Profitability, Leverage and Competition : How Did Norwegian Firms React to China's Exports Shocks?

For Fama and French (2002), the established evidence of negative profitability-leverage relation contradicts Trade-Off Theory (TOT). I test TOT under its static and dynamic versions using exogenous expected profitability. Using the “double instrumental variable” approach, the first stage predicts the exogenous competition from China where the instrument is the Chinese exports towards rich countries; the second stage predicts the decrease of Norwegian firms' profitability that is explained by the increases of exogenous competition from China; the third stage investigates how leverage reacts to the predicted profitability. Concerning the tests of the static TOT, I find that profitability decreases leverage, assets and retained earnings, while debt remains stable. Moreover, tests of the dynamic TOT illustrate a negative profitability-leverage relation at non-refinancing points, which corroborates the dynamic TOT. I also find, at refinancing points, insignificant profitability-leverage relation, which does not corroborate the dynamic TOT