Inefficient resource allocation can occur at two levels: funding firms and the production process. | © shutterstock.com
The role of firm productivity in enhancing living standards and driving sustained economic growth is widely acknowledged. Extensive academic research, newspaper articles, and influential reports have highlighted the various channels through which firm productivity contributes to prosperity. However, the factors driving firm and aggregate productivity still need to be understood.
The ability of firms to finance investments in physical and human capital is central to economic growth and societal well-being. Yet, not all firms in developing countries have access to finance. Indeed, some must pay a higher cost than others despite being the most productive. A myriad of factors, such as frictions and distortions often opaque investors’ capacity to properly evaluate firms’ performance. Beyond restricting access to finance, these factors also alter firms’ capital structure—the debt-to-equity mix businesses use to produce a good or service—relative to the optimum in a frictionless economy. As a result, financial resources are allocated inefficiently, high-productivity firms produce less output than low-productivity ones, and the economy generates less output than it would in the absence of distortions.
In a recent paper, we study the role of financial frictions and distortions in driving productivity at the firm and aggregate levels. We do so by implementing Whited and Zhao’s (2021) methodology to infer finance misallocation across firms in 24 European countries from 2010-2016. The methodology, which mirrors the approach of Hsieh and Klenow (2009) to measure the misallocation of productive resources, identifies finance misallocation by observing the dispersion in the distribution of the marginal returns to debt and equity across firms in narrow industries. The data, drawn from the ORBIS database, enables the implementation of the methodology due to the rich information on firms’ balance sheets, particularly by reporting the levels of debt and equity (internal and external) at the firm level.
Our first result shows that removing distortions and reallocating financial resources more efficiently is highly correlated with eliminating distortions and reallocating labor and capital towards the most productive firms. In other words, a more efficient allocation of financial resources increases productivity and output at the aggregate level (Figure 1).
Our research explicitly investigates whether firms' financial resource allocation impacts their efficiency in converting inputs (such as labor and capital) into outputs. The underlying intuition is that firms utilize equity and debt to acquire production inputs used to produce and deliver products and services. This means inefficient resource allocation can occur at two levels: funding firms and the production process. Our paper presents evidence that the allocation of financial resources is deeply intertwined with the allocation of real inputs, highlighting the complex relationship between these two sources of (potential) distortions.
Figure 1: The variability in the allocation of real inputs is explained by the variability in the allocation of financial distortions
Our analysis also reveals that, on average, three-quarters of potential gains from improving financial allocation across countries can be attributed to improved access to finance, with the remaining quarter resulting from optimizing the debt-to-equity ratio. Distortions in financial markets can affect productivity and output at the firm and aggregate level through two channels: scale effect and composition effect. The first determines the total amount of finance, while the second channel affects the debt-to-equity mix.
Both aspects have policy implications: limited access to funds may require scaling up financial resources for companies, while the second aspect is linked to the availability of suitable financial instruments.
Figure 2: Better access to finance is the main source of firms’ sub-optimal allocation of funding
Our research also shows that financial distortions disproportionately affect young, smaller, and more productive firms. Identifying firm characteristics influencing financial resource allocation can inform policy design to address potential distortions. As financial misallocation leads to lower aggregate productivity through allocative inefficiency, policies aimed at removing this distortion can help alleviate constraints on productivity growth by targeting specific firms. This, in turn, may reverse the productivity slowdown observed in many economies, particularly in the European Union. Overall, our study confirms financial development's critical role in spurring economic growth.
Figure 3: Poorer countries benefit more from reversing the inefficient allocation of financial resources
Financial frictions play an important role in determining total factor productivity. Our work provides new evidence on the global properties of financial misallocation and its ability to account for the inefficient allocation of real resources.
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