China has been growing at a high rate and has at the same time accumulated a stag-
gering foreign surplus. We constructs a theory that explain these seemingly puzzling ob-
servations, while being consistent with salient features of the Chinese growth experience
since 1992: high output growth, sustained returns on capital investments, extensive real-
location within the manufacturing sector, falling labor share and accumulation of a large
foreign surplus. The theory makes only minimal deviations from a neoclassical growth
model. Its building blocks are …nancial imperfections and reallocation among …rms with
heterogeneous productivity. Some …rms use more productive technologies than others, but
low-productivity …rms survive because of better access to credit markets. Due to the …-
nancial imperfections, high-productivity …rms –which are run by entrepreneurs –must be
…nanced out of internal savings. If these savings are su¢ ciently large, the high-productivity
sector outgrows the low-productivity sector, and attracts an increasing employment share.
During the transition, low wage growth sustains the return to capital. The downsizing of
the …nancially integrated sector forces a growing share of domestic savings to be invested
in foreign assets, generating a foreign surplus. We test some auxiliary implications of the
theory and …nd robust empirical support.