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

Prior research extensively discusses the significance of financial frictions at macro and micro levels, highlighting their multidimensional influence on firms and economies. Financial frictions are defined as costs incurred in financial transactions. These manifest in various forms: monitoring expenses (Akinci, 2021), taxes on borrowing and monetary policy interest rates (Cesa-Bianchi and Rebucci, 2017), global oil prices (Huntington, 2005), government policies (Akinci and Olmstead-Rumsey, 2018; Gomes, Jermann, and Schmid, 2016), liquidity requirements, bank securities, collaterals, and tight credit supply (Peia and Romelli, 2022), information asymmetries, market inefficiencies, and obstacles in capital markets (Quadrini, 2011), and agency problems, capital adjustment, labor, and operational costs (Khan and Thomas, 2013). While prior studies examine financial frictions' impact on macroeconomic indicators, this study addresses the gap by investigating their combined impact (macro, micro, and financial market-level) on firm value in emerging Asian economies. The classical Modigliani-Miller (MM) theory assumes perfect capital markets, neglecting frictions. This study investigates firm value dynamics under various friction levels, considering earnings management and productivity growth interactions and mediation. Agency theory underpins the study's examination of firm value, considering agency costs at macro, micro, and financial market levels. Firms use strategies like political connections, capital structure adjustments, cash holdings, and financial development to mitigate these frictions; however, internal strategies like earnings management and productivity growth are also crucial.

The concept of financial friction initially emerged as "international financial frictions" (Fujita et al., 1989), referring to limitations faced by firms in international operations. Studies show that macroeconomic shocks, especially monetary policy, affect firms' responses (Ottonello and Winberry, 2020), with firms having lower leverage being more responsive. The housing sector, in particular, is significantly affected by macroeconomic frictions due to macroprudential regulations (Akinci and Olmstead-Rumsey, 2018). At the microeconomic level, frictions arise from the interplay of risk-weighted capital requirements, interest rates, lending, and intermediate output (Grodecka and Finocchiaro, 2018; Covas and Driscoll, 2014; Chen and Columba, 2016). Financial market frictions stem from information asymmetry, market inefficiencies, and costs (Quadrini, 2011; Levin et al., 2004; Labadie, 1998), hindering efficient capital market functioning. Studies have connected financial frictions to various economic aspects; however, the relationship between financial frictions and firm value needs further clarification. Customer markets (Duca et al., 2017; Montero, 2017; Montero and Urtasun, 2021), business cycles (Li et al., 2020; Zhang, 2019), and firm value (Arellano et al., 2019; Bai et al., 2018; Hassan and Marimuthu, 2016; Desai and Dharmapala, 2009) have been considered in relation to financial frictions. However, the relationship between firm value and financial frictions in the context of earnings management and firm productivity growth remains largely unexplored. This study bridges this gap.

This study examines the causal relationship between financial frictions and firm value, with earnings management as a mediating variable and productivity growth as a moderating variable. Data were collected from 735 non-financial firms (primarily manufacturing) in China, India, Pakistan, Bangladesh, and Sri Lanka from 2005 to 2019. Macroeconomic friction is proxied by the total debt-to-total asset ratio, microeconomic friction by the sum of trade credits, accounts payables, and short-term borrowings to total debt, and financial market friction by the difference between the interbank rate and the treasury bond rate. Firm value is proxied by Tobin's Q, earnings management by discretionary accruals (Kothari et al., 2005), and productivity growth by sales growth. Control variables include firm size, operating cash flow, and financial leverage. A hierarchical linear moderated mediation model using autoregressive path analysis (Hayes, 2015) is employed, including models 1 and 2 to estimate the mediating impact of earnings management and the moderated mediation effect of productivity growth. A partial adjustment model (equations 3-6) is used to examine the short-term and long-term effects of financial frictions on firm value. Panel data models are used for estimation, with diagnostic tests (Hausman, Pesaran, Wooldridge, and Wald tests) assessing model efficiency.

Descriptive statistics reveal variability in macroeconomic and microeconomic frictions and firm size, with high skewness and kurtosis. Short-run analysis (Table 3) reveals significant negative relationships between financial frictions (MAF, MIF, FMF) and firm value. Financial market frictions (FMF) have the strongest negative impact across all countries. Productivity growth (PG) has a positive effect, mitigating the negative effects of financial frictions, especially for FMF. Earnings management (EM) mediates the relationship between financial frictions and firm value positively, reducing the negative impact of financial frictions on firm value. The long-run analysis (Table 4) using a partial adjustment model shows that the negative effects of financial frictions on firm value are reduced in the long run compared to the short run, suggesting short-run overestimation of these effects. Tables 5 and 6 show the conditional direct and indirect effects of financial frictions on firm value in the short and long run. Financial market frictions consistently demonstrate the most significant adverse impact. Productivity growth significantly moderates the relationship. Diagnostic tests (Table 7) support the validity and efficiency of the panel data models used.

The findings confirm a negative relationship between financial frictions and firm value, consistent with agency theory. Earnings management, used as a mediating factor, alleviates the negative impact of financial frictions, supporting the countercyclical earnings management theory. Productivity growth moderates this relationship, enhancing the mediating effect of earnings management and aligning with signaling theory. The observation of stronger negative effects of financial frictions in the short run compared to the long run suggests that firms can adapt and mitigate these effects over time. The significant role of financial market frictions highlights the importance of addressing information asymmetry and capital market inefficiencies in emerging economies. The finding of a positive relationship between firm size and firm value is consistent with previous literature.

This study contributes to the literature by examining the multifaceted impact of financial frictions on firm value in emerging economies, incorporating earnings management and productivity growth. Financial market frictions are identified as having the most significant impact, and earnings management serves as a crucial mediating factor. Productivity growth moderates this relationship. The study also highlights the short-term overestimation of financial frictions' negative effects. Future research could extend this study to other emerging markets, sectors, and macroeconomic frameworks and investigate other types of frictions.

The study focuses on specific emerging economies in South Asia and primarily manufacturing firms. The limited measures used for macroeconomic and microeconomic frictions might also limit the generalizability of findings. Future research should address these limitations by expanding the geographical scope, considering other sectors, and utilizing more comprehensive measures of financial frictions.