Incentives and Firm Investment: Evidence from China's Reform

We study how managerial incentives affect firm behavior by studying a staggered reform in the Chinese state-owned enterprise (SOE) performance evaluation policy. To improve capital allocation efficiency, starting in 2010, Chinese regulators switched from using the return on equity (ROE) to economic value added (EVA) when evaluating SOE performance. This EVA policy adopts a one-size-fits-all approach by stipulating a fixed cost of capital for virtually all SOEs. We show that SOEs did respond to the performance evaluation reform by altering their investment decisions, more so when the actual borrowing rate was further away from the stipulated cost of capital. Our paper provides causal evidence on the impact of incentive schemes on real investment and sheds new light on challenges faced by economic reforms in China. JEL Classification: G31, G34, M12, M52, P31