Investment Frictions and the Aggregate Output Loss in China
| Published date | 01 June 2015 |
| Author | Guiying Laura Wu |
| DOI | http://doi.org/10.1111/obes.12064 |
| Date | 01 June 2015 |
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©2014 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 77, 3 (2015) 0305–9049
doi: 10.1111/obes.12064
Investment Frictions and theAggregate Output Loss
in China*
Guiying Laura Wu†
†Division of Economics, Nanyang Technological University, 14 Nanyang Drive, 637332
Singapore (e-mail: guiying.wu@ntu.edu.sg)
Abstract
Investment frictions reduce, delay or protract investment expenditure that is necessary for
firms to capture growth opportunities. Using an investment model with capital adjustment
costs, this article estimates the gap between China’s actual and frictionless aggregate output.
It applies the method of simulated moments to a fully structural investment model on a
panel of Chinese firms and takes into account potential unobserved heterogeneities and
measurement error in the data. The estimated capital adjustment costs imply that if Chinese
firms had faced a lower levelof adjustment costs such as in the US, China’sagg regateoutput
would be 25% higher.
I. Introduction
Substantial economic transformation in China has brought strong growth opportunities
and a high return to capital (Song, Storesletten and Zilibotti, 2011). In a frictionless envi-
ronment, firms will optimally respond by increasing their investment expenditureinstanta-
neously and costlessly. However, as in many developing economies, the actual investment
behaviour in China might be subject to various frictions, which are caused by a poor
investment climate (World Bank, 2005).
Table 1 presents a list of selected indicators based on which the World Bank has
constructed the global and subnational Doing Business ranking as a measure of invest-
ment climate. Compared with its counterpart in the US, a typical Chinese firm has to
spend many more days and pay a much higher cost on starting a business, registering
property, getting credit and enforcing contract. Within China, western inland cities like
Guiyang and Lanzhou havemuch poorer indicators than Beijing and Shanghai. Such invest-
ment frictions may prevent the instantaneous and costless adjustment of capital stock and
potentially make the actual capital stock different from the frictionless benchmark. An
under accumulation of capital stock at the firm-level is then translated into a gap between
*I would liketo thank the editor and anonymous referees for their constructive suggestions; my former supervisors
Steve Bond and M˚ans S¨oderbom for their invaluable support and the economists at the Enterprise Analysis Unit of
the WorldBank for providing the data and explaining the survey. Financialsuppor t from the NewSilk Road research
grant at Nanyang Technological University is gratefully acknowledged.
JEL Classification numbers: C15, D92, E22.
438 Bulletin
TABLE 1
Selected indicators for the Doing Business ranking
US China
National Beijing/Shanghai Guiyang/Lanzhou
Starting a business
Days to open a business (days) 5 35 37/35 50/47
Cost to open a business (% of income
per capita)
0.7 9.3 3.2/3.1 26.6/14.1
Registering property
Days to register property (days) 12 32 59/29 77/78
Cost to register property (% of property
value)
0.5 3.1 3.1/3.6 12.6/7.8
Getting credit
Strength of legal rights index (0–10) 7 2 n.a. n.a.
Depth of credit information index (0–6) 6 4 n.a. n.a.
Days to create and register collateral
(days)
n.a. n.a. 15/8 17/20
Cost to create and register collateral
(% of loan value)
n.a. n.a. 2.7/2.9 6.9/8
Enforcing contract
Days to enforce contracts (days) 300 292 340/292 397/440
Cost to enforce contracts (% of claim
value)
7.7 26.8 9.6/9 23/29.9
Notes: n.a., not applicable. The time and cost of registering collateral were not reported in the global Doing
Business study. The strength of legal rights index and depth of credit information were not reported in the Doing
Business in China 2008.
Source: The data for US and China national level are from pages 150 and 105 ofWorld Bank (2007). And the data
for cities Beijing, Shanghai, Guiyang and Lanzhou are from pages 38 and 39 of World Bank (2008). See website:
http://www.doingbusiness.org for more information on the Doing Business ranking.
the actual aggregate output and the first-best aggregate output in an otherwise frictionless
environment.
The sharp contrast between strong growth opportunities and large investment frictions
motivates the research questions of this article. For a given investment opportunity, how
much lower is the aggregate output in China as a result of investment frictions? How much
more would Chinese firms invest and produce if they enjoyed a better investment climate,
such as the one that prevails in the US? Would fir ms in underdeveloped regions catch
up had they operated in an environment that is typical of more developed areas within
China?
The list of frictions that may affect investment is long and complex. As surveyed in
Banerjee and Duflo (2005), specific reasons, such as government failure, poorly function-
ing credit markets and lack of insurance markets, have been examined in the literature.
Although each particular friction is of interest, this article aims to understand the quantita-
tive significance of their overall effects. It therefore serves as an important complement to
existing research. First, as different frictions may interact, reinforce or offset one another,
sometimes it is the total effect that is of the real interest to economists and policy makers.
Second, whilemost research focus on the micro mechanism of specific frictions, this ar ticle
provides a general approach to quantify their macro impact.
©2014 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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