Financial Structure, Misallocation and TFP

Abstract

This paper studies the quantitative relevance of the cross-sectional dispersion of firm financial structure in explaining the intra-industry allocation efficiency of productive factors. I solve a heterogenous firms model with financial constraints and distortions to the marginal rental-rate of capital, and develop a measure for the intra-industry misallocation of factors of production. The distribution of rental rate of capital and two types of firm-level balance sheet characteristics (pledgeability and collateralizable asset positions) determine the extent of misallocation and industry level total factor productivity (TFP). In the model firms that face high capital rental rates borrow in the financial market to lower the marginal cost of production and increase the scale of investment up to the limit that is allowed by the balance sheet positions. Using Compustat data, I calibrate the model for seven major industry clusters from the U.S. economy. The counterfactual policy experiments show that weakening the observed balance sheet positions for financially constrained firms leads to a reallocation of production factors from firms that face high cost distortions to firms with low cost distortions and cause industry level TFP losses. The value added from firm-level financial access for aggregate industry performance varies across sectors: For example, in IT and Textile & Fabrics industries where external finance dependence plays an important role for industry performance shutting down financial access lowers aggregate industry TFP to 50% of the existing level. The results suggest that the aggregate economic benefits from financial sector development vary with external finance dependence of industries confirming the results obtained by Rajan and Zingales (1998).