Decentralization and Firm Investments: Evidence from China

• DOI: http://doi.org/10.1111/irfi.12181
• Published date: 01 June 2019
• Author: Xiaofei Pan,Huihang Wu,Yiping Wu
• Date: 01 June 2019

Decentralization and Firm

Investments: Evidence from China*

XIAOFEI PAN

†

,YIPING WU

‡

AND HUIHANG WU

‡

†

School of Accounting, Economics and Finance, University of Wollongong,

Wollongong, New South Wales, Australia and

‡

Shanghai University of Finance and Economics, Shanghai, China

ABSTRACT

Taking advantage of decentralization reform that enlarges the authority of

county government in China, we construct a quasi-experiment. Using a large

sample of Chinese firms, we show that after the implementation of decen-

tralization reform, firms located in decentralized counties experienced a sig-

nificant increase in investment expenditure compared with other firms. We

also find that after the decentralization reform, state owned enterprises

(SOEs) experienced greater increase in investment expenditure on average

compared with non-SOEs, and that, within non-SOEs, collective firms have

an even larger increase in investments, followed by foreign firms and private

firms. Further analysis shows that the influence of decentralization reform

was more significant in more developed markets, and that the increased

investment was associated with improved productivity, which was more pro-

nounced in SOEs. These results are robust to an alternative sample and endo-

geneity issues. Overall, these findings support the view that decentralization

reform improves government efficiency and creates positive externalities,

thereby encouraging firms to invest.

JEL Codes: E22; G18

Accepted: 28 December 2017

I. INTRODUCTION

Decentralization involves the devolution of authorities and responsibilities

from the central government to local governments. Recent studies on decentral-

ization and its economic implications present two conflicting views. The first

argues that decentralization reduces government hierarchy, can improve gov-

ernment efficiency and promotes economic growth (Xie et al. 1999; Akai and

Sakata 2002; Zhang 2006; Enikolopov and Zhuravskaya 2007). The second,

however, contends that decentralization enlarges the autonomy of local gov-

ernments, which could impede coordination and lead to government ineffi-

ciency (Treisman 2000).

* Yiping Wu gratefully acknowledges generous financial support from the National Natural Science

Foundation of China (No. 71673174).

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 19:2, 2019: pp. 287–313

DOI: 10.1111/irfi.12181

Existing studies almost exclusively focus on developed markets, while the

extent to which decentralization affects the real economy in emerging markets

is still unclear. The effectiveness of decentralization is perhaps more important

in emerging markets, where business is known to be heavily influenced by gov-

ernment intervention. Moreover, existing literature on the economic implica-

tions of decentralization mainly focuses on its effect on the macroeconomy,

such as regional economic growth and government quality (Treisman 2002).

Whether and how the microeconomy is influenced by decentralization is still a

controversial issue, particularly as there is still no systematic empirical evidence

as to whether and how the decentralization influences corporate investment

decisions and, in turn, firm profitability. This issue is crucial in gaining an

understanding of the influence of decentralization and the associated change of

political environments because the political environment usually affects firms’

investment policies. Thus, whether the decentralization is important and how

it affects firms’investment policies are particularly relevant for emerging

markets.

To investigate this issue, this study investigates the largest emerging market

in the world: China. More importantly, some provinces in China introduced

devolution of political and fiscal responsibilities to local governments at the

county level to various extents and did so at different times.

1

The timing of this

decentralization was largely independent from the characteristics and economic

growth opportunities of the local firms in the county. Thus, the introduction of

the decentralization reforms led to an exogenous shock of government policy

for the firms headquartered in those counties. This enabled the design of a

quasi-natural experiment and the application of the difference-in-difference

method for empirical analysis.

This study explicitly examines whether decentralization affects the invest-

ment decisions of firms within the decentralized regions in China, which fit

our theoretical analysis quite well. First, the Chinese economy is a hybrid of

central planning and market-based activities in which the government controls

the key resources essential to the corporate sector. By directly controlling the

activity of state owned enterprises (SOEs) through government ownership and

indirectly controlling the behavior of non-SOEs through soft channels (such as

regulation, license, and social and political networks), governments can explic-

itly and implicitly shape the incentives and decisions of economic entities

(Piotroski and Zhang 2014). This heavy government intervention in business

creates reasonable incentives for decentralization and provides an excellent

environment for our theoretical analysis. Second, it is well documented that

China possesses an underdeveloped institutional environment. On the one

hand, in the presence of a weak legal system, enlarged fiscal responsibilities for

1 The Chinese political system consists of five layers of government administration, namely

state, province, prefecture, county and township. This wave of decentralization mainly

involves devolution from the prefecture level to the county level and enlarges the responsibil-

ities of the government at the county level.

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