FINANCIAL FRICTIONS AND CAPITAL ALLOCATION EFFICIENCY: EVIDENCE FROM EMERGING MARKETS

Abstract

This paper looks at whether financial frictions hurt how capital is allocated in emerging markets. It uses public data on 148 emerging and developing economies (1996–2024), about 450 listed Pakistani firms (2009–2023) and 1,300 unlisted Pakistani firms surveyed by the World Bank. There are three main findings. First, investment goes with faster growth across countries, but the payoff does not change with bank credit depth or interest spreads. It rises with equity-market depth only in a fragile result. Second, Pakistani firms run almost entirely on internal funds. Only 2% of surveyed firms have bank credit, investment at listed firms moves strongly with cash flow, and about half of surveyed firms say they are discouraged from borrowing. Even so, firms that look constrained do not invest less, earn higher returns on capital or grow more slowly. Two quasi-experiments, the 2020–23 interest-rate cycle and the 2020 opening of subsidized long-term refinance to all manufacturers, show no differential response either. Third, Pakistan invests far less than its peers (12.6% of GDP against a median of 22.0%), and the spread of returns to capital among listed firms widened from 1.27 to 1.45 log points. The evidence points to too little capital formation more than to visible misallocation. All estimates are associations.