When Do Financial Frictions Matter for Misallocation?

Yan Bai, Dan Lu, Xu Tian and Yajie Wang

No 34930, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper reassesses the role of financial frictions in capital misallocation through a model disciplined by both firm-level borrowing costs and the average revenue product of capital (ARPK). Using Chinese manufacturing data, we document substantial dispersion in ARPK, alongside a strong positive relationship between ARPK and the borrowing costs firms face---patterns absent in U.S. data. We develop a heterogeneous-firm model with endogenous firm-specific borrowing costs and additional capital distortions modeled as exogenous wedges. In this model, eliminating financial frictions raises total factor productivity (TFP) by 25 percentage points. In contrast, without other capital distortions, removing financial frictions increases TFP by less than 2 percentage points. The stark difference arises from the interaction between financial frictions and permanent firm-level distortions, which generate endogenous financial heterogeneity and selection, making productive firms the most constrained. Our findings suggest that financial frictions can be highly distortionary when other sources of misallocation are present.

JEL-codes: E2 F3 (search for similar items in EconPapers)
Date: 2026-03
New Economics Papers: this item is included in nep-bec, nep-cna, nep-dge, nep-eff, nep-fdg and nep-ifn
Note: EFG
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