The Effect of Corporate Leverage Regulation on Innovation: Evidence From a Quasi‐Natural Experiment in China

ABSTRACT This study examines the impact of Corporate Leverage Regulation (CLR) on corporate innovation. Innovation is key to firm performance and sustainable competitiveness, which may be affected by a firm's financial risk, and deleveraging is an essential measure to mitigate corporate financial risk. Taking advantage of the quasi‐natural experiment of CLR in China, which requires over‐indebted state‐owned companies to reduce their debt ratio, we examine the effects of the reduction in financial leverage on corporate innovation. We find that firms are more likely to enhance their innovation efficiency after CLR, which has a significant increase in corporate innovation outputs, while no significant increase in innovation inputs, and this increase is more pronounced for firms with a higher proportion of institutional investors, a lower degree of digital transformation, and less media attention. These findings suggest that appropriate government guidance and intervention to reduce excessive financial leverage risk is helpful for corporations to maintain sustainable growth and stay competitive in their industry. We also document that managerial myopia reduction, resource allocation efficiency improvement, and accounting information quality enhancement are the channels through which CLR affects firm innovation. Furthermore, we find that CLR significantly increases the value of firms. Taken together, our results suggest that a decrease in leverage has a causal effect on firms' innovation efficiency.