Asset pledgeability and firm innovation

China is rapidly becoming a leading innovator, even as its financial system remains heavily debt based. We examine the effect of debt financing capacity on firm innovation by employing a shock in China that increases firms' asset pledgeability. We find that firms increase their innovation activities after the shock, and the increase is greater in regions with more effective enforcement and in firms with more tangible assets, even after using a matching firm analysis. After using three instrumental variables, we find that the increase in innovation is stronger in firms with higher market tangibility. We also find that firms with more tangible assets are associated with a higher level of bank loans after legal enactments, have higher R&D activities, engage in more mergers and acquisitions targeting high-tech firms, and hire more inventors.