We study the efficiency of capital allocations at state-controlled and privately owned business groups in China. Using highly granular data on within-group capital transfers, we document stark differences: while private groups allocate more capital to units with better investment opportunities, state groups do the opposite, especially when part of the "national team." Minority shareholders in state owned enterprises suffer as a result. External monitoring by outside investors helps discipline state groups' tendency to ignore investment opportunities. We trace capital allocation decisions to the objectives of the Chinese Communist Party, which incentivizes managers to maintain social stability. Consistent with the party's policy preferences, capital allocations are used to prop up struggling employers in high-unemployment areas and when many young men enter the local labor market, but the interests of the party and of managers may be misaligned. We ask how efficiently capital is allocated under state capitalism. Our focus is on China, the country where state capitalism is perhaps the most entrenched.3 F 2 Because China's capital markets are relatively underdeveloped and firms cannot access them without political approval (Allen, Qian, and Qian 2005), we focus on firms' internal allocations of capital -i.e., the internal capital markets operating inside business groups. As we show, Chinese firms rely much more heavily on capital obtained from fellow group members than they do on external capital markets.
Alexander LjungqvistWe investigate the efficiency of capital allocation empirically by contrasting how state business groups and privately owned business groups in China allocate capital across their member firms. Prior evidence suggests that we should find greater capital efficiency at private groups. Allen, Qian, and Qian (2005), for example, document that private enterprises in China are often credit-rationed by state banks and face higher interest rates. These financial constraints translate into a high shadow cost of capital, suggesting that private enterprises should allocate capital efficiently. State owned enterprises, in contrast, often face soft budget constraints (e.g., in the form of state directed lending) and can thus afford to be more profligate (Kornai, Maskin, and Roland 2003). Our empirical findings confirm this prediction, with an important twist.1 See, for example, "The Rise of State Capitalism", The Economist, Jan. 21, 2012. 2 To illustrate, China's state firms account for two-thirds of China's stock market capitalization in 2014. The combined profits of three of the largest, PetroChina, Sinopec, and China Shenhua, exceed the combined profits of all the 1,531 private enterprises listed on China's A share market in 2014. China's state firms are large even by global standards: 92 of Fortune's 2014 list of the 500 largest firms worldwide are Chinese, and 85 of these are state owned firms; their collective revenues of $4.6 trillion are equivalent to over 60% of China's 2014 GDP. 2 Us...