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

55 Pages Posted: 27 Feb 2007

See all articles by Qiao Liu

Qiao Liu

The University of Hong Kong - School of Economics and Finance; Peking University - Guanghua School of Management

Alan Siu

The University of Hong Kong - School of Economics and Finance

Date Written: December 25, 2006

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 Classification: G3, D21, O16

Suggested Citation

Liu, Qiao and Siu, Alan K. F., Institutions, Financial Development, and Corporate Investment: Evidence from an Implied Return on Capital in China (December 25, 2006). Available at SSRN: https://ssrn.com/abstract=965631 or http://dx.doi.org/10.2139/ssrn.965631

Qiao Liu (Contact Author)

The University of Hong Kong - School of Economics and Finance ( email )

School of Economics and Finance
Pokfulam
Hong Kong
Hong Kong
852-2859-1059 (Phone)
852-2548-1152 (Fax)

Peking University - Guanghua School of Management ( email )

Peking University
Beijing, Beijing 100871
China

Alan K. F. Siu

The University of Hong Kong - School of Economics and Finance ( email )

8th Floor Kennedy Town Centre
23 Belcher's Street
Kennedy Town
Hong Kong
+852 2859 2192 (Phone)
+852 2548 1152 (Fax)

HOME PAGE: http://www.econ.hku.hk/~asiu

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