Good Finance and Bad Finance: the Effects of Different Aspects of Financial Development on Resource Misallocation During China’s Reform Era

Using municipal cities during China’s reform era as the setting, we investigate how different aspects of financial development affect resource misallocation in an integrated framework. Using different identification strategies, we find that local government-driven finance exacerbates the misallocation problem, while non-local government-driven finance improves allocative efficiency. We further show that local government-driven finance causes excessive allocation of resources to state-owned enterprises and large firms, lowers investment efficiency, and exerts larger impacts in the earlier period of local politicians’ terms. Our analysis suggests that distinguishing between good finance and bad finance is critical to develop a socially desirable financial system.