Do Financial Frictions Explain Chinese Firms’ Saving and Misallocation

This paper uses Chinese firm-level data to quantify financial frictions in China and asks to what extent they can explain firms’ saving and capital misallocation. We first document features of the data, in terms of firm dynamics and financing. Relatively smaller firms have lower leverage, face higher interest rates and operate with a higher marginal product of capital. We then develop a heterogeneous-firm model with two types of financial frictions, default risk and a fixed cost of issuing loans. We estimate the model using evidence on the firm size distribution and financing patterns and find that financial frictions can explain aggregate firm saving, the co-movement between saving and investment across firms, and around 60 percent of the dispersion in the marginal product of capital (MPK). The endogenous financial frictions, however, generate a negative MPK-size relationship, which has important implications for total factor productivity losses.