Trade policy uncertainty & resource misallocation

This paper investigates the role of trade policy uncertainty (TPU) on resource allocation across heterogeneous Chinese producers and aggregate productivity in the Chinese manufacturing sector. Using detailed Chinese data and common cost minimization conditions we measure the difference between optimal capital and labor holdings for each firm, or the efficiency gap. We document that (i) efficiency gaps decline sharply with China’s accession to the WTO and the declines are disproportionately pronounced among industries most exposed to TPU; (ii) efficiency gap declines were larger among Chinese exporters; (iii) efficiency gap declines occur simultaneously with a rise in the variance of firm-level employment and investment in new capital. Using China’s accession to the WTO as an exogenous change in the degree of uncertainty faced by Chinese producers, we quantify the implied change in productivity due to the reduction in TPU. Our estimates imply that the reduction in TPU induced by WTO accession accounted for a 17% increase in aggregate productivity through reduced resource misallocation.