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Raymond Fisman

Inessa Love

Working Paper 9582



1050 Massachusetts Avenue

Cambridge, MA 02138

March 2003

We thank Raghuram Rajan and Luigi Zingales, as well as Rafael La Porta, Florencio Lopez de Silanes, and Andrei Shleifer, for kindly allowing us the use of their data. Finally, we thank Thorsten Beck, Asli DemirgüçKunt, Ann Harrison, Charles Himmelberg, Andrei Kirilenko, Luc Laeven, Sendhil Mullainathan, Jan Rivkin, Tarun Khanna and Luigi Zingales for extremely helpful conversations and advice. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research.

©2003 by Raymond Fisman and Inessa Love. All rights reserved. Short sections of text not to exceed two paragraphs, may be quoted without explicit permission provided that full credit including ©notice, is given to the source.

Financial Dependence and Growth Revisited Raymond Fisman and Inessa Love NBER Working Paper No. 9582 March 2003 JEL No. G15, G21


In this note, we revisit an earlier, highly influential paper on Financial Dependence and Growth by Rajan and Zingales (1998), by re-examining their assumptions, and the robustness of their results to alternative theories and interpretations. We first show that they may be implicitly testing whether financial intermediaries allow firms to better respond to global shocks to growth opportunities, rather than the extent that financial intermediaries allow firms to grow in industries with an inherent (technological) financial dependence. Furthermore, if this is the case, we claim that there exists a more direct measure of growth opportunities. In particular, if U.S. capital markets are perfect, then actual growth in the U.S. is a good proxy for global growth opportunities. We test this directly, by including U.S. industry growth in Rajan and Zingales' original specification, and find that our direct growth measure outperforms their financial dependence measure and, moreover, is less vulnerable to controlling for outliers and level of development. This still suggests an important role for finance in the allocation of resources, but shifts the emphasis from 'financial dependence' to 'global growth opportunities.' Raymond Fisman Inessa Love 823 Uris Hall The World Bank Columbia University

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market development and finance. This idea, that financial institutions play an important role in the resource allocation process, dates back to at least Schumpeter (1911), who conjectured that banks help to identify entrepreneurs with good growth prospects, and therefore help to reallocate resources to their most productive uses. Therefore, well-developed financial institutions will be crucial to an efficient allocation of resources in response to growth opportunities. The difficulty in testing this hypothesis is that growth opportunities are not generally observable to the econometrician: a firm (or industry, or country) may not be growing because there are no growth opportunities, or because there are opportunities, but no financing to allocate resources to them.

Rajan and Zingales (RZ) point out that this reallocation 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. RZ further posit that this allows them to identify the extent to which financial market development facilitates the allocation of resources to needy entrepreneurs: industries that are ‘external finance dependent’ should grow relatively less in countries with underdeveloped capital markets.

In this comment, we begin by developing a simple theoretical model upon which we base a new test of the growth – financial development hypothesis. We assume that there exist global shocks to growth opportunities, due to demand shocks and/or shifts in factor prices. Further, following previous work, we claim that if firms in the United States respond perfectly to these shocks, then growth of firms in the U.S. should be a proxy for these growth opportunities. The extent to which firms in other countries respond to these opportunities, and therefore the degree to which growth in these countries is correlated with the growth of U.S. firms, will depend on the level of financial market development in these countries.

We then go on to present a model that yields a monotonic relationship between (unobserved) growth opportunities and reliance on external financial markets – firms that rely on external financial markets are naturally those with strong future opportunities relative to current cash-generating capacity. Based on this model, we show that RZ’s original measure of ‘technological’ external dependence may be proxying for shocks to the global growth

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substantively different interpretation of RZ’s results: rather than suggesting that countries with well-developed financial markets have a natural ‘affinity’ ex ante for growth in certain industries, our explanation suggests that for any industry, when industry-specific opportunities present themselves, they will be most rapidly and effectively exploited by firms in countries with well-developed financial markets.1 If our modeling assumptions are correct, we claim that, rather than using RZ’s external dependence measure, the estimating equation should use a more direct measure of these growth shocks, such as sales growth of firms within the United States. Our empirical specification, which closely parallels that of RZ, finds that the ‘global shocks’ hypothesis strongly outperforms the ‘technological dependence’ hypothesis. Moreover, we find that the RZ (technological dependence) result is much more vulnerable to the robust treatment of outliers, particularly once one controls for the standard trade-development theories of resource allocation, which posit that countries at similar levels of economic development should grow in similar industries. Since the techniques and variables utilized by Rajan and Zingales have been much utilized in the Finance Furthermore, in a related paper, we claim that the ‘global shocks’ hypothesis may be more efficiently tested using an entirely different methodology. See Fisman and Love (2003) for further details.

and Growth literature since the publication of their original paper2, we believe that these results should be important in guiding both the formulation of new and related empirical tests, as well as the choice of variables in estimating these new models.

The rest of this paper is organized as follows: in Section 1, we describe our theoretical framework in greater detail. In Section 2 we describe our data and present our results. Section 3 concludes.

1. Financial Development and Growth: Theory Rajan and Zingales hypothesize that some industries have an inherent need for outside financing due to a “technological” demand for external financing; these industries are referred to as “financially dependent”. If financial development reduces the cost of external finance, such industries will have a relative advantage in countries with well-developed financial markets. RZ

implement this model using the following functional form:

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In this expression, i indexes industry, c indexes country, EXTFINUSi is industry i’s need for outside financing, which was measured using the US data (we have emphasized this assumption by adding the subscript US; note that their model also includes industry and country dummies which we omit for simplicity of notation).

To more fully develop the theory underlying this reduced form, we consider exactly what it is that determines a firm’s external financing needs, and why this should be affected by See Beck (2003), Beck and Levine (2002), Cetorelli and Gamberra (2001), Klingebiel, Kroszner and Laeven (2002), Svaleryd and Vlachos (2002), Vlachos and Waldenstrom (2002), Fisman and Love (2003) among others who used this methodology and utilized the financial dependence measure.

financial development. We begin by emphasizing that a firm may not be growing either because there exist no opportunities, or because it is unable to take advantage of opportunities because of financing constraints. For simplicity of exposition, we assume that the degree of financing constraints is measured as a percent of desired external financing that the firm can actually raise in the financial markets. Thus, actual growth will be a function of growth opportunities (i.e. the potential increase in production or value added, represented by GO*) times the percent of desired

financing the firm was able to obtain (FC*):

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The subscripts above emphasize that for each firm or industry i, in a country c, growth opportunities will be industry and country specific (the time dimension is suppressed for notational simplicity). The asterisks underscore the fact that these variables are not observable to the econometrician.

The hypothesis that financial development loosens financing constraints, and therefore allows firms or industries to invest according to their growth opportunities, implies that FC*ic = f(FDc) + ηic, where f’()0, i.e., in countries with higher FD firms are able to obtain a larger portion of their optimal (desired) level of financing. Thus, the test of whether financial development improves the allocation of capital will be a test whether financial development reduces the financing constraints and therefore allows firms or industries to invest according to their growth opportunities. Substituting for FC in (2), and assuming a linear relationship between

FC and financial development, we may rewrite (2) as:

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To derive an observable proxy for growth opportunities, we make two additional assumptions.

First, as in RZ, we assume that capital markets in the United States function perfectly. Hence, to a first approximation, FC*=1, so that

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Additionally, we assume that there exist global industry-specific shocks to growth opportunities due, for example, to shocks to factor prices, or shocks to demand. Hence, some component of

GO*ic is common across countries, so that:

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This assumption allows us to use industry-level growth opportunities in the US as a proxy for the growth opportunities in other countries. Substituting (4) and (5) into (3), and combining error

terms, we get:

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Since we observe actual growth within the United States, (6) may now be readily estimated, with β reflecting the degree to which financial development loosens financing constraints.

To understand how our model potentially relates to the specification of RZ given in (1), we need to understand better what generates a firm’s needs for external finance. In the appendix, we present a model whereby the desired level of external financing of a firm is a linear function of its growth opportunities, so that desired EXTFIN*ic = fi(GO*ic), where fi(.)’0 The intuition is clear: Firms with high expected future demand, and hence a need to invest in capacity expansion beyond that which can be financed with current cash flow, desire more outside financing. Note that we allow the functional form to be industry-specific to reflect the fact that some industries might need more upfront financing in response to their growth opportunities, i.e. explicitly incorporating the original “technological dependence” idea of RZ.

Next, we observe that the actual level of external finance will be determined by a combination of the desired amount of external finance, and the extent of its financing constraints.

However, if, as assumed by RZ, financing constraints are insignificant in the United States, then actual external finance will be equivalent to desired external finance for firms in the U.S., and hence measured external finance will be a function of growth opportunities. If growth opportunities, in turn, are translated into actual growth in an economy free of financing constraints, then external finance will be positively related to actual growth. Under this scenario, (1) may be directly transformed into (6). Thus, we claim that in addition to measuring any underlying technological or industry-specific need for external finance, the specification in (1) may be picking up on the fact that there exist global shocks to growth opportunities, and that by virtue of its well-developed capital markets, U.S. firms take advantage of these global shocks by seeking external finance. The positive coefficient on the interaction term in (1) would then be a reflection of the fact that firms in other countries with well-developed financial markets are also responding to these shocks, rather than an indication that firms in these countries are better positioned to take advantage of opportunities in inherently ‘externally dependent’ industries.

We can, in some sense, test these theories against one another, by simultaneously including the RZ external dependence measure, as well as a more direct measure of growth opportunities, such as sales growth in the U.S., essentially including the right-hand side variables from both (1) and (6). If the RZ measure of external dependence is simply picking up on correlated growth patterns across countries due to common shocks, then it should no longer be significant after we control for these shocks, using U.S. growth as a proxy. If, on the other had, RZ’s measure does reflect an underlying ‘technological’ dependence then it should remain significant after adding this proxy. We provide the results of this test in the next section.

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