**1. Introduction**

To compete effectively, a country's enterprises must continuously innovate their competitive advantages [1]. Innovation comes from sustained investment in physical as well as intangible assets [2,3]. China has the largest number of state-owned enterprises (SOEs) in the world, which have played a pivotal role in the economy, though the innovation profile of these firms is as appealing as their corporate governance. On the one hand, many high-tech entities in China are created and managed in the form of SOEs. On the other hand, previous studies show that the expenditure and performance of R&D in SOEs remain significantly lower than that in non-SOEs [4]. It is generally acknowledged that under state dominance, the control rights rest with bureaucrats who have only an indirect interest in profit, which leads to inefficiencies [5]. Latter theoretical work by Huang and Xu (1999) and Zhang et al. (2003) also show that the state sector has significantly lower R&D efficiency than the non-state sector, which may be attributed to their differences in ownership structure and associated agency problems [6,7]. Similarly, Le and O'Brien (2010) found that SOEs were inefficient in R&D activities because of the conflict of interest between shareholders and governments, with a higher likelihood for the latter to pursue social objectives and political objectives rather than profit maximization [8]. If this is the case, we can reasonably expect a decrease in R&D expenditure or efficiency with the increase in state ownership of firms. However, there exists evidence showing that the introduction of state-owned shareholders to financing-constrained non-SOEs also helps increase their R&D expenditure [9,10]. Regarding the financing constraints, state-owned

**Citation:** Meng, Q.; Liu, Y.; Li, W.; Yu, M. Bonding or Indulgence? The Role of Overborrowing on Firms' Innovation: Evidence from China. *Sustainability* **2023**, *15*, 1079. https://doi.org/10.3390/su15021079

Academic Editor: Akrum Helfaya

Received: 20 November 2022 Revised: 29 December 2022 Accepted: 3 January 2023 Published: 6 January 2023

**Copyright:** © 2023 by the authors. 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/).

shareholders not only contribute to expanding the equity capital but also facilitate firms' access to finance, which is called the certification effect.

A consensus has yet to be reached on the way to finance corporate innovation efficiently in transition economies, which is very different from motivating routine tasks [11]. Although direct financing has been verified to have significant positive impacts on a firm's innovation [12], firms' proportion of direct financing in China is still lower than in many emerging markets. Indeed, debt financing, especially bank loans, is still the manifest financing source of SOEs, even if most have already been significantly deleveraged. While there is some empirical evidence regarding the relationship between bank loans and firm innovation, they produce mixed results. Some studies have shown that bank loans can theoretically bring tax benefits [13,14], thereby encouraging firms to increase R&D expenditure. However, the Chinese banking sector features poor corporate governance and government-oriented financial allocation, under which the government tends to transfer funds from productive sectors and regions to less productive sectors and regions [15,16]. In addition, in the process of promoting economic transition, the government could legally exert their formal shareholder's rights or supervision authority on local banks to intervene in their decision of loan granting.

Some observers argue that capital misallocation or financing frictions would worsen a firm's productivity and innovation [17,18]. Scholars including Huang and Xu (1999), Demetriades and Fattouh (2006), and Mian et al. (2017) have analyzed the negative effect of debt overhang to investment [6,19,20], whereas the relationship between firm-level overborrowing and innovation has not been investigated in detail. Previous studies on state ownership have paid much attention to various external governance determinants on firms' economic performance, such as market structure [21], soft budgets [22], or credit discrimination [23]; however, there is an ongoing debate and a lack of convincing evidence regarding whether and how banks' credit discrimination is driven by state ownership and its exact negative effect on firms' R&D expenditure, and to the best of our knowledge, there has to date been no empirical investigation of it in emerging economies in general, and in China in particular where the institutional environment is significantly different.

In this context, we shall refer to the measurement of overinvestment [24,25] to capture a firm's overborrowing as the statistical discrepancy between the actual bank loan the firm obtains and the forecasted value the firm demands from an econometric model. Focusing on the interplay of internal and external governance, we analyze the firm-level conditions through which overborrowing would manifest its negative impact, shedding light on potential ways to reduce the adverse impact of overborrowing and facilitate the innovation capability of SOEs. What makes our study more interesting is that a significant variation of governance profile exists between different-level SOEs in China [26]. Even if under the control of the same governmental agency, different management mechanisms in SOEs of different administrative levels matters in China. Therefore, China's unique institutional settings provide a good opportunity to test whether the overborrowing associated with state ownership would polarize the innovation ability of SOEs.

The remainder of this study is organized as follows. In the second section, we provide an overview of the relevant literature on banks' monitoring and corporate innovation and present the research hypotheses. The next section outlines our samples, measures, and analytical techniques. Section four further discusses the empirical results and provides further analysis of the moderating effect of a firm's political connection level and top managers' R&D functional experience, while section five concludes this study.

#### **2. Theory and Hypotheses**

*2.1. Overborrowing and Firms' Innovation Behaviour: Bonding or Indulgence?*

The development of the banking system benefits corporate governance and innovation [27,28]. From the perspective of agency, bank debt is generally acknowledged to be an alternative governance mechanism for firms [29–34]. In the general context of corporate governance, the monitoring for corporate governance provided by banks helps alleviate the

agency costs of asset substitution or underinvestment in the focal firms [35,36]. Specifically, the cash disbursement of debt would limit the manager's discretionary cash flow and inappropriate decisions about capital expenditure [30]. Therefore, Grossman and Hart (1982) described the issuing of risky debt by the entrepreneur or manager as a means of "bonding" his or her behavior [29]. Regarding R&D activities with high technology risks and information asymmetry, the monitoring benefits are more likely to exceed the cost of the debt itself, which will facilitate promoting firms' innovation [37]. Bank loans thus can be viewed as "insider" debt—that is, compared with bonds and equity, bank loans provide inside information about the firms [38,39]. Along this line of thinking, Friend and Lang (1988) found that debt financing decisions were consistent with the decline of focal firms' agency costs [40]. In addition, the threat of bankruptcy and compulsory interest payment obligations based on debt covenants would help jointly activate a firm's innovation behavior [41]. Shahzad et al. (2021) found evidence of an inverted U-shaped relationship between debt financing and corporate innovation, which implies that firms undertake external debts at the start and decline their debt financing in the long run [42].

While banks may possess capacities to control agency conflicts within the focal firms, they are subject to an agency dilemma themselves. Thus, the delegated monitoring of banks is a double-agency problem in itself [43]. One agency problem of the banks' administrativeeconomic governance lies in the administrative appointment of its top managers [44]. Government owners can send bureaucrats to banks as top managers or directors through which government policies about firms are executed. With the nature of "quasi-bureaucrats", these top managers of state-owned banks are usually restricted in executive compensation and more inclined to pursue political promotion [45,46]. More generally, the relationship between the government and banks can lead to harmful dependencies and interactions. In particular, there is the danger of regulatory capture [47]. Research on bank loan granting decision also proves that state-owned banks not only charge lower interest rates than privately owned banks, but also inflate credit in the political election cycle [48]. Allen et al. (2005) and Fan et al. (2008) have reported evidence on the rent-seeking hypothesis in emerging markets [16,49]. As a result, the incentives and intervention effects of administrative governance would accrue excess debt in focal firms.

Another agency dilemma exists when state-owned banks' monitoring is not transparent to outside investors. Governmental owned banks are usually accountable only to the government, and the disclosure requirements are minimal. As a result, the moral hazard in focal firms will arise. With a long duration of technological innovation and high risks, top managers in focal firms are generally reluctant to take risks in long-term R&D projects, because such investment often means a higher failure rate and occupational risks [50,51]. To protect themselves against such "expropriation", top managers tend to invest less in innovative projects that are difficult for outside investors to understand, and more in routine projects with quicker and more certain returns [52]. Empirical evidence also verifies that SOEs tend to have easier access to bank credit funds in a state-controlled banking system [53]. Overborrowing, as one form of resources redundancy which defends top managers of SOEs from competition in the market, would in turn urge them to give up valuable R&D investment opportunities and choose a relatively "safe" policy [54]. Given the higher agency costs associated with overborrowing, SOEs are not likely to devote a large amount of capital to R&D projects. Thus, we hypothesize the following:

**H1:** *SOEs are more inclined to a higher level of overborrowing, which leads to decrease in firms' R&D spending*.
