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Fiscal policy volatility and capital misallocation

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How does fiscal policy volatility influence capital allocation efficiency in China’s manufacturing sector?

Image courtesy of interviewee. December 11, 2024

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This video discusses the importance of fiscal policy as a tool for managing economic conditions, particularly its impact on the manufacturing sector in China. It emphasizes that government spending and taxation decisions can significantly affect firms' operational costs, market demand, and overall profitability.

Fiscal policy in China has experienced volatility due to structural issues, notably stemming from tax reforms over 30 years ago that created a mismatch between local revenue and expenditure responsibilities. This video volatility leads to unpredictable government spending and increased uncertainty for firms regarding future profitability. Firms may struggle with capital misallocation, where resources are not invested in their most productive uses, slowing down economic growth.

The presentation highlights the concept of "Marginal Revenue Product of Capital" (MRPK), which indicates how capital is used across firms. Misallocation occurs when firms with less productivity possess more capital, while more efficient firms are limited. The study suggests that fiscal policy volatility contributes to MRPK dispersion and, thus, resource misallocation.

Future research directions include exploring sectoral variations in misallocation and the interaction of fiscal policy volatility with trade openness. The findings indicate that reducing fiscal policy volatility can improve capital allocation efficiency and productivity growth.

Additionally, the text suggests alternative strategies for policymakers to address capital misallocation without necessarily reducing fiscal policy volatility. These strategies include lowering capital adjustment costs, diversifying firms' customer bases, and focusing on expenditures that significantly impact profitability.

The overall conclusion emphasizes the critical relationship between fiscal policy stability and capital allocation efficiency and the implications for economic growth, particularly in developing countries like China.

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Here are five key points extracted from the video regarding fiscal policy and its impact on capital allocation and economic growth:

1. **Importance of Fiscal Policy in Economics**: Fiscal policy, which encompasses government spending and taxation decisions, plays a crucial role in managing economic conditions. In many economies, especially in the manufacturing sector, government infrastructure investments significantly influence firms' costs and market demand, thereby impacting capital allocation and economic growth.

2. **Capital Misallocation and Its Effects**: Capital misallocation occurs when resources are not directed toward their most productive uses. This misallocation can hinder economic growth and aggregate productivity, as it leads to situations where less productive firms operate with disproportionately more capital, while more productive firms face capital constraints.

3. **Impact of Fiscal Policy Volatility**: The volatility of fiscal policy, particularly in China, creates uncertainty for firms regarding future profitability, which impacts their investment decisions. Unpredictable government spending can lead to suboptimal investment, causing firms to invest either too much or too little compared to optimal levels, thus exacerbating capital misallocation.

4. **Measuring Fiscal Policy and Capital Misallocation**: The study employs a systematic approach to measure fiscal policy volatility and capital misallocation by analyzing unexpected fiscal policy shocks and the marginal revenue product of capital (MRPK). A significant correlation is identified, indicating that reduced fiscal policy volatility can enhance capital allocation efficiency.

5. **Recommendations for Future Research and Policy Directions**: The research suggests exploring the sectoral or regional dimensions of capital misallocation further and investigating the interaction between fiscal policy volatility and trade openness. Additionally, it recommends that policymakers focus on reducing discretionary and unpredictable fiscal actions while maintaining the flexibility to respond to economic conditions to improve resource allocation efficiency.

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Here are some key quotes extracted from the video regarding fiscal policy, capital misallocation, and their implications:

1. **On the Role of Fiscal Policy**:
- "Fiscal policy... is actually a very powerful tool for managing economic conditions."
- "In many countries, fiscal policy plays a very important role in the manufacturing sector..."

2. **On the Importance of Expenditure**:
- "Expenditures on infrastructure like public goods and services directly influence the firm's cost and market demand."
- "Physical spendings on economic construction accounted for a significant portion of the total government expenditure."

3. **On Fiscal Policy Volatility**:
- "Fiscal policy is often voluntary and... there are frequent and sometimes discretionary changes in the government spending that are not necessarily driven by economic conditions."
- "This mismatch created a larger likelihood of discretionary government spending and eventually fiscal volatility."

4. **On Capital Misallocation**:
- "Capital misallocation refers to a situation where the capital is not distributed to their most productive usage."
- "When misallocation happens, some less productive firms operate with more capital, while more productive firms are left with constraints."

5. **On the Impact of Policy on Investment Decisions**:
- "Fiscal policy volatility increases... uncertainty by creating an unpredictable shift in the cost and demand held to the government spending that directly affects the firm's future profitability."
- "Uncertainty leads to suboptimal decisions on investment where the firms either invested too little or too much compared with the optimal levels."

6. **On Measurement and Findings**:
- "We found that the fiscal policy volatility is a significant and independent driver of MRPK dispersion."
- "A 10% decrease in the fiscal policy volatility can lead to a 0.2% decrease in the MRPK dispersion."

7. **On Recommendations to Policymakers**:
- "Reducing the fiscal policy volatility would enhance the capital allocation efficiency and put the capital in its best use."
- "Predictable fiscal policy can... lead to a more efficient capital allocation."

8. **On Future Research Directions**:
- "The first direction could be to study the sectoral or regional dimensions of misallocation."
- "Exploring the sectoral or regional variations could be very important... to understand how the fiscal volatility affects regions with less developed financial markets."

9. **On Alternative Policy Tools**:
- "One possible direction is to reduce the capital and adjustment costs."
- "The government could encourage industry to export... reducing the dependency on government purchases."

These quotes encapsulate the critical themes of the video, emphasizing the relationship between fiscal policy, capital misallocation, and recommendations for improving economic conditions.

X-TIMESTAMP-MAP=LOCAL:00:00:00.000,MPEGTS:90000

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So fiscal policy, which involves in the government

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decisions on spending

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and taxation, is actually a very powerful tool

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for managing economic conditions.

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In many countries, fiscal policy plays a very important role

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in the manufacturing sector

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where the government expend expending

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and expenditures on infrastructure like public goods

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and services as well directly influence the firm's cost

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and market demand.

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And this eventually affect the firm's

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profitability in China.

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Physical spendings on economic construction accounted

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for a significant portion

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of the total government expenditure.

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However, physical policy is often voluntary

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and they are frequent and sometimes

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discretionary changes in the government spending

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that are not necessarily driven by economic conditions.

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In the context of China,

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this volatility from the structure issues such

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as the tax reform about 30 years, 30 years ago,

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that centralized the revenue connection

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but left expenditure responsibility to local government.

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This has created a significant mismatch between expenditures

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and the revenue of local government.

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And this mismatch created a, a, a larger likelihood

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of discretionary government spending

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and eventually physical volatility.

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In addition, usually the physical policy is not transparent

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enough to minimize the discretionary changes of expenditures

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and this further increase that volatility which lead

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to a larger uncertainty when firms anticipate

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or predict their future profitability.

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But to understand how volatility lead

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to capital misallocation, first we need to understand

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what capital misallocation is.

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While capital misallocation referred to a situation

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where the capital is not distributed

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to their most productive usage.

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Yet efficient economy firms equalize their marginal revenue

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product of capital.

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We call them as MRPK.

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And consequently this means that a capital flows

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to the firms who can generate most value out of that.

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However, when misallocation happens,

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some less predictive firms operate with more capital,

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while more predictive firms are left with constraint.

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And this misallocation slow down aggregate productivity

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and economic growth.

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And this is particularly critical issue for many countries,

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especially for developing countries like China.

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So how does capital misallocation can be induced

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by physical policy volatility?

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Well, let's consider firm which decide each year on

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how much to invest in in the capital.

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For example, for, for example, wanted

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to expand the firm's production capacity or not, right?

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Such investment often come with a significant cost

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to adjust the capital

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and those costs that are referred to

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as the capital adjustment cost.

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Those costs include, for example, expenditures of the firm

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for acquiring or selling machinery

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and the disruption to the business operations.

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It's make the, it make it very difficult for the firm

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to change the capital levels.

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Frequently in the context of China, in manufacturing sector,

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like in many other countries, that adjustment cost

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for the capital stock is quite high.

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As a result, the uncertainty about the future profitability

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disrupt the firm's investment decisions.

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And this is often a case

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that a capital stock determined in the last year is not the

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optimal amount after profitability shock.

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So the physical policy volatility increased this kind

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of uncertainty by creating an unpredictable shift in the

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cost and a demand held to the government spending

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that directly affecting the firm's future profitability.

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For example, while a firm may hesitate

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to invest in a new machinery

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or capacity expansion,

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if they cannot anticipate a wider infrastructure spending

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of the government in its own region will rise, will fall.

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So you can see the uncertainty leader

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to suboptimal decisions on investment

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where the firms either invested too little

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or too much compared with the optimal levels.

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So when this happens across different firms in the entire

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industry, it create a dispersion

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in the marginal revenue product of capital.

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We call it M-R-M-R-P-K, of course,

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among the firms in the industry.

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And this is the key indicator of the capital misallocation,

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meaning that the capital is not distributed

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to the most productive uses a larger capital

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dis Mr RPK dispersion to be precise, it's likely to

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indicate there's a more serious misallocation

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problem of capital.

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And our study aimed to quantify how much

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of the capital misallocation can be attributed

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to the physical policy volatility and

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consequently provide insight on important

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but often overlooked driving force

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of the inefficiency in the resource allocation.

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Yeah. Thank you so much.

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Most welcome. Okay, so, moving to point number two

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or question two is about future research directions.

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Do you suggest based on your findings about physical policy,

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quality, volatility and capital efficiency?

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Well, we're talking about the future

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directions of research, right?

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Well, the first direction could be study the sectoral

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or regional dimensions of misallocation.

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Our work, the current work we have done

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actually identified the aggregate effect,

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but exploring the sectoral

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or regional variations could be very important as well.

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For example, how does the physical volatility affect the

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industries with a long capital investment circles

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or regions with less developer financial

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market in different ways.

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So that's gonna be the first direction to go.

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But the second possible direction is

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to examine the interaction

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between the physical policy volatility

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and the trade openness.

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International trade literature suggests

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that the trade openness can enhance the resource allocation.

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Well, it would be very valuable to study

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how the physical policy volatility interacts

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with trade policies to affect the,

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to affect the capital allocation.

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So overall our research emphasized the physical policy

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volatility is a significant driver

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of the resource misallocation

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and is to introduce a new perspective

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to the broader literature on the policy uncertainty.

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And that the phase the, the future research

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can expand on those insight by exploring this kind

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of sectoral and policy dimensions of design.

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And I'm quite sure those effort could help the policy makers

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to design frameworks

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that promote both the macroeconomic conditions

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and the efficient resource allocation.

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We found that the physical policy volatility

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is a significant and independent driver of MRPK dispersion.

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We showed that a 10% decrease

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in the physical policy volatility can lead to a 0.2%

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decrease in the MRM RPK dispersion.

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Well is this a bigger or small effect?

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Well, in our opinion it is quite a sizable actually.

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So over the sample period over decades in, in our study

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the decline, the physical policy volatility contributed

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to approximately 8%

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of the observed improvement in the capital allocation

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efficiency in China.

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So indeed this is a big number

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and this result is robust across different specifications

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and remain very consistent.

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Even we look at the industrial level data.

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So this result indeed has a critical implications

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for the policy makers.

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Reducing the physical policy volatility would enhance the

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capital allocation efficiency

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and put the capital in its best use.

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And this consequently would induce the higher rate

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of productivity growth

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and eventually, stronger economic growth as well.

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Importantly, NAMIC ified

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that this doesn't mean the physical policy should be the

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same all the time or right,

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because the government indeed needed the flexibility

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to respond to the economic cycles.

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Those anticipated responses are generally understood

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by the firm and do not generate the same

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harmful uncertainty.

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So instead the focus should be on reducing the discretionary

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and unpredictable physical actions.

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So you can put it in another way.

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Predictable physical policy can be used for

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to build up economic environment

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where the firms make better informant investment decisions

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and consequently lead

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to a more efficient capital allocation.

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So let me begin by explain how we measure

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physical policy volatility and what kind of data we use for

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that physical policy can be voluntary

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for under least the two reasons.

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The first is the government response

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to the economic conditions such as recession or boom.

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Those type of volatility is typically anticipated by firms.

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However, even

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after they're accounting for those systematic responses,

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fiscal policy can still vary due

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to the discretionary government expenditures such as

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decreases and increases in the expanding on infrastructure

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project and the government purchases.

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This discretionary component represented unexpected aspect

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of the physical policy volatility,

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which can prevent the firm from making the optimal

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investment decisions.

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Our study focused on specifically on this

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form of volatility.

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Formally we measure this kind of physical policy volatility

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as the variation in the unexpected physical policy shocks

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after the controlling for predictable

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economic cycle responsive policies.

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And this measurement is conducted

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for all the 31 provinces across China using the

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data from the China statistics yearbook from the period

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of 1998 to 2007.

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And this period actually capture very important trend.

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We observe a decline in the physical policy volatility

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following a sequence of reforms,

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but the regional differences are still quite persistent.

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For example, the coastal areas in China,

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like Eastern China experience a lower physical policy

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volatility compared with the in inland regions.

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And those variation in the physical policy volatility across

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regions and over time provide an excellent basis

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to explore the effect on the capital misallocation.

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So how do we measure the capital misallocation anyway,

224
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while we use the firm level data from the annual report

225
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of China's National Bureau of Statistics,

226
00:11:47.165 --> 00:11:49.345
we focus on the manufacturing sector of course.

227
00:11:49.765 --> 00:11:53.250
So the marginal revenue product of capital, we call them as

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MRPK, is calculated from the firm's revenue

229
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and capital input using production function framework.

230
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The MRPK dispersion is computed as the AV

231
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province standard division of MR MRPK across all the firms.

232
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So after we obtained those two key measures,

233
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we explore their relationship using a regression model.

234
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A key challenge of this analysis is the,

235
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is the potential indigeneity that is the province

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with a higher level

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00:12:25.405 --> 00:12:29.045
of MRPK dispersion might adopt a voluntary

238
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physical policies just to support the inefficient firms

239
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and to address this kind of problem we use a GMM estimation

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with a set of instrumental variables.

241
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So overall, those are the method

242
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and the data we use to recover the strong relationship

243
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between the physical policy volatility

244
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and the capital misallocation.

245
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Well, what would be the alternative tools for the government

246
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or policy makers to,

247
00:12:56.425 --> 00:13:00.325
to reduce the capital misallocation if there's a little room

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to reduce the physical policy volatility, right,

249
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because they are indeed a situation such as the

250
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physical policy volatility is already very low

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or the, when reducing the

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physical policy volatility further is quite costly.

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So would that be any alternative tools,

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policy tools for that?

255
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Well, in our study we actually explore the three key

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mechanism that physical policy volatility impacted them,

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capital allocation

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and each of them actually can offer a way to, as,

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as the alternative policy tool

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to reduce the capital misallocation without reducing

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the physical policy volatility.

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So let me explain a little bit on each.

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The first dimension is to, is about the capital

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and adjustment cost that I mentioned before.

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Well imagine a scenario

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where the firms can freely adjust the capital investment

267
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such as purchasing a new machinery

268
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or selling of the old equipment without any friction.

269
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In this ideal situation,

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firms face zero at adjustment cost for capital.

271
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So the firms could respond immediately

272
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to the physical policy shocks even when those shocks

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are unexpected.

274
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However, of course in in reality

275
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at adjusting the capital stock comes with a significant cost

276
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and those costs are limited the firm's ability

277
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to adapt quickly to the policy shocks.

278
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So naturally the policy makers could target

279
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reducing the capital and adjustment cost.

280
00:14:34.175 --> 00:14:38.075
For example, government could encourage the secondary market

281
00:14:38.135 --> 00:14:41.235
for capital goods to enable firms to sell

282
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and purchase secondhand capital goods.

283
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So by lowering those at adjustment cost,

284
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the firms can become more adaptable to physical shocks,

285
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reducing the misallocation

286
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of capital even when the physical policy remain voluntary.

287
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So that's the first possible direction to go.

288
00:15:01.105 --> 00:15:05.845
The second direction is related to the government dependency

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in the industries with a higher reliance on government

290
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contract or the purchases, they are going to be more likely

291
00:15:13.735 --> 00:15:16.995
to be affected by at the physical policy volatility.

292
00:15:17.385 --> 00:15:18.755
This is quite intuitive

293
00:15:18.755 --> 00:15:20.755
because those, those firms,

294
00:15:21.285 --> 00:15:25.275
their profitability are directly depends on the government

295
00:15:25.675 --> 00:15:28.235
spending, which can be quite unpredictable.

296
00:15:28.975 --> 00:15:30.795
So policy makers

297
00:15:31.735 --> 00:15:34.715
can focus on diversifying the firm's customer basis

298
00:15:35.175 --> 00:15:37.435
to reduce their dependency on the

299
00:15:37.435 --> 00:15:39.035
government purchases or demand.

300
00:15:39.415 --> 00:15:41.155
For example, the government can

301
00:15:41.155 --> 00:15:42.755
encourage industry to export.

302
00:15:43.025 --> 00:15:44.915
They can also encourage innovation

303
00:15:45.295 --> 00:15:48.475
and diversification to decrease the reliance

304
00:15:49.175 --> 00:15:50.995
on the NA narrow set

305
00:15:50.995 --> 00:15:53.035
of the revenue associated of those firms.

306
00:15:53.825 --> 00:15:57.235
This is effectively weakening the link

307
00:15:57.305 --> 00:16:00.555
between the government spending and the firm's profitability

308
00:16:00.735 --> 00:16:02.955
and the consequently reduce the impact

309
00:16:03.055 --> 00:16:06.555
of the physical policy volatility on the capital stock,

310
00:16:06.965 --> 00:16:10.675
sorry, on the capital misallocation without reducing the

311
00:16:10.915 --> 00:16:13.115
physical policy volatility itself.

312
00:16:14.205 --> 00:16:17.505
The third solution would be related to the type

313
00:16:17.505 --> 00:16:19.065
of government expenditures

314
00:16:19.175 --> 00:16:20.865
because not all the type

315
00:16:20.885 --> 00:16:25.065
of expenditure volatility have the same impact on

316
00:16:25.535 --> 00:16:28.295
capital misallocation, for example,

317
00:16:28.635 --> 00:16:32.335
the infrastructure spending is directly tied to the cost

318
00:16:32.335 --> 00:16:34.895
and the market demand faced by the manufacturing firms

319
00:16:35.275 --> 00:16:38.295
and those expenditures significantly affect

320
00:16:38.295 --> 00:16:39.335
the firm's profitability.

321
00:16:40.065 --> 00:16:43.875
However, the expenditures on, for example, the government

322
00:16:44.515 --> 00:16:48.355
employees and administrative courses are less likely

323
00:16:48.495 --> 00:16:50.835
to direct the effect the operation costs

324
00:16:50.895 --> 00:16:53.515
or the demand of manufacturing firms and

325
00:16:53.515 --> 00:16:55.395
therefore they're gonna have a less

326
00:16:55.695 --> 00:16:58.515
or weaker impact on the firm's profitability.

327
00:16:59.415 --> 00:17:00.995
So in the context of China,

328
00:17:01.575 --> 00:17:04.995
the infrastructure related expenditures are typically

329
00:17:05.595 --> 00:17:06.995
included in the government.

330
00:17:08.335 --> 00:17:11.975
Budgetary expenditures spending on the administrative

331
00:17:11.975 --> 00:17:15.815
courses is often under the extra budgetary expenditures.

332
00:17:16.315 --> 00:17:18.055
So in our study we show

333
00:17:18.055 --> 00:17:21.615
that the physical policy volatility from the budgetary

334
00:17:21.615 --> 00:17:24.975
expenditures have a more significant impact on the capital

335
00:17:25.005 --> 00:17:28.775
misallocation, while the volatility in the extra budgetary

336
00:17:29.565 --> 00:17:32.245
expenditures has a much less impact.

337
00:17:33.105 --> 00:17:35.195
This suggests the strategic approach

338
00:17:35.895 --> 00:17:39.275
the government perhaps should prioritize reducing the

339
00:17:39.435 --> 00:17:41.115
volatility of expenditures

340
00:17:41.585 --> 00:17:44.115
that directly affect the firm's profitability,

341
00:17:44.315 --> 00:17:46.915
particularly when the overall ability

342
00:17:47.215 --> 00:17:49.885
to reduce the physical policy volatility is limited.

343
00:17:50.585 --> 00:17:54.005
So overall reducing the physical policy volatility

344
00:17:54.935 --> 00:17:59.785
perhaps is still the most effective tool to improve capital

345
00:18:00.385 --> 00:18:03.825
allocation efficiency, but indeed alternative strategies,

346
00:18:04.325 --> 00:18:06.465
available for the policy makers.

347
00:18:07.435 --> 00:18:09.245
Okay, thank you so much for the question.

348
00:18:09.265 --> 00:18:10.365
That's very valuable.

The Impact of Fiscal Policy on Economic Conditions

00:00:00 - So fiscal policy, which involves in the government decisions on spending and taxation, is actually a very powerful tool for managing economic conditions. In many countries, fiscal policy plays a very important role in the manufacturing sector where the government expend expending and expenditures on infrastructure like public goods and services as well directly influence the firm's cost and market demand. And this eventually affect the firm's

00:00:33 - Physical spendings on economic construction accounted for a significant portion of the total government expenditure. However, physical policy is often voluntary and they are frequent and sometimes discretionary changes in the government spending that are not necessarily driven by economic conditions. In the context of China, this volatility from the structure issues such as the tax reform about 30 years, 30 years ago,

00:01:03 - but left expenditure responsibility to local government. This has created a significant mismatch between expenditures and the revenue of local government. And this mismatch created a, a, a larger likelihood of discretionary government spending and eventually physical volatility. In addition, usually the physical policy is not transparent enough to minimize the discretionary changes of expenditures

Understanding Capital Misallocation and Its Impacts

00:01:37 - to a larger uncertainty when firms anticipate or predict their future profitability. But to understand how volatility lead to capital misallocation, first we need to understand what capital misallocation is. While capital misallocation referred to a situation where the capital is not distributed to their most productive usage. Yet efficient economy firms equalize their marginal revenue

00:02:06 - We call them as MRPK. And consequently this means that a capital flows to the firms who can generate most value out of that. However, when misallocation happens, some less predictive firms operate with more capital, while more predictive firms are left with constraint. And this misallocation slow down aggregate productivity and economic growth. And this is particularly critical issue for many countries,

00:02:40 - So how does capital misallocation can be induced by physical policy volatility? Well, let's consider firm which decide each year on how much to invest in in the capital. For example, for, for example, wanted to expand the firm's production capacity or not, right? Such investment often come with a significant cost to adjust the capital and those costs that are referred to

Impact of Adjustment Costs on Investment Decisions

00:03:12 - Those costs include, for example, expenditures of the firm for acquiring or selling machinery and the disruption to the business operations. It's make the, it make it very difficult for the firm to change the capital levels. Frequently in the context of China, in manufacturing sector, like in many other countries, that adjustment cost for the capital stock is quite high.

00:03:44 - disrupt the firm's investment decisions. And this is often a case that a capital stock determined in the last year is not the optimal amount after profitability shock. So the physical policy volatility increased this kind of uncertainty by creating an unpredictable shift in the cost and a demand held to the government spending that directly affecting the firm's future profitability.

00:04:15 - to invest in a new machinery or capacity expansion, if they cannot anticipate a wider infrastructure spending of the government in its own region will rise, will fall. So you can see the uncertainty leader to suboptimal decisions on investment where the firms either invested too little or too much compared with the optimal levels. So when this happens across different firms in the entire

Capital Misallocation and Future Research Directions

00:04:45 - in the marginal revenue product of capital. We call it M-R-M-R-P-K, of course, among the firms in the industry. And this is the key indicator of the capital misallocation, meaning that the capital is not distributed to the most productive uses a larger capital dis Mr RPK dispersion to be precise, it's likely to indicate there's a more serious misallocation

00:05:14 - And our study aimed to quantify how much of the capital misallocation can be attributed to the physical policy volatility and consequently provide insight on important but often overlooked driving force of the inefficiency in the resource allocation. Yeah. Thank you so much. Most welcome. Okay, so, moving to point number two or question two is about future research directions. Do you suggest based on your findings about physical policy,

00:05:48 - Well, we're talking about the future directions of research, right? Well, the first direction could be study the sectoral or regional dimensions of misallocation. Our work, the current work we have done actually identified the aggregate effect, but exploring the sectoral or regional variations could be very important as well. For example, how does the physical volatility affect the

Exploring Fiscal Policy Volatility and Trade Openness for Resource Allocation

00:06:18 - or regions with less developer financial market in different ways. So that's gonna be the first direction to go. But the second possible direction is to examine the interaction between the physical policy volatility and the trade openness. International trade literature suggests that the trade openness can enhance the resource allocation. Well, it would be very valuable to study

00:06:49 - with trade policies to affect the, to affect the capital allocation. So overall our research emphasized the physical policy volatility is a significant driver of the resource misallocation and is to introduce a new perspective to the broader literature on the policy uncertainty. And that the phase the, the future research can expand on those insight by exploring this kind of sectoral and policy dimensions of design.

00:07:23 - to design frameworks that promote both the macroeconomic conditions and the efficient resource allocation. We found that the physical policy volatility is a significant and independent driver of MRPK dispersion. We showed that a 10% decrease in the physical policy volatility can lead to a 0.2% decrease in the MRM RPK dispersion.

Enhancing Capital Allocation Efficiency Through Reduced Fiscal Policy Volatility

00:07:52 - Well, in our opinion it is quite a sizable actually. So over the sample period over decades in, in our study the decline, the physical policy volatility contributed to approximately 8% of the observed improvement in the capital allocation efficiency in China. So indeed this is a big number and this result is robust across different specifications and remain very consistent.

00:08:22 - So this result indeed has a critical implications for the policy makers. Reducing the physical policy volatility would enhance the capital allocation efficiency and put the capital in its best use. And this consequently would induce the higher rate of productivity growth and eventually, stronger economic growth as well. Importantly, NAMIC ified that this doesn't mean the physical policy should be the

00:08:54 - because the government indeed needed the flexibility to respond to the economic cycles. Those anticipated responses are generally understood by the firm and do not generate the same harmful uncertainty. So instead the focus should be on reducing the discretionary and unpredictable physical actions. So you can put it in another way. Predictable physical policy can be used for

Measuring Fiscal Policy Volatility and Its Impact on Investment Decisions

00:09:26 - where the firms make better informant investment decisions and consequently lead to a more efficient capital allocation. So let me begin by explain how we measure physical policy volatility and what kind of data we use for that physical policy can be voluntary for under least the two reasons. The first is the government response to the economic conditions such as recession or boom. Those type of volatility is typically anticipated by firms.

00:09:58 - after they're accounting for those systematic responses, fiscal policy can still vary due to the discretionary government expenditures such as decreases and increases in the expanding on infrastructure project and the government purchases. This discretionary component represented unexpected aspect of the physical policy volatility, which can prevent the firm from making the optimal investment decisions. Our study focused on specifically on this

00:10:31 - Formally we measure this kind of physical policy volatility as the variation in the unexpected physical policy shocks after the controlling for predictable economic cycle responsive policies. And this measurement is conducted for all the 31 provinces across China using the data from the China statistics yearbook from the period of 1998 to 2007.

Regional Variations in Fiscal Policy Volatility and Capital Misallocation Analysis in China

00:11:02 - We observe a decline in the physical policy volatility following a sequence of reforms, but the regional differences are still quite persistent. For example, the coastal areas in China, like Eastern China experience a lower physical policy volatility compared with the in inland regions. And those variation in the physical policy volatility across regions and over time provide an excellent basis

00:11:36 - So how do we measure the capital misallocation anyway, while we use the firm level data from the annual report of China's National Bureau of Statistics, we focus on the manufacturing sector of course. So the marginal revenue product of capital, we call them as MRPK, is calculated from the firm's revenue and capital input using production function framework. The MRPK dispersion is computed as the AV

00:12:10 - So after we obtained those two key measures, we explore their relationship using a regression model. A key challenge of this analysis is the, is the potential indigeneity that is the province with a higher level of MRPK dispersion might adopt a voluntary physical policies just to support the inefficient firms and to address this kind of problem we use a GMM estimation

Reducing Capital Misallocation Amidst Fiscal Policy Volatility

00:12:41 - So overall, those are the method and the data we use to recover the strong relationship between the physical policy volatility and the capital misallocation. Well, what would be the alternative tools for the government or policy makers to, to reduce the capital misallocation if there's a little room to reduce the physical policy volatility, right, because they are indeed a situation such as the physical policy volatility is already very low

00:13:13 - physical policy volatility further is quite costly. So would that be any alternative tools, policy tools for that? Well, in our study we actually explore the three key mechanism that physical policy volatility impacted them, capital allocation and each of them actually can offer a way to, as, as the alternative policy tool to reduce the capital misallocation without reducing the physical policy volatility.

00:13:44 - The first dimension is to, is about the capital and adjustment cost that I mentioned before. Well imagine a scenario where the firms can freely adjust the capital investment such as purchasing a new machinery or selling of the old equipment without any friction. In this ideal situation, firms face zero at adjustment cost for capital. So the firms could respond immediately to the physical policy shocks even when those shocks

Strategies for Reducing Capital Adjustment Costs

00:14:15 - However, of course in in reality at adjusting the capital stock comes with a significant cost and those costs are limited the firm's ability to adapt quickly to the policy shocks. So naturally the policy makers could target reducing the capital and adjustment cost. For example, government could encourage the secondary market for capital goods to enable firms to sell and purchase secondhand capital goods.

00:14:47 - the firms can become more adaptable to physical shocks, reducing the misallocation of capital even when the physical policy remain voluntary. So that's the first possible direction to go. The second direction is related to the government dependency in the industries with a higher reliance on government contract or the purchases, they are going to be more likely to be affected by at the physical policy volatility.

00:15:18 - because those, those firms, their profitability are directly depends on the government spending, which can be quite unpredictable. So policy makers can focus on diversifying the firm's customer basis to reduce their dependency on the government purchases or demand. For example, the government can encourage industry to export. They can also encourage innovation and diversification to decrease the reliance

Impact of Government Expenditures on Capital Misallocation

00:15:50 - of the revenue associated of those firms. This is effectively weakening the link between the government spending and the firm's profitability and the consequently reduce the impact of the physical policy volatility on the capital stock, sorry, on the capital misallocation without reducing the physical policy volatility itself. The third solution would be related to the type of government expenditures

00:16:20 - of expenditure volatility have the same impact on capital misallocation, for example, the infrastructure spending is directly tied to the cost and the market demand faced by the manufacturing firms and those expenditures significantly affect the firm's profitability. However, the expenditures on, for example, the government employees and administrative courses are less likely to direct the effect the operation costs

00:16:53 - therefore they're gonna have a less or weaker impact on the firm's profitability. So in the context of China, the infrastructure related expenditures are typically included in the government. Budgetary expenditures spending on the administrative courses is often under the extra budgetary expenditures. So in our study we show that the physical policy volatility from the budgetary

Mitigating Policy Volatility for Improved Capital Allocation Efficiency

00:17:25 - misallocation, while the volatility in the extra budgetary expenditures has a much less impact. This suggests the strategic approach the government perhaps should prioritize reducing the volatility of expenditures that directly affect the firm's profitability, particularly when the overall ability to reduce the physical policy volatility is limited. So overall reducing the physical policy volatility

00:18:09 - allocation efficiency, but indeed alternative strategies, available for the policy makers. Okay, thank you so much for the question. That's very valuable.

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