Capital Misallocation Effect of Financial Repression in Less-Developed Economies

Abstract

In this paper, we theoretically analyze the capital misallocation effect of financial repression---namely, a regulation to provide cheap loans to (public) firms, in less-developed economies. Limited contract enforcement and asymmetric information between lenders and borrowers are the features of the environment we study. We show raising the interest rate does not screen low-productive firms; due to adverse selection such firms borrow and strategically default. Hence, financial repression does not cause capital misallocation. Advanced enforceability of financial contracts and/or a rise in asset collateralizability of firms break the neutrality result, in which case the free market outcome achieves the optimal allocation of capital.