Project Matching and Overcapacity in China

Based on the features of China's project investment, we consider the formation of production capacity as a matching behavior between local governments and investment enterprises. Using the search and matching model, we illustrate that the excess capacity in China mainly results from the asymmetry between the gains from and contribution to the project matching: The capacity will be excessive when the proportion of local governments' return exceeds its contribution to the project, and the more unbalanced the return–contribution relationship, the more severe the overcapacity. Meanwhile, we test this theoretical prediction based on a quasi-natural experiment: the reform of administrative approval system. The empirical results show that the reduction of the local governments' return–contribution ratio will significantly raise the capacity utilization rate and mitigate the overcapacity. Industry-specific regression results further indicate that governments' return–contribution asymmetry is more prominent in industries dominated by state-owned enterprises, high-monopoly industries, heavy industries, and industries with serious overcapacity. This paper offers a novel mechanism of overcapacity, a theoretical criterion for judging optimal capacity, and some new regulatory tools with the micro foundation.