Summary:
Since Schumpeter (1911), innovation has frequently been considered to have a critical role in promoting economic growth; subsequent adherents of this view include Solow (1957) and Kogan et al. (2017). After the 2008 international financial crisis, against a background of slow economic growth and sluggish recovery, many countries, including China, faced the historic goal of economic transformation. In such a transformation, innovation and technological progress would be the major drivers of economic growth. In practice, however, due to the significant investment costs, high levels of uncertainty, and long gestation periods involved in innovative ventures, innovation-focused firms face many financial constraints. Therefore, it is vital to develop a financing system that can better serve firms' R&D activities and thus create an innovation-oriented economy. The question of how to do so has become an important issue for China in both the present and the future. Theoretically, a well-developed financial system that is capable of encouraging savings, allocating resources, and managing risks can alleviate the severe financial constraints faced in the R&D sector and thus incentivize firm innovation and lead to greater economic growth. In the literature, the relationships between financial development, firm innovation, and economic growth have been widely explored. However, most studies have only focused on the relationship between two of these three, e.g. between financial development and R&D investment or between finance and economic growth. Studies investigating the interactions and transmission mechanisms among all three are surprisingly lacking. Additionally, although there are many relevant empirical studies, there have been few attempts at theoretical modeling and little specific analysis of China's actual situation. This paper contributes to the literature both theoretically and empirically by highlighting firm innovation as a mechanism through which financial development enhances economic growth and providing specific evidence from China. Specifically, to investigate how financial support affects firm innovation, we introduce into the creative destruction model developed by Howitt and Aghion (1998) a banking sector that takes deposits and allocates credit to producers and researchers. We show that as the financial system evolves, the transformation of savings into investment in the economy improves, and information asymmetry is alleviated. Financial development thus reduces the cost of external financing in the R&D sector, thus stimulating firm innovation incentives and R&D investment and ultimately promoting economic growth. This theoretical prediction is tested empirically using a panel data set of 31 provinces of China over the period 2008-2016. We find that (1) financial development significantly encourages firm innovation; (2) this positive effect is more pronounced for provinces with higher levels of industrialization and foreign investment and lower levels of government expenditure and education; and (3) firm innovation enhances economic growth. Our theoretical and empirical analysis reveals the endogenous transmission mechanism of “financial development-firm innovation-economic growth” as it operates in China. It thus lays the preliminary theoretical and practical foundation for future reforms to support China's innovation-driven economy. Based on the empirical results, several policy implications are obtained. First, considering the significant positive effects of financial development on firm innovation, deepening financial reform and promoting financial development will improve the financing environment, foster innovation, and promote technological progress and industrial transformation. Second, it is essential to continue the process of industrialization and opening-up. At the same time, for regions with weak fiscal capacity and scarce human resources (or low education levels), special attention should be paid to utilizing financial development to enhance innovation-driven growth. Third, R&D activities should be encouraged through greater cultivation of creative talent, protection of intellectual property, and support for innovation.
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