Constraints on business finance may lead to underinvestment in productivity-raising physical and knowledge capital. At the same time, well-functioning financial markets provide useful discipline on managers and their business decisions, signalling a reasonable expected return on investment accounting for risk.
We use the Longitudinal Business Database to show that firms that self-report being finance constrained face higher average interest rates than unconstrained firms. These differences in interest costs are, at least in part, due to constrained firms undertaking higher risk activities than unconstrained firms.
While our analysis cannot prove that financial markets are always functioning effectively, the triangulation of subjective survey data and objective finance data identifies a clear link between firm perceptions of finance constraints and the observed cost of debt, which is influenced directly by the characteristics of the firms. The observed relationships suggest that reporting firms may not fully understand the market risk premia on borrowing associated with their business activities, and/or that borrowers and lenders have different views on the risk associated with those activities.
Fabling, R. 2021. “Of interest? Estimating the average interest rate on debt across firms and over time”. Motu Working Paper 21-05. Motu Economic and Public Policy Research. Wellington, New Zealand.