Hold-up Problem with the Government: Evidence from China

Abstract

This paper studies the hold-up problem with the government, namely that the government may be provided an opportunity to expropriate firm investment in an incomplete contract. We employ the enactment of the 2007 Property Law in China as a natural experiment to empirically test the effect of the hold-up problem. We document that firm investments increase 12% on average after the Law enactment, and this effect tends to be stronger for private enterprises. We then provide evidence from four perspectives suggesting that mitigating the risks of being held up by the government may encourage firm investment. We show that in the post-enactment period firms become less likely to withhold their investments during local government official rotations. We also find a larger post-enactment increase in investments for firms headquartered in regions with more local government fiscal pressure, more corruption, and worse government-business relations which may indicate a higher prevalence of the hold-up problem. Our findings hold for a group of robustness checks and are valid after taking account of alternative explanations.