Bank Credit, Firm Entry and Exit, and Economic Fluctuations in China

Abstract

This study explores how a worsening bank credit quality affects firms’ entry and exit decisions (i.e., changes in the extensive margin), and how the extensive margin variation amplifies the transmission of financial and technological shocks to the real economy. Using a vector autoregression (VAR) model, our empirical evidence indicates that deteriorating Chinese bank credit conditions have a significant negative influence on net firm entry to the market. To explore the potential mechanism behind the stylized fact, we establish a dynamic stochastic general equilibrium (DSGE) model featuring fixed production costs, loss-related bank credit quality shocks and an endogenous balance sheet constraint which restricts the aggregate credit supply by the level of the banks’ net worth. Model simulations indicate that the interaction of financial constraints and the extensive margin variation amplifies the impact of bank credit shocks on the real economy. When banks experience loss-related financial shocks, bank credit tightens, which increases firms’ external financing costs. When the firms’ expected income is not sufficient to cover the fixed production cost, some firms exit from or stop entering the market. As a result, the economy displays a severe recession and a slow recovery.