Investing Like China

There are several facts that we document about the Chinese economy during the last decade in this paper: i) The skill premium in wage has been rising till 2008 but falls afterwards; ii) the aggregate investment rate in China increases from 42% in 2008 to 47% in 2013, among which structure investment contributes most of the surge; iii) on the firm level, the return to capital is lower for the firms with lower averaging schooling year. This paper attempts to explain the above features of the capital and labor markets in the Chinese economy using a two-sector model. Our model shows that these facts that exist in Chinese capital and labor market are likely to be caused by the distortion in the government investment, which is modeled as government’s subsidizing the infrastructure sector by offering a lower loan rate, and related structural change. Given that the infrastructure sector can absorb capital with low rate, large amount of investment flows into this sector, which also drives up the demand for unskilled labor. The rising demand for unskilled labor leads to an increase of unskilled wage. On the other hand, since infrastructure sector can borrow at a low rate, it has the incentive to borrow a lot, thus pushing up the market interest rate for the general good sector. The resulting reduction of investment in the general good sector reduces the demand for skilled labor and hence the growth of skilled labor wage, leading to a fall in the skill premium in wage. The model is calibrated to match the Chinese data. Our results suggest that the government has strong incentive to invest in the infrastructure sector if they are only interested in the short-run output level. This also helps to explain the high local government debt during recent years, as the local government has strong incentive to invest in the infrastructure sector, they borrow more. We also find that the more government deviates from the non-distortionary rate, the larger the welfare loss. More interestingly, when there exists abundant unskilled labor due to frictions to migration from the rural area, distortionary government investment could in fact increase the marginal product of labor and help overcome the frictions, and hence increase welfare. However, once rural to urban migration is completed, there is only welfare loss associated with distortionary government investment.