Institutions, Financial Development, and Corporate Investment: Toward an Implied Cost of Capital in China’s Emerging Financial Market∗

This study examines the corporate investment behavior during China’s reform era. We apply the Generalized Method of Moments (GMM) estimation to the investment Euler equation models that characterize the Chinese firms’ investment decisions. Based on the estimated structural parameters, we derive the effective discount rate (“implied” cost of capital) perceived by the firm managers to decide investment spending. The derived “implied” cost of capital is the managers’ equilibrium required rate of return, hence measures investment efficiency well. We apply this empirical approach to a panel of 12,607 industrial firms in China and find: (1) all else equal, the “implied” costs of capital derived from the corporate investment data for private firms, Hong Kong and Taiwan invested firm, foreign firms, mixed-ownership firms, and collective firms are respectively 18.9%, 18.2%, 19.8%, 13.7%, and 11.9% higher than that of state owned enterprises; and (2) regions with better institutions and a market-prone financial system have more efficient private sector relative to the public sector. Our estimates show that redirecting the capital from less efficient public sector to more efficient private sector can unleash a 4.5% GDP growth in China every year, and the welfare loss due to capital mis-allocation is about 8% of China’s GDP. JEL Classification: G31, G32, D23, O16, and P23