The Role of Financial (Mis)allocation on Real (Mis)allocation: Firm-level Evidence for European Countries

Ana Paula Cusolito, Roberto Fattal Jaef, Davide Salvatore Mare and Akshat Vikram Singh

No 10811, Policy Research Working Paper Series from The World Bank

Abstract: This paper leverages the novel methodology by Whited and Zhao (2021) to identify financial distortions and applies it to a sample of 24 European countries. The analyses reveal that less developed economies face more severe financial misallocation. Distortions in the allocation of financial resources raise the relative cost of finance for younger, smaller, and more productive firms. Counterfactual analysis indicates that alleviating financial distortions could boost aggregate productivity by approximately 30-70 percent. On average, 75 percent of these gains across countries result from better access to finance, with the remainder from optimizing the debt-to-equity ratio. The paper also quantifies the link between financial misallocation and real-input allocative inefficiency, showing that reducing financial misallocation from the median to the 25th percentile of the cross-industry distribution can increase aggregate productivity by an average of 5.2 percent. The effect is larger, at 6.4 percent, for industries heavily reliant on external finance.

Date: 2024-06-20
New Economics Papers: this item is included in nep-cfn, nep-eec, nep-eff, nep-eur and nep-fdg
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