Place-based policies and capital misallocation: Evidence from Chinese cities

Abstract

This study examines the impact of place-based policy on urban capital misallocation, primarily using China’s special economic zone (SEZ) reform and city-level data from 2003–2018. This study finds that creating SEZs leads to an over-allocation of capital to cities, increasing capital misallocation in cities by at least 20%. This results in an average annual loss of 0.34% of real gross domestic product for cities that establish SEZs. The heterogeneity analysis at the spatio-temporal level suggests that SEZs can cause capital misallocation by distorting the efficient location of capital flows. Moreover, SEZs primarily created to help economically distressed regions can lead to even more significant capital misallocation. The reform leads to the most considerable misallocation in the city with the most efficient initial capital allocation, which is the main path to its effect. In addition, this study finds that the industrial selection preferences of SEZs and local protection behaviour are two important channels through which SEZs exert their effects.