The Collateral Channel under Imperfect Debt Enforcement

Does a country’s ability to enforce debt contracts affect the sensitivity of economic activity to collateral values? To answer this question, we introduce a novel industry-specific measure of real asset redeployability - the ease with which real assets are transfered to alternative uses - as a proxy for collateral liquidation values. Our measure exploits the heterogeneity of expenditures in new and used capital and the heterogeneity in the composition of real asset holdings across U.S. industries. Using a cross-industry cross-country approach, we find that industry size and growth are more sensitive to collateral values in countries with weaker debt enforcement. Our estimates indicate that the differential effect is sizeable. The sensitivity of economic activity to collateral values is not affected by a country’s financial development once the quality of debt enforcement is accounted for. We then rationalize our empirical findings based on a model of credit under imperfect enforcement and discuss an important implication of our empirical result: macroeconomic volatility generated by fluctuations in collateral values is higher in countries with weaker debt enforcement institutions.