This dissertation studies two key determinants of economic development: infrastructure and financial frictions. Concretely, I study their impact on firms in China, a country of rapid economic development. In the first two chapters, I explore what is the impact of the National Highway System in China on firm growth. In the last chapter, I interpret the relationship between firm productivity and liquidity management when financing is costly.
The first chapter studies the world’s largest expressway system, China’s National Trunk Highway System (NTHS), to understand the impact of improved road networks on the economic growth of the areas of China that are away from major urban centers. To do this, I construct a novel dataset with the precise location and completion date of each segment of the NTHS from a variety of sources including Chinese State Council announcements, news articles and atlases published in China. I combine this with comprehensive data on every medium and large manufacturing firm in China. At first sight, the results show that when firms in peripheral regions become connected to the highway system, their growth decline significantly. By exploiting the timing of highway construction, I show incumbent firms drive the decline of firm productivity because of outside competition. There is evidence that these negative effects are temporary as the new firms that open in connected regions are more productive than they were before the highway. Exploring further with a traceable trade model, I find that lower prices drive the decline in nominal growth. The evidence of more productive entrants replacing less productive incumbents and the positive real growth in the connected peripheral regions suggest that the impact of the NTHS on firms in connected regions was positive.
The second chapter also studies the effects of China’s National Trunk Highway System (NTHS) on firms in the peripheral regions. Although the NTHS planning process does not explicitly target peripheral regions, there might still be endogenous concerns in the highway placement. To address these issues, I develop a novel time-varying instrumental variable based on a civil engineering model of least-cost construction and local completion rates. The IV results show that firms connected in the peripheral regions experience faster growth in output and sales. To understand the mechanism, I study firms’ input choices. Highway connection increases the firms’ growth in intermediate inputs and capital, while the growth of labor declines. This is consistent with a decline in the prices of capital and intermediate inputs because of access to outside markets. Using panel data is crucial for showing these effects: when using methods similar to previous studies, I find either null or opposite results.
The third chapter explores theoretically and empirically the relationship between firm productivity and liquidity management in the presence of financing frictions. We build a dynamic investment model in which heterogeneously productive firms choose to accumulate assets in the form of risky capital or risk-free cash. Firms with assets that exceed an upper “payout” threshold pay out dividends, whereas firms with assets that fall short of a lower “refinancing” threshold must refinance at a cost. We find that more productive firms endogenously set their payout threshold lower such that it is closer to the refinancing threshold, effectively making them more risk averse. If the greater risk aversion dominates the benefit of holding capital, more productive firms could demand more liquidity and hold more cash. This outcome emerges as the equilibrium if refinancing cost is sufficiently high. We empirically test this prediction using a comprehensive dataset of Chinese manufacturing firms, and find that firms that are more productive with capital do actually hold less capital and more liquid assets such as cash, a pattern that is not observed among U.S. firms. Our study suggests a larger capital misallocation problem in markets with significant financing frictions than previously documented.