Financial constraints and firm productivity: Evidence from Chinese manufacturing

This paper explores the link between financial constraints and productivity using firm-level data from Chinese manufacturing industries. Based on a dynamic optimization model which provides a direct measure of the degree of firms’ external financial constraints, we endogenize the relationship between firms’ financial constraints and productivity through the research and development (R&D) investment channel. We resolve the simultaneity issues in the estimation of productivity with the proxy variable method. Using an unbalanced panel including 312,534 Chinese manufacturing firms over the period 1998–2007, we find that about 90% of firms face external financial constraints and the state firms are much less constrained than the non-state firms. We hypothesize that financial constraints have two opposite effects: (i) they raise productivity by reducing “sub-optimal” investment, and (ii) they reduce productivity because the paucity of funds reduces productivity-enhancing investment. Consistent with our hypothesis, we find an inverted U-shaped relationship between financial constraints and firm productivity. If the level of financial constraints for a typical unconstrained firm is adjusted to the productivity-maximizing level, its productivity will increase by 11% in the short run and 16% in the long run after controlling for firm specific characteristics. The empirical results are robust when we control for the sample selection issue in the estimation of productivity.