing 81 firms. Table 1shows summary statistics for the sample used in the study. The median firm invests no more than 1.5% while an average firm makes new investments to total assets equal to 4%. The minimum value of the firm investment is zero, indicating that those firms do not have capital expenditures. The average firm has a mean MBV equal to 1.47, cash flow to total assets of 5.3%, debt to total assets of 15% and cash to total assets of 7.3%. Table 2shows the characteristics of sample firms categorized based on: (i) period, and (ii) access to a line of credit. 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