Institutions, Financial Development, and Corporate Investment: Evidence from an Implied Return on Capital in China

Abstract:     
This paper presents a new approach to infer return on capital from firms' capital expenditures, and then examines how institutions and financial development affect this implied return on capital. We apply the Generalized Method of Moments (GMM) estimator derived from a structural investment model to a large sample of Chinese industrial firms in China. Based on the estimated structural parameters, we compute the stochastic discount rate perceived by the managers to decide investment spending. We identify robust evidence that this return on capital measure is a function of variables capturing institutions and financial development. The results from our benchmark estimation show that return on capital for a non-state firm is more than 10 percentage points higher than that of an otherwise similar state firm. We document evidence that regions with better institutions and a market-prone financial system have more efficient non-state sectors. Our estimates show that redirecting the capital from less efficient state sector to more efficient private sectors can unleash a 4.5% GDP growth in China every year, and the deadweight loss due to capital mis-allocation is about 8% of China's GDP.

Keywords: institutions and financial development, implied return on capital, investment Euler equation model, Chinese economy

JEL Classifications: G3, D21, O16

Working Paper Series