Real and Financial Sector Linkages in China and India by Jahangir Aziz

Author:Jahangir Aziz
Language: eng
Format: epub
Publisher: International Monetary Fund
Published: 2008-08-15T00:00:00+00:00

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As noted earlier, wages need to be paid before production so that firms need to borrow wtet. However, the funds that a firm can borrow are subject to a collateral constraint. The only collateral is the capital the firm owns. And this is the key institutional set up that drives the result. In other papers that have used a similar set up, such as Chakraborty (2005) and Kobayashi and Inaba (2006) in the case of Japan during the 1990s, the collateral is either land or equity, both of which are difficult to pledge as collateral given China’s private property rules. In addition, until 2006–07 the stock market was not a significant source of financing. How representative is this stylization of the Chinese economy? Using the World Bank survey of firms, Aziz and Cui (2007) show that 40 percent of all firms and 80 percent of privately owned firms are financially constrained in meeting their working capital needs and that this constraint adversely affects the number of workers firms employ. The average employment growth for firms that are not financially constrained is about 5.5 percent annually, while in firms that reported facing financial constraints employment growth was less than 0.8 percent per year. In contrast, financial constraint had no impact on firm investment, i.e., the investment growth was statistically the same for firms that were financial constrained and those that were are not. This evidence and the fact that neither land nor equity can be pledged as collateral given China’s private property rules (only after the 2007 reforms is urban land treated as private property) suggests that assuming that firm capital is the only source of collateral is not an unrealistic stylized representation. Banks lend to firms such that its debt service, (1 + rt)wtet, does not exceed, 0 < θt < 1, fraction of the firm’s capital stock.

After some substitutions, when the borrowing constraint is binding the equilibrium conditions for this economy become:

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