# **Efficient Financial Allocation and Productivity Growth in Brazil**

## **1. Introduction**

Aggregate productivity gains are usually thought as primarily driven by upgrades in processes, products and machinery used by firms, in turn affected by investments in human capital and R&D. In this context, low total factor productivity (TFP) growth is usually caused by barriers preventing the diffusion and adoption of new technologies (Parente and Prescott, 2002). However, recent studies have suggested an alternative explanation: low aggregate TFP growth can be explained by a number of policy and market failures that determine the allocation of resources across firms (see, for example, Restuccia and Rogerson, 2013, and references therein). One important source of distortions, widely studied in the literature, is represented by financial frictions.

The idea that an economy needs intermediation to match borrowers and lenders, channeling resources to their most efficient use, is a generalized conclusion of modern economics. There is a large literature on the relationship between finance and economic growth. Though recent evidence points to a non-monotonic relationship between financial development and economic growth (e.g. Cecchetti and Kharroubi, 2012, and Arcand et al., 2015 ) , it is generally accepted that finance is good for growth (Goldsmith 1969; McKinnon, 1973; Shaw, 1973; Fry, 1978; Bencivenga and Smith, 1991; King and Levine, 1993a, 1993b), with causality running from finance to growth.<sup>1</sup> Productivity is the main channel through which financial development affects economic growth.

In the presence of financial market imperfections, this virtuous process of efficient allocation of resources can break up. Financial frictions can reduce aggregate productivity via two channels. First, they may distort entry and technology adoption decisions and thus reduce the productivity of individual firms (see Cole et al., 2012). Second, financial frictions may generate differences in the returns to capital across individual firms, thus generating efficiency losses through misallocation (Banerjee and Duflo, 2005; Restuccia and Rogerson, 2008; and Hsiew and Klenow, 2009).

The role of financial frictions for innovation and growth has been studied mainly in the development literature. Banerjee and Duflo (2005) provide evidence that firms in many emerging markets and developing economies face financing constraints. Brazil is no exception. In Brazil, private debt markets for firms, especially for long-term finance, remain relatively underdeveloped. While total market-based credit to non-financial firms accounted for 25 percent of GDP in 2016, long-term outstanding private debt was only about 5 percent, signaling the presence of market failures for long-term credit markets. There is evidence that Brazilian firms are financially constrained. Terra (2003), Aldrighi and Bisinha (2010) and World Bank (2012) all attest that Brazilian firms do face financing constraints, especially smaller and non-listed firms with limited export capacity.<sup>2</sup>

> 1 See Levine et al. (2000) for cross-country evidence; Rajan and Zingales (1998) for industry-level evidence; and Beck et al. (2000) for firm-level evidence. 2 See also Ambrozio et al. (2016), who recently investigated credit constraints using firm-level data in the manufacturing sector.

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