Government financial institutions and capital allocation efficiency in Japan

This paper uses the industry-level panel data from 1975–2005 and estimates Wurgler's η, the elasticity of industry investment to value-added, for each of Japan's 47 prefectures. We find that Wurgler's η varies considerably across prefectures even though there is no regulatory restriction on inter-regional flow of financial capital. Moreover, exploiting cross-prefecture variation in Wurgler's η, we show that the share of government loans is strongly and negatively correlated with the quality of capital allocation. We also find that this negative correlation is robust to controlling for local economic and financial development, and more pronounced in declining industries than growing industries. Moreover, the share of government loans is positively correlated with investment-to-output ratio but negatively correlated with total factor productivity growth. Taken as a whole, the results are broadly consistent with the view that Japan's government financial institutions stimulate investment in declining industries while distorting capital allocation and reducing overall productivity growth.