Title: Estimating Corporate Investment Inefficiency: Evidence from an Implied Return on Capital in China
Reference Number: 1166
Publication Date: May 2007
JEL Classifcation: G3, D21, O16

Qiao Liu
The University of Hong Kong

Alan Siu
The University of Hong Kong


In this paper we infer the return on capital from firms' actual capital expenditures and study how institutions affect corporate investment efficiency through an examination of various crosssections of the inferred return on capital. We apply the Generalized Method of Moments (GMM) estimator derived from a structural investment model to a large sample of Chinese industrial firms. Based on the estimated structural parameters, we compute the stochastic discount rate perceived by managers to decide investment spending. We document robust evidence that ownership is the primary institutional factor affecting the firm-level return on capital in China. The results from our benchmark estimation show that return on capital for a non-state firm is approximately 10 percentage points higher than that of an otherwise similar state firm. We also find that privatization leads to improvement in corporate investment efficiency. Applying the same estimation to the universe of China's listed firms, we further identify that firms with better corporate governance have higher returns on capital. Our estimates show that redirecting the capital from less efficient state sector to more efficient private sector can unleash a 4.4% GDP growth in China every year, and that the deadweight loss due to capital mis-allocation is about 4% of China's GDP.


Key words: Ownership, institutions and financial development, implied return on capital, investment Euler equation model, Chinese economy

Last modified: 06/08/2007