Underutilized Capital

• Author: David Dollar and Shang-Jin Wei
• Position: World Bank's Country Director for China and Mongolia/Assistant Director

Uneven access to finance- Policy implicationn

If the investment bias toward inefficient state enterprises ended, China could increase living standards substantially without sacrificing growth

China is growing at such a breakneck speed that it may appear superfluous to suggest how to do better. The Chinese growth is in large part driven by capital accumulation and exports. The country's investment-to-GDP ratio has been high and rising in recent years, growing from less than 35 percent a decade ago to more than 40 percent in 2005 (see Chart 1). This is substantially higher than in advanced economies and even most other East Asian countries (which have averaged around 25 percent in recent years). Many China watchers worry that some of the investment, especially that by state-owned enterprises (SOEs), is not efficient because domestic private and foreign firms both have higher returns to capital than SOEs. Private and foreign firms could achieve the same output using less capital, thus freeing resources in China for other uses such as increased consumption. Improved efficiency would also result in higher profitability for the corporate sector and contribute to an improvement in the balance sheet of the banks that fund the firms.

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There are several reasons why SOEs may, on balance, be less efficient than domestic private firms:

- They may face more administrative interference, such as restrictions on hiring and laying off workers and on switching product lines in response to changing market conditions.

- SOEs often do not have a compensation scheme that encourages management to maximize economic efficiency and avoid overinvestment and "empire building."

- Some SOEs also have weak corporate governance that may provide opportunities for management to divert firm assets into their private pockets.

- Banks owned mostly by the state, as well as the domestic capital market, favor state- owned firms, directly in the past and mostly indirectly now.

Thus, for these various reasons-weak corporate governance, inappropriate incentives at the SOEs, inappropriate incentives at the state-owned banks, and limited access of private firms to stock equity-there could be a gap in returns to capital across firms of different ownership. Such a return differential would imply that if the distortion to capital allocation were reduced, the massive national investment in China could be reduced without affecting growth outcomes. In this article, we report some new research that quantifies the gap in returns to capital in China and estimates possible gains in consumption that could result from removing the inefficiencies.

Uneven access to finance

The Chinese financial system, dominated by banks largely owned by the state, appears to continue to favor SOEs in spite of steady effort by the authorities over the years to increase the commercial orientation of these banks (see Chart 2). Although SOEs represent a...