Interest Rate Liberalization and Capital Allocation

Published on: 2015-10-27

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Abstract / Seminar Summary

Private firms in China have limited access to credit markets. The government has maintained tight controls over interest rates and credit availability. These regulations have been considered an important source of inefficiency because they lead to misallocations of capital. Various reform plans that aim at liberalizing interest rate controls and promote financial deepening have been proposed. It is important to understand the effectiveness of and potential tradeoffs under these liberalization policies for improving capital allocation and aggregate productivity. We construct a two-sector model with financial frictions to study the effects of interest-rate liberalization. Firms in the state sector (SOEs) have lower productivity than private firms (POEs), but easier access to credit. Interest rates are regulated by the government, giving rise to a wedge between the loan rate and the deposit rate. Private firms face idiosyncratic productivity shocks and they maximize profit subject to a borrowing constraint. SOE firms maximize a weighted average of profit and revenue, with the latter capturing an agency problem specific to SOE firms.

The model suggests that, although interest rate liberalization improves within-sector allocations, it worsens cross-sector allocations of capital. In particular, when interest-rate liberalization leads a fall in the loan rate, capital flows from the private firms to SOEs, despite that SOE firms have lower productivity because SOE firms have incentives to expand investment (to achieve their revenue goals) and they also have easier access to credit. The opposing effects of the within-sector productivity improvement and the cross-sector deterioration render the net effects of interest rate liberalization ambiguous. When the model is calibrated to Chinese data, complete interest-rate liberalization leads to a permanent decline in aggregate TFP.

About the Speaker

Pengfei Wang is an Associate Professor in the Department of Economics, Hong Kong University of Science and Technology. He received his Ph.D. in Economics from Cornell University in 2007. Professor Wang’s research areas include macroeconomics, monetary economics, and financial economics. Her current research focus on understanding the macroeconomics of asset price bubbles and investor sentiments. His work has published in many top journals in economics and finance such as Econometrica, Journal of Economic Theory, Journal of Monetary Economics, and Journal of Financial Economics.

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