Working Capital or Investment, that is the question: A Firm-Level Analysis of Credit Channel in Iran

Abstract

This study investigates the existence and functionality of the credit channel of monetary policy transmission based on two primary needs of external financing: working capital and investment. Using the novel database of the “Annual Survey of Iranian Manufacturing Establishments”, which covers more than 13,000 establishments annually, we find that financially-constrained firms with a higher external finance dependence (EFD) perform worse under a monetary contraction. To identify the transmission mechanism, we focus on the unequal effects of ex-ante EFD on the performance of two groups of highly constrained and almost unconstrained firms. Separating the two dimensions of EFD, we find evidence of the importance of working capital dependence (WCD). The instrumental variable regression shows that firms with higher financial constraints and greater WCD perform worse when confronting a contractionary monetary shock. The impact is quantitatively significant since a 10-day longer WCD (21 percent of average) causes a 5.54, 5.34, and 1.28 percentage-point lower production, sales, and employment growth among highly constrained firms compared to almost unconstrained ones. However, these impacts do not persist longer than a year, and the shock does not disturb investment and R&D expenditures that may affect firms’ long-run production.

Keywords: Monetary Policy Transmission Mechanism, Credit Channel, Working Capital, Financial Constraint, Credit Contraction.

JEL Classification: E3, E5, G3.