Financial Constraints, Innovation Quality, and Growth

Abstract

This paper investigates the role of financial constraints in shaping innovation quality and firm-growth dynamics through heterogeneous innovation. Using patent activities and operating data of private Chinese manufacturing firms, I show a strong negative relationship between the severity of financial constraints and a) firm growth, b) innovation intensity, and quality. Based on these empirical regularities, I build a tractable endogenous growth model in which a multi-product firm invests in heterogeneous innovation in the face of imperfect financial markets. Tighter financial constraints cause firms to undertake more low-quality innovation, which yields temporary payoffs but no longer-term productivity improvements. This could lower firm and aggregate growth rates. The quantitative model suggests financial frictions reduce incumbents' R&D investment by 21.6 percent on average and slows aggregate annual productivity growth by 16.7 percent (0.62 percentage point annually)