«WPS3319 Financial Development and Growth in the Short- and Long-Run* Public Disclosure Authorized Raymond Fisman, Columbia Business School and NBER ...»
Public Disclosure Authorized
Financial Development and Growth
in the Short- and Long-Run*
Public Disclosure Authorized
Raymond Fisman, Columbia Business School and NBER
Inessa Love, World Bank DECRG
We analyze the relationship between financial development and inter-industry resource allocation in the
short- and long-run. We suggest that in the long-run, economies with high rates of financial development
will devote relatively more resources to industries with a ‘natural’ reliance on outside finance due to a comparative advantage in these industries. By contrast, in the short-run we argue that financial development facilitates the reallocation of resources to industries with good growth opportunities, Public Disclosure Authorized regardless of their reliance on outside finance. To test these predictions, we use a measure of industry-level ‘technological’ financial dependence based on the earlier work of Rajan and Zingales (1998), and develop new proxies for shocks to (short run) industry growth opportunities. We find differential effects of these measures on industry growth and composition in countries with different levels of financial development.
We obtain results that are consistent with financially developed economies specializing in ‘financially dependent’ industries in the long-run, and allocating resources to industries with high growth opportunities in the short-run.
World Bank Policy Research Working Paper 3319, May 2004 Public Disclosure Authorized The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors.
They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org.
allocation. The hypothesis that financial development facilitates the efficient allocation of resources dates back to at least Schumpeter (1912), who conjectured that banks identify entrepreneurs with good growth prospects, and therefore help to reallocate resources to their most productive uses. More recently, Levine (1997) describes a number of channels through which financial development may affect allocative efficiency, including information generation, risk-sharing, financing, and monitoring. Rajan and Zingales (1998) point out that allocation may be differentially affected by industry characteristics: those that require a lot of upfront outside financing (relative to generated cash flow), such as drugs and pharmaceuticals (perhaps due to R&D costs), will be less likely to grow in the presence of capital market imperfections than other industries where investment more closely coincides with cash generation. More recently, a number of other researchers have used a similar approach to look at the interaction of various ‘fixed’ industry characteristics and different aspects of financial development in predicting sectoral growth.
In this paper, we suggest that there is an important theoretical distinction in considering the role of financial development on industry growth in the short- and long-run that has heretofore gone largely unrecognized. In the short-run, we emphasize the role of financial institutions in reallocating resources to any industry that has experienced a positive shock to growth opportunities. We contrast this with a long-run view of the allocative effects of financial development, suggested by Rajan and Zingales (RZ), who argued that certain industries will naturally be more reliant on financial institutions to finance growth. Intuitively, this leads to separate predictions on the allocative effects of financial development in the short- and long-run.
In the short-run, sectoral growth will be more correlated with growth opportunities in countries with well-developed financial institutions that allow firms to take advantage of these opportunities. In other words, in an economy with high financial development, actual industry growth in the short-run will be a function of growth opportunities (i.e. potential), regardless of inherent industry characteristics. In the long-run, financially dependent industries will have comparative advantage in countries with well-developed financial institutions and will thus capture a larger share of total production (relative to an economy with a low level of financial development), i.e., countries with high financial development will specialize in financially dependent industries. Thus, sector share of financially dependent industries will be higher in countries with high financial development.
In order to examine these contrasting predictions empirically, we require proxies for short-run shocks, as well as inherent industry reliance on financial intermediation. We develop measures of short-run shocks based on the assumption that there exist global shocks to growth opportunities that may be proxied for by actual growth in the United States. One interpretation of this measure is that it is a reflection of U.S. companies’ optimal responses to worldwide shocks (such as oil shocks). Based on the assumption that if the United States has very well developed financial markets (as suggested by RZ), global shocks will be quickly reflected in actual growth rates in the United States. Under this assumption, actual industry growth in the United States may be used as a proxy for growth opportunities for the same industry in other countries.
Alternatively, we may think of these shocks as originating in the United States (due to demand and/or productivity shocks within the United States) and propagated to other countries with economic links with the United States. This interpretation allows for a further refinement of our measure of growth opportunities: We allow actual growth in the United States to differentially affect industries in different countries, based on their trade linkages to the United States. To implement this, we weight U.S. growth by the extent of trade with the United States for each industry in each country. Thus, our assumption of U.S.-based shocks allows us to generate a country-industry specific proxy for growth opportunities. This is in contrast to earlier work in this literature, which has always taken U.S.-based measures to apply uniformly around the world.
Our measure of underlying financial dependence builds on the earlier work of Rajan and Zingales (1998), which measures financial dependence as the mismatch between cashflow and investment, calculated using data on U.S. publicly traded firms. The rationale for this approach is that there exist time-invariant, i.e. ‘inherent,’ industry characteristics, which make some industries more (or less) reliant on external financing, and that this dependence will be reflected in U.S. firms, due to the efficiency of U.S. capital markets. Financially dependent industries will be at a comparative advantage in countries with well-developed financial markets that allow firms to take advantage of opportunities in industries with such characteristics, and will thus garner a larger share of production (which represents long-run accumulated growth rates) in these countries. This stands in contrast to the idea of shocks to growth opportunities that is based on temporary, i.e. time-specific, shocks that will be reflected in short-run growth.
Our results are broadly consistent with the arguments laid out above: industry sectoral growth is more correlated with our measures of industry shocks in countries with well-developed financial markets; industry sectoral shares are more correlated with financial dependence in countries with high financial development. Further, we find similar patterns for alternative measures of financial dependence, including R&D intensity (Beck and Levine, 2002) and trade credit dependency (Fisman and Love, 2003).
Our results highlight the important distinction between the roles of financial development in resource allocation in the short- and long-run, and also provide some guidance and structure for future work in this area. In particular, we introduce a broader measure of ‘growth opportunities’ that we claim is more suited to studying allocation through sectoral growth, while intrinsic industry characteristics (such as financial dependence) should be more useful in predicting allocation of sector shares. Further, our paper suggests a reinterpretation and a potential augmentation to a number of earlier works that follow the methodology of Rajan and Zingales (1998). To cite just a few examples, Claessens and Laeven (2003) examine industryspecific tangibility of assets and its relationship to property rights protection; Fisman and Love (2003) study industry-specific trade credit affinity; and Cetorelli and Gambera (2003) analyze the relationship between different aspects of financial development, ‘external dependence,’ and sectoral growth.
The rest of the paper is structured as follows: Section 1 gives a brief overview of the various mechanisms through which financial institutions may facilitate efficient resource allocation; Section 2 describes our empirical approach; our data are described in Section 3; in Section 4, we report our results; and in Section 5, we conclude.
1. Theories of Financial Development and Resource Allocation While financial development may affect the level of economic growth through numerous channels, we focus here on the role of financial institutions in allocating resources to firms or industries with good growth opportunities. Even within this limited realm, there exists a vast body of work; we provide only a brief and limited overview to highlight the fact that there are several functions of financial intermediaries that could have implications for both short- and long-run sectoral growth.1 These include the provision of external financing; information See Levine (1997) for an overview with greater breadth and depth.
acquisition and dispersion; governance and oversight; and risk diversification. We briefly discuss each of these in turn, emphasizing the role of financial institutions in both the short- and long-run.
Provision of External Finance – As described by Schumpeter (1912), financial institutions provide funding to entrepreneurs with good growth prospects. Any industry with high growth opportunities will require a relatively large amount of outside financing, since future cash flow (and current investment) will be high relative to current cash flow. Since financial institutions allow firms (and hence industries) that have good growth opportunities to better finance current investment, industries with good growth opportunities should grow relatively more in countries with high financial development. In addition, as suggested by Rajan and Zingales (1998), there may be certain industries where there is a ‘natural’ lag between investment opportunities and cash flow. Industries with this inherent need for external finance (i.e. financially dependent industries) will be relatively advantaged in responding to growth opportunities at all times in countries with well-developed financial institutions, i.e., these countries will have a comparative advantage in finance-dependent sectors. These incremental relative advantages will accumulate over time. Hence, we anticipate that a relatively large share of output in high financial development economies will be in high external finance industries.
We further note that conversely, some industries may be naturally better suited to obtain external financing from sources other than formal financial intermediaries. One example is suggested by Fisman and Love (2003), who examine trade credit access and intersectoral allocation. Following their theoretical discussion, we suggest here that industries with ready trade credit access should be less reliant on formal financial institutions to finance growth opportunities, and should therefore be relatively well-represented in countries with low financial development.
Information Acquisition and Dispersion – In addition to the financing role described above, King and Levine (1993) emphasize the role of financial institutions in overcoming informational problems that are likely to loom large in areas with new and emerging opportunities. Through price signals and specialized resources devoted to evaluating firms’ prospects, well-functioning financial institutions may both directly devote resources to promising ventures, and also signal high potential sectors to the broader economy. In addition to facilitating growth in any new and uncertain sector, therefore, this reasoning suggests that industries in which information is inherently difficult to acquire (such as high R&D sectors, which we consider below) will obtain a relatively large share of output in high financial development economies.
Risk and Uncertainty – In addition to limited information, the financing of new opportunities is likely to be accompanied by risk. In the model of De la Fuente and Marin (1996), for example, this leads entrepreneurs to devote resources to safer but lower growth projects. This implies a weaker response to growth opportunities, and suggests that industries that are generally risky (once again, we will suggest high R&D sectors have this attribute) will have a relatively large share of production in high financial development economies.
Monitoring – The model of Blackburn and Hung (1998) focuses on the monitoring role of financial institutions in promoting growth. Closely related to their model is the idea that financial intermediaries may ‘create winners’ in addition to ‘picking winners.’ That is, in addition to financing projects that are expected to grow through the provision of funds, financial institutions may ensure that the firms that receive funding use their resources to best take advantage of growth opportunities. Furthermore, it is plausible that high R&D industries (or intangible-intensive industries generally) are more likely to be subject to concerns of moral hazard.
2. Empirical Approach