How does policy uncertainty affect corporate diversification?

Abstract

The research aims to investigate the linkage between corporate diversification and economic policy uncertainty (EPU) in China. We find that there is a positive association between economic policy uncertainty and corporate diversification, meaning that high economic policy uncertainty will lead to an increase of diversification for firms. This is consistent with the hypothesis that diversification is encouraged so that risk will be reduced when uncertainty increases. Our empirical results also show that the positive impact of EPU is significant for large-cap and medium cap firms, but not for small-cap ones. The findings also reveal that high EPU is associated with higher diversification, and the effect of EPU on diversification of SOEs is greater than that on non-SOEs’ diversification. Our results are robust through different measures of economic policy uncertainty and corporate diversification and remain significantly unchanged when dealing with endogeneity problems. Further, regarding information asymmetry, diversification of the firms with a high number of analyst followers and equity reports will increase during high economic policy uncertainty. Our findings suggest that diversification plays an active role in mitigating economic-policy related risks, thus enhancing firm performance. The paper provides new insights into the relationship between economic policy uncertainty and diversification at firm level.