Excess Liquidity and Credit Misallocation: Evidence from China

China's M2/GDP ratio keeps rising, although it is already in the highest tier throughout the world. In this paper, we investigate empirically this puzzle using different levels of data. We first provide a quantitative approach to estimate the degree of China's excess liquidity based on cross-country regression. Our results show that excess liquidity in China is over 50 percent of the liquidity implied by cross-country benchmark. Monetary expansion in fact hasn't led to severe inflation in recent decades, indicating that there must be some credit inefficiently utilized or even laid idle in the real economy. Using province-level evidence, we show that credit misallocaton between state-owned enterprises (SOEs) and private enterprises (PEs) within province may lead to local credit inefficiency, and hence generate regional excess liquidity. We further validate this channel using manufacturing firm-level data, and find that credit misallocation is deteriorated after the 4 Trillion Stimulus Plan in 2008, making the deleveraging in China's manufacturing sector more challenging.