Factor Adjustments and Liquidity Management: Evidence from Japan's Two Lost Decades and Financial Crises

To reveal the cause of Japan's recent weak physical investment, this study estimates and compares the Euler equations for physical investment, R&D investment, and employment. We construct an unbalanced panel from Japanese firms' microdata from 1994 to 2014. The estimation results suggest that firms face weak financial constraints in the sense that their borrowing amount is not restricted, but their internal funds are insufficient.To address such constraints, firms first allocate their cash flows and cash reserves to buffer their employment and then incur R&D investment rather than protect physical investment. We suggest the following reason for this result: employment and R&D investment are more productive and/or impose larger adjustment costs than physical investment, and thus, firms prioritize the stabilization of employment and R&D over funding physical investment. This study also shows that young, small-sized, and manufacturing firms are likely to suffer from weak financial constraints. Furthermore, even during financial crises, firms rely only on internal funding and are not restricted by external funding in the same way as they are during usual times.