Capital market integration and firm innovation: theory and evidence from China

Innovation is a driver of economic growth, and a substantial body of research shows that capital market development is conducive for firm innovation. Yet, for China, the world's second largest economy with an impressive economic growth record, the empirical evidence linking capital market integration and firm innovation is limited. This paper shows theoretically and investigates empirically the association between capital market integration and firm innovation across Chinese provinces. The paper uses data on about 983,100 Chinese firms ranging from 1998 to 2015. We find that capital market integration has a positive effect on firm innovation. The positive effect works via a reduction in financial constraints and via the reduction of capital misallocation across provinces. The paper also unveils heterogeneity of the effect across regions, industries, and firm ownership structures. Given the still substantial capital market segmentation in China, and given that China is entering the stage of high-quality economic development based on innovation, the findings signal to policy makers the importance of speeding-up the process of capital market integration via capital market liberalization.