Song 2011

American Economic Review 101 (February 2011): 196–233
http://www.aeaweb.org/articles.php?doi=10.1257/aer.101.1.196
Growing Like China
By Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti*
We construct a growth model consistent with China’s economic

transition: high output growth, sustained returns on capital, reallo-
cation within the manufacturing sector, and a large trade surplus.
Entrepreneurial firms use more productive technologies, but due to
financial imperfections they must finance investments through internal
savings. State-owned firms have low productivity but survive because
of better access to credit markets. High-productivity firms outgrow
low-productivity firms if entrepreneurs have sufficiently high savings.
The downsizing of financially integrated firms forces domestic sav-
ings to be invested abroad, generating a foreign surplus. A calibrated
version of the theory accounts quantitatively for China’s economic
transition. (JEL E21, E22, E23, F43, L60, O16, O53, P23, P24, P31)
Over the last 30 years, China has undergone a spectacular economic transforma-
tion involving not only fast economic growth and sustained capital accumulation,
but also major shifts in the sectoral composition of output, increased urbanization
and a growing importance of markets and entrepreneurial skills. Reallocation of
labor and capital across manufacturing firms has been a key source of productivity
growth. The rate of return on investment has remained well above 20 percent, higher
than in most industrialized and developing economies. If investment rates have been
high, saving rates have been even higher: in the last 15 years, China has experienced
a growing net foreign surplus: its foreign reserves swelled from 21 billion USD in
1992 (5 percent of its annual GDP) to 2,130 billion USD in June 2009 (46 percent
of its GDP); see Figure 1.
The combination of high growth and high return to capital, on the one hand,
and a growing foreign surplus, on the other hand, is puzzling. A closed-economy
* Song: School of Economics, Fudan University, 618–600 GuoQuan Road, Shanghai 200433, China and
Chinese University of Hong Kong, 929 Esther Lee Building, Shatin, Hong Kong (e-mail: zheng.michael.song@
gmail.com); Storesletten: Research Department, Federal Reserve Bank of Minneapolis, 90 Hennepin Avenue,
Minneapolis, MN 55401 (e-mail: [email protected]); Zilibotti: Department of Economics, University
of Zurich, Mühlebachstrasse 86, CH-8008 Zurich (e-mail: [email protected]). We thank the two ref-
erees, Chong-En Bai, Francesco Caselli, Chang-Tai Hsieh, Yikai Wang, and Xiaodong Zhu for comments. We
also thank participants at the LSE conference on “The Emergence of China & India in the Global Economy”
(July 3–5, 2008), the China Economics Summer Institute 2009, the 2009 Minnesota Workshop in Macroeconomic
Theory, and the 2009 Tsinghua Workshop in Macroeconomics, and seminar participants at various departmental
seminars. Financial support from the European Research Council (ERC Advanced Grant IPCDP-229883), from the
Swiss National Science Foundation (100014-122636), from the Research Council of Norway (grants 162851 and
183522), from the 985 platform at Fudan, the Social Science Foundation of China (06CJL004), and the Natural
Science Foundation of China (70703006) are gratefully acknowledged. This paper is part of the research activities
at ESOP supported by the Research Council of Norway (179522). Any views expressed here are those of the authors
and not those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
196
VOL. 101 NO. 1 song et al.: growing like china 197
60
Foreign reserves
Difference between deposits and loans
50
40
Percentage of GDP
30
20
10
0
1992 1994 1996 1998 2000 2002 2004 2006
Year
Figure 1. Foreign Reserves and the Difference between Deposits and Loans
Note: The figure plots China’s foreign reserves (solid line) and the domestic bank deposits minus
domestic loans (dotted line), both expressed as a percentage of GDP.
Source: CSY, various issues.
n eoclassical growth model predicts that the high investment rate would lead to a fall
in the return to capital. An open-economy model predicts a large net capital inflow
rather than an outflow, owing to the high domestic return to capital. In this paper,
we propose a theory of economic transition that solves this puzzle while being con-
sistent with salient qualitative and quantitative features of the Chinese experience.
The focal points of the theory are financial frictions and reallocation of resources
across firms. In our theory, both the sustained return to capital and the foreign sur-
plus arise from the reallocation of capital and labor from less productive externally
financed firms to entrepreneurial firms that are more productive but have less access
to external financing. As financially integrated firms shrink, a larger proportion of
the domestic savings is invested in foreign assets. Thus, the combination of high
growth and high investment is consistent with the accumulation of a foreign surplus.
Our paper is part of a recent literature arguing that low aggregate total factor pro-
ductivity (TFP)—especially in developing countries—is the result of micro-level
resource misallocation (see Stephen L. Parente, Richard Rogerson, and Randall
Wright 2000; Francesco Caselli and Wilbur J. Coleman II 2001; Abhijit Banerjee
and Esther Duflo 2005; Diego Restuccia and Rogerson 2008; Gino Gancia and
Fabrizio Zilibotti 2009; and Chang-Tai Hsieh and Peter J. Klenow 2009). While
pockets of efficient firms using state-of-the-art technologies may exist, these firms
fail to attract the large share of productive resources that efficiency would dictate,
due to financial frictions and other imperfections. Most of the existing literature
198 THE AMERICAN ECONOMIC REVIEW february 2011
e mphasizes the effects of resource misallocation on average productivity. In con-

trast, our paper argues that when a country starts from a situation of severe ineffi-
ciency but manages to ignite the engine of reallocation, it has the potential to grow
fast over a prolonged transition, since efficient firms can count on a highly elastic
supply of factors attracted from the less productive firms.
To analyze such a transition, we construct a model in which firms are heteroge-
neous in productivity and access to financial markets. High-productivity firms are
operated by agents with entrepreneurial skills who are financially constrained and
who must rely on retained earnings to finance their investments. Low-productivity
firms can survive due to their better access to credit markets, since the growth poten-
tial of high-productivity firms is limited by the extent of entrepreneurial savings. If
the saving flow is sufficiently large, high-productivity firms outgrow low-produc-
tivity ones, progressively driving them out of the market. During the transition, the
dynamic equilibrium has AK features: within each type of firm, the rate of return
to capital is constant due to labor mobility and to the financial integration of the
low-productivity firms. Due to a composition effect, the aggregate rate of return to
capital actually increases. Moreover, the economy accumulates a foreign surplus.
While investments in the expanding firms are financed by the retained earnings of
entrepreneurs, wage earners deposit their savings with intermediaries who can invest
them in loans to domestic firms and in foreign bonds. As the demand for funds from
financially integrated domestic firms declines, a growing share of the intermediated
funds must be invested abroad, building a growing foreign surplus. This prediction
is consistent with the observation that the difference between deposits and domestic
bank loans has been growing substantially, tracking China’s accumulation of foreign
reserves (see again Figure 1). After the transition, the economy behaves as in a stan-
dard neoclassical model, where capital accumulation is subject to decreasing returns.
Reallocation within the manufacturing sector—the driving force in our model—
has been shown to be an important source of productivity growth in China. In an
influential paper, Hsieh and Klenow (2009) estimate that reallocation across manu-
facturing firms with different productivity accounted for an annual two percentage
point increase in aggregate TFP during 1998–2005. Loren Brandt, Johannes Van
Biesebroeck, and Yifan Zhang (2009) estimate that up to two-thirds of the aggregate
TFP growth in Chinese manufacturing was due to productivity differences between
entering and exiting firms during 1998–2005.
Our theory yields several additional predictions consistent with the evidence of
China’s transition:
(i) The theory predicts that the surplus—savings minus investment—should

increase with the share of entrepreneurial firms. Consistent with this predic-
tion, we find that the net surplus is significantly higher in Chinese provinces
in which the employment share of domestic private firms has increased faster.
(ii) In our benchmark model, all firms produce the same good and differ only in
TFP. We extend the theory to a two-sector model in which firms can special-
ize in the production of more or less capital-intensive goods. This extended
model predicts that financially constrained firms with high TFP will spe-
cialize in labor-intensive activities (even though they have no technological
c omparative advantage). Thus, the transition proceeds in stages: first low-

productivity firms retreat into capital-intensive industries, and then they
gradually vanish. This is consistent with the observed dynamics of sectoral
reallocation in China, where young high-productivity private firms have
entered extensively in labor-intensive sectors, while old state-owned firms
continue to dominate capital-intensive industries.
The theory is related to the seminal contribution of Arthur W. Lewis (1954), who
constructs a model of reallocation from agriculture to industry where the supply of
labor in manufacturing is unlimited due to structural overemployment in agriculture.
While his mechanism is similar in some respects to ours, productivity increases
in his model rely on some form of hidden unemployment in the traditional sector.
Lewis’ theory captures aspects of the reallocation between rural and urban areas in
China, while our focus is on the reallocation within the industrial sector. Our paper
is also related to Jaume Ventura (1997), who shows that in economies engaging in
external trade, capital accumulation is not subject to diminishing returns because
resources are moved from labor-intensive to capital-intensive sectors. Ventura’s
model does not assume any initial inefficiency, nor does it imply that TFP should
grow within each industry—a key implication of our theory.1
Neither Lewis’ nor Ventura’s theory has any implication regarding trade imbal-
ances. Kiminori Matsuyama (2004, 2005) shows that financial frictions may induce
trading economies to specialize in industries in which they do not have a technologi-
cal comparative advantage. See also the work of Pol Antràs and Ricardo J. Caballero
(2009). In our model, by a similar mechanism, less efficient firms can survive and
even outgrow more productive ones. Our two-sector extension also predicts that
financial constraints generate specialization in spite of the lack of any technological
comparative advantage, though the mechanism is different.
Pierre-Olivier Gourinchas and Olivier Jeanne (2009) document that it is common
to observe capital outflow from fast-growing developing economies with high mar-
ginal product of capital. As in the case of China, countries with fast TFP growth tend
to have both large capital outflows and large investment rates, while the opposite
is true for slow-growing countries. They label this finding the “allocation puzzle.”
Our theory can provide a rationale to this observation. In a related paper, Francisco
J. Buera and Yongseok Shin (2010) focus on the current account surpluses experi-
enced by a number of Asian economies in the 1980s (with the notable exception
of China, which experienced current account deficits during the 1980s). Buera and
Shin argue—as we do—that financial frictions can contribute to the explanation
of this puzzle. While in our paper the foreign surplus is driven by the dwindling
demand for domestic borrowing, due to the decline of financially integrated firms,
they emphasize increased domestic savings by agents who are planning to become
entrepreneurs but need to save to finance start-up costs.
A few recent papers address the more specific question of why China is accumu-
lating a large foreign surplus. Most papers emphasize the country’s high saving rate.
Louis Kuijs (2005) shows that household and enterprise saving rates in China are,
1
In this respect, our work is related to the seminal papers of Simon Kuznets (1966) and Hollis Chenery and
Moises Syrquin (1975), who study sources of productivity growth during economic transitions.
respectively, 11.8 and 8.6 percentage points higher than those in the United States.
Demography, an imperfect financial sector, and the lack of welfare and pension ben-
efits are among the factors proposed as explanations for this (e.g., Aart Kraay 2000).
However, it remains unclear why domestic savings are not invested domestically
given the high rate of return to capital in China. Enrique G. Mendoza, Vincenzo
Quadrini, and José-Víctor Ríos-Rull (2009) argue that this may be explained by dif-
ferences in financial development inducing savers in emerging economies to seek
insurance in safe US bonds (see also Caballero, Emmanuel Farhi, and Gourinchas
2008; and Damiano Sandri 2010). Michael P. Dooley, David Folkerts-Landau, and
Peter Garber (2007) propose a strategic political motive: the Chinese government
would influence wages, interest rates, and international financial transactions so as
to foster employment and export-led growth.
Our paper is organized as follows. Section I describes some empirical evidence of
China since 1992. Section II describes the benchmark model and characterizes the
equilibrium. Section III discusses quantitative implications of the theory with the aid
of a calibrated economy. Section IV presents an extension to a two-sector environ-
ment that captures additional features of the Chinese transition. Section V concludes.
A technical Appendix available from our Web pages contains the formal proofs.
I. The Transition of China: Empirical Evidence
A. Political Events and Macroeconomic Trends
China introduced its first economic reforms in December 1978. The early reforms
reduced land collectivization, increased the role of local governments and communi-
ties, and experimented with market reforms in a few selected areas. After a period of
economic and political instability, a new stage of the reform process was launched in
1992, after Deng Xiaoping’s Southern Tour, during which the leader spoke in favor
of an acceleration of reforms. Since then, China has moved towards a full-fledged
market economy. The process gained momentum in 1997, as the 15th Congress of
the Communist Party of China officially endorsed an increase in the role of private
firms in the economy.
The focus of this paper is on the post-1992 Chinese transition, a period character-
ized by fast and stable growth and by a pronounced resource reallocation within the
manufacturing sector. In spite of very high investment rates (39 percent on average),
the rate of return to capital has remained stable: while the aggregate return to capital
has fallen slightly (from 28 percent in 1993 to 21 percent in 2005), the rate of return
to capital in manufacturing has been increasing since the early 1990s and climbed
close to 35 percent in 2003, according to Figure 11 in Chong-En Bai, Hsieh, and
Yingyi Qian (2006). High corporate returns have not been matched by the return on
financial assets available to individual savers: the average real rate of return on bank
deposits, the main financial investment of Chinese households, was close to zero
during the same period. Wage growth has been lower than growth in output per cap-
ita in recent years.2 Similarly, the labor share of aggregate output fell gradually from
2
According to Judith Banister (2007, Table 10, based on the China Labor Statistical Yearbook) the average real
annual growth of wages in the urban manufacturing sector between 1992 and 2004 was 7.5 percent, and a mere
60
DPE/(DPE+SOE), in NBS
(DPE+FE)/Total, in NBS
50 DPE/(DPE+SOE), in CLSY
(DPE+FE)/Total, in CLSY
40
Percent
30
20
10
0
1992 1994 1996 1998 2000 2002 2004 2006
Year
Figure 2. Private Employment Share
Notes: The figure shows, first, the DPE share of employment as a share of SOE +  DPE employ-
ment in manufacturing (NBS 1998–2007) and in the urban sector (CLSY 1992–2007). Second,
it plots DPE + FE employment as a share of total employment in manufacturing (NBS 1998–
2007) and in the urban sector (CLSY 1992–2007).
Source: CSY and CLSY, various issues.
59 percent in 1998 to 47 percent in 2007 (Bai and Zhenjie Qian 2009, Table 4).3 The
falling labor share has contributed to rising inequality even across urban households
(Dwayne Benjamin, Brandt, John Giles, and Sangui Wang 2008).
B. Reallocation in Manufacturing
The reallocation of capital and labor within the manufacturing sector is a focal point
of our paper. Figure 2 plots alternative measures of the evolution of the employment
share of private enterprises. Our preferred measure is based on annual firm-level sur-
veys conducted by China’s National Bureau of Statistics (NBS), which include the
universe of Chinese industrial firms (manufacturing, mining, and construction) with
sales over 5 million RMB. The solid line plots the proportion of domestic private
4.6 percent if one excludes state-owned and collectively owned enterprises. In the same period, the average growth
rate of real GDP per capita was about 9 percent. Using data from the NBS Urban Household Surveys 1992–2006,
Suqin Ge and Dennis T. Yang (2009) report an annual growth rate of 4.1 percent for the basic wage (the lowest skill
category) and of 6.2 percent for workers with “middle-school education and below.” These are useful benchmarks
since they separate the wage growth due to technological progress from that due to human capital accumulation—
which reflects the increasing quantity and quality of education. Two additional remarks are in order. First, wages are
deflated using the provincial consumer price index (CPI). The annual CPI growth rate was on average 0.9 percent-
age points lower than that of the GDP deflator in these years. Second, the compliance rate for pension contributions
paid by employers declined dramatically in this period. Both considerations suggest that the growth of labor costs
per worker for firms was lower than the figures above.
3
Bai and Qian (2009) report data until 2004. The estimates for 2004–07 were kindly provided by Bai and Qian.
enterprises (DPE) as a percent of DPE plus state-owned enterprises (SOE) in the

NBS surveys. It shows an increase from 4 percent in 1998 to 56 percent in 2007.
This is the most relevant measure for our theory.4 However, it excludes two impor-
tant firm categories: foreign enterprises (FE) and collectively owned enterprises
(COE). Therefore, for completeness, we also report a broader measure of the private
employment share, namely, (DPE+FE)/(DPE+FE+SOE+COE); see the dashed
line. The NBS measures of private employment share could be biased downwards,
due to the exclusion of small firms and nonindustrial firms. Therefore, we also report
the corresponding ratios from aggregate statistics from the China Labor Statistical
Yearbook (CLSY).5 According to this measure, the DPE/(DPE+SOE) share was 19
percent in 1997 and 54 percent in 2007. All measures suggest that the share of DPE
was low until 1997 and that most of the transition took place thereafter. This accords
well with the political events outlined above.
C. Productivity and Credit Frictions
DPE and SOE differ in two important aspects: productivity and access to financial
markets. SOE are, on average, less productive and have better access to external
credit than do DPE. This makes ownership structure a natural proxy for the different
types of firms in our theory. Figure 3 shows a measure of profitability, i.e., the ratio
of total profits (measured as operation profits plus subsidies plus investment returns)
to fixed assets net of depreciation. Based on this measure, the gap between DPE
and SOE is about 9 percentage points per year, similar to that reported by Nazrul
Islam, Erbiao Dai, and Hiroshi Sakamoto (2006).6 Large productivity differences
also emerge from TFP accounting: Brandt, Hsieh, and Xiaodong Zhu (2008, Table
17.3) estimate an average TFP gap between DPE and SOE of 1.8 during 1998–2004,
while Brandt and Zhu (2010) estimate a gap of 2.3 in 2004. Using a different meth-
odology, Hsieh and Klenow (2009) estimate a “revenue-TFP gap” of 1.42.
Financial and contractual imperfections are also well documented. In a cross-country
comparative study, Franklin Allen, Jun Qian, and Meijun Qian (2005) find that China
scores poorly in terms of creditor rights, investor protection, accounting standards,
nonperforming loans, and corruption.7 In this environment, Chinese firms must rely
heavily on retained earnings to finance investments and operational costs. Financial
repression is far from uniform: private firms are subject to strong discrimination in
4
NBS data are available only since 1998. The figure shows the share of firms classified as DPE by the NBS. If,
instead, we classify as DPE all firms with a private ownership share above 50 percent, the DPE shares would rise
from 12 percent in 1998 to 59 percent in 2007.
5
One problem with the CLSY is that it does not classify ownership for all urban employment. More precisely,
the provincial data classifying employment according to ownership add up to only 60 percent of the aggregate
measure of urban employment. The dotted line is then computed by assuming that the ratio of DPE to SOE in the
unclassified aggregate data is the same as that in the provincial data.
6
A concern with the official data is that the ownership classification is based on ownership at the time of initial
registration. However, many firms have subsequently been privatized. This problem is addressed by David Dollar
and Shang-Jin Wei (2007), who use survey data on 12,400 firms, classified according to their current ownership.
They find the average return to capital to be twice as high in private firms as in fully state-owned enterprises (Dollar
and Wei 2007, Table 6). Interestingly, collectively owned firms also have a much higher productivity than SOE.
7
Interestingly, some reforms of the financial system have been undertaken, including a plan to turn the four
major state-owned commercial banks into joint-stock companies. This effort involves consulting foreign advisors to
improve the managerial efficiency of banks (Chi Hung Kwan 2006). In Section IIG we discuss the role of financial
development during the economic transition.
35
SOE
DPE
30
FE
25
20
Percent
15
10
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Year
Figure 3. Total Profits over Net Value of Fixed Assets
Note: The figure plots the average ratio between total profits and the book value of fixed assets
across firms of different ownership, in percent.
Source: CSY, various issues.
credit markets. The Chinese banks—mostly state owned—tend to offer easier credit
to SOE (Genevieve Boyreau-Debray and Wei 2005). As a result, SOE can finance a
larger share of their investments through external financing. Figure 4 shows that SOE
finance more than 30 percent of their investments through bank loans compared to
less than 10 percent for DPE. Similarly, Dollar and Wei (2007, Table 3.1) and James
Riedel, Jing Jin, and Jian Gao (2007, Table 3.1) report that private enterprises rely
significantly less on bank loans and significantly more on retained earnings and family
and friends to finance investments. Other forms of market financing are marginal for
private firms. Despite the rapid growth of the Chinese stock market in recent years,
equity and debt markets continue to play an insignificant role for DPE, while these
markets have become increasingly important for large semiprivatized SOE (Neil
Gregory and Stoyan Tenev 2001; and Riedel, Jin, and Gao 2007, ch. 7).
Another sign that DPE are financially repressed is that both capital-output and cap-
ital-labor ratios are substantially lower in DPE than in SOE. In 2006, the average
capital-output ratio was 1.75 in SOE and 0.67 in DPE (China Statistical Yearbook
(CSY) 2007). In the same year, capital per worker was almost five times larger in SOE
than in DPE, although part of this difference reflects the higher average educational
attainment of SOE workers. This gap arises from both an intensive and an extensive
margin. First, SOE are more capital intensive even within three-digit manufacturing
industries, both in terms of capital per worker and in terms of the capital-output ratio
(Figure A1 in the Appendix). Second, DPE have taken over labor-intensive industries,
40
SOE
35 DPE
FE
30
25
Percent
20
15
10
0
1997 1998 1999 2000 2001 2002 2003
Year
Figure 4. Share of Investment Financed by Bank Loans and Government Budgets
Note: The figure plots the average share of investment financed by bank loans and government
subsidies across firms of different ownership, in percent.
Sources: CSY 1998 to 2001 and 2003, China Economy and Trade Statistical Yearbook 2002
and 2004.
while the share of SOE remains high in capital-intensive industries. Panel A of Figure
5 plots the 2001 SOE share of total employment across three-digit manufacturing
industries against the capital intensity that each of these industries had in the United
States (2001 is the first year for which data are available). Already in 2001 SOE were
significantly more represented in those industries which are more capital intensive in
the United States. For instance, the SOE employment share in the ten most capital-
intensive industries was 57.9 percent, while in the ten least capital-intensive industries
it was 25.8 percent.8 The withdrawal of SOE from labor-intensive sectors has contin-
ued thereafter. Panel B of Figure 5 plots the percentage change in the SOE employ-
ment share between 2001 and 2007 against the capital intensity of the corresponding
industry in the United States. The correlation coefficient is highly positive (0.576).
D. Income Inequality
The economic transition of China has been accompanied by increasing income

inequality—even within the urban sector. For instance, the Gini coefficient of
8
Industries are classified according to the capital-labor ratio in the United States in 1996 (classifying according to
their respective Chinese ratios would create an endogeneity problem). The US data are from NBER-CES Manufacturing
Industry Database, http://www.nber.org/nberces. We match the industries listed by the 2002, 2003, and 2004 China
Industrial Economy Statistical Yearbook (CIESY) to the SIC codes. Among 31 industries in CIESY, only 27 can be
matched, 18 at the SIC two-digit level and 9 at the SIC three-digit level. Details are available upon request.
Panel A. 2001 employment share of SOE Panel B. Change in SOE employment share
100 20
Change in SOE empl. share, in percent

90
SOE empl. share, in percent
0
80
70 −20
60
50 −40
40
−60
30
20 −80
10
0 −100
0 50 100 150 200 250 300 0 50 100 150 200 250 300
Capital−labor ratio in United States Capital−labor ratio in United States
Figure 5. SOE Employment Shares across Industries
Notes: Panel A plots the 2001 employment share (in percent) of SOE in 28 major Chinese man-
ufacturing industries against their respective capital-labor ratio in the United States. Panel B
plots the change in SOE employment share (in percent) for these 28 industries between 2001
and 2007.
Sources: CIESY and CSY, various issues. We use the 1996 US capital-labor ratios, computed
from the NBER-CES manufacturing industry database. The industry petroleum and coal products
has extremely high capital labor ratio and is excluded from the figures for visual convenience.
income in China grew from 0.36 in 1992 to 0.47 in 2004. Our theory suggests that
this development may be due in part to the slow growth of wages relative to entre-
preneurial income. The pattern of income inequality across regions can offer some
insight. We classify Chinese provinces by the percentage of industrial workers who
are employed in DPE. Figure 6 shows a high positive correlation between the Gini
coefficient at the provincial level in 2006 and the employment share of DPE: prov-
inces with more private firms have a substantially higher income dispersion.
E. Foreign Surplus and Productivity Growth
Finally, the reallocation process in manufacturing has an interesting statistical

relationship with the accumulation of a foreign surplus and the productivity growth.
Consider, first, the foreign surplus. At the aggregate level, the timing of structural
change from SOE to DPE follows quite closely that of the accumulation of for-
eign reserves: Both accelerate around year 2000 (Figures 1 and 2). Interestingly, the
breakdown of the net surplus (savings minus investment) across provinces suggests
the same pattern in the cross section: the net surplus is systematically larger in prov-
inces with a larger increase in the DPE employment share.
We document this pattern by using data for 31 provinces with NBS data from
2001 to 2007.9 The dataset allows us to construct province-level measurements of
investment in fixed assets and savings (defined as provincial GDP minus private
The data cover all Chinese provinces for the years 2001–2003 and 2005–2007 (data for 2004 are not available).
9
The employment statistics for 2001–2003 are from CIESY 2002–2004. The CSY 2006 –2008 provide data for
2005–2007. Annual data for investment, saving, and GDP are from the CSY (2002–2008).
0.65
0.6
0.55
Gini coefficient
0.5
0.45
0.4
0.35
0.3
0.25
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
DPE employment share
Figure 6. Income Inequality and Private Employment Share across Provinces
Notes: The figure plots the Gini coefficient of income against the DPE employment share across
31 Chinese provinces in 2006. The DPE share is computed as DPE/(DPE + SOE).
Source: CIESY 2007. Provincial Gini is from Report to the Seventeenth National Congress of
the Communist Party of China.
and government consumption expenditures). In column 1 of Table 1, we report

the results of a regression of the provincial net surplus-to-GDP ratio on the annual
change in the employment share of DPE, defined as the employment in DPE divided
by the sum of employment in DPE and SOE at the province level. To avoid that the
correlation be driven by a common trend in the two variables, we include time dum-
mies. The estimated coefficient is positive and highly significant: a 10 percentage
points larger increase in the DPE employment share is associated with an average
10 percentage point larger net surplus relative to GDP.10 Controlling for lagged pro-
vincial GDP per capita reduces the estimated coefficient from 1.0 to 0.89, which is
significant at the 10 percent confidence level.11
There is also a positive and highly significant (>99 percent) correlation between the ratio of net surplus to
10
provincial GDP and the level of the DPE employment share. A 10 percentage point difference in the DPE employ-
ment share is associated with a 3.5 percentage point larger net surplus relative to GDP. In the theory presented in
Section II, both a high level and a high growth of the DPE share increase the foreign surplus, consistent with the
evidence in Table 1.
11
All regressions described in this subsection are of the form
DEP_VARrt = αt + β1 (EMPL PRIV   ) + εr t ,
rt  − EMPL rt−1
PRIV
where the dependent variable, DEP_VAR r t , is the provincial net surplus (savings minus investments) over GDP
in columns 1 and 2, the growth rate of provincial GDP per capita in columns 3 and 4, and the growth rate of the
industry-level value added per worker in columns 5 and 6. EMPL PRIVrt  denotes the DPE (or non-SOE, as discussed in
the text) employment share. In columns 2, 4 and 6, we control for lagged GDP per capita (value added per worker).
αtdenotes time-dummies, included in all regressions. Standard errors are clustered at the province (industry) level.
The coefficient of interest is β1.
Table 1
(S-I)/GDP Growth rate of GDP p.c. Growth rate of VA p.w.

Dependent variable (1) (2) (3) (4) (5) (6)
D.(EMPLPRIV) 0.9964** 0.8920* 0.1893*** 0.1903*** — —
(0.4889) (0.4659) (0.0603) (0.0610)
D.(EMPLNONSOE) — — — — 1.4257*** 1.5973***
(0.4785) (0.3572)
L.(GDP p.c.) — 6.6268*** — −0.0646 — —
(2.3952) (0.2136)
L.(VA p.w.) — — — — — 0.1283***
(0.0152)
Year dummy Yes Yes Yes Yes Yes Yes
Observations 124 124 124 124 112 112
R2 0.0424 0.1984 0.2252 0.2258 0.2104 0.2577
Notes: Dependent variables: (S-I)/GDP*100 is the provincial ratio of net surplus over GDP. S and I stand for aggre-
gate savings and investment, respectively. S = GDP − C − G, where C and G are household consumption and
government consumption expenditures, respectively. GDP p.c. is the real provincial GDP per capita in the value
of 10 thousand RMB (adjusted by provincial GDP deflators). VA p.w. is the industry value-added per worker (10
thousand RMB). Growth rates are in percent. Regressors: EMPLPRIV is equal to DPE/(DPE + SOE)*100, i.e., the
ratio of private employment over the sum of private and state employment. EMPLNONSOE is equal to (1 − SOE/
Total)*100, i.e., the ratio of non-SOE employment over total employment. D.(·) and L.(·) stands for the difference
and the one-period lag, respectively. Standard errors clustered at the province or industry level. Robust standard
errors are in brackets.
*** Significant at the 1 percent level.
** Significant at the 5 percent level.
* Significant at the 10 percent level.
Consider, next, productivity growth. Columns 3–4 of Table 1 show that labor pro-
ductivity has grown faster in provinces where the DPE employment share has grown
faster. A 10 percentage points larger increase in the DPE share is associated with
a 1.9 percentage points higher annual productivity growth rate. Similar evidence
emerges from looking at the variation of the speed of reallocation across industries;
see columns 5–6.12 In this case, a direct measure of the DPE employment share
is not available before 2005, so we use the employment share of non-SOE over
total employment as a measure of reallocation. The coefficient of interest is positive
and significant. The quantitative effect is even larger: a 10 percentage points larger
increase in the non-SOE employment share is associated with a 14.3 percentage
points higher growth rate of productivity. The correlation is strengthened when con-
trolling for industry-specific lagged productivity.
The province-level results of columns 1–4 are mainly driven by cross-province
variation. The estimated coefficients become smaller and statistically insignificant
when province fixed effects are included (only marginally insignificant in the pro-
ductivity regressions of columns 3–4). In contrast, the cross-industry results hold
up to the inclusion of industry fixed effects, which leave the estimated coefficient
almost unchanged. Thus the results of columns 5–6 are mostly driven by within-
industry variation.
The data cover 28 major manufacturing industries. The sample period is 2001–07 (data for 2004 are not avail-
12
able). The data for 2001–03 are from the CIESY (2002–04). The data for 2005–07 are from the CSY (2006–08).
II. The Benchmark Model
In this section, we develop a theory of economic transition consistent with the

empirical facts documented in the previous section.
A. Preferences, Technology, and Markets
The model economy is populated by overlapping generations of two-period

lived agents who work in the first period and live off savings in the second period.
Preferences are parameterized by the following time-separable utility function:
1−  _
1    1−  _
1   
(c1t) θ  − 1 (c2t+1
) θ  − 1
(1) Ut =  _ + β  __
   
       
,
1 −  _   
1 1 −  _
1   
θ θ
where β is the discount factor and θ is the intertemporal elasticity of substitution in
consumption ct. We focus on the case when agents’ savings are nondecreasing in the
rate of return, i.e., when θ ≥ 1.
Agents have heterogeneous skills. Each cohort consists of a measure Ntof agents
with no entrepreneurial skills (workers), and a measure μ Nt of agents with entre-
preneurial skills (entrepreneurs) which are transmitted from parents to children.13
The population grows at the exogenous rate ν; hence, Nt+1 = (1 + ν)Nt . The rate
ν captures demographic trends, including migration from rural to urban areas. For
simplicity ν is assumed to be exogenous.
There are two types of firms, both requiring capital and labor as well as one man-
ager. Financially integrated (F) firms are owned by intermediaries (to be defined
below) and operate as standard neoclassical firms. Entrepreneurial (E) firms are
owned by old entrepreneurs. The entrepreneurs are residual claimants on the profits
and hire their own children as managers (cf. Caselli and Nicola Gennaioli 2006).
The key assumption is that, due to financial and contractual imperfections, only
some firms (F firms) have access to the deep pockets of banks, which are perfectly
integrated in international financial markets. Other firms (E firms) are owned by
agents who have superior skills and can run more productive technologies. However,
there are frictions restricting the flow of funds from the agents with a deep pocket
to those with superior skills. As a result, the latter end up being credit constrained.
This, in turn, allows less productive firms to survive in equilibrium.
Different microfoundations would be consistent with heterogeneous productivity
across firms to exist in equilibrium. Here, we present one such example: following
Daron Acemoglu et al. (2007), we assume that each firm can choose between two
modes of production: either the firm delegates decision authority to its manager, or
it retains direct control of strategic decisions. There is a trade-off. On the one hand,
delegation leads to higher total factor productivity (TFP)—e.g., the manager makes
decisions based on superior information. Thus, a firm delegating authority can attain
χ > 1 extra efficiency units per worker compared with a firm retaining centralized
13
Lowercase characters will denote per capita or firm-level variables; uppercase, aggregate variables.
authority. On the other hand, delegation raises an agency problem: the manager
can divert a positive share of the firm’s output for his own use. Such opportunistic
behavior can only be deterred by paying managers a compensation that is at least
as large as the funds they could steal. The key assumption is that entrepreneurs are
better at monitoring their managers, so that E firm managers can steal only a share
ψ < 1 of output. In contrast, F firms are weak at corporate governance and cannot
effectively monitor their managers: under delegation, all output would be stolen.
Thus, F firms will always choose a centralized organization, while E firms opt for
delegation, given a condition that will be spelled out below. Of course, less produc-
tive firms could not survive unless they had the benefit of having better access to
external funds. Such advantage is due to entrepreneurs being subject to credit con-
straints, as explained below.
The technology of F and E firms are described, respectively, by the following
production functions:
yFt = k αFt (
  At nFt)1−α
, yEt = k αEt (χ
  At nEt)1−α
,
where y is output and k and n denote capital and labor, respectively. Capital depreci-
ates fully after one period. In the case of F firms, the input of the manager is equiva-
lent to that of a regular worker and is included in nF . The technology parameter A
grows at an exogenous rate z; A t+1 = (1 + z)A t .
We now analyze agents’ savings. Young workers earn a wage w and deposit their
savings with a set of competitive intermediaries (banks) paying a gross interest rate
R d. These workers choose savings so as to maximize utility, (1), subject to an inter-
temporal budget constraint, c W 1t  + 
c W  /
2t+1  R d = wt . This yields the optimal savings
s t  = ζ wt, where ζ  ≡ (1 + β R ) . Young entrepreneurs in E firms earn a
W W W −θ 1−θ −1
managerial compensation, m t . Their savings can be invested either in bank deposits
or in their family business.
Banks collect savings from workers and invest in loans to domestic firms and
foreign bonds. The bonds yield a gross return R. Contractual imperfections plague
the relationship between banks and entrepreneurs. The output of E firms is nonveri-
fiable, and entrepreneurs can only pledge to repay a share η of the second-period
net profits.14 In a competitive equilibrium, the rate of return on domestic loans must
equal the rate of return on foreign bonds, which in turn must equal the deposit rate.
However, lending to firms is subject to an iceberg cost ξ, which captures operational
costs, red tape, etc. Thus, ξ is an inverse measure of the efficiency of intermedia-
tion. In equilibrium, R d = R and R l = R/(1 − ξ), where R l is the lending rate to
domestic firms.15
For F firms, profit maximization implies that R l equals the marginal product of
capital and that wages equal the marginal product of labor:
  α   
 αl    1−α  At. ( )
_
(2) wt = (1 − α) _
R 
14
The assumption that output is not verifiable rules out that financially integrated firms hire old entrepreneurs. If
the entrepreneurs could commit to repay, all firms would be run by private entrepreneurs.
In the analysis of this section, ξ plays no role, so we could set ξ = 0 without loss of generality. However, ξ will
15
become important in the extension about financial development.

Consider now the value of an E firm, owned by an old entrepreneur with capital
kEt. This value is the solution to the following problem:
 
(3) ) =   
Ξt(kEt max    {
 (kEt − mt − wt nEt}
)α (χAt nEt)1−α
m , n
t Et
subject to the incentive constraint that mt ≥ ψ(kEt

)α (AEt
nEt)1−α
, where mt is, again,
the payment to the manager, and arbitrage in the labor market implies that the wage
is as in (2).16 The optimal contract implies that the incentive constraint is binding:
(4) mt = ψ(kEt

)α (χAt nEt)1−α
.
Taking the first-order condition with respect to nEand substituting in the equilib-
rium wage given by (2) yields that
( )
_
 1    l 1−α kE t   1    
(5) nEt = ((1 − ψ)χ)α _ Rα      _
_
  . 
χAt
Plugging (4) and (5) into (3) yields the value of the firm:
_
1 _
(6) Ξt(kE t) = (1 − ψ) α   χ  α  
R kEt ≡ ρE kEt ,
 l
1−α
where ρE is the E firm rate of return to capital. In order to ensure that ρE  > Rl, we
make the following assumption.
χ   ≡ _
_
      
( )
1
ASSUMPTION 1: χ > _   1    
1−α .
1 − ψ
Given this assumption, (i) E firms prefer delegation to centralization and (ii)
young entrepreneurs find it optimal to invest in the family business. If Assumption 1
were not satisfied, there would be no E firms in equilibrium. Thus, a sufficiently
large productivity difference is necessary to trigger economic transition.
Consider, next, the contract between banks and entrepreneurs. The E firm’s
capital stock comprises the savings of the young entrepreneur and the bank loan,
kEt = s Et−1
   
 + l Et−1
  .
 The incentive-compatibility constraint of the entrepreneur implies
that R l  ≤ ηρE (sE + l E ). This constraint is binding if and only if η < R l/ρE , which
l E
we assume to be the case. Thus, the share of investments financed through bank
loans is
lE ηρE
(7)  _ =  _
         
.
lE + sE R l
The managerial compensation must also exceed the workers’ wage rate (mt > wt ). We restrict attention to
16
parameters such that the participation constraint is never binding in equilibrium. In contrast, F firms are not subject
to any incentive constraint since their managers make no discretionary decisions. Thus, the managers’ participation
constraint is binding, and they earn the same wage as ordinary workers.
The entrepreneur’s investment problem can be expressed as the choices of lE and sE
that maximize discounted utility, U, subject to c1 = m − sE , c2 = ρE(lE + sE ) − 
RllE, and the incentive-compatibility constraint, (7). If we use (7) to substitute away
lE, the problem simplifies to
( )
(1 − η)ρE R l 1−  _θ   
1
1−  _
1    _
  l  
  s
  E  − 1
  __
(m − sE )

θ  − 1
__ R − ηρE
  s     
 
max         + β  
           .
E
1 −  _
1    1 −  _ 1   
θ θ
This implies that the optimal savings are s E = ζE m, where
( ( ) )
1−θ −1
(1 − η)ρE R l
ζ ≡ 1 + β   _
E −θ
  l       .
R − ηρE
B. Discussion of Assumptions
Before discussing equilibrium dynamics, we review our main assumptions.

The theory describes a growth model characterized by heterogeneous firms that
differ in productivity and access to credit markets. In the application to China, the
natural empirical counterparts of E firms and F firms are private and state-owned
enterprises, respectively. In our model, we do not emphasize the public ownership
of less productive firms. However, we focus on two salient features that are related
to the ownership structure. First, due to their internal bureaucratic structure, SOE are
weak in corporate governance and grant less autonomy and incentives to their man-
agement. This feature is well documented. For instance, Deqiang Liu and Keijiro
Otsuka (2004) show that profit-linked managerial compensation schemes are rare
for SOE, while they are 10 to 20 times more prevalent for township and village
enterprises. The rigidity of the SOE structure is emphasized by Eric C. Chang and
Sonia M. L. Wong (2004). Second, thanks to connections to state-owned banks,
SOE enjoy better access to borrowing (as suggested in the evidence discussed in
Section I).
In assuming F firms to be “competitive,” we abstract from other institutional fea-
tures, such as market power or distortions in the objectives pursued by firms and
their managers, that may be important in Chinese SOE. We do so partly for trac-
tability. However, we should note that since the 1990s, SOE have been subject to
an increased competitive pressure that has forced many of them to shut down or
restructure. Thus, we find the abstraction of competitive profit-maximizing firms
to be fruitful since it helps us to focus on the two distortions discussed above (in
Section IVB we explore the implications of granting F firms market power). Also
for simplicity, we model the labor market as competitive and frictionless. While
the Chinese labor market is characterized by important frictions (e.g., barriers to
geographical mobility), we do not think that including such frictions would change
any of the qualitative predictions of the theory, although it would affect the speed of
reallocation and wage growth.
The assumption that private firms are less financially integrated is also well rooted
in the empirical evidence discussed in Section I, showing that Chinese private firms
rely heavily on self-financing and receive only limited funding from banks and
insignificant equity funding. The assumption that monitoring is easier within flex-
ible organizations—and most notably in family firms—seems natural. In the model,
we do not emphasize interfamily altruistic links: parents transmit genetically entre-
preneurial skills to their children but also must provide them with incentives to avoid
opportunistic behavior. Alternatively, we could have focused on parental altruism
and assumed that incentive problems are altogether absent in family firms. In such
an alternative model, parents would leave voluntary bequests to their children, who
in turn would invest in the family firm.
The essential feature of our model’s reallocation mechanism is that financial and
contractual frictions obstruct the flow of capital towards high-productivity entre-
preneurial firms. If the entrepreneurs could borrow external funds without impedi-
ments, the transition would occur instantaneously, and only the more efficient E
firms would be active in equilibrium. The fact that the growth of E firms is con-
strained by the savings of entrepreneurs implies a gradual transition.
C. Equilibrium during Transition
In this section, we characterize the equilibrium dynamics during a transition in

which there is positive employment in both E and F firms. We drop time subscripts
when this causes no confusion. We start by showing that, due to the disadvantage
in raising funds, E firms choose in equilibrium a lower capital-output ratio than do
F firms. To see this, denote by κJ ≡ kJ/(AJ nJ)the capital per effective unit of labor.
As discussed above, in a competitive equilibrium, the lending rate R lpins down the
marginal product of capital of F firms. Thus,
( )
 αl    1−α .
_
κF = _
  1    
(8)
R
Since κF is constant, the equilibrium wage in (2) grows at the rate of technical
change, z, as in standard neoclassical open-economy growth models. Equation (5)
then implies immediately that
−  _
κE = κF ((1 − ψ)χ) α .
1   
(9)
Lemma 1: Let Assumption 1 hold, i.e., χ > _ χ.  Then E firms have a lower capital-
output ratio (κE  < κF ) and a lower capital-labor ratio than F firms.
Consider, next, the equilibrium dynamics. The key properties of the model are
that (i) KE t and At are state variables (whereas KFt
is determined by equation (8)
and is therefore not a state variable), (ii) capital per effective unit of labor for each
type of firm, κE and κF , is constant for each type of firm, and (iii) entrepreneurial
savings in period t (hence, KEt+1) is linear in KEt

. These three properties imply
that the employment, capital and output of E firms grow at a constant rate during
transition.
Lemma 2: Given KEt and At, the equilibrium dynamics of total capital and
employment of E firms during transition are given by KE t+1/KEt  = 1 + γK E and
NEt+1/NEt
 = (1 + γK E )/(1 + z) ≡ 1 + νE , where
( ( ) )
−1
Rl      (1 − η)ρERl 1−θ _ ψ _ ρ
(10) 1 + γK E =  _ +
β −θ _
             
 E   ,
1 − ψ α
1   
Rl − ηρE Rl − ηρE
and ρE  = (1 − ψ)1/α χ(1−α)/α Rl and Rl = R/(1 − ξ). There exists χ   

=  χ (β, χ, ψ, η, α, ν, z, R, ξ) < ∞ such that the employment share of E firms NE /N

grows over time (i.e., νE > ν) if and only if χ >  χ
 . χ
   is defined in the Appendix.
Moreover, χ    is decreasing in β and in η and increasing in ν and in z. Thus, the
employment share of E firms grows if, ceteris paribus, β or η are sufficiently large
or if ν or z are sufficiently small.
Equation (10) follows from the aggregation of the E firm investments, after
r ecalling that kEt+1 = s Et  + l Et , where s Et  = ζE mt(with mtbeing determined by (4)),
and l Et is determined by (7). The constant growth rate of K hinges on the facts that
the rate of return to capital in E firms is constant and that young entrepreneurs’
earnings and savings are proportional to E firms’ profits. To illustrate this point,
suppose that z = 0. In this case, the workers’ wage remains constant during the
transition. However, the managerial compensation, mt, still grows in proportion to
the output of E firms. The growing earning inequality between workers and entre-
preneurs is key for the transition to occur, since (i) the investment of E firms is
financed by entrepreneurial savings, and (ii) constant wages avoid a falling return
to investment. If young entrepreneurs earned no rents and just earned a work-
ers’ wage, entrepreneurial investments would not grow over time. Substituting
the expression of ρE into (10) shows that the growth rate is hump-shaped in ψ. If
entrepreneurial rents are low (small ψ), young entrepreneurs are poor, and there
is low investment. However, if ψ is large, the profitability and growth of E firms
(ρE ) fall.
Note that both assumptions, that χ > χ _  and that χ >  χ  , require the TFP gap,
χ1−α, to be large. Thus, generically, only one of them will be binding. Interestingly,
the theory can predict failed take-offs. For instance, suppose that initially both con-
ditions were satisfied. Then, the saving rate ζ Ewould fall, due to, e.g., a fall in β, so
that χ  (·, β) > χ > _
χ after the shock. Then investment by E firms would continue to
be positive, but their employment share would shrink over time.
The equilibrium dynamics of the set of F firms can be characterized residually
from the condition that KFt = κF At(Nt − NEt ), namely, F firms hire all workers not
employed by the E firms, and KFadjusts to the optimal capital-labor ratio. Standard
algebra shows that, as long as the employment share of E firms increases, the growth
rate of KF declines over time.17 The aggregate capital accumulation of F firms is
hump-shaped during the transition. Initially, when the employment share of E firms
is small, KF grows at a positive rate (provided that either ν > 0 or z > 0). However,
as the transition proceeds, its growth rate declines and eventually turns negative.
Finally, standard algebra shows that GDP per worker is given by
Nt
YFt + YE t
(11)  _t    =  _
Y
  
Nt
= κ αF  1 +  _
 
ψ _ N t
     
 E 
1 − ψ Nt t
  A. ( )
The growth rate of GDP per worker accelerates during a transition as long as χ >  χ  ,
reflecting the resource reallocation towards more efficient firms. Under the same
condition, the average rate of return to capital in the economy increases during the
transition, due to a composition effect, even though the rates of return to capital in
E firms and F firms are constant. Intuitively, this reflects the increasing share of the
capital stock of E firms that yields the high return ρE.18
Figure 7 illustrates the transitional dynamics of employment, wages, output,
the average rate of return, foreign reserve over GDP, and the saving rate in the
model economy. In the figure, the transition ends in period T, when all workers are
employed by E firms. During the transition, the employment share of E firms grows
(panel A). Moreover, the average rate of return (panel B) and the output per effec-
tive units of labor (panel D) are growing, whereas wages per effective units of labor
(panel C) remain constant.
D. Foreign Surplus, Savings, and Investments
In this section, we derive the implications of the model for the accumulation of
foreign surplus, which is a focal point of our theory. Consider the banks’ balance
sheet:
ηρE
(12) KFt +  _    Et + Bt = ζW
  K wt−1Nt−1.
Rl
The left-hand side of (12) consists of the banks’ assets: loans to F firms, loans to
E firms (as in equation (7)), and foreign bonds, Bt. The right-hand side of (12)
captures their liabilities (deposits). The analysis of the previous section leads to the
following Lemma:
17
More formally,
_K
  Ft+1  
KF t
AFt+1
=  _
 
_
AFt
 
   
N
NFt
  (NE0 _
= (1 + z)(1 + ν) 1 −  _
  Ft+1       
  
N0 1 + ν (
1 + νE t+1
 
 
  ) )/ (
NE0 _
1 −  _     
0 1 + ν
N (
1 + νE t
 
 
  ))
≡ 1 + γK F t ,
( )( ) ( ( ))
−2
N 1 + νE t _ 1 + νE 1 + νE t
where  _
d  ( 1 + γ ) = 1 + z _
KF
t ( )  E0   _
   
 
  ln    
 
  (ν − νE ) 1 −  _
   
 
   < 0 iff νE  > ν.
dt N0 1 + ν 1 + ν 1 + ν
18
More formally, the average rate of return is
ρE KEt + ρF KFt R   

ρt =  __   =  ___
( )
l
          ,
KE t + KF t 1    NEt
1 −  1 − χ((1 − ψ)χ) α   _
− _
   
Nt
which is increasing as long as NE t/Ntincreases.
Panel B. Return on capital ( ρ)

E firm employment share Panel A. E firm employment share
1
Annualized return
Return E firms ↓
1.06
0.5 1.04
Average return ρt →
1.02 Return F firms ↑

0
T T
Time Time
Wage rate per efficiency unit
Output per efficiency unit

Panel C. Wage rate Panel D. Output
0.18
0.4
0.16
0.35
0.14
0.3
0.12 0.25
T T
Time Time
Panel E. Foreign surplus−GDP ratio, B/Y Panel F. Aggregate savings rate: S/Y
Savings rate
0.15 0.28
B/Y
0.1 0.26
0.05
0.24
0
T T
Time Time
Figure 7. Transition in the Analytical Model
Notes: The figure shows the evolution of key variables during and after the transition in the analytical model. Time
T denotes the end of the transition, when all workers are employed in E firms.
Lemma 3: The country’s foreign surplus is given by
(13) Bt = ζW__

 
( 1 − α)κ α−1
  
F 
(
    − 1 + (1 − η)_
(1 + z)(1 + ν)
N t
  E    κ A N .
Nt F t t )
As long as the employment share of the E firms (NEt/Nt) increases during the
transition, the country’s foreign surplus per efficiency unit, Bt/(At Nt), increases.
When the transition is completed (in period T, say) and all workers are
employed by E firms (NET/NT = 1), the net foreign surplus becomes BT
= (ζ W(1 − α)κ α−1
F  /((1 + z)(1 + ν)) − η) κ αF  AT NT. If E firms are sufficiently
credit constrained (i.e., if η is low), then the transition necessarily ends with a posi-
tive net foreign position.
The intuition for the growing foreign surplus is that as employment is reallocated
towards the more productive E firms, investment in the financially integrated F firms
shrinks. Hence, the demand for domestic borrowing falls and banks must shift their
portfolio towards foreign bonds. Although there is a potentially increasing demand
of loans from E firms, this is small, due to the financial frictions. The growth rate of
the foreign surplus can exceed that of GDP, resulting in a growing Bt/Ytratio (as in
panel E of Figure 7). This is the case if ψ and η are sufficiently small, i.e., if (asym-
metric) credit market and contractual imperfections are sufficiently severe.19
During the transition, the country’s gross saving rate, St/Yt(where St = ζW
wt Nt + 
ζ  μmt), increases (panel F of Figure 7), whereas the gross investment rate, It/Yt
E
(where It = KEt+1
 + KFt+1
), falls. Both forces contribute to the growing foreign sur-
plus during the transition. The aggregate saving rate grows for two reasons. First,
workers employed by the F firms earn a constant share, 1 − α, of the output of those
firms and save a fraction ζW . In contrast, workers employed by E firms save a frac-
tion ζW (1 − α)(1 − ψ)of the output of those firms. Second, young entrepreneurs
save a share ζ Eψ. Thus, the saving rate out of the output of E firms equals ( 1 − α)ζ W
+ αψζ E + (1 − α)ψ(ζ E − ζ W )which exceeds the saving rate out of the output of
F firms, since ζ E ≥ ζ W.20
Next, consider the country’s investment. Suppose, for simplicity, that z = ν = 0.
Then every worker who is shifted from an F firm to an E firm works with less
capital. Therefore, domestic investment falls during the transition (a result which
generalizes to positive z and ν). We return to this prediction in Section IIG. For now,
we note that the growing foreign surplus does not hinge on a falling investment rate
since the saving rate is growing during the transition. The following proposition
summarizes the main results so far.
Proposition 1: Suppose that χ > max{_ χ,    

χ}. Then, during the transi-
tion, the equilibrium employment among the two sets of firms is given by NE t
= KEt/(AtκF(1 − ψ)−1/α
χ−(1−α)/α) and NFt = Nt − NE t , where κF is given by
(8), and KEt and At are predetermined in period t. The rate of return to capital is
constant over time for both types of firms, and higher in E firms than in F firms:
ρF = Rl and ρE = (1 − ψ)1/α χ(1−α)/αRl. Capital and employment in E firms grow
over time as in Lemma 2. The stock of foreign assets per efficiency unit grows over
time, as in equation (13). If ψ and/or η are sufficiently small (strong contractual
imperfections and/or credit market discrimination), then the foreign surplus-to-
GDP ratio increases during the transition.
19
More formally,
( 1 − α)κ α−1
F  N t
__
ζW          − 1 + (1 − η)_  E    
_t
B ___
( 1 + z )(
1 + ν ) Nt
      =              1−α
  κ  F 
,
Yt ψ _ N t
1 +  _       E   
1 − ψ Nt
/Ntprovided that
which is increasing with NEt
__ ψ α(1 + ν)(1 + z) _
1 + β−θ
R1−θ
       <  __     
           .
1 − η(1 − ψ) (1 − α) Rl
The set of parameters satisfying this condition together with Assumption 1 and the condition of Lemma 2 is
nonempty.
20
To see this, recall that ρE > R l. Since the intertemporal elasticity of substitution θ ≥ 1, the young entrepre-
neurs have a higher saving rate than the workers: ζ E ≥ ζ W. This is the only result in the paper that hinges on the
restriction that θ ≥ 1.
E. Post-Transition Equilibrium
Once the transition is completed (in period T in Figure 7) all workers are employed
by E firms. Thereafter, the theory predicts standard OLG-model dynamics. Consider,
for instance, the case of θ → 1 (log preferences). Then, the aggregate capital stock
is given by KE t+1 = (β/(1 + β))(Rl/(Rl − ηρEt
))mt, which implies—after substi-
tuting in the equilibrium expressions of mt and ρEt—a standard neoclassical law of
motion (see Appendix):
β __ ψ Rl      (κ )α .
(14) κEt+1 =  _      
        __
1 + β (1 + z)(1 + ν) R − ηα(1 − ψ)κ α−1
l
Et 
Et
Investments bring about capital deepening until either the rate of return to capital
falls to R lor the capital per efficiency unit converges to a steady state such that the
rate of return to capital exceeds R l. Along the converging path, wages and output per
effective units, as well as the net foreign surplus, increase, while the rate of return
to capital falls.
F. Discussion of Results
Our theory fits some salient features of the recent Chinese growth experience
discussed in Section I. First, in spite of the high investment and growth of industrial
production, the rate of return of firms does not fall. Second, E firms—similarly to
DPE in China—have a higher TFP and less access to external financing than other
firms. This induces a lower capital intensity in E firms than in F firms (Lemma 1)—
again in line with the empirical evidence. Moreover, the rate of return to capital is
higher in E firms than in F firms, just as in the data DPE are more profitable than
SOE. Third, the transition is characterized by factor reallocation from financially
integrated firms to entrepreneurial firms, which is similar to the reallocation from
SOE to DPE in the data. Fourth, such reallocation leads to an external imbalance—
as in the data, the economy runs a sustained foreign surplus. Finally, the model
predicts a growing inequality between workers’ wages and entrepreneurial earnings.
While the focus of our paper is on China, our model can also cast light on the
experience of other industrializing countries. In particular, it provides a potential
explanation for Gourinchas and Jeanne’s (2009) observation that developing coun-
tries with high (low) TFP growth experience current account surpluses (deficits).
The hallmark of our theory is the reallocation from less to more financially con-
strained firms, which sustains high productivity growth and feeds a growing gap
between domestic saving and investment.21 According to Gourinchas and Jeanne
(2009), capital flows out of Korea and Taiwan in the 1980s represent two canonical
examples of the “allocation puzzle.” Similar to China 20 years later, those econo-
mies experienced an acceleration of productivity growth at a time in which they ran
large balance of payment surpluses.22
21
Note that a low χ can make our mechanism go in reverse. As discussed above, if _χ < χ <  
  χ
 , the employment
share of the E firms would fall over time, causing low TFP growth and a falling foreign balance. This is reminiscent
of the negative part of the allocation puzzle.
The annual growth rate of GDP per worker went up from 4.5 percent (1972–82) to 6.9 percent (1982–92) in
22
Korea, and from 5.3 percent (1972–82) to 6.8 percent (1982–92) in Taiwan (Penn World Tables 6.2).
In the 1960s and 1970s, the industrialization process of South Korea relied sub-
stantially on foreign loans. As of the early 1980s, Korea had one of the highest ratios
of foreign debt to GDP ratio among developing countries. The imbalance was sig-
nificantly corrected in the 1980s. Especially in the second half of that decade, Korea
experienced booming growth and a sequence of large current account surpluses.
This structural change coincided with important changes in the Korean development
strategy. In the period 1960–1980, the government had provided strong support to
the large local conglomerates (chaebol). One pillar of this strategy was the strong
integration between banks and chaebol that granted the latter privileged access to
low-cost credit. Barriers to entry were substantial. In 1980, the ten largest chaebol
accounted for 48 percent of the Korean GNP (Linsu Kim 1997), while the employ-
ment share of manufacturing of small and medium enterprises (SME) with fewer
than 200 workers had declined from 68 percent in 1960 to less than 50 percent in
1980. Following the crisis of 1979–1980, the Korean government set out a major
policy shift. The Fair Trade Act of 1980 introduced a set of measures aimed to favor
competition and the entry of small firms, by, e.g., reducing subsidies to large firms,
regulating the chaebol’s market power, and offering tax breaks to SME (Heather
Smith 1994). As a result, the activity of SME soared. Their number more than dou-
bled between 1980 and 1990 (Moon-Gi Suh 1998, Table 3.13), and their employ-
ment share in manufacturing increased to 62 percent, a trend that continued in the
early 1990s (Jeffrey Nugent and Seung-Jae Yhee 2002, Table I). While the Korean
reform package included some elements of financial liberalization (privatization
of commercial banks), there were no major financial reforms until the 1993–1997
Financial Sector Reform Plan. Thus, throughout the 1980s and early 1990s, the
growing SME continued to be subject to heavy credit-market discrimination (Yung
Chul Park 1994; and Hyun-Han Shin and Young S. Park 1999). Similar to China,
the differential access to bank loans in Korea resulted in different capital intensi-
ties: in the period 1979–1997 the ratio of gross value added to total assets was 46
percent higher in large enterprises than in SME. Moreover, again similar to China,
“in the latter half of the 1980s the chaebol placed an increasingly disproportionate
emphasis on capital-intensive industries, using their ability to raise funds as the
main source of their competitiveness” (Smith 2000, 64). During the same period,
the chaebol system showed increasing cracks, resulting in a growing share of non-
performing loans and government-sponsored bailouts.23
Taiwan recorded trade deficits in all but two years during 1951–1970 (the sur-
pluses in 1964 and 1966 were merely 0.75 percent and 0.27 percent of GDP, respec-
tively). Thereafter, the trade balance turned consistently positive, except during the
oil shock (1974–1975) and in 1980, which had a tiny deficit. The size of the surplus
became especially remarkable in the 1980s: the annual net export–GDP ratio was a
staggering 12 percent in 1982–1988. Compared with Korea’s, the Taiwanese SME
23
Park and Dong Won Kim (1994) note that “it was an open secret that Korea’s commercial banks were awash
in a sea of nonperforming loans” (p. 212). To remedy this situation, the government often identified healthy com-
panies in the same chaebol and induced them to absorb the troubled companies in exchange for subsidies or pref-
erential credit arrangements. For instance, in 1978 and 1986, Daewoo acquired at the government’s request the
Kyungnam enterprise, receiving in exchange preferential loans for 230 million USD and a transfer from the Korean
Development Bank for 50 million dollars to bail out its shipbuilding activity that was in distress. This influx of
money contributed significantly to the subsequent expansion of Daewoo. The Daewoo case is a good example of
how credit arrangements were biased in favor of large chaebol.
played a more important role all along the process of industrialization. Nevertheless,
the U-shaped trajectory of the Taiwanese SME share is reminiscent of that of Korea:
the employment share of firms employing fewer than 100 persons fell from 58 per-
cent in 1961 to 36 percent in 1971 and then went up again to 59 percent in 1991.
This reversal was encouraged by policy changes, such as the plan of economic lib-
eralization of 1984 (Smith 1997).
Although bank-firm ties were weaker than in Korea and mainland China, access
to credit markets was highly unequal across Taiwanese firms. Public and large pri-
vate enterprises satisfied more than 90 percent of their external borrowing from the
formal financial sector, while SME had to rely on the informal curb market for a
large fraction of their financial needs.24 Jia-Dong Shea (1994) reports that “over the
1965–1988 period the rate of loans from financial institutions relative to value added
averaged 47 percent for public enterprises but only 29 percent for private enter-
prises” (p. 242). This was largely due to an “emphasis on collaterals rather than the
profitability or productivity of the borrowers” (p. 241). The interest in the informal
lending market was more than twice as high as the bank lending rate for unsecured
loans (see Smith 1997, Table 6). Shea (1994) concludes that
… easier access to bank loans by public enterprises and large firms inevitably induced
them to adopt more capital-intensive technologies, the result of which is a higher pro-
ductivity for labor and a lower productivity for capital in larger enterprises relative to
private and medium and small enterprises. If we could reallocate resources in such a way
to shift some capital from public and large enterprises to private and medium and small
enterprises … the total productivity of the whole economy might increase (p. 244).
Given these premises, the growth in the share of credit-constrained SME during
the 1980s contributed to productivity growth in Taiwan. Interestingly, the timing of
reallocation coincides with the massive accumulation of foreign reserves.
In conclusion, in spite of important differences, the 1980s experiences of Korea
and Taiwan share some commonalities with the recent development of China. All
featured a pronounced reallocation within the manufacturing sector characterized
by a strong growth of credit-constrained high-productivity firms. The reallocation
was accompanied on the macroeconomic front by an acceleration in productivity
growth and a foreign surplus. These features are consistent with the predictions of
our theory.
G. Financial Development
In Section IID, we noted that the theory predicts falling investment rates during
the transition. Different from a standard neoclassical growth model, the investment
rate does not fall in our theory because of capital deepening bringing about decreas-
ing returns. Rather, the fall is due to a composition effect: financially constrained
firms—which have a lower capital-output ratio—expand, while financially uncon-
24
The Taiwanese curb market consists of all borrowing and lending activities occurring outside of the supervi-
sion and regulation of monetary authorities. According to Smith (1997), private enterprises borrowed 35 percent of
their external finance from such an informal market in the period 1981–1987. In the same period, SME borrowed
about four times as much from it as did large enterprises (see Smith 2000, Table 4.3).
strained firms contract. However, in the Chinese experience there is no evidence of

a falling investment rate: Bai, Hsieh, and Qian (2006) document that this rate has
instead followed an U-shaped pattern over the period 1992–2006.
One way to reconcile our theory with the data is to introduce a mechanism that
generates capital deepening within both E and F firms. A simple such mechanism is
a reduction of financial frictions during the transition. This change is motivated by
the observation that over the last decade the Chinese government has made consid-
erable effort to improve the financial system. For instance, the lending market has
been deregulated, allowing for both more competition and more flexibility in the
pricing of loans.25 A symptom of the improvement in the efficiency of the banking
system is the sharp reduction in the ratio of nonperforming loans (Podpiera 2006).
We incorporate financial development into our theory by letting the ice-
berg intermediation cost, ξ, fall over time, causing a decrease in the lending rate
R lt  = R/(1 − ξt). Ceteris paribus, a reduction in ξ and R lt pushes up wages and capi-
tal-labor ratios in both E and F firms. The reduction in ξ over time can offset the ten-
dency for the investment rate to fall (and for the average rate of return to increase).
Such financial development slows the transition via two channels: (i) it increases
wages, which in turn strengthens the comparative advantage of F firms—entrepre-
neurs must save more to attract workers from F firms—and (ii) it reduces ρE and the
saving rate of entrepreneurs.26 We will return to the effects of financial development
in the next section.
III. Quantitative Analysis
We have focused so far on qualitative predictions of the theory. In this section,

we show that a calibrated version of our theory can also account quantitatively for
China’s growth experience during 1992–2007. In particular, it captures the rise in
private employment, the rise in foreign surplus and the U-shaped rates of investment
and aggregate savings.
A. The Quantitative Multiperiod Model
Given the goal to match the theory with China’s experience over the last 15 years,
a two-period OLG model, in which one period corresponds to 30 years, would be
inadequate. Therefore, we extend our theory to an Auerbach-Kotlikoff OLG model,
in which agents live T periods. Preferences are CRRA as in the model above, U
= ∑ t=1   β t( (ct)1−1/θ − 1)/(1 − 1/θ). Agents are born with zero wealth and cannot
   
T
die with negative wealth. Workers supply one unit of labor each period. They retire
after J years of work. Their lifetime budget constraint is ∑  t=1
   
  R −tct = ∑ t=1
   
  R −t wt ,
T J
where w tis the wage in period t.
25
Before 1996, banks in China had to lend at the official lending rate. In 1996, a reform allowed them to set
the rate between 0.9 and 1.1 times the official rate. The upper limit gradually increased to 1.3 times for small and
medium enterprises in the late 1990s and was eventually removed completely in 2004 (Richard Podpiera 2006). The
increase in competition can also be seen in the loan share of the four major state-owned banks, which fell from 61
percent in 1999 to 53 percent in 2004, and by the growing equity market.
26
An alternative form of financial development would be a reduction of η, i.e., better credit market access for
entrepreneurs. This would unambiguously speed up transition without affecting either capital intensity (κE ) or
wages. In China, there is no clear evidence that credit market access of DPE improved relative to SOE; see Figure 4.
Young entrepreneurs work as managers for T/2 periods and as entrepreneurs

for the remaining T/2 periods—in line with the two-period model above. During
each period of their management phase, they earn a compensation given by (4) and
deposit their savings in banks.27 As they become entrepreneurs, they invest their
accumulated wealth, ∑  t=1   RT/2−t(mt − ct), in E firms. They borrow part of the capi-
T/2
tal from banks, as in the two-period model (see equation (7)). After becoming entre-
preneurs, their budget constraint becomes
R ltρ
  Et
=  _
ct + sEt+1 sEt ,
    
R t  − ηρEt
l

where the net return on equity, R ltρ

  Et/(R lt  − ηρEt
), incorporates the gain from lever-
ing up equity by borrowing at a rate R  lt. 
Given an aggregate entrepreneurial capital stock KE t , prices and aggregate alloca-
tions are determined as in the two-period model. However, capital no longer depre-
ciates fully, so the law of motion for aggregate capital is Kt+1 = (1 − δ)Kt + It,
where δ < 1 denotes the constant depreciation rate. Equations (2), (4), (5), and (7)
are unchanged, while equations (3), (6), (8), and (9) are modified to incorporate
the new assumption that δ < 1. To avoid the counterfactual prediction of declining
investment rates, we follow the discussion in Section IIG and allow ξt to change
over time due to financial development. Aggregate savings equal aggregate produc-
tion minus consumption minus intermediation costs. Aggregate bank deposits is the
aggregate financial wealth of workers, retirees and managers. The initial distribution
of wealth is the only state variable. Given this, the model is solved by standard itera-
tion on the sequence of wage rates { wt} ∞ t=0 
. 28
B. Calibration
The calibration of our multiperiod model focuses on matching empirical moments

during 1998–2005 because this is the period covered by NBS. Some parameters are
calibrated exogenously. The rest are estimated within the model.
Consider, first, the parameters set exogenously. One period is one year. Agents
enter the economy at age 28 and live until 78 (T = 50). The average retirement age
in China is 58, so workers retire after J = 30 years of work. The annual deposit rate
is R = 1.0175, which is the average one-year real deposit rate (deflated by the CPI)
during 1998–2005. The capital share is set to α = 0.5, consistent with Bai, Hsieh,
27
We assume that entrepreneurs must pay a (possibly infinitesimal) fixed turnover cost if they replace the man-
ager (e.g., new managers must be trained). Then, the T/2-period optimal contract has the same solution as the
repeated one-period contract. This is easily shown through backward induction. In the last-period stage game the
manager would steal unless his incentive constraint, (4), is met. Suppose that in the second-to-last period the entre-
preneur offered the manager a lower compensation and threatened to replace him if he stole. Such threat would not
be credible, as a new manager would be subject to the same incentive constraint in the last period. In addition, the
entrepreneur would have to pay the turnover cost. The same argument applies to earlier periods. So, the optimal
contract implies a managerial compensation given by (4) in every period.
28
Given a guess for {wt} ∞  
t=0 and the initial wealth distribution, the prices and allocations are given by the modi-
fied version of (2)–(9) and the individuals’ savings problems. Recall that in equilibrium wt must be given by (2)
as long as NEt  < Nt, and it is given by neoclassical dynamics after the end of the transition. If the implied alloca-
tions are consistent with the guess for {wt} ∞  
t=0 , then an equilibrium has been found. Otherwise, update the guess for
{wt} t=0 . Iterate until convergence.
∞
and Qian (2006), and the annual depreciation rate of capital is set to δ = 0.1. The
annual population growth rate is set to ν = 0.03, which is the average urban popula-
tion growth during 1998–2005 (according to the World Bank’s World Development
Indicators). Finally, the intertemporal elasticity of substitution is set to θ = 2.
We now turn to the remaining parameters, which are estimated within the model.
The discount factor β is calibrated to match China’s average aggregate saving rates
during 1998–2005. This gives β = 0.997.
Recall that SOE report to have a more than three times larger share of invest-
ments financed through bank loans than do DPE (Figure 4). Since DPE have some
alternative sources of financing in addition to bank loans and withheld earnings,
such as friends and family, we assume that E firms can finance externally half their
investments. This implies that the share of profits entrepreneurs can pledge to repay
is η = 0.86.29
The parameters χ and ψ are set so as to match two empirical moments: (i) the
capital-output ratio of Chinese SOE is 2.65 times larger than that of DPE (average
1998–2005); and (ii) the rate of return to capital is 9 percent higher for E firms
than F firms (in line with Figure 3 and Islam, Dai, and Sakamoto 2006). This yields
χ = 4.79 and ψ = 0.45. This calibration implies a TFP gap of 2.2, which is in the
upper end of the range of the estimates in the literature discussed in Section I.30
The initial iceberg intermediation cost ξ is set so that the gross aggregate rate
of return to capital is 20 percent in the 1990s (in line with the estimates of Bai,
Hsieh, and Qian 2006). This implies that ρF  = 9.3 percent, ρE = 18.3 percent and
ξt = ξ = 0.069 for 1992 ≤ t < 2000. For t ≥ 2000, the sequence of intermedia-
tion costs { ξt} ∞ 
t=2000  
is calibrated so as to best fit, given the other calibrated param-
eters, the time path of aggregate investment. In particular, we assume that ξt = 0
for t ≥ 2020 and set ξt = (1 − ((t − 2000)/19)υ)ξ for t ∈ [2000, 2019], where
υ = 2.38 is set to match the aggregate investment rate in 2007. The ρF timplied by
the assumed sequence of ξ tis illustrated in panel A of Figure 8.
The rate of secular labor-augmenting technical progress is set to z = 3.8 percent
so as to target an annual 11.2 percent output growth rate over 1998–2005. This is
slightly lower than the output growth rate of China’s urban areas (based on the 35
largest cities, 11.7 percent) and slightly higher than the growth rate of industrial
output (10.4 percent).
Finally, consider the initial conditions. The initial entrepreneurial wealth is set so
as to match the average DPE employment share during 1998–2005. This yields a
1992 E firm employment share of 3 percent, which is close to the empirical obser-
vation. The initial life-cycle distribution of wealth for managers and entrepreneurs
is similar to a scaled-up version of the distribution of wealth over the life cycle for
workers in the initial steady state. The initial assets of the workers and retirees are
29
In the data, even SOE finance about half of their investments through internal savings (China Fixed Asset
Investment Statistical Yearbook, various issues). However, this observation is per se no evidence of SOE being
subject to large credit constraints. For our purposes, it is crucial that DPE be significantly more credit constrained
than SOE. Therefore, we retain the convenient assumption that SOE are unconstrained.
30
The comparison between TFP in the model and in the data is complicated by the peculiar technology of our
E firms. An income-based TFP calculation that excluded the payments to management would yield a TFP gap of
1.62. Given this ambiguity, we chose to calibrate χ so as to match the observed rates of return to capital rather than
matching TFP differences.
Panel A. Rate of return in F firms Panel B. E firm employment share

0.8
0.1
0.6
0.4
0.05
0.2
0 0
1995 2000 2005 2010 1995 2000 2005 2010
Year Year
Panel C. Aggregate saving rate Panel D. Aggregate investment rate

0.6
0.4
0.5
0.35
0.4
0.3
1995 2000 2005 2010 1995 2000 2005 2010
Year Year
Panel E. Foreign reserve/GDP Panel F. TFP growth rate

0.1
0.6
0.4 0.05
0.2
0 0
1995 2000 2005 2010 1995 2000 2005 2010
Year Year
Figure 8. Transition in the Calibrated Economy
Notes: The figure shows the evolution of key variables during and after the transition in the calibrated economy. The
solid and dashed lines refer to the simulated results from the model and the data, respectively. The dashed and dotted
lines in panel B refer to private employment shares in NBS and CLSY data, respectively (see Figure 2).
set to 60 percent of the wealth in a steady state where there are only F firms. This
ensures that the model matches China’s net foreign surplus-to-GDP ratio in 1992.
C. Results
The dynamics of the calibrated multiperiod economy are illustrated in Figure 8.

Panels B–F display various salient macroeconomic outcomes of the model versus
the data.
First of all, the calibrated economy generates a speed of employment reallocation
comparable to its empirical counterpart (panel B). Second, the aggregate saving rate
(panel C) tracks remarkably well the U-shaped dynamics of the Chinese aggregate
saving rate. Recall that the economy is calibrated to match the average saving rate,
but not its time path. The decline during the 1990s is due to the assumption of low
initial wealth of workers, implying that they save a lot initially. The rise after 2000
is driven by the fast reallocation towards E firms, the managers of which have high
saving rates. This is the mechanism driving increased savings in the two-period
model (Figure 7). Third, the calibrated model matches closely the trend of the net
foreign surplus (panel E), although the predicted growth is slightly too high in
1998–2002 and slightly too low in 2003–2007. Since the model matches the saving
rate, its success in this dimension hinges on predicting accurately the investment
rate (panel D). This was not a calibration target because ξt determines the invest-
ment’s dynamics, not its level. Interestingly, the model predicts an acceleration in
the foreign surplus from 2007 onwards. This is driven by a continued increase in the
saving rate and a declining investment rate.
Consider now the evolution of aggregate TFP, computed as a standard Solow
residual of a one-sector aggregate production function using aggregate capital and
labor as inputs. This is plotted in panel F. The 1998–2005 annualized growth rate is
5.9 percent. This is in the range of the estimates from empirical productivity studies.
Barry Bosworth and Susan M. Collins (2008) estimate a TFP growth rate in indus-
try of 6.1 percent over the period 1993–2004. Brandt, Van Biesebroeck, and Zhang
(2009) report estimates of the annual TFP growth of 4 percent and 7.7 percent.31
We can decompose the TFP growth rate into one part due to exogenous technical
change and another part due to reallocation. Reallocation yields 4.2 percent annual
TFP growth. Thus, about 70 percent of the 1998–2005 TFP growth in our model
is driven by reallocation from less efficient F firms to more efficient E firms. This
large effect is broadly consistent with the findings of Brandt, Van Biesebroeck, and
Zhang (2009), who estimate that between 42 percent and 67 percent of the aggre-
gate TFP growth in Chinese manufacturing was due to productivity differences
between firms entering and exiting during 1998–2005. They also document that
SOE and collectively owned enterprises represent the lion’s share of exiting firms,
while most that enter are DPE. See their Figure 1.32 However, our model implies
a substantially larger gain from reallocation than what Hsieh and Klenow (2009)
estimate; they find an annual TFP growth gain from reallocation between Chinese
manufacturing firms of 2 percent. Finally, the model predicts an increasing TFP
growth over time (panel F). This is also consistent with Brandt, Van Biesebroeck,
and Zhang (2009), who find an even steeper increase in the growth rate than pre-
dicted by our model.
Finally, our model implies an average wage growth of 5 percent per year, which
is reasonable given the discussion in footnote 2. In the model, wage growth arises
from both technical change and capital deepening. The assumption of a competitive
and frictionless labor market implies that during transition the growth of DPE has no
effect on wages. Introducing frictions may deliver higher wage growth.
The most problematic feature of our calibration concerns the average rates of
return within SOE and within DPE. In the calibration these rates fall due to financial
development (recall that ρF and ρE would be constant in the absence of financial
Brandt, Van Biesebroeck, and Zhang (2009) use the NBS. The 4 percent estimate is obtained by calculating
31
the difference between the weighted average productivity level of all firms active in 2006 and in 1998 (Table 7).
The 7.7 percent estimate is the authors’ “preferred estimate” found by averaging year-to-year productivity growth
over the entire sample of firms (Figure 3).
Brandt, Van Biesebroeck, and Zhang (2009) conclude that “relative to the US experience, productivity growth
32
in China’s manufacturing sector is to a much greater extent due to changes at the extensive margin, entry and exit.”
In our model, the number of firms is indeterminate, due to constant returns to scale. Thus, we cannot distinguish
between reallocation along an extensive and an intensive margin. Alternatively, we could have considered a model
where firms face entry costs and decreasing returns. In such a model, reallocation would occur along both the
extensive and intensive margin.
development). However, Figure 3 suggests that both rates of return increased during
1998–2005. This hints at the presence of additional sources of efficiency gains
within SOE and DPE that offset the decreasing returns. In part, this discrepancy
can be related to the stark way in which we have mapped the theory into the data.
In particular, we have interpreted F and E firms as SOE and DPE, respectively,
abstracting from within-group heterogeneity. Since our theory emphasizes realloca-
tion across firms of heterogeneous productivities, it is natural to expect that some
reallocation took place within each group, e.g., through the entry of new efficient
firms and the exit of less productive ones. A simple extension of our theory where
entrepreneurs differ in human capital and productivity (i.e., with a distribution of
χiacross E firms) would be consistent with the observation of an increasing return
to capital within DPE. Intuitively, since the growth of E firms is constrained by
retained earnings, more productive E firms would grow faster, causing an increase
of the average productivity of E firms over time.33 No such straightforward exten-
sion works for F firms, since there can be no productivity differences across them in
equilibrium. This is due to the simplifying assumption that F firms are subject to no
credit constraints. In principle, one could relax this assumption and generate real-
location within SOE. We do not pursue this extension. Instead, in the next section
we explore an alternative multi-industry set-up in which F firms have market power
in some industries. This extension predicts increasing profit rates in surviving SOE.
In conclusion, this calibration exercise has shown that reallocation from F firms to
E firms can generate quantitative outcomes that are broadly in line with the empiri-
cal facts for China, suggesting that our mechanism might be important for under-
standing the empirical facts laid out in Section I.
D. Robustness
To illustrate the behavior of the model we examine four alternative parameteriza-

tions: (1) no financial development, (2) no borrowing for entrepreneurs, (3) log
preferences, and (4) low TFP advantage. In each case we change β so as to match
the average aggregate saving rates during 1998–2005, as we did in the benchmark
calibration. Suppose first that there is no financial development. This case is labeled
experiment 1 and is plotted against the benchmark calibration in Figure 9. The
dynamics of the no–financial development economy are very similar to those of the
benchmark economy until 1999. As discussed in Section IIG, the investment rate in
this experiment falls monotonically during the transition and increases sharply when
the transition is completed. The transition is faster than in the benchmark economy
because F firms are not able to borrow at lower and lower interest rates after 1999.
Thus, without financial development the foreign reserves and TFP would grow sub-
stantially faster after 1999.
Consider now the case when entrepreneurs cannot borrow at all, i.e., η = 0 (exper-
iment 2 in Figure 9). For simplicity, we maintain the assumption that ξtis constant
Let χidenote firm i′ s productivity and Kibe the corresponding capital stock. Then, the rate of return to capital
33

for firm i is = ρiE
( 1 − ψ)1/α  χ (1−α)/α
i  R l. If ρEt
 = ∑     ρiEKit/KEt
denotes the average rate of return of E firms, it is
easy to show that ρE grows over time, because the growth rate of Kitis increasing in χi . Intuitively, more efficient E
firms have higher earnings and can finance larger investments. So they grow faster than less efficient firms, thereby
increasing the average rate of return of DPEs over time. We develop this extension in the Appendix.
Panel A. Rate of return in F firms Panel B. E firm employment share

1
0.1
benchmark
experiment 1
0.5
0.05
experiment 2
experiment 3
0 0
1995 2000 2005 2010 1995 2000 2005 2010
Year Year
Panel C. Aggregate saving rate Panel D. Aggregate investment rate

0.6
0.6
0.4
0.5
0.4 0.2
0.3 0
1995 2000 2005 2010 1995 2000 2005 2010
Year Year
Panel E. Foreign reserve/GDP Panel F. TFP growth rate

1.5
0.15
1
0.1
0.5
0.05
0
0
1995 2000 2005 2010 1995 2000 2005 2010
Year Year
Figure 9. Sensitivity Analysis
Notes: The figure shows the evolution of key variables in the calibrated economy (solid line) and various alter-
native parameterizations. Experiment 1 has a constant ξ. Experiment 2 has η = 0. Experiment 3 has logarithmic
preferences.
(no financial development). The key difference relative to the benchmark economy
is that the transition is slower. For example, the E firm employment share reaches
20 percent in 2015, while in the benchmark this level is reached already in 2000.
Consequently, both the growth in foreign surplus and TFP are substantially slower
than in the benchmark economy. The foreign reserves-to-GDP ratio, for instance,
starts to grow only after 2000 and then gradually climbs up to 25 percent in 2017
and 50 percent in 2021.
To examine the role of intertemporal elasticity to substitution θ we solve the
model for θ → 1, i.e., logarithmic preferences (experiment 3 in Figure 9). We also
recalibrated the sequence { ξt} ∞  
t=2000  
so as to match the investment rate in 2007 (recall
that the benchmark economy was calibrated in the same way). The results are quali-
tatively similar to the benchmark case, including a growing foreign surplus. However,
the transition is slower. This implies a higher investment rate and a lower growth of
foreign reserves and TFP. The two-period OLG model provides intuition for the slow
transition. The entrepreneurs’ savings rate ζ Eis lower when θ is lower, and Lemma 2
showed that in the analytical model the speed of transition is increasing in ζ  E.
Finally, suppose the TFP advantage of E firms is low, χ1−α  = 2.0, compared to
2.2 in the benchmark calibration. This implies a smaller difference ρE − ρF and a
smaller difference between capital-output ratios of E firms and F firms than in the
benchmark calibration. This in turn implies a slower transition because entrepre-
neurial firms are less profitable. To understand why, recall that a lower χ implies
a lower return ρE. This in turn lowers the rate of transition because entrepreneurs
and managers have less income and, hence, less savings. Quantitatively, the low-
χ economy is almost indistinguishable from experiment 3, so we omitted it from
Figure 9.
IV. A Two-Sector Model
In this section, we extend the model to a two-sector environment in which

industries have different capital intensities. In such environment, credit-market
discrimination generates an endogenous comparative advantage for E firms in labor-
intensive industries, leading them to specialize in those industries, and inducing F
firms to retreat to capital-intensive industries. This prediction is consistent with the
empirical evidence: as we documented in Section I, the share of SOE has declined
dramatically in Chinese labor-intensive industries, while remaining high in capital-
intensive industries. The retreat from labor-intensive industries has further widened
the gap between the capital-output ratio of SOE and that of private firms since the
mid-1990s (Robert Dekle and Guillaume Vandenbroucke 2006).
For simplicity, we specialize the analysis to logarithmic utility and assume that
η = 0 ; i.e., entrepreneurs cannot get any external financing. Moreover, we assume
that ν = ξ = z = 0. None of these assumptions are essential for the results.
A. Capital- and Labor-Intensive Industries
In this section, we assume the final good, Yt, to be a CES aggregate of two inter-
mediate goods:
( )
_ σ
σ−1
 _ σ−1
 _        
(15) Yt = φ(Y k t ) σ + (Y lt  ) σ σ−1 .
 
     
The superscripts k and l stand for capital- and labor-intensive intermediate goods,
respectively, and σ is the elasticity of substitution between these goods. Both goods
can be produced by either E or F firms, with the following technologies:
(16) y lJ    = (A lJ )  1−α

 (k lJ )   (n lJ )  1−α
, y kJ   = (A kJ)  1−α
α
k kJ, 
where J ∈ {E, F}. The production technology for the labor-intensive good is identi-
cal to that of our benchmark model. The assumption that the capital-intensive good
is produced without labor is for convenience. We assume the same TFP gap between
E and F firms in the two industries. More formally, χ ≡ A kE /  A kF   = A lE /  A lF .  Raising
both A kJ and A lJ  to the power of 1 − α ensures that the TFP gap is the same across
industries.
We set the final good to be the numeraire. Profit maximization of final producers
subject to (15) yields that
( )
σ
(17)  _
Y k    = φ  _P l    ,
Y l P k
where P kand P lare goods prices. The standard price aggregation holds:
( )  _
1    
(18) φσ (P k)1−σ
+ (P l )1−σ
1−σ = 1.
When F firms are active in the production of the labor-intensive good, they behave
as in the benchmark model of Section II. In particular, the following analogues of
equations (2) and (8) hold:
α
(19) w = P lt(  1 − α)A lF (  κ lF )  ,
( ) P lα  
κ lF    =  _
_
      
1
(20)  1−α .
R
In addition, when F firms are active in the production of the capital-intensive
good, perfect competition pins down its price level:
(21) P k(A kF )  1−α

= R.
Given these equilibrium conditions, we can determine the return E firms require
to invest in each industry. The following lemma characterizes the patterns of spe-
cialization of F and E firms. Recall that KE tis predetermined by the entrepreneurial
savings.
Lemma 4: (i) If, in period t, K lF t  > 0 and K kF t  > 0, then ρ lEt    > ρ kEt  ,  implying that
K lE t  = KE t and K kE t  = 0. (ii) If, in period t, K lE t  > 0 and K kE t  > 0, then R ≥ ρ kFt    >
ρ lFt  ,  implying that K  lF t  = 0 and K
 kF t  ≥ 0.
Lemma 4 characterizes the dynamics of the equilibrium in the two-sector model.

There are four distinct stages of the transition:
Stage 1: Only F firms invest in the capital-intensive sector, while both E and F
firms invest in the labor-intensive sector. The employment share of F firms declines
as entrepreneurial investment increases. Consequently, the employment share of F
firms decreases over time in the labor-intensive industry. However, the capital-inten-
sive good is produced only by F firms. This is consistent with the retreat of Chinese
SOE from labor-intensive industries. Due to this specialization in the capital-inten-
sive industry, the average capital-output ratio of F firms increases during the transi-
tion, consistent again with the Chinese evidence. Eventually, F firms completely
abandon the labor-intensive activity.
Stage 2: All workers are employed by E firms. Entrepreneurs continue to invest

their savings in the labor-intensive sector since it yields a higher return than do both
foreign bonds and investment in the capital-intensive industry. However, the labor-
intensive sector’s rate of return falls over time, because employment cannot grow,
and investment leads to capital deepening. Consequently, wages grow. Eventually,
the incentive to accumulate capital in the labor-intensive industry comes to a halt.
 > α(1 + β)/(βψR), entrepreneurs turn to the capital-intensive industry and
If χ1−α
the economy enters stage 3. If χ1−α  < α(1 + β)/(βψR), the economic transition
stops and the capital-intensive industry remains dominated by F firms, in spite of
their lower productivity.
Stage 3: E firms invest in both industries. Gradually, F firms are crowded out of
the capital-intensive industry.
Stage 4: The economy enters the post-transition equilibrium of Section IIE.
Table 2 summarizes the main features of each of the four stages of the transition.
The complete characterization of the equilibrium can be found in the Appendix.
In conclusion, this extension of our benchmark model has shown that the pres-
ence of asymmetric credit frictions generates comparative advantages for credit-
constrained firms to specialize in labor-intensive activities. Since the growth of E
firms is only gradual, we see F firms first withdrawing from labor-intensive indus-
tries and then, possibly, from capital-intensive industries. The theory also offers
the interesting possibility that E firms never take over capital-intensive industries.
The steady state may be characterized by high-productivity firms in labor-intensive
industries and low-productivity firms in capital-intensive industries.
B. Monopoly in the Capital-Intensive Industry
As discussed in Section IIIC, there is evidence that profits have increased over
time in surviving SOE. This may seem puzzling since a large number of SOE have
been declining. In this section, we extend the two-sector model and assume that
the labor-intensive industry is competitive, while the capital-intensive industry is
monopolized by a large F firm. With this set-up, the theory predicts that as the tran-
sition proceeds, the increased efficiency in the labor-intensive industry increases the
profit of the monopolist F firm.
The assumption that SOE have market power in capital-intensive industries is
consistent with the industrial policy in China. Since 1997, under the slogan “Zhuada
Fangxiao” (“grab the big ones and release the small ones”), the Ninth Five-Year
Plan exposed SOE to competition in labor-intensive industries, while promoting the
merger and restructuring of SOE in strategic capital-intensive sectors—e.g., pet-
rochemicals, railway, and telecommunication—into large transregional groups.34
This strategy gave surviving SOE a significant monopoly power in their industries.
34
By the end of 2001, there were 179 Chinese enterprises with value added over 500 million USD. Of them, 165
were state-owned or state-controlled groups. The stated objective of the policy was to help large SOE be competi-
tive internationally like chaebol in Korea.
Table 2—Investment Patterns in E and F Firms, across Transition Stages
Stage 1 Stage 2 Stage 3 Stage 4

Industry E F E F E F E F
Labor-intensive Yes Yes Yes No Yes No Yes No
Capital-intensive No Yes No Yes Yes Yes Yes No
Arguably, this has been a main reason why SOE profits have soared over the last ten
years (Figure 3).
Without loss of generality, we normalize A kF   = 1. Moreover, to guarantee that
the problem of the monopolist is well defined, we assume that σ > 1. The model is
identical to the two-sector model of Section IVA, except that the capital-intensive
sector is now a legal monopoly. We assume the monopoly firm to be one-period
lived, and to be owned by a set of old agents (“bureaucrats”) who are neither work-
ers nor entrepreneurs, and who neither produce nor consume in the first period of
their lives. This implies that the monopoly has a static objective function.35
Formally, the equilibrium allocation differs from the competitive equilibrium
of Section IVA in two respects. First, y kE   = 0, since E firms cannot enter the
capital-intensive industry. Second, equation (21) does not hold, since there is no
competition driving profits to zero in the capital-intensive industry. Instead, P k is
determined by the profit-maximizing choice of a price-setting monopolist, max P k Π kt 
≡ (P kt  − R)K k, subject to technology (16) and the equilibrium conditions (17),
(18), and (20).
Proposition 2: The optimal markup set by the monopolist in the capital-inten-

sive industry, P k/R, is the unique solution satisfying the following condition:
( ) ( ( ) )( )
−1 −1
P k  P k  Y lF t 
(22) σ _
  t     − (σ − 1) = 1 −  _
  t    σ − 1 +  _   _
1         
R R 1 − α Y lt 
φσR1−σ(P k/R)1−σ

×  __       .
1 − φ R (P /R)1−σ
σ 1−σ k

The optimal markup is decreasing in the share of F firms (Y lF /  Y l ) in the labor-
intensive industry. Thus, monopoly power increases during a transition in which the
share of F firms declines in the labor-intensive industry.
Note that the left-hand side of (22) is decreasing in P k/R, while the right-hand
side is increasing in P k. This guarantees that (22) pins down the unique equilibrium
solution. Since the right side is increasing in Y lF /  Y l, it is then immediate to establish
that the markup is decreasing in the share of F firms in the labor-intensive industry.
35
Since F firms have no equity capital and perfect access to external finance, they face no dynamic investment
problem. However, a long-lived monopoly could use its market power to affect the speed of transition, which in turn
would affect its future profits. This is an artifact of the assumption (which is made for simplicity) that there is only
one large monopolized industry in the economy. If there were a continuum of monopolized industries, each firm
would maximize its period-by-period monopoly profit, and the results would be identical to those in this section.
Intuitively, as the productivity of the labor-intensive industry increases during the

transition, so does the demand for the capital-intensive good, which strengthens the
power of the monopolist.36
V. Conclusions
In this paper, we have constructed a neoclassical model augmented with financial

and contractual imperfections that affect different types of firms in the economy
asymmetrically. The model is consistent with salient patterns of the recent Chinese
experience, most notably sustained high returns on investment in spite of high
capital accumulation, large productivity differences across firms, reallocation from
low-productivity to high-productivity firms (as documented by Hsieh and Klenow
2009), and the accumulation of a large foreign surplus. A calibrated version of the
model has been shown to be quantitatively consistent with these facts.
A number of simplifications that were made for the sake of tractability will be
relaxed in future research. In particular, we do not explore in depth potential deter-
minants of the high household savings in China. Theories of entrepreneurial sav-
ings with financial constraints such as Quadrini (1999) and Marco Cagetti and
Mariacristina De Nardi (2006) could add new insights to reinforce and complement
the mechanism of our theory. Moreover, by assuming an exogenous rate of TFP
growth, we have abstracted from endogenous technology adoption, which may be
an important driver of China’s performance.
In spite of these limitations, we believe the theory explored here offers a useful
tool for understanding one of the major puzzles of the recent growth experience:
how is it that China grows at such a stellar rate and at the same time increases its for-
eign surplus? Some commentators have tried to explain this puzzle by attributing it
to government manipulation of the exchange rate that holds the value of the Chinese
currency artificially low. This argument is controversial, as it attributes a long-stand-
ing imbalance to a nominal rigidity, without explaining why the peg of the nominal
exchange rate did not trigger an adjustment of the real exchange rate through infla-
tionary pressure (see Song, Storesletten, and Zilibotti 2010). In this paper we have
provided substantial empirical evidence corroborating the economic mechanism of
an alternative theory that explains the build-up of a large foreign surplus in China as
the outcome of structural imperfections. We believe this is a more credible explana-
tion for a phenomenon that has by now persisted for almost two decades.
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American Economic Review 101 (February 2011): 196–233

Growing Like China

By Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti*

We construct a growth model consistent with China’s economic

e­ mphasizes the effects of resource misallocation on average productivity. In con-

(i) The theory predicts that the surplus—savings minus investment—should

c­ omparative advantage). Thus, the transition proceeds in stages: first low-

I. The Transition of China: Empirical Evidence

A. Political Events and Macroeconomic Trends

enterprises (DPE) as a percent of DPE plus state-owned enterprises (SOE) in the

C. Productivity and Credit Frictions

Figure 3. Total Profits over Net Value of Fixed Assets

Figure 4. Share of Investment Financed by Bank Loans and Government Budgets

The economic transition of China has been accompanied by increasing income

Change in SOE empl. share, in percent

Figure 5. SOE Employment Shares across Industries

E. Foreign Surplus and Productivity Growth

Finally, the reallocation process in manufacturing has an interesting statistical

Figure 6. Income Inequality and Private Employment Share across Provinces

and ­government consumption expenditures). In column 1 of Table 1, we report

(S-I)/GDP Growth rate of GDP p.c. Growth rate of VA p.w.

II. The Benchmark Model

In this section, we develop a theory of economic transition consistent with the

A. Preferences, Technology, and Markets

The model economy is populated by overlapping generations of two-period

become important in the extension about financial development.

subject to the incentive constraint that ​m​t​ ≥ ψ​​(​kEt

(4) ​m​t​ = ψ​​(​kEt

Before discussing equilibrium dynamics, we review our main assumptions.

C. Equilibrium during Transition

In this section, we characterize the equilibrium dynamics during a transition in

savings in period t (hence, ​K​Et+1​) is linear in ​KEt

and ​ρE​ ​ = (1 − ψ)1/α χ(1−α)/α ​Rl​​ and ​Rl​​ = R/​(1 − ξ)​. There exists χ​ ​ 

D. Foreign Surplus, Savings, and Investments

Panel B. Return on capital ( ρ)

1.02 Return F firms ↑

Output per efficiency unit

Figure 7. Transition in the Analytical Model

Lemma 3: The country’s foreign surplus is given by

(13) ​B​t​ = ​ ​ζ​W__

Proposition 1: Suppose that χ > max{​_ χ​, ​ 

strained firms contract. However, in the Chinese experience there is no evidence of

III. Quantitative Analysis

We have focused so far on qualitative predictions of the theory. In this section,

A. The Quantitative Multiperiod Model

where w ​ ​t​is the wage in period t.

Young entrepreneurs work as managers for T/2 periods and as entrepreneurs

where the net return on equity, ​R​ lt​​ρ​

The calibration of our multiperiod model focuses on matching empirical moments

Panel A. Rate of return in F firms Panel B. E firm employment share

Panel C. Aggregate saving rate Panel D. Aggregate investment rate

Panel E. Foreign reserve/GDP Panel F. TFP growth rate

Figure 8. Transition in the Calibrated Economy

The dynamics of the calibrated multiperiod economy are illustrated in Figure 8.

To illustrate the behavior of the model we examine four alternative parameteriza-

Panel A. Rate of return in F firms Panel B. E firm employment share

Panel C. Aggregate saving rate Panel D. Aggregate investment rate

Panel E. Foreign reserve/GDP Panel F. TFP growth rate

Figure 9. Sensitivity Analysis

e mphasizes the effects of resource misallocation on average productivity. In con-

c omparative advantage). Thus, the transition proceeds in stages: first low-

and government consumption expenditures). In column 1 of Table 1, we report

subject to the incentive constraint that mt ≥ ψ(kEt

(4) mt = ψ(kEt

savings in period t (hence, KEt+1) is linear in KEt

and ρE  = (1 − ψ)1/α χ(1−α)/α Rl and Rl = R/(1 − ξ). There exists χ   

(13) Bt = ζW__

Proposition 1: Suppose that χ > max{_ χ,    

where w tis the wage in period t.

where the net return on equity, R ltρ

(16) y lJ    = (A lJ )  1−α

(21) P k(A kF )  1−α