Banks and Bank Systems, Volume 10, Issue 2, 2015 60 Hai-Chin Yu (Taiwan), Dung Phuong Tong (Taiwan) Banking relationships, R&D investment, and growth opportunities in China Abstract This study investigates whether the relationships with banks moderate the relationship of innovation investment and firm growth. Using panel data of Chinese-listed firms from 1999 to 2008, this study examines the effect of banking relationships on innovation investment and the influence of such investment on firm growth opportunities. After em- ploying a two-stage least squares simultaneous equation model, find a non-linear relationship between banking rela- tionships and innovation investment, which in turn has a positive and significant effect on firm growth opportunities. Results suggest that maintaining relationships with one or two banks is optimal for firms to maximize their innovation capacity and achieve significant growth. When firms borrow from five banks or more, their innovation investment starts to decline. Our findings provide evidence in support of the relationships with banks affect innovative investment and facilitate firm growth opportunities. Keywords: R&D, innovation, banking relationships, growth opportunity. JEL Classification: G32, L33, O31, O43. Introduction ､ Innovation has been viewed as one of the key fac- tors for firms to keep sustainable growth, profits, and survival. Innovation can be new products, processes, or markets to meet customers’ new needs (Brouwer, 1991). Prior studies indicated that innovation is the core factor behind the intensification of firm growth and the relationship between innovation and firm growth have been investigated over the past decades. Schum- peter (1934) claimed that innovation positively affects firm profitability. This view has been considered true for the last few decades. Sirelli (2000) suggested that firms are encouraged to innovate because doing so leads to higher growth rates. Klette and Griliches (2000) presented the model of endogenous firm growth with innovation as an engine of growth. Bottazzi et al. (2001) analyzed the world’s largest pharmaceutical companies and provided evidence that innovative chemical entity or patent products have a significant effect on firm growth. The present work attempts to fill the gap in the literature on the relationship between innovation and firm growth in the context of China. China is a typical example of an economy that has undergone considerable growth. Since the mid- 1990s, the Chinese government has nurtured tech- nology-based industries and encouraged firms to innovate products and processes. Wu (2011) ex- plored the force behind China’s economic growth using provincial statistics and found innovation as the decisive factor for China’s rapid economic growth. ､ Hai-Chin Yu, Dung Phuong Tong, 2015. Hai-Chin Yu, Professor, Department of International Business, Chung Yuan Christian University, Chung-Li, 32023, Taiwan. Dung Phuong Tong, Ph.D. Candidate, College of Business, Chung Yuan Christian University, Chung-Li, 32023,Taiwan. However, innovation investment is uncertain and involves greater asymmetric information than phy- sical investments. These features hinder investors from easily measuring the effect of innovation on firm growth. Despite the mixed empirical results, the topic still draws the interest of researchers. Chan et al. (1990) and Zantout and Tsetsekos (1994) identified a positive (negative) market response to innovation among firms in high-tech (low-tech) industries. Acs and Isberg (1996) indicated that the effect of innovation on Tobin’s Q varied with firm size. Many researchers suggested a significant rela- tionship between innovation and firm growth 1 . By contrast, Link (1981) and Sassenou (1988) claimed that innovation has a limited or even a negative effect on corporate performance. Due to innovation is the core of firm growth, many scholars have been exploring the financing of inno- vation. Innovation entails high-risk and uncertainty that internal sources such as free cash flow are not favorable because of the agency problem. Share- holders prefer to stable dividends instead of uncer- tain investments. Equity is also an obstacle for fi- nancing innovation because of the costly process and the possible dilution of ownership. Therefore, firms may need external funding from private len- ders such as banks to finance their innovation. Bila- teral contracts between banks and firms require firms to attach the details of their innovation in- vestments. In this case, banks, as insiders, may re- duce the asymmetric information on the firms. The banking relationships are obviously crucial for the innovation capability of firms. Our issue is whether endogenous innovation via banking relationships indirectly influences firm growth. 1 See, for example, Nelson and Winter (1982), Aghion and Howitt (1992), Klette and Griliches (2000), and Klette and Kortum (2004).