This study investigates the role of financial development in shaping the relationship between FDI and firm innovation, based on Chinese firm-level dataset during 2008-2014. Our findings reveal that bank deregulation significantly enhances the positive effect of FDI on firm innovation. We also find that firms with greater financial constraints and those located in cities with lower levels of bank competition exhibit a more pronounced response. These results underscore the importance of considering financial market conditions and highlight the role of financial constraints and bank competition as crucial channels through which bank deregulation influences the effect of FDI on firm innovation.

Can bank competition help attenuate the prevalence of zombie firms? Motivated by a stylized model, this paper studies the effect of bank competition on the formation of zombie firms in two stages: the formation of distressed firms and distressed firms obtaining zombie lending. Using China’s 2009 bank entry deregulation as a quasi-natural experiment, the paper finds that bank competition lowers the probability of the formation of distressed firms, while it increases the probability of distressed firms obtaining zombie lending. Overall, bank competition decreases the formation of zombie firms. In addition, the findings show that a higher ex ante proportion of bad loans and higher probability of bad loan recovery will lead to a higher probability of distressed firms receiving zombie lending. Both factors encourage banks to sustain lending to distressed firms to keep them alive and to gamble that those firms may recover in the future.