Do Financing Constraints Matter for R&D? New Tests and Evidence

Information problems and lack of collateral value should make R&D more susceptible to financing frictions than other investments, yet existing evidence on whether financing constraints limit R&D is decidedly mixed, particularly in studies of non-U.S. firms. We study a large sample of European firms and show that prior studies likely understate the impact of financing constraints on R&D because they ignore: i) firm efforts to smooth R&D with stocks of liquidity, and ii) firm use of external equity finance. We find a strong negative link between changes in cash reserves and R&D, and a large increase in the estimated impact that other financial factors (cash flow and stock issues) have on R&D when we directly control for R&D smoothing with cash reserves. Taken together, these findings offer strong evidence that financing constraints affect R&D because they cannot readily be attributed to problems controlling for investment demand. More generally, our results show how endogenous liquidity management complicates testing for financing constraints on investments with high adjustment costs. Our findings also indicate that access to equity finance matters for R&D, highlighting a causal channel through which stock market development and liberalization can promote economic growth by increasing firm-level innovative activity. This version: September 28, 2010 JEL Classification: G31; G32