The Puzzle of Firm Performance in China: An Institutional Explanation

China has achieved phenomenal economic growth in an institutional environment that defies conventional economic rationales. Researchers offer different theories to explain this puzzle. But so far, due to the lack of data, little effort has been made to test these theories at the firm level. We develop a framework of endogenous institutional change to explain this puzzle and we test our framework with firm-level data. We argue that the decentralization from the central to the local governments and from government to firms are the driving forces behind China's institutional changes that have shaped the roles of government and market, which in turn significantly affect firm performance. We then submit our theory to a vigorous empirical test using data from China's industrial census, covering all 2000 counties and over 500 manufacturing industries. The test shows that two results of decentralization, the involvement of low-level governments in business and the process of privatization, positively affect firm performance.