Summary:
In the current phase of China's economic development, scholars and policy makers are becoming increasingly concerned about the financial capital that is now either “shifting from the real economy to the virtual economy” or self-circulating in the financial system. As a matter of fact, this is part of a trend in which large amounts of financial capital, even the operating funds of the real economy, are entering the virtual economy through various channels. The most objective method of judging the role of these phenomena in the rapid expansion of the financial value added component of China's GDP is to test whether the expansion of China's financial sector or the extension of its financial industry chain to the shadow banking system have either effectively matched or supported local enterprises' ability to independently innovate or have instead diverted resources from the sustainable development of the real economy, which is dominated by the manufacturing industry. While the continuous expansion of financial value added in GDP is a periodic condition in the economic development of developing countries like China, it can have both positive or negative implications. On the one hand, it is an expected component of economic development, but on the other hand, it may indicate the presence of deep-seated risk factors that may slow financial development and the transformation of the financial structure. Accordingly, using detailed micro data on innovation in enterprises, this study summarizes the characteristics of the rapid expansion of China's financial value added in GDP. Then, by taking advantage of the policy impacts of the Chinese government's deregulation of banking business in 2005, and referring to Stevenson (2010) and Ahern and Dittmar (2012), this study constructs a variety of unique instrumental variables and uses them to empirically explore the impact of financial expansion on the innovation activities of local enterprises in China and the mechanism that drives this process. We find that the relationship between the continuous expansion of the added value of GDP in the financial industry and the innovation investment of local enterprises has a stable inverted U-shaped, which verifies the basic fact that the financial expansion of China's provinces and regions has a dual effect on the innovation activities of micro enterprises. The results show that reasonable financial expansion is conducive to the innovation activities of China's local enterprises, but rapid expansion may have a significant inhibitory effect, particularly on the innovation activities of private enterprises. In an analysis of the impacts on internal and external innovation, we find that the inhibitory effect is stronger on the internal innovation activities of private owned enterprises and the external innovation activities of private enterprises. More precisely, we find that the inhibitory effect is concentrated in 31.55% of the local enterprises and 45.98% of the privately owned enterprises in our sample. The analysis of internal and external innovation shows that the financial expansion of China's provinces has a significant inhibitory effect on the internal innovation activities of 31.38% of local enterprises and 55.66% of private enterprises. The inhibitory effects on external innovation activities are strongest in enterprises with independent legal personalities and private owned enterprises. These empirical findings not only provide a unique perspective for understanding the theoretical relationship between financial development and innovation in developing countries like China, they also clearly highlight the occurrence and spread of the phenomenon of “shifting from the real economy to the virtual economy” in the financial system and the internal circulation of financial funds in China. They also show the impact of overly rapid financial expansion on the innovation activities of local enterprises. These insights have important policy implications for China as it seeks to accelerate the reform of its financial system through the development of financial services in the real economy and to build a modern industrial system that coordinates the development of the real economy, scientific and technological innovation, and modern finance.
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