Capital misallocation and credit constraints: Theory and evidence from natural

Overview & Synopsis

This article builds a model of financial frictions to explain the aftermath of natural disasters. In constrained economies, after a large shock on capital, affected entrepreneurs might lose access to credit together with their stock of capital. Investment does not flow to high-returns projects. Accordingly, in constrained economies, a shock on capital is associated with an initial decrease of domestic credit and an investment slack. I find direct support for the theoretical model using objective measures on sudden natural disasters between 1980 and 2006. Constrained economies experience an initial decline in their level of investment, which reflects on the immediate GDP growth. This effect fades away after 3 years. In frictionless environment, the increase of credit offsets almost perfectly the estimated capital losses. The underlying credit frictions computed using a structural equation prove to be correlated to more classic measures of financial development.