The effect of financial development, financial agglomeration, and financial constraint on China’s economic development

It has been generally acknowledged that financial development has been critical to economic growth for several decades. Nonetheless, the empirical evidence supporting the association between financial development and economic growth is inconclusive. The majority of existing studies mainly concerned developed countries such as the USA and the UK; there is only a few research focusing on this topic in the context of China. Thus, the main goal of our study is to fill the gap in the previous empirical research. We investigate the impacts of financial development on the economy from both the macro and micro levels in three different aspects: the impact of the informal financial sector (shadow banking sector) on the economic growth in Chinese provinces, the spatial effect of financial agglomeration spillovers on the economic growth among three different regions of China, and the financial constraint on firms’ innovation activities.

Firstly, to better understand China's financial industry and the influence it has on the country's economic growth, we conducted an assessment of the present status of the development in China's financial sector. Based on endogenous growth theory, we have gathered data from more than 4000 enterprises to create a shadow banking index and employ a unique dataset from 30 provinces and municipalities during the period 2005 to 2016, which we use to estimate the impact of the financial sector on provincial economic growth in China. According to the findings, we find that the development in both the formal financial sector and shadow banking sector is positively affecting the economic development in China's provinces. Although the shadow banking coefficients are not as high as the formal financial sector, economic development in China's provinces is still supported to a large extent by the informal financial sector.

Secondly, we attempt to determine the indirect effect of financial agglomeration (also called the spatial spillover effect) on economic growth in different regions of China by adopting the spatial econometric approach with data collected from 30 provinces and municipalities between 2005 and 2016. We find out that the different spatial effects of financial agglomeration spillovers within regions could be believed as one of the reasons to explain the regional growth disparity in China. Specifically, the spatial effect of financial agglomeration spillovers provided a significant favourable influence on economic development in the eastern region of China, which ties the local economic growth and development in the neighbouring areas together. By contrast, the spillover effect generated a depressing effect on provincial economic growth in the central region of China. At the same time, financial agglomerating has an insignificant spillover effect in China’s western region.

Last, we examine how financial constraint impacts Chinese enterprises' innovative activities at a micro-level. We introduced the Euler equation to estimate the financial constraint on different types of firms in China. According to the Euler equation, the financial constraint is associated with the sensitivity of investment in innovation activities to cash flow. We believe that the firm’s cash flow should not influence future investment if absent financial constraint; otherwise, the results can be interpreted as the financial constraint exists, the availability of capital flow has little effect on the innovative activities of State-Owned Enterprises (SOEs) and collective enterprises’ assets, but it has the most significant impact on private firm.