Firm value adjustment speed through financial friction in the presence of earnings management and productivity growth: evidence from emerging economies

The paper examines how different levels of financial frictions—macroeconomic (MAF), microeconomic (MIF), and financial market frictions (FMF)—affect firm value (FV) in emerging Asian economies, and how firms’ internal strategies—earnings management (EM) and productivity growth (PG)—alter these effects. Financial frictions arise from transaction, monitoring, policy, and market costs and constraints at macro, micro, and market levels, producing latent influences on firms. Prior literature has largely evaluated macro-level effects or assumed frictionless Modigliani–Miller settings, leaving a gap on how multi-level frictions transmit to firm-level valuation, particularly via EM and PG. Grounded in agency theory, the study extends the principal–agent framework beyond firm boundaries to include governments, market intermediaries, and counterparties as principals imposing agency-type costs (e.g., taxes, prudential policy, collateral, brokerage/flotation costs). EM is proposed as a legal, internal mechanism that can mitigate frictional impacts, potentially varying with the business cycle (countercyclical or procyclical). Signaling theory motivates PG as a positive signal that can attenuate the adverse effects of frictions and strengthen the EM–FV link. The study focuses on non-financial firms in emerging Asia (China, India, Pakistan, Bangladesh, Sri Lanka), where market imperfections and growth potential are pronounced, to address the research question: What are the short-run and long-run (adjustment) effects of MAF, MIF, and FMF on FV, and to what extent does EM mediate and PG moderate these effects?

The literature traces financial frictions to transaction, monitoring, policy, and information costs and constraints across macro, micro, and market levels (Cooley & Quadrini, 2001; Cesa-Bianchi & Rebucci, 2017; DeGennaro & Robotti, 2007). Macroprudential and monetary policies, taxes, oil prices, and other policy variables generate MAF; collateral, liquidity constraints, and trade costs drive MIF; and information asymmetry, flotation and brokerage fees, and market inefficiencies drive FMF (Stiglitz & Weiss, 1981; Quadrini, 2011). Frictions propagate through firms and markets, affecting investment, leverage, and output (Khan & Thomas, 2013; Spaliara, 2011). Existing studies largely emphasize macro outcomes (e.g., business cycles) rather than firm value and often conflate risks and frictions. The authors distinguish frictions (predetermined costs) from risks (unforeseeable shocks). Earnings management can be countercyclical (used more in downturns) or procyclical (used more in booms) and may cushion frictional shocks (Cohen & Zarowin, 2007; Al Hussaini, 2018). Productivity growth, through technology, labor, and capital deepening, can mitigate the adverse effects of frictions and support valuation via signaling (Impullitti, 2022; Levine & Warusawitharana, 2021). The study formulates and tests these hypotheses: - H1: Financial frictions significantly associate with firm value. - H1a: MAF significantly impacts FV. - H1b: MIF significantly impacts FV. - H2: FMF significantly impacts FV. - H2 (mediation): EM mediates the FF–FV relationship. - H3: PG moderates the relationship between FF and EM (H3), between EM and FV (H3a), and the indirect FF→EM→FV path (H3b). The authors highlight gaps in integrating EM and PG into firm-level valuation under multi-level frictions in emerging Asian contexts and posit moderated mediation as the appropriate framework.

Design: Panel moderated mediation with autoregressive dynamics and partial adjustment. The study estimates both short-run (immediate) and long-run (adjustment) effects of financial frictions on firm value via EM, moderated by PG. Sample: 735 listed non-financial (primarily manufacturing) firms from emerging Asia: China (n=310), India (n=200), Pakistan (n=100), Bangladesh (n=50), Sri Lanka (n=75). Annual data from 2005–2019. Post-2019 excluded due to COVID disruptions. Firm data from Refinitiv DataStream; macro/micro/market indicators from World Bank/IMF; cross-checked with company and regulatory sources. Selection: actively listed throughout the period; highest market capitalization. Measures (see Table 1 references): - MAF: Total Debt / Total Assets (loan-to-asset ratio) as proxy for macro friction linked to external funding/interest-rate conditions. - MIF: (Trade credits + Accounts payable + Short-term borrowings) / Total Debt. - FMF: Interbank rate – Treasury bond rate. - FV: Tobin’s Q. - EM: Discretionary accruals per Kothari et al. (2005). - PG: Sales growth (% change in sales). Controls: SIZE (ln total assets), OCF (operating cash flow / total assets), LEV (Total Debt / Equity). Modeling: - Moderated mediation (Hayes PROCESS framework, Model 59; Preacher & Hayes, 2004; Hayes, 2015) with panel estimators. Model 1 (EM equation): EM on MAF, MIF, FMF, PG and their interactions with PG. Model 2 (FV equation): FV on MAF, MIF, FMF, EM, EM×PG, PG, FF×PG interactions, and controls (SIZE, OCF, LEV). Bootstrap percentile CIs used for indirect effects without normality assumptions. - Partial adjustment model to capture long-run adjustment: scaling coefficients by adjustment factor λ to estimate long-run effects in EM and FV equations, recognizing lagged adjustment of firm value. Estimation and diagnostics: Panel data methods with fixed/random effects selection (Hausman). Cross-sectional dependence (Pesaran), serial correlation (Wooldridge), heteroskedasticity and joint significance (Wald). Country-wise estimations reported for short run (Table 3) and long run (Table 4). Conditional direct and indirect effects with bootstrap CIs (Tables 5–6).

- Financial frictions lower firm value. Across countries, coefficients on MAF, MIF, and especially FMF are predominantly negative and significant for FV in the short run (Table 3) and remain adverse though attenuated in the long run (Table 4). - Financial market frictions (FMF) have the strongest negative impact on firm value among the three friction types. Examples (short-run coefficients, Model 2): Pakistan FMF ≈ −3.7432; Bangladesh FMF ≈ −0.1466; India FMF ≈ −0.0556; China FMF ≈ −0.0190; Sri Lanka FMF ≈ −0.0297. In the long run, magnitudes decrease (e.g., Pakistan FMF ≈ −2.9381; Bangladesh ≈ −0.0210; India ≈ −0.0080; China ≈ −0.0173; Sri Lanka ≈ −0.0215). - Earnings management (EM) mediates the FF → FV relationship and mitigates frictions’ adverse effects. Inclusion of EM reduces the absolute magnitude of FF coefficients on FV. Reported FMF coefficient reductions after EM mediation: China 23.64%, India 20.69%, Pakistan 30.43%, Bangladesh 56.75%, Sri Lanka 47.22%. - Productivity growth (PG) moderates both direct and indirect paths, generally weakening the negative effects of FF and strengthening the EM → FV link. PG main effects on FV are positive, with larger effects in Bangladesh and Sri Lanka in short run; interaction terms (FF×PG and EM×PG) often significant with signs indicating mitigation of frictions. - Conditional direct and indirect effects (bootstrap) corroborate significance in most cases (Table 5). Notable short-run conditional direct effects (DE): FMF largest in Pakistan (≈ −0.9493), then India and China; MIF exhibits the lowest DE/IE magnitudes consistently. Long-run conditional DE/IE magnitudes are smaller than short-run (Table 6), indicating normalization over time. - Adjustment dynamics: Short-run estimates tend to overstate frictions’ effects; long-run partial adjustment models show stabilized (smaller absolute) coefficients. Conversely, moderated mediation (EM and PG effects) strengthens over the long run. - Firm characteristics: SIZE and OCF generally positively associated with FV; LEV tends to negatively associate with FV. Larger firms exhibit higher firm value than smaller ones. - Country heterogeneity: Pakistan shows the highest FMF-related adverse impacts; MIF effects are the weakest across countries. China and India display strong positive size effects on FV. - Robustness: Hausman tests generally favor fixed effects (except some Pakistan cases); Pesaran indicates cross-sectional dependence; Wooldridge shows limited autocorrelation (mainly Bangladesh and addressed via lags); Wald tests support joint significance and indicate no problematic heteroskedasticity.

The findings support an agency-theoretic view that multi-level financial frictions act as agency-type costs depressing firm value. EM serves as a mediating internal mechanism that partially offsets frictions—consistent with countercyclical EM arguments where managers smooth earnings to stabilize perceptions during adverse conditions. PG functions as a signaling mechanism of firm strength and operational efficiency, moderating the negative effects of frictions and amplifying the EM–FV pathway. The stronger adverse role of FMF relative to MAF and MIF highlights the centrality of market-level informational and transactional constraints for valuation in emerging markets. Adjustment analysis reveals that while short-run impacts of frictions are pronounced—possibly reflecting immediate market overreactions and liquidity constraints—firms adapt over time, and the mitigating roles of EM and PG become more salient in the long run. H1–H2 are supported (significant frictions–value links, with FMF most impactful). The moderated mediation hypotheses (H3/H3a/H3b) are supported by significant interaction terms and conditional indirect effects. Managerially, enhancing PG (through technology, process innovation, and capacity expansion) and disciplined, accrual-based EM can buffer frictional costs, particularly where market frictions are acute. Policymakers should recognize FMF’s outsized role and improve market transparency and transaction efficiency while calibrating macroprudential tools to avoid excessive frictions.

The study shows that financial frictions at macro, micro, and especially financial market levels significantly depress firm value in emerging Asian economies. Accrual-based earnings management mediates and reduces these negative effects, and productivity growth further moderates and strengthens the mediation, improving firm value. Short-run effects of frictions are overestimated relative to long-run, where impacts normalize; meanwhile, the influence of EM and PG grows over time. The work advances firm valuation research by integrating multi-level frictions with moderated mediation dynamics and adjustment speeds, offering a more realistic framework than frictionless paradigms. Practical implications include prioritizing PG initiatives (technology, innovation, labor/capital investments) and prudent EM to counter frictions; policy implications include reducing FMF via better market infrastructure and balanced macroprudential policy. Future research should broaden friction constructs (e.g., international, labor, and channel frictions), extend to other sectors (services, finance, public), and embed the framework into macro models (e.g., New Keynesian).

- Friction measures are limited in scope: macro frictions proxied by loan-to-asset (debt-to-assets) ratios; micro frictions focused on trade credit and short-term financing; other dimensions (e.g., oil price shocks, exchange rate risks) not modeled directly. - Geographic scope limited to emerging economies in South Asia (China, India, Pakistan, Bangladesh, Sri Lanka), which may constrain generalizability; inclusion of other regions could yield broader insights. - Sample restricted to non-financial (primarily manufacturing) listed firms with highest market capitalization; may not represent smaller/private firms or service sectors. - Time window ends in 2019 (excludes COVID-19 period), potentially omitting recent structural changes. - Use of proxies (e.g., FMF as interbank–treasury spread; PG as sales growth; EM via discretionary accruals) entails measurement error risks despite literature support.