Financial frictions, capital misallocation, and total factor productivity: evidence from China

From the perspective of credit constraints and heterogeneous financing costs, this paper aims to enrich our understanding on how financial frictions affect capital misallocation and total factor productivity (TFP). Our model predicts that financial frictions could lead to greater capital misallocation and TFP losses. Moreover, credit constraints exacerbate capital misallocation and amplify TFP losses caused by heterogeneous financing costs. On this basis, we use micro-level data of the Chinese industrial firms to quantify the TFP losses caused by financial frictions. The results show that: (1) financial frictions have caused huge TFP losses in China’s manufacturing industry, and credit constraints have contributed to 120.7% of annual manufacturing TFP losses on average. (2) The manufacturing TFP losses are significantly higher in the post-crisis period than in the pre-crisis period because of the more prevalent and tighter credit constraints. (3) The increase in the post-crisis TFP losses is largely accounted for by the tightening credit constraints faced by firms in central China and non-state-owned enterprises. Our findings highlight the importance of alleviating financial frictions to improve capital allocation efficiency and promote economic growth.