Growing (with Capital Controls) like China

This paper explores the effects of capital controls and policies regulating interest rates and the exchange rate in a model of economic transition applied to China. It builds on Song, Storesletten, and Zilibotti (2011) who construct a growth model consistent with salient features of the recent Chinese growth experience: high output growth, sustained returns on capital investment, extensive reallocation within the manufacturing sector, sluggish wage growth, and accumulation of a large trade surplus. The salient features of the theory are asymmetric financial imperfections and heterogeneous productivity across private and state-owned firms. Capital controls and regulation of banks’ deposit rates stifle competition in the banking sector and hamper the lending to productive private firms. Removing such regulation would accelerate the growth in productivity and output. A temporarily undervalued exchange rate reduces real wages and consumption, stimulating investments in the high-productivity entrepreneurial sector. This fosters productivity growth and a trade surplus. A high interest rate mitigates the disadvantage of financially constrained firms, reduces wages, and increases the speed of transition from low- to high-productivity firms.