Growth and Change DOI: 10.1111/grow.

12116
DOI: 10.1111/grow.12116
Vol. ••
47No.
No.••1(•• 2015),2016),
(March pp. ••–••
pp. 72–92

Determinants of Firm Failure: Empirical Evidence

from China
CANFEI HE AND RUDAI YANG

ABSTRACT During the economic transition, Chinese industries are highly dynamic, with substantial firm entry and
failure. This study investigates the driving forces of firm failure in China. Based on the annual survey of industrial firms
during 1998–2007, this study first describes the patterns of firm failure. On average, less productive and older firms are
more likely to fail, while firms with governmental supports are more likely to survive. Statistical results based on the linear
probability model for panel data indicate that market competition crowds out less productive firms. Competition domi-
nates learning effects and imposes challenges on the survival of older firms. There is an inverted U-shaped relationship
between firm age and firm failure. Local supportive policies such as subsidies and banking loans can reduce the chance
of firm failure. Governmental policies also moderate the impact of productivity and firm age on firm failure. The findings
from this study enrich the understanding of industrial dynamics in the transitional China.

Introduction

A n economy keeps its vitality through a continual process of firm entry, survival, and exit.
Those are fundamental components of the structural changes taking place in industries. It is
critical to investigate forces underlying firm dynamics to understand spatial economic changes
(Buenstorf and Geissler 2011; Nyström 2007). Reflecting the importance of firm dynamics, there has
been a large body of literature examining the determinants using firm-level data from developed
economies (Acs, Armington, and Zhang 2007; Audretsch, Houweling, and Thurik 2000; Berglund
and Brännäs 2001; Carree, Santarelli, and Verheul 2008; Cheng and Li 2011; Fotopoulos and Spence
2001; Kangasharju 2000; Nyström 2007; Siegfried and Evans 1994). Faced with extensive institu-
tional changes, vibrant business climate and governmental interventions, firms in developing and
transitional economies may find it more difficult to survive (Bojnec and Xavier 2004; Estrin and
Prevezer 2010; Giarratana and Torrisi 2010; Männasoo 2008; Močnik 2010; Tybout 2000). A
systematic investigation of firm dynamics in those economies would significantly enrich the under-
standing of industrial development.
During the past three decades, China has undergone economic transition, which has been con-
ceptualized as a triple process of marketization, globalization, and decentralization (He, Wei, and Xie
2008; Wei 2001). The transition process has brought about the liberalization of prices, markets and
trade, and the privatization of the state-owned sector, triggering market competition. Meanwhile,
decentralization grants local governments authority to intervene in economic development,
Canfei
Canfei He
He is
is aa Professor
Professor at the College
College of Urban
of Urban andand Environmental
Environmental Science,
Science, Peking
Peking University-Lincoln
University-Lincoln Institute
Institute Center
Center for
for Urban
Urban Development
Development andand
LandLand Policy,
Policy, Beijing,
Beijing, China.
China. HisHis e-mail
e-mail address
address is: is: hecanfei@urban.pku.edu.cn.
hecanfei@urban.pku.edu.cn. Rudai
Rudai Yang
Yang is
is an
an Associate
Associate Professor
Professor at the School
at School of Economics,
of Economics, Peking Peking University,
University, Beijing,Beijing,
China. China. His e-mail
His e-mail addressaddress is: rdyang@pku.
is: rdyang@pku.edu.cn.
edu.cn. An earlier
An earlier versionversion
of thisofpaper
this paper
was was presented
presented at the
at the Second
Second International
International WorkshopononRegional,
Workshop Regional,Urban
Urban andand Spatial
Economics
Economics inin China,
China,June June2829,
28–29,2013,
2013, Beijing, China.
Beijing, TheThe
China. authors would
authors likelike
would to acknowledge funding
to acknowledge fromfrom
funding the Natural Sci-
the Natural
ence Foundation
Science Foundationof China (No.
of China 41425001;
(No. 41425001; NoNo41271130;
41271130;No.41201124)
No.41201124) andand
thethe
valuable comments
valuable commentsfrom thethe
from participants in
participants
the workshop.
in the Special
workshop. Special thanks
thanksgogototothethethree
threeanonymous
anonymousreviewers
reviewersfor
forproviding
providingvery
veryconstructive
constructivesuggestions.
suggestions. TheThe authors
are responsible
responsible for
for the
theremaining
remainingerrors.
errors.

Submitted August 2013; revised May 2014; accepted August 2014.

© 2015 Wiley Periodicals, Inc
2 GROWTH AND CHANGE, •• 2015 DETERMINANTS OF FIRM FAILURE 73

activating interregional competition (He 2006). Moreover, globalization brings international com-
petition into local development. Chinese firms face substantial challenges from market competition
and institutional uncertainties, resulting in remarkable business failure. Surprisingly, firm failure has
been extremely underexplored in China. Published in Chinese, Mao and Sheng (2013) is an excep-
tion. They find that both entry and exit rates of Chinese firms are fairly high; firm size matters for
both entry and exit. However, business failure in China is driven by both state power and market
forces and deserves further investigation.
The objective of China’s gradual economic reform is to introduce market competition, which
occurs at local, regional, and global levels. Firms that are now responsible for their own operations
face fierce market competition. Gradual economic transition has created the opportunities for firms
to learn. Inefficient firms are therefore more likely to fail because of competition effects, while
experienced old firms would be more likely to survive because of learning effects. The goal of
economic reform is to develop the Chinese economy. Governments, from the central to the local
level, now have strong incentives to provide support to firms, mitigating the competition effects and
helping inefficient firms to survive. Based on the annual survey of industrial firms in China during
1998–2007, this study will investigate the pattern of firm failure and identify the role of market
forces and governmental support. In particular, this study will first examine the relationship between
firm total factor productivity (TFP) and firm failure. This study will then focus on the relationship
between firm age and firm failure, and finally, test the direct and moderating role of local supports.
On average, failing firms are less productive than survivors in China. Older firms are more likely
to fail, while firms with local support have a greater chance to survive. Statistical results indicate that
competition effects do crowd out less productive firms. There is, however, an inverted U-shaped
relationship between firm age and firm failure. In other words, when older firms overcome the market
challenges, they can survive for a longer time. Local supportive policies can certainly enhance the
survival chance of some firms. Particularly, they can help older firms to mitigate the impact of
competition effects. This study sheds light on industrial dynamics through the lens of firm failure in
China. Both market forces and state supports underpin the continual process of firm entry, survival
and exit.
The paper is structured as follows. The second section presents the literature review and develops
the research hypotheses, followed by the introduction of data sources. The fourth section describes
the patterns of firm failure. This paper then discusses the results of linear probability models and
concludes with a summary of empirical findings.

Literature Review and Research Hypothesis

There is a large body of literature exploring the determinants of firm survival and failure using
data from developed economies. Much of the work has broadly argued that productive and efficient
firms will survive and inefficient firms will fail (Agarwal 1996; Cefis and Marsili 2006; Shiferaw
2009; Siegfried and Evans 1994).
Industrial organization literature examines firm-specific and industry-specific factors. At the firm
level, studies report that larger firms are less likely to fail, consistent with the learning models of
industry dynamics (Audretsch and Mahmood 1995; Dunne and Hughes 1994; Ericson and Pakes
1995; Geroski 1995; Mata and Portugal 1994; Wagner 1999). The effect of size is however not uniform
and may be nonlinear (Mata and Portugal 1994; Esteve-Pérez and Llopis 2004). Those studies also
report a negative relation between firm age and failure. As pointed out in Thompson (2005), theories
that could explain the observed pattern include learning, financial frictions, and the fact that older firms
74 GROWTH AND CHANGE, MARCH 2016 DETERMINANTS OF FIRM FAILURE 3

are possibly active in a larger number of submarkets. A few studies find an inverted U-shaped
relationship between firm age and firm exit Agarwal et al. (2002) Both size and age effects differ across
industries and firms (Hannan et al. 1998; López-García, Puente, and Gómez 2007).
Ownership is a major determinant of firm survival in the literature (Mata and Portugal 1994). For
instance, Agarwal and Gort (2002) and Agarwal et al. (2002) show that diversifying firms have lower
failure rates than de novo entrants. Görg and Strobl (2003) conclude that foreign firms are more likely
to exit than indigenous plants, while Mata and Portugal (2002) and Kimura and Fujii (2003) do not
report a significant impact of foreign ownership. Another major concern is the impact of innovative
activities on firm dynamics, confirming that firms with substantial innovation inputs and outputs are
less likely to fail (Audretsch 1995; Cefis and Marsili 2005; Fontana and Nesta 2009; Hall 1987;
Kimura and Fujii 2003; Wagner and Cockburn 2010).
Industrial characteristics such as market size, growth rate, technology, market structure, entry
rates and scale economies, and the life cycle consistently explain differences in survival rates across
firms after controlling for firm-specific factors (Agarwal 1998; Agarwal and Audretsch 2001; Mata
and Portugal 1994). Firms in high-technology industries are more likely to fail (Agarwal and
Audretsch 2001; Audretsch 1995). High entry rates exert a positive effect on the likelihood of firm
failure (Mata and Portugal 1994, 2002). Firms live longer in growing industries than in declining
industries, even controlling for industry turbulence, size, scale, type of entrant, and concentration
(Mata and Portugal 1994; López-García, Puente, and Gómez 2007).
A few studies examine the impacts of local factors on firm dynamics. Fotopoulos and Louri
(2000) show that firms located in greater urban areas have lower hazard rates than those located
outside those areas. Industrial localization is also a key local variable to explain firm survival. Higher
agglomeration is associated with higher firm mortality rate (De Silva and McComb 2012; Folta,
Cooper, and Baik 2006; Honjo 2000; Staber 2001). For instance, De Silva and McComb (2012) find
that greater firm density within 1 mile of firms in the same industry increases mortality rates. Other
studies, however, report a positive impact of clusters on entrepreneurship and firm survival (Delgado,
Porter, and Stern 2010; Renski 2011; Sorenson and Audia 2000; Wennberg and Lindqvist 2010).
In addition, there are reports about the impacts of local supportive programs. Almus (2001)
studies business survival 5 years after creation in Eastern Germany and finds that firms’ failures are
negatively related to the receipt of public subsidies. Crépon and Duguet (2003) explore the impacts
of capital subsidies and banking loans on French firms created in 1994 during the subsequent 3 years
and report a positive effect of this subsidy on survival of new firms created by both short-term and
long-term unemployed people. Bank loans alone have no positive effect, but they reinforce the effect
of public subsidies on firm survival.
With the transition process, Chinese firms face substantial challenges from market competition
and institutional uncertainties, causing remarkable business failure. Surprisingly, firm dynamics have
been extremely underexplored. Mao and Sheng (2013) examine firm entry and exit in China and find
that both entry and exit rates of Chinese firms are fairly high. They report that size matters for both
firm entry and exit; less productive firms are more likely to exit. Business failure in China is a
complicated phenomenon and is driven by multiple forces. We highlight the roles of competition
effects, learning effects, and governmental support in firm dynamics.
As is well known, China has taken a gradualism approach to reform its economic system (Zhang
2000). The goal is to build a market-oriented economy by introducing market competition and
opening up to the international market. This competition not only occurs locally but also regionally
and internationally and has generated significant impacts on industrial development in China. For
instance, Girma and Gong (2008) find that market competition from foreign firms in the same sector
4 GROWTH AND CHANGE, •• 2015 DETERMINANTS OF FIRM FAILURE 75

and foreign firms in downstream sectors have a deleterious impact on the survival probability of
State-owned Enterprises (SOEs) in China. Facing intensive market competition, only productive
firms can survive. This is the competition effect, which would force inefficient firms out of the
market. As a consequence, less productive firms are more likely to fail as reported in the studies
based in data from developed economies (Siegfried and Evans 1994).
During the economic transition, China has gradually introduced market forces and market ori-
ented institutions (Zhang 2000). Both local governments and firms take time to learn how to
experiment with the market system and tackle the market forces. Firms gradually learn how to
compete with their domestic and international competitors and how to interact with governments. As
firms get older, they may accumulate rich experiences and develop their own core competence
(Thompson 2005). Experiences and competence may help Chinese firms to survive in the versatile
environment. This learning process may take a long time. Thereby, learning effects would reduce the
failure of firms in markets for a longer time. Meanwhile, economic reform has significantly inspired
Chinese entrepreneurs to create a large number of new firms annually, leading to growing compe-
tition (Huang 2008). Cheap labor, a large market, and favorable Foreign Direct Investment (FDI)
policy regime further attract many foreign firms to the Chinese market (Huang 2003). Meanwhile,
firms created in the earlier times often suffer from institutional difficulties such as vague ownership
and updated equipment (Huang 2008). Chinese firms are often accused of not investing in innovation
activities and not developing core competences. Increasing competition and institutional challenges
may dominate the learning effects, resulting in higher mortality rates of relatively older firms in
China. We expect a nonlinear relationship between firm age and failure.
With economic transition, decentralization has granted local governments greater authority over
their economies. Local governments have a primary responsibility for economic development in their
respective jurisdictions. Fiscal decentralization in particular has enhanced the importance of local
budget constraints. More authorities together with hardening budgets have led to the fierce interre-
gional competition for regional development and also provided local governments with strong
incentives to protect businesses by shielding local firms from interregional competition (Young
2000). In the name of assistance to local economies, local governments use their heightened
administrative power in terms of trade and investment to implement multiform protection of firms
under their authority (Zhao and Zhang 1999). It is a common practice for local governments in China
to provide subsidies to firms, including income tax breaks for companies with foreign investment,
located in special development zones or designated as having high technology; loans to encouraged
industries from government-owned banks, rebates of value added tax, and import duties for equip-
ment purchases; low priced land for SOEs and companies located in special development zones and
the provision of goods and services at below market prices by the government and SOEs; and cash
payments to companies based on factors such as export performance, taxes paid, innovation, and
environmental protection (Barbieri, Di Tommaso, and Bonnini 2012). Local protectionism would
shield firms from competition, downplaying competition effects and increasing the surviving
chances of inefficient firms. Local supportive policies may allow the less productive firms to remain
in existence, at least in the short run. Based on the above analysis, we postulate the following two
research hypotheses to guide our empirical analysis.
H1 Less productive firms are more likely to fail due to competition effects, while governmental supports will mitigate the
competition effects, reducing the chance of firm failure.

H2 There is an inverted U-shaped relationship between firm age and firm failure; local support policies would reduce the
likelihood that older firms fail.
76 GROWTH AND CHANGE, MARCH 2016 DETERMINANTS OF FIRM FAILURE 5

Data Source and Firm TFP Estimation

Data used in this study are from the Annual Survey of Industrial Firms (ASIFs) provided by the
State Statistical Bureau in China. The data set includes all state-owned industrial enterprises and non
state-owned enterprises with sales revenues greater than 5 million yuan. The entry criteria were set
in 1998 by the State Statistical Bureau and exclude a larger number of small firms
from the data set. The data set, however, provides the data for the official statistics of Chinese
industries, reported in all types of official statistical yearbooks. Industries in this data set
include mining, manufacturing, and electricity, gas and water production. The data set provides
detailed information about firms’ identification, starting year, location, total employees, and inter-
mediate inputs, among others. There is inconsistency in reporting information about Chinese firms
during 1998–2007. Following Brandt, Van Biesebroeck, and Zhang (2012), we use the legal person
as the basis to match industrial firms. Firms with the same legal person but different names are
treated as different firms. Firms with the same code but different names are treated as different firms.
We construct the panel data as the following three steps. First, we match firms for two consecutive
years using the legal person codes. The firms left will be matched using names of firms. If necessary,
we will further use the legal person code, county code or county code, telephone number, and starting
year to match the remaining firms. We generate an unbalanced panel for two consecutive years by
combining the matched and unmatched firms. Second, there may be some firms with missing
information for several years. To match those firms in different years, we first apply similar methods
to identify the corresponding firms. Considering the following situation, firm A in the first year has
no match with any firm in the second year but a good match for firm C in the third year. Firm C,
however, can be matched with firm B in the second year. Consequently, firms A, B, and C in the three
consecutive years can be treated as the same firm. By doing so, we construct the panel data for three
consecutive years. Finally, based on the panel data for three consecutive years, we could expand the
panel data to cover firms during the 1998–2007 period.
There are 2,224,380 observations and 576,143 industrial enterprises in total during 1998–2007.
Among the 576,143 enterprises, 26,135 enterprises report information throughout the 10 years,
accounting for 5.14 percent. 130,921 enterprises are only reported for 1 year, accounting for 25.75
percent. The average survival year is 3.86 years. Recently, the ASIFs are widely applied in economic
studies, generating some high-quality publications, including some published in American Economic
Review (Song, Storesletten, and Zilibotti 2011), Quarterly Journal of Economics (Hsieh and Klenow
2009), and Papers in Regional Science (Yang and He 2014), significantly improving economic
research in China.
To investigate industrial dynamics, we first define firm entry and firm failure. Assuming firmit is
reported in the survey in year t, if there is no reported information for firmit in year t-1, then firmit
is a new entry. If there is no reported information for firmit in year t+1, then firmit fails. Failure rate
is the ratio of number of failing firms to the total number of existing firms while entry rate is the ratio
of number of new entries to the total number of existing firms. Since the annual survey of industrial
firms only includes those with sales revenues greater than 5 million yuan, failing firms only mean
that they fail to meet the criteria in the data set. Given this issue, we use the term of firm failure rather
than firm exit.
Table 1 reports the temporal patterns of firm entry and failure. Chinese industries are fairly
dynamic, with annual firm entry rate of more than 20 percent. The year 2004 is the economic census
year and may include more newly created firms, with a firm entry rate 45.13 percent. Failure rate,
however, fluctuates significantly, ranging from 11.82 to 24.88 percent. The aggregate analysis
conceals the variations of firm dynamics and it is critical to explore the industrial dynamics at the
 6

TABLE 1. FIRM ENTRY AND FAILURE IN CHINA DURING 1998–2007.

GROWTH AND CHANGE, •• 2015

Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Number of firms 127,030 132,439 129,924 143,136 151,526 166,081 225,906 226,256 253,685 283,409
Firm entries 30,602 27,352 45,543 31,849 39,326 101,952 42,574 55,213 59,717
Entry rate (%) 23.11 21.05 31.82 21.02 23.68 45.13 18.82 21.76 21.07
Firm failure 25,193 29,867 32,331 23,459 24,771 42,127 42,224 27,784 29,993
Failure rate (%) 19.83 22.55 24.88 16.39 16.35 25.37 18.69 12.28 11.82
DETERMINANTS OF FIRM FAILURE
77
78 GROWTH AND CHANGE, MARCH 2016 DETERMINANTS OF FIRM FAILURE 7

micro level. In the statistical analysis, we will check the impacts of year 2004 and the 5 million Yuan
as the entry standard on the model estimations.
It is worthwhile to point out that failing firms growing back to sales revenues more than 5 million
Yuan would be re-included in the data set. Table 2 shows the number of firms re-included in the data
set after different years. For instance, 25,193 firms which were in the data set in 1998 failed in 1999.
There were 4,849 and 1,054 firms re-included in 2000 and in 2007, respectively. About 27,784 firms
included in the data set in 2005 failed in 2006 but 5,352 firms came back in 2007. However, given
the definition of firm failure in the coming year in this study, the reappearance of firms would not
influence our investigation of firm failure.
This study will link firm TFP to firm failure. The key task is to estimate firm TFP.
TFP is the difference of output growth rate and the weighted average of growth rate of input
factors. It assumes the contribution is from technological progress or institutional changes. TFP is
often estimated using the C-D production function with constant return to scale. This estimation,
however, suffers from endogeneity issues derived from simultaneity and selection bias. Olley and
Pakes (1996) develop a three-step regression model (the OP model) to solve the endogeneity issues.
This study follows the OP model to estimate the TFP of Chinese firms.

Pattern of Firm Failure in China

Firm TFP and firm failure. Based on the estimated firm TFP, we calculate the annual average
firm TFP. The often-used method is to weight firm TFP to compute the average TFP (Brandt, Van
Biesebroeck, and Zhang 2012; Hsieh and Klenow 2009). The weight can be the share of output or
employment. This study applies the traditional method to compute the annual average TFP. This
estimation does not weight industries, which may differ in technology. This assumes that the relative
importance of industries remains the same during 1998–2007, which is not necessarily true in reality.
The estimation would underestimate firm TFP if input factors are reallocated from less productive
industries to more productive ones.
Comparing with weights by output and value added, the employment weight is better able to
reflect labor mobility. We examine the trend of employment weighted TFP for failing and surviving
firms (Figure 1). We also report the annual average firm TFP. Clearly, failing firms are significantly
less productive than surviving firms. In 1998, the average TFP for failing firms and surviving firms
are 1.84 and 2.67, respectively. In 2006, it turns to be 2.35 and 2.66, respectively. In other words, less
productive firms are more likely to fail. Productivity seems a critical factor for firms to survive in the
Chinese market. Interestingly, the productivity gap between failing and surviving firms has been
narrowed down. As China entered the World Trade Organization (WTO), the Chinese market is
widely open to foreign investors, bringing international competition into domestic market. Mean-
while, the post-WTO period has also inspired the Chinese entrepreneurship class to create many
more firms, heightening market competition (Huang 2008). The increasing competition could force
some firms to be more productive.
Firm age and firm failure. We compute firm age based on the difference between the reporting
year and the starting year. Figure 2 reports the average age of Chinese firms. During 1998–2006, the
average age dropped from 14.3 years to 8.8 years. In the right figure, we dropped SOEs and observe
a lower average age of Chinese firms. SOEs are relative older in China. As the older SOEs failed, the
average age difference between SOEs and other firms has converged. The declining average age of
Chinese firms can be explained by the relationship between firm age and business failure. Figure 3
shows that older firms are more likely to fail. In other words, on average, failing firms are older than
 8

TABLE 2. NUMBER OF FIRMS REAPPEARING IN THE DATA SET AFTER DIFFERENT YEARS.

1998 1999 2000 2001 2002 2003 2004 2005

Failing firms 25,193 29,867 32,331 23,459 24,771 42,127 42,224 27,784
Reappearing
GROWTH AND CHANGE, •• 2015

firms
2000 4,849 (19.2%)
2001 2969 (11.8%) 7,362 (24.6%)
2002 2,432 (9.7%) 6,445 (21.6%) 3446 (10.7%)
2003 2,021 (8.0%) 5,306 (17.8%) 3,006 (9.3%) 3,762 (16.0%)
2004 1,512 (6.0%) 3,696 (12.4%) 2,274 (7.0%) 2,942 (12.5%) 4,098 (16.5%)
2005 1,356 (5.4%) 3,375 (11.3%) 2,112 (6.5%) 2,760 (11.8%) 3,554 (14.3%) 8,017 (19.0%)
2006 1,233 (4.9%) 3,122 (10.5%) 1,988 (6.1%) 2,596 (11.1%) 3,360 (13.6%) 8,012 (19.0%) 8,334 (19.7%)
2007 1,054 (4.2%) 2,740 (9.2%) 1,772 (5.5%) 2,299 (9.8%) 3,027 (12.2%) 6,835 (16.2%) 7,623 (18.1%) 5,352 (19.3%)

Note: Numbers in parentheses are percentages of reappearing firms.

DETERMINANTS OF FIRM FAILURE
79
80 GROWTH AND CHANGE, MARCH 2016 DETERMINANTS OF FIRM FAILURE 9

2.8

2.6
2.6

2.4
Weighted TFP

Average TFP
2.4

2.2
2.2

2
2
1.8

1.8
1998 2000 2002 2004 2006 1998 2000 2002 2004 2006
Year Year
failing firms survival firms failing firms survival firms

FIGURE 1. FAILING FIRMS, SURVIVING FIRMS AND FIRM TFP.

14
14

Average Age of Firms

Average Age of Firms

12
12

10
10

1998 2000 2002 2004 2006

8

Year
1998 2000 2002 2004 2006 all firms excluding SOE
Year

FIGURE 2. AVERAGE AGE OF CHINESE FIRMS DURING 1998–2006.

16
.24

14
.22
Average failure rate

Average Age
12
.2

10
.18

1998 2000 2002 2004 2006

.16

Year
0 10 20 30 40 50 failing firms survival firms
Age

FIGURE 3. FIRM AGE AND FIRM FAILURE IN CHINA.

surviving firms. It is clear that firm age seems to have a positive relationship with firm failure. Older
firms may face more challenges to survive. Learning effects can be offset by competition effects.
Local support and firm failure. We can identify direct subsidies from governments and loans
from formal financial institutions for individual firms. Whether firms get subsidies and banking loans
actually is more important than how much they get since both subsidies and loans represent
governmental support. Figure 4 shows that the share of firms with subsidies is lower for failing firms
than for surviving ones. Failing firms are also less likely to get banking loans. Subsidies and financial
supports seem to reduce the chances of firm failure in China and keep some less productive firms in the
markets.
10 GROWTH AND CHANGE, •• 2015 DETERMINANTS OF FIRM FAILURE 81

.75
.16
Ratio of firms with subsidy

Ratio of firms with loans

.7
.14

.65
.12

.6
.1

.55
.08

.5
1998 2000 2002 2004 2006 1998 2000 2002 2004 2006
Year Year
failing firms survival firms failing firms survival firms

FIGURE 4. LOCAL SUPPORT AND FIRM FAILURE.

16
18

Average Age of the Firms

Average Age of Firms

14
14 16

12
12

10
10

8
8

1998 2000 2002 2004 2006 1998 2000 2002 2004 2006
Year Year
firms with subsidy firms without subsidy firms with loans firms without loans

FIGURE 5. FIRM AGE, LOCAL SUPPORTS, AND FIRM FAILURE.

2.65
2.7

Average TFP of Firms

Average TFP of Firms
2.65

2.6
2.6

2.55
2.55

2.5
2.5

1998 2000 2002 2004 2006 1998 2000 2002 2004 2006
Year Year
firms with subsidy firms without subsidy firms with loans firms without loans

FIGURE 6. LOCAL SUPPORTS AND FIRM TFP.

We further take a look at the relationship between local support and firm age. Figure 5 indicates
that firms with subsidies are older than those without subsidies. Similarly, firms with banking loans
are also older than those without loans. Local supports may help firms to survive for a longer time
and mitigate the impacts of firm age on firm failure. Subsidies, banking loans, and firm TFP do not
have a clear relationship (Figure 6). In the late 1990s, less productive firms are more likely to have
subsidies and then more productive firms are subsidized for a couple of years. Recently,
productivities of subsidized and nonsubsidized firms have been converging. Firms with banking
loans on average are less productive. The findings indicate that TFP is just one of the many factors
82 GROWTH AND CHANGE, MARCH 2016 DETERMINANTS OF FIRM FAILURE 11

to influence local governments’ choice of favorable firms. SOEs are often easy to have subsidies and
banking loans even they are less productive. Firms in local key industries are also often granted
favorable supports.

Variables and Model Specification

The descriptive analysis suggests that firm TFP, age, subsidies, and banking loans are possible
determinants for firm dynamics in China. We will conduct a systematic analysis to identify the
determinants of firm failure. Based on the theoretical propositions, we particularly focus on two sets
of explanatory variables. One set of variables includes firm TFP (TFP) and firm age (AGE). Firm
TFP is estimated based on the model proposed by Olley and Pakes (1996). Firm age is the difference
between the reporting year and the starting year of a firm. Firms with high TFP are less likely to fail
and firm TFP will be expected to have a negative coefficient. The existing literature reports a negative
influence of firm age on firm failure due to the learning effects. In China, competition effects may
dominate learning effects, causing higher mortality rate of older firms. If that is the case, firm age
will have a positive association with firm failure and vice versa. To test the nonlinear relationship
between firm age and firm failure, we introduce its squared term (AGE × AGE) in the model.
The other set of variables quantifies governmental supports. Both central and local governments
have many different measures to support industrial development. Typically, those policies work
against market forces. Firms in local key industries are more likely to get favorable supports such as
cheap land, subsidized electricity, and tax holidays from local governments. We identify the local key
industries using the location quotient of three-digit industries at the prefecture level cities (LQ). Key
industries have larger LQs. Because of the different pattern of industrial specialization, cities would
differ in key industries, ranging from high-tech industries to the traditional textile industry. Mean-
while, firms in key industries may face intensive competition. If governmental support can help firms
to overcome the competition effects, LQ will have a negative coefficient. Otherwise, LQ can have a
positive coefficient. Typically, local governments provide subsidies to specific firms in particular
industries and even encourage state-owned banks to provide loans to some firms in particular
industries. In the data set, we can identify the actual subsidies and interest paid to the banks for each
firm. The amount of subsidies and banking loan depends on the nature of firms and varies signifi-
cantly. Whether a firm gets subsidies or banking loans suggests whether local governments support
the firm. We therefore design two dummy variables to indicate firms with governmental subsidies and
bank loans (SUBSIDY and LOAN) and expect negative coefficients. To explore the moderating role
of governmental interventions, we further introduce the interactions between the two sets of variables
in the models.
To make the estimations robust, we control for a number of variables. First, firm size (SIZE) is
included. We use the number of employees to measure firm size. Second, dummies for exporters
(EXP) and foreign firms (FDI) are included. Third, the overall failing rate of three-digit industry in
the prefecture level city a firm is included (EXITRATE). A higher failing rate of an industry suggests
that the industry may suffer from intensive market competition, leading to more firm failure. Finally,
we include dummies for two-digit industries, years, and provinces. Firm failure may vary across
industries, provinces, and time. Variables are summarized in Table 3.
The dependent variable (Exitstay) is a dummy variable, equal to 1 indicating firms failing in the
coming year, and 0 for firms surviving the coming year. The data structure is an unbalanced panel
data. It is not proper to conduct survival analysis since firms are likely to enter or exit multiple times
in this data set. Both the linear probability model (LPM) for panel data and the probit model for panel
12 GROWTH AND CHANGE, •• 2015 DETERMINANTS OF FIRM FAILURE 83

TABLE 3. DEFINITION OF DEPENDENT AND EXPLANATORY VARIABLES.

Variables Definitions Mean SD

Exitstay 1 for firms failing in the coming year; 0 for firms 0.18 0.38
surviving in the coming year
TFP Firm total factor productivity 2.57 1.29
AGE Firm age defined as differences between the reporting year 11.01 12.05
and the starting year
LQ Location quotient of three-digit industries at the prefecture 0.46 1.18
city a firm is located
SUBSIDY 1 for firms with governmental subsidies, 0 for firms 0.12 0.33
without subsidies
LOAN 1 for firms with banking loans, 0 for firms without 0.63 0.48
banking loans
SIZE Log of number of employees 4.77 1.12
EXP 1 for exporters; 0 for nonexporters 0.27 0.45
FDI 1 for foreign firms, 0 for others 0.20 0.40
EXITRATE Exit rate of three-digit industry at the prefecture level city 0.18 0.40
Industry Dummy for two-digit industries that a firm belongs to — —
Province Dummy for provinces where a firm is located — —
Year Dummy for years (1998–2006) — —

data are proper methods. However, given the data structure in this study, some theoretical problems
exist regarding the interpretation and robustness of the average effects of the interaction items in the
probit model estimations. With the support of a large sample, the estimation of LPM has no
significant difference from those based on other discrete choice models such as probit models.
Therefore, this study will apply LPM for panel data to estimate the coefficients. In addition, panel
data are critical to mitigate the endogeneity associated with self-selection in the sample. However,
panel data model only stress the within group variation instead of the between group variation. We
also apply the probit model to check the robustness of the estimations of parameters.
We define the following base model,

exitstayit = α + β1TFPit + β 2 Ageit + δ X it + γ i + λ t + ε it (1)

Where exitstay is the dependent variable, TFP and AGE are firm TFP and firm age. Xit represents
other explanatory variables, including firm size (LnSIZE), dummy variables for exporters (EXP) and
for foreign firms (FDI), and exit rate (EXITRATE), dummies for two-digit industry and provinces.
γi is firm-fixed effects, λt stands for time-fixed effects. To further investigate the role of governmental
supports on firm failure, we introduce the interactions between policy proxies and TFP and AGE.
Policy proxies include LQ, SUBSIDY, and LOAN. The expanded model is as follows:

exitstayit = α + β1TFPit + β 2 Ageit + β3 policyit + β 4 policyit × TFPit

(2)
+ β5 policyit × Ageit + δ X it + γ i + λ t + ε it
84 GROWTH AND CHANGE, MARCH 2016 DETERMINANTS OF FIRM FAILURE 13

Empirical Results
The correlation analysis implies that explanatory variables are only weakly correlated (Table 4).
There is no serious collinearity issue in the estimations.
Table 5 reports the regression results from LMP for panel data. The results from the probit model
for panel data do not show significant differences (to save space, we will not report the probit results).
The first column presents the base model estimation. From columns 2 to 7, we introduce LQ,
SUBSIDY, and LOAN and their interactions with TFP and AGE into the models. All models are
statistically significant, indicating that our models have significant explanatory power.
Statistical results suggest that firm TFP is a key determinant for firm survival. The coefficient on
Firm TFP is −0.039, indicating that increasing firm TFP would reduce the likelihood of firm failure.
In other words, productive firms are less likely to fail. The results are consistent with the existing
literature on developed market economies (Siegfried and Evans 1994). The less productive firms
suffer from low profitability and in turn a low level of investments. Competition would force
inefficient firms out of the market and redistribute resources to productive firms, improving industrial
competitiveness and facilitating industrial upgrading in China. This is the positive role of market
forces in industrial development.
The coefficients on AGE and AGE × AGE are 0.051 and −0.023 and significant in all models,
indicating that initially as firms get mature, they are more likely to fail in the coming year. When
firms survive the market competition for a certain time period, they become more competitive and
will be less likely to fail in the coming year. There is an inverted U-shaped relationship between firm
age and firm failure. In the existing literature, firm age is typically positively associated with firm
survival because of the learning effects although a few studies report an inverted U-shaped age effect
(Agarwal and Sarkar 2002). In the developed market economies, firms would accumulate experience
and knowledge and develop their own core competence as they stay in the market longer, reducing
their chances of failure. In the transitional China, firms in their first several years face substantial
challenges. Rapid industrial upgrading and constantly adjusted institutional frameworks could make
some Chinese firms quickly outdated. When firms survive the competitive markets for a long time,
some firms may accumulate sufficient market knowledge, or invest in innovative activities to develop
core competence, reducing their chance of failure. This is still consistent with the learning model of
industrial dynamics. The difference is that firms take longer time to learn in the transitional China.
Based on the magnitude of the coefficient, firm age seems to have more significant impact on firm
failure than firm TFP. This implies that knowledge and market experience accumulation is a critical
factor for firm to survive in China.
Three proxies for governmental supports (LQ, SUBSIDY, and LOAN) hold the expected negative
coefficients in all models, indicating that firms in local key industries are less likely to fail and firms
with subsidies and banking loans are more likely to survive the coming year. The coefficient on
SUBSIDY has the largest magnitude, implying that subsidies to specific firms are more important for
firm survival than other measures. Studies in Germany and France report a positive role of subsidies
in firm survival (Almus 2002; Crépon and Duguet 2003). In an undeveloped market economy,
governmental support is expected to be more important for firms to survive, even allowing some
inefficient firms to survive. In addition, firms in local key industries may also benefit from localiza-
tion economies since related firms could develop localized business networks. The agglomeration
benefits could improve the chance of firm survival (Renski 2011). Governmental supports have
significant moderating roles in firm failure. TFP × LQ, TFP × SUBSIDY, and TFP × LOAN are all
positive and significant. Given the presence of governmental support, firms with higher TFP are more
likely to fail. In other words, given the same level of TFP, firms with governmental support such as
 14

TABLE 4. CORRELATION COEFFICIENTS BETWEEN PAIRS OF EXPLANATORY VARIABLES.

Variables TFP AGE LQ SUBSIDY LOAN lnSIZE EXP FDI EXITRATE

TFP 1
GROWTH AND CHANGE, •• 2015

AGE 0.051 1
LQ −0.0002 −0.034 1
SUBSIDY 0.0244 0.0741 0.0099 1
LOAN 0.011 0.1173 0.0348 0.0698 1
lnSIZE −0.007 0.2705 0.1742 0.1442 0.1679 1
EXP 0.089 −0.0205 0.0779 0.0885 −0.0113 0.2828 1
FDI 0.0384 −0.1679 −0.0164 0.0079 −0.1268 0.1403 0.3965 1
EXITRATE −0.0987 0.0444 −0.0587 −0.0253 −0.0336 −0.0684 −0.0602 −0.0195 1
DETERMINANTS OF FIRM FAILURE
85
 86
TABLE 5. REGRESSION RESULTS FROM LPM FOR PANEL DATA.

Variables (0) (1) (2) (3) (4) (5) (6)

Exitstay Exitstay Exitstay Exitstay Exitstay Exitstay Exitstay

TFP −0.039*** −0.039*** −0.039*** −0.039*** −0.040*** −0.039*** −0.040***

AGE 0.051*** 0.051*** 0.051*** 0.051*** 0.051*** 0.051*** 0.052***
AGE × AGE −0.023*** −0.023*** −0.023*** −0.023*** −0.023*** −0.024*** −0.024***
LQ −0.005*** −0.004***
TFP × LQ 0.001***
AGE × LQ 0.000***
SUBSIDY −0.018*** −0.018***
TFP × SUBSIDY 0.004***
AGE × SUBSIDY −0.001***
LOAN −0.013*** −0.004**
TFP × LOAN 0.001**
AGE × LOAN −0.001***
LnSIZE −0.072*** −0.071*** −0.071*** −0.071*** −0.071*** −0.071*** −0.071***
EXP −0.015*** −0.015*** −0.015*** −0.014*** −0.014*** −0.014*** −0.014***
EXITRATE 0.826*** 0.827*** 0.827*** 0.826*** 0.826*** 0.826*** 0.826***
FDI −0.012*** −0.013*** −0.013*** −0.012*** −0.012*** −0.012*** −0.013***
Industry Y Y Y Y Y Y Y
Year Y Y Y Y Y Y Y
Province Y Y Y Y Y Y Y
Constant 0.162 0.164 0.164 0.160 0.158 0.168 0.158
Observations 1,555,981 1,555,981 1,555,981 1,555,981 1,555,981 1,555,981 1,555,981
R-squared 0.258 0.258 0.258 0.258 0.258 0.258 0.258
GROWTH AND CHANGE, MARCH 2016 DETERMINANTS OF FIRM FAILURE

*** p < 0.01; ** p < 0.05.

15
16 GROWTH AND CHANGE, •• 2015 DETERMINANTS OF FIRM FAILURE 87

subsidies and banking loans are hard to survive. In fact, subsidies are often granted to high-tech
industries and so-called strategic new industries such as bio-tech industries, new energy industry,
advanced equipment manufacturing, and new materials. Compared with the traditional industries,
those new industries are typically productive and are also more likely to fail because of the uncertain
market demand. For instance, as a heavily subsidized industry, the solar panel industry in China has
suffered deeply from the anti-dumping investigation in Europe and the U.S. in the last couple of
years. Many firms in this industry have gone out of business recently.
Governmental supports also moderate the impacts of firm age on firm failure. AGE × LQ is
positive and significant. Older firms in key industries are more likely to fail. Literally, key industries
mean important industries for a city and have a large number of firms. Local intra-industry compe-
tition among key industries is often very intensive, imposing substantial challenges for firms to
accumulate knowledge and to learn. In those industries, new firms are often equipped with advanced
technology and better organization structure, providing new firms the advantage of latecomers. In the
key industries, competition effects dominate learning effects. It is reasonable that older firms in the
key industries are hard to survive the market competition. However, AGE × SUBSIDY and
AGE × LOAN are negative and significant, suggesting that subsidies and banking loans can reduce
the failing chances of older firms. Figure 5 also shows that firms with subsidies and banking loans
are older than those without. Subsidies and banking loans have favored older firms. Firm-specific
support policies rather than industry-targeted policies can mitigate the competition effects, increas-
ing the business survival of older firms in China.
The findings basically confirm our research hypotheses. The control variables are largely consis-
tent with the theoretical expectation and the existing literature. LnSIZE has a negative and significant
coefficient, indicating that large firms are easier to survive. Being an exporter or foreign firm is less
likely to fail. Direct engagement into the globalization process is a critical factor to survive Chinese
firms. EXITRATE has a significant and positive coefficient in all models, suggesting that firms find
it hard to survive when the city industry is suffering. We also include the dummies for two-digit
industries, Chinese provinces, and the reporting years to make the estimations robust.

Robustness Analysis
We now conduct several robust checks. The year 2004 is the economic census year and may
include more newly created firms, with an entry rate 45.13 percent and failing rate of 18.69 percent.
The entry rate is significantly higher than other years. It may impose some influence on the
estimations. We dropped the 2004 sample and re-estimated the parameters (Table 6). The results are
largely consistent with the results derived from the full sample. The key variables remain significant
with expected signs. There are some very minor changes. The magnitude of the coefficient on TFP
drops from 0.039 to 0.028, while the coefficient on AGE increases from 0.051 to 0.075. AGE × LQ,
TFP × SUBSIDY, and TFP × LOAN turns insignificant. But overall, the 2004 sample does not cause
significant influence on the effectiveness of the models.
Furthermore, the data set only includes firms with sales revenues greater than 5 million yuan,
which is at the current year price. The 5 million yuan entry standard may influence the model
estimation since the sample used in this study may be biased. We then use 6 million yuan and
8 million yuan to choose two subsamples to re-estimate the results. We also use the producer price
index in 1998 to redefine the 5 million yuan standard and make another subsample of firms during
1998–2007 and rerun the models. The main findings from the above exercises remain almost the
same. Given the large sample of firms in our model estimations and the robust results from different
 88
TABLE 6. REGRESSION RESULTS FROM LPM FOR PANEL DATA (EXCLUDING THE SAMPLE OF YEAR 2004).

Variables (0) (1) (2) (3) (4) (5) (6)

Exitstay Exitstay Exitstay Exitstay Exitstay Exitstay Exitstay

TFP −0.028*** −0.028*** −0.028*** −0.028*** −0.028*** −0.028*** −0.027***

AGE 0.075*** 0.075*** 0.075*** 0.075*** 0.075*** 0.075*** 0.076***
AGE × AGE −0.022*** −0.022*** −0.022*** −0.022*** −0.022*** −0.022*** −0.023***
LQ −0.006*** −0.004***
TFP × LQ 0.001*
AGE × LQ 0.000
SUBSIDY −0.021*** −0.010***
TFP × SUBSIDY 0.000
AGE × SUBSIDY −0.001***
LOAN −0.011*** 0.003
TFP × LOAN −0.000
AGE × LOAN −0.001***
lnSIZE −0.066*** −0.065*** −0.065*** −0.065*** −0.065*** −0.065*** −0.065***
EXPORT −0.014*** −0.014*** −0.014*** −0.014*** −0.014*** −0.014*** −0.014***
EXITRATE 0.725*** 0.726*** 0.726*** 0.725*** 0.725*** 0.725*** 0.725***
FDI −0.011*** −0.012*** −0.012*** −0.011*** −0.011*** −0.011*** −0.012***
Industry Y Y Y Y Y Y Y
Year Y Y Y Y Y Y Y
Province Y Y Y Y Y Y Y
Constant −0.282 −0.279 −0.279 −0.287 −0.287 −0.279 −0.289
Observations 1,302,296 1,302,296 1,302,296 1,302,296 1,302,296 1,302,296 1,302,296
R-squared 0.293 0.293 0.293 0.294 0.294 0.294 0.294
GROWTH AND CHANGE, MARCH 2016 DETERMINANTS OF FIRM FAILURE

Note: *** p < 0.01; * p < 0.1.

17
18 GROWTH AND CHANGE, •• 2015 DETERMINANTS OF FIRM FAILURE 89

estimations, we are fairly confident in our empirical findings. The results indicate that both market
forces and state power determine firm dynamics in China.

Summary
China has intended to build a market-oriented economy gradually since the late 1970s. The
economic transition process can be coded as marketization, globalization, and decentralization. The
triple process has fundamentally changed the institutional framework for firms to survive.
Marketization and globalization have clearly introduced harsh market competition but decentraliza-
tion has granted local governments strong incentives to protect and support local businesses. This
may provide institutional advantage for firm survival. We argue that the competition effect, the
learning effect, and governmental support underpin firm survival and failure in China.
Based on the annual survey of industrial firms during 1998–2007, this study explored the pattern
of firm failure. It is reported that on average, failing firms are less productive than surviving ones.
Older firms are more likely to fail, while firms with governmental supports have more chance to
survive. More old firms have governmental supports. Productivity is just one of the many factors for
governments to choose favorable firms. Statistical results provide strong evidence to support our
research hypotheses. It is implied that competition effects crowd out less productive firms. When
firms are in their young ages, competition dominates learning effects and imposes challenges on the
survival of growing firms. However, when firms overcome the challenges and stay in the market for
a certain time, they can survive for a longer time. There is an inverted U-shaped age effect. Local
protectionism and supportive policies such as supports for local key industries and firm-specific
subsidies can certainly reduce the chance of firm failure. Particularly, they can help older firms to
mitigate the impact of competition effects. However, governmental supports could generate negative
externalities, reducing the survival chances of firms without supports. This means there could be
social costs of governmental intervention in industrial development. For instance, local governments
often lease cheap land to favored firms, while leaving others to compete for industrial land, resulting
in unfair local competition. The unfair treatment would impose challenges to the survival of other
firms.
This study contributes to the related literature from the following aspects. First, we process the
annual survey of industrial firms in systematic ways and estimate firm TFP using the semi-parameter
method, which can solve the selection bias and endogeneity issues. Second, this study is the first to
explore the impacts of Chinese industrial policies on firm failure and the findings are essential to
understand industrial dynamics in China. Third, the findings enrich our understanding about the
importance of state power and market forces in the development of industries and local economies
in the transitional China. Fourth, we realized some limitations in the data and definition of firm
failure; we conduct several robust checks and confirm the results. This is just an initial effort to
understand firm dynamics in China. Future research can extend the understanding of firm dynamics
in China by exploring the industrial, spatial, and temporal variation of firm failure and its impacts on
industrial upgrading and productivity improvement in Chinese industries and regions.

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