Investment Distortion by Collateral Requirements: Evidence from Japanese SMEs

We examine the significance of the distortionary effect of collateral requirements for investments in pledgeable assets by small and medium-sized enterprises (SMEs). The theory predicts that the binding collateral constraint causes over-investment if land prices are expected to go up steeply while it causes under-investment otherwise. Our structural estimation of the Euler equation under a collateral constraint using the dataset on Japanese SMEs in the 1980s, the period in which Japanese land prices were skyrocketing, shows that the collateral constraint was not binding on average, whereas the estimation using data on the 1990s, during which land prices went down precipitously, shows that the constraint was binding and caused under-investment in the 1990s. This result indicates that the distortion in resource allocation resulting from the binding collateral constraint was a significant cause of the subsequent prolonged economic slump.