Local Government Behavior behind China’s Excessive Investment under Decentralization

Duan Guorui, and Zang Xuheng
 School of Economics, Shandong University, Jinan, China
School of International Economics and Trade, Shandong University of Finance and Economics, Jinan
Institute of Industrial Economics, Shandong University

Abstract:  This paper investigates the effect of local government intervention on capital deepening of manufacturing sector by using interprovincial panel data sets of 28 Chinese provinces, municipalities and autonomous regions between 1994 and 2011. Theoretical research indicates that as a transitional economy, China’s local government intervention in corporate investment behaviors will cause excessive investment, thus bringing about a long-term and sustained tendency of capital deepening in manufacturing sector. Empirical test further discovers that in a certain range, the phenomenon of capital deepening in manufacturing sector is not an inevitable result endogenous to economic development and technology progress, and that investment behaviors of manufacturing sector are largely subject to the external institutional environment. Fiscal decentralization has indeed promoted capital deepening of manufacturing sector. Financial credit expansion and interventions in SOEs are major instruments for local governments to intervene in the capital deepening of manufacturing sector and such an influence is particularly significant for China’s central, western and northeast regions. Therefore, clarifying government functions and improving local government performance review mechanism are of great significance to the healthy development of China’s manufacturing sector.

Keywords: fiscal decentralization, local government behavior, excessive investment, capital deepening

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