Leverage and Productivity

Financial frictions can reduce aggregate productivity, in particular when firms with high productivity cannot borrow against their earnings. This paper investigates the quantitative importance of this form of borrowing constraint using a large panel of firms in Japan. The firms are young and unlisted, precisely the firms for which credit frictions are expected to be the most severe. In this data, I find that firm leverage (asset-to-equity ratio) and firm output-to-capital ratios rise with firm productivity, both over time in a firm and across firms of the same age and cohort. I use these facts in indirect inference to estimate a standard general equilibrium model where financial frictions arise from the limited pledgeability of earnings and assets. In this model more financially constrained firms have higher output-to-capital ratios. The model matches the two facts the best when firms can pledge the equivalent of over half of their one-year-ahead earnings and one-fifth of their assets. Compared to the common assumption that firms can pledge only assets, aggregate productivity loss due to financing frictions is one-third smaller when earnings are also pledgeable to the degree seen in Japan.