Capital Freedom, Financial Development and Provincial Economic Growth in China

• Author: Bengt Söderlund,Patrik Gustavsson Tingvall
• Date: 01 April 2017
• DOI: http://doi.org/10.1111/twec.12391
• Published date: 01 April 2017

Capital Freedom, Financial Development

and Provincial Economic Growth in China

Bengt S€

oderlund

1

and Patrik Gustavsson Tingvall

2

1

Stockholm School of Economics, Stockholm, Sweden and

2

The Ratio Institute, S€

odert€

orn University,

Stockholm, Sweden

1. INTRODUCTION

SINCE the introduction of a set of market reforms in the late 1970s, China has

experienced sustained and extraordinarily high growth levels. However, despite funda-

mental reforms in both the agricultural and manufacturing sectors, the financial sector is

lagging behind.

1

Moreover, despite a series of financial sector reforms implemented since

1994, banks and other financial institutions are strictly regulated and the government exerts

substantial control over how capital is allocated (Naughton, 2007). A large share of credit has

been channelled to inefficient state-owned enterprises (SOEs), whereas private firms face con-

siderable constraints in obtaining financing. As a consequence, non-performing loans have a

tendency to accumulate in the economy. Additionally, in response to the lack of market-

driven financial allocation, a large shadow banking system has emerged (Naughton, 2007).

The discrepancy between economic growth and the pace of financial reform in China raises

questions regarding the causal relationship between the two. An extensive body of theoretical

and empirical literature suggests that weak financial institutions are detrimental to growth

(Goldsmith, 1969; Levine, 1998, 2005; Rajan and Zingales, 1998; Benhabib and Spiegel,

2000; Beck et al., 2003). The subsequent question is therefore whether the Chinese experience

in recent decades represents an exception to the finance–growth nexus. Would Chinese growth

have been more substantial if financial markets had been liberalised to a greater extent?

A recent strand of the literature that empirically examined the finance–growth nexus in

China has obtained mixed results. Studies that highlight the detrimental effects of limited

financial reform include Aziz and Duenwald (2002), Boyreau-Debray (2003), Cheng and

Degryse (2010) and Zhang et al. (2012). In contrast to these studies, Liu and Li (2001) and

Chen (2006) demonstrate that there is a positive relationship between finance and growth in

China. At least some of the conflicting results are likely explained by differences in the def-

inition of financial development. While certain scholars focus on the size of financial mar-

kets (e.g. the volume of total loans, bank deposits), others emphasise the impact of specific

types of finance. There is also disagreement over the importance of market-driven forms of

finance. While, for instance, Allen et al. (2005) highlights the importance of market-driven

financial institutions, Ayyagari et al. (2010) concludes that a regulat ed banking sector plays

an important role, as opposed to informal sources of financing outside the reach of Chinese

regulators.

1

Some of the largest reforms to the Chinese banking sector include the 1994 reform, in which the

People’s Bank of China (PBC) was transformed into a formal central bank. The PBC had in practice

acted as a central bank ever since its establishment in 1948; however, the 1994 reform meant that is role

received a legal recognition. Also in 1994, the four large and state-owned banks were transformed into

state-owned commercial banks. In 1995, a new bank law was introduced, and in 2003, the China Bank-

ing Regulatory Commission (CBRC) was established.

©2016 John Wiley & Sons Ltd

764

The World Economy (2017)

doi: 10.1111/twec.12391

The World Economy

The mixed empirical results obtained thus far and the design of the Chinese financial

system indicate that simple measures of financial development might conceal the underlying

structures of financial mechanisms that are important for economic growth. To perform a mul-

tifaceted analysis of the association between financial market development and growth in

China, this study employs a new and uniquely rich data set on capital freedom and regional

financial development at the provincial level. These data allow us to discern various measures

of capital freedom and financial market development, thus enabling us to disentangle specific

factors of financial development that are important for economic growth.

To further scrutinise the finance–growth nexus, we not only analyse how different mea-

sures of capital freedom and financial sector development impact growth, but we also analyse

whether the effect is asymmetric across provinces with different income levels. This has

implications for economic policies in less developed regions of China. Poorer provinces have

been systematically targeted since the early 2000s in what is typically called the ‘Go West

programme’ or ‘China Western Development programme’ (Goodman, 2004). Thus, the impact

of institutional reform could potentially carry important policy implications that are relevant

for the interior and western parts of China.

This study contributes to the literature in several dimensions. First, the indices considered

capture a wide variety of the institutional aspects of financial markets, yielding a rich picture

of how different features of capital freedom and financial development impact regional growth

in China. Second, by analysing the heterogeneous effect of capital freedom and financial

development across the income distribution, we can analyse the extent to which improvements

in a given type of institution benefits poor or rich provinces to the greatest extent.

The results of this study suggest that improving the conditions for capital freedom and

financial sector development enhances growth and that the impact is most pronounced in rela-

tively poor provinces. The positive impact is found to be particularly robust for policies that

improve legal and governmental institutions but also for policies that increases the marketisa-

tion of financial intuitions. Thus, improving the financial system not only enhances growth in

China but also decreases regional inequality. Considering the intensive debate on increasing

regional inequality and Go West policies, these results are easily translated into viable policy

recommendations.

2. BACKGROUND

a. The Finance–Growth Nexus

A large strand of theoretical and empirical literature has examined the relationship between

the development of financial markets and economic growth. Beginning with the early contri-

butions of Goldsmith (1969), scholars have extended and deepened our understanding of the

finance–growth nexus. Levine (2005) highlights a number of financial market functions that

impact the allocation of resources and subsequent growth. The allocation issue includes func-

tions such as producing information on possible investments, monitoring investments and

exerting corporate governance after financing is provided, facilitating trade, diversification,

risk management, mobilising and pooling savings, and facilitating the exchange of goods and

services.

Although Goldsmith (1969) successfully described the dynamics of how financial market s

evolve, it was more challenging to provide evidence of a causal relationship between finance

and growth. One factor complicating attempts to identify a causal relationship between

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