sou · GOB311d5 · 2001-01-01 00:00:00 — Instead of examining the effect of changes in financial development on growth as Jayaratne and Strahan do, they examine the differential effect of financial development across industries within a country. Their rationale is a theoretical one. They argue that the way to make progress on causality is to focus on the details of the theoretical mechanisms through which financial development affects economic growth and empirically document their working. Specifically, theorists argue that financial markets and institutions help a firm overcome problems of moral hazard and adverse selection, thus reducing the firm's cost of raising money from outsiders. So financial development should disproportionately help firms (or industries) typically dependent on external finance for their growth. Such a finding, they argue, could be the smoking gun in the debate about causality. There are two virtues to this simple test. First, it looks for evidence of a specific mechanism by which finance affects growth, thus providing a stronger test of causality. Second, it can correct for fixed country (and industry) effects. As a result, the empirical test is less dependent on a specific macroeconomic model of growth. and Zingales construct the test as follows. They identify an industry's need for external finance (the difference between investments and cash generated from operations) from data on U.S. Volym D:20 Supplement 23 assumption that capital markets in the , especially for the large listed firms they analyze, are relatively frictionless, this method allows them to identify an industry's technological demand for external financing. Under the further assumption that such a technological demand over to other countries, they examine whether industries that are more dependent on external financing grow relatively faster in countries that, a priori, are more financially developed. In contrast to prior studies that have used measures of financial development that are based on actual financing – such as the quantity of domestic credit or the size of the stock market – and Zingales use the accounting standards in that particular country. This has the advantage of measuring the potential of the financial infrastructure rather than its past use. Their hypothesis would imply that, ceteris paribus, an industry such as Drugs and Pharmaceuticals, which requires a lot of external funding, should develop relatively faster than Tobacco, which requires external finance, in countries that are more financially developed. Consider, for instance, , , and , which are moderate- income fast-growing countries, that differ considerably in their financial development. Consistent with their hypothesis, in , which was the most financially developed by their metric, Drugs and Pharmaceuticals grew at a higher annual real rate over the 1980s than Tobacco (the growth rate for each industry is adjusted for the worldwide growth rate of that industry). In , which was moderately financially developed, Drugs grew at a higher rate than Tobacco. In , which was in the lowest quartile of financial development, Drugs grew at a lower rate than Tobacco. So financial development seems to affect relative growth rates of industries in the way predicted.5 5 Demirguc-Kunt and Maksimovic (1998) also use micro data to develop a test of the influence of financial development on growth. Using firm-level data, they estimate the proportion of firms whose rate of growth exceeds the growth that could have been supported only by internal resources. They then run a cross country regression and find that this proportion is positively related to the stock market turnover and to a measure of law enforcement. While their paper is similar in spirit to and Zingales (1998b), there are two essential differences. First, their estimate of the internal growth rate of a firm is dependent on the firm's characteristics. While it is potentially more accurate than and Zingales' measure of external dependence, it is also more endogenous. Second, they focus on between-country differences in the spirit of traditional cross-country regressions, while and Zingales' focus is on within-country, between-industry differences. , Industrial Structure, and Growth Volym D:21 and Zingales do two additional tests that suggest causality from finance to economic growth. First, they instrument indicators of financial development with measures of the origin's of a country's legal system (whether British, French, German or Scandinavian as classified by La Porta et al., 1998), and with the efficiency of the country's judicial system. These instruments, especially the former, are likely to be pre- determined, and do not reflect development in anticipation of economic growth. The results persist after instrumenting. Second, and Zingales drop industries that were large at the beginning of the period and are more likely to have been responsible for the country's financial development. They find that industries that are small at the beginning of the period and financially dependent grow faster in countries that are more financially developed than do less dependent industries. This finding in a sample that is unlikely to be responsible for the state of development of the financial markets, suggests that financial development does indeed facilitate growth, and is not simply correlated with it. and Zingales' findings indicate that financial markets and institutions may develop to meet the needs of one set of industries, but then facilitate the growth of another younger group of industries, consistent with 's (1977) description of the evolution of financial infrastructure in the in the nineteenth century. Goldsmith (1985, p. 2) based on a study of the balance-sheets of twenty countries echoes this when he writes The creation of a modern financial superstructure, not in its details but in its essentials, was generally accomplished at a fairly early stage of a country's economic development. 1.3Financial Development and Growth: Details 1.3.1The Kinds of Firms that are Financed There is now a growing body of work that documents in greater detail the kinds of firms in the modern economy that financial development helps. and (1998) present an extremely interesting set of correlations. Using data from 27 industries in 20 countries over the period 1970 to 1995, they find that industries funding a lot of investment with equity tend to grow faster, and do more R&D, in Volym D:22 Supplement 23 SOU 2000:11 countries that have better accounting standards. They also find that industries where workers have high skill levels tend to grow faster and do more R&D in countries with better accounting standards.6 Interestingly, equity financed industries undertake less fixed capital formation in countries with better accounting standards. In direct contrast to equity financed industries, bank debt financed industries tend to grow more slowly in countries that are more financially developed and also tend to undertake less R&D. Finally, in contrast to what happens in developed countries, bank dependent industries in countries with low GDP grow faster as the banking system develops but are relatively unaffected by improvements in accounting standards. What do we make of these findings? Once we think of fixed capital as collateral, then interpretation becomes much easier. Typically, equity financed industries tend to have few hard assets, and substantial intangible assets such as growth opportunities, see (1977). In economies with underdeveloped financial markets and institutions, collateral is essential to obtain outside financing. Thus we would expect industries that would optimally use few hard assets if finance were easy to come by, to use more of them in countries with underdeveloped financial systems. But as accounting standards and credit markets develop, equity financed industries would tend to use less fixed capital, as the evidence suggests. In other words, the intangible assets that they typically possess in abundance become easier to finance, and they do not have to distort asset holdings towards fixed capital. and 's other findings are also consistent with the above interpretation. Because the intangible assets in equity financed firms become easier to finance as the financial system develops (where development is measured as better accounting standards, or more bank credit), the industry grows faster, and can finance more R&D – one of the biggest sources of intangible assets. Similarly, a highly skilled workforce is an important intangible asset, and the finding that industries with highly skilled workers tend to grow more and do more R&D as financial markets develop corroborates our interpretation. Finally, industries dependent on bank finance in (which is where and measure bank dependence) tend to be physical capital 6 Following and Zingales (1998), and proxy for an industry's dependence on equity finance by the amount of equity that industry uses to finance investment in the . They measure the industry's dependence on bank finance by how much that industry uses in , and they measure the industry's use of skilled workers based on how many workers in that industry in are not classified as unskilled. , Industrial Structure, and Growth Volym D:23 intensive, smoke-stack industries, see Hoshi, Kashyap, and Scharfstein (1990). When financial markets and institutions are poorly developed, these industries have excess collateral and can invest in intangible activities such as R&D that others would undertake if financial constraints were not important. As finance develops, these industries lose their comparative advantage, and tend to grow less, and do less R&D. In sum, it appears that industries can raise finance more easily as the financial system develops because physical collateral becomes less important, while intangible assets and future cash flows can be financed. 1.3.2The Effects of Development of Firm Size and Industry growth can be decomposed into the growth in the number of firms and the growth in the average size of firms. As and Zingales (1998b) find, 2/3rd of industrial growth over the 1980s in their sample of 43 countries comes from the growth in the average size of , 1/3rd from the growth in the number of . But in their regressions, they find financial development has almost twice the economic effect on the latter than on the former. So the effect of financial development on both the size and the birth of firms seems important. In a study of 15 countries, Kumar, and Zingales (1999) find that industries dependent on external finance tend to have smaller firms on average, as do countries with low levels of financial development. Moreover, financially dependent industries tend to have larger firms in countries with better-developed financial markets. Therefore, even though large firms typically finance more of their growth from internal funds, the lack of development of financial markets does constrain their growth. This may be because even though large firms use external funds to a much smaller extent, at the these funds are important for growth. It may also be that large firms need to continuously re-assure existing claimants about additional growth, and only a developed financial system contains adequate tools of corporate governance to enable large firms to provide such . By constraining firms from growing to their full potential, the lack of financial development could have serious effects. Firms in financially underdeveloped countries could be inefficiently small, or left unable to undertake the necessary takeovers that would allow them to compete in a increasingly border-less world. Volym D:24 Supplement 23 The absence of financial development could also prevent the emergence of new ideas. When firms start out, many of their assets are intangible ideas and project opportunities. These ideas typically do not respect the status quo, and often make possible Schumpeterian waves of creative destruction. By allowing intangible assets to be financed, financial development facilitates innovation and change. We have more evidence in favor of this hypothesis. Kukies (in progress) finds that the growth in the number of (though not the growth in average firm size) is relatively higher for industries that do a lot of R&D, and for industries that have a higher portion of long term assets, in countries where financial markets are more developed. This indicates that it is very hard for emergent firms to finance intangible or illiquid assets without financial market development. There are also some puzzling pieces of evidence. Some developed countries have both good accounting standards (which, across countries, is strongly positively correlated with stock market capitalization) and a high proportion of bank lending, but in general these countries are exceptions. In fact, and find the raw correlation between the two measures of financial development to be negative in their sample. Why is it that bank credit tapers off as stock markets develop? That economies seem to emphasize either institutions or markets has led economists to classify financial systems as relationship based (or bank dominated) and arms length (or market based). What distinguishes these two types of systems? Moreover, do they have different effects when countries are at different stages of growth? Could this explain why bank dependent industries grow faster in bank dominated economies only when the economies are relatively under-developed? To answer these questions, we have to ask how relationship based systems work and how they are different from arm's length systems. This is the subject of the next section. , Industrial Structure, and Growth Volym D:25 2Relationship vs Arms length systems Let us begin with a sketch of the salient features of these two kinds of systems. Like all sketches, this one has elements of caricature, but this is the price we have to pay to avoid being distracted by the details. A financial system has two primary goals: to channel resources to their most productive uses and to ensure that an adequate portion of the return flows to the financier. The latter is, of course, crucial to the former. Without the of an adequate return, funds will not be made available for investment. Even when it is clear that the social returns from a project are high, it is not necessary that the financier will be able to appropriate an adequate return. The borrower may take actions that improve its private return at the expense of the financiers return. This is the problem of moral hazard. Alternatively, the financier may not be able to distinguish between honest entrepreneurs and knaves, and this problem of adverse selection may again prevent the financier from recovering the amount invested. What is really needed is that the financier have both information, as well as the ability to act on that information. Relationship based systems ensure a return to the financier by granting her some power over the firm being financed. The sources of power can be varied. It may be purely financial, stemming from the financiers monopoly control over supply of funds to the firm because of its firm-specific information. It may be legal, stemming from the financiers majority ownership of the firm. Or it may come from the product market because the financier is, or controls, a major supplier or customer. Regardless of the source of power, the financier attempts to secure her return on investment by exercising this power. Also, as with every system based on monopoly, barriers to entry are required. For example, financial monopolies could be created by limiting the number of institutions that are chartered, and by limiting the amount of information disclosed in the system so that outside supply of finance is thwarted by lack of transparency. Contrast this with the arm's-length, , market based system, where the financier is protected by explicit contracts and transparency. In such systems, contracts and associated prices determine the transactions that are undertaken. As a result, institutional Volym D:26 Supplement 23 relationships matter less and the market becomes a more important medium for directing/governing the terms of transactions. An important distinction between these two systems is their different degree of reliance on legal enforcement. Relationship based systems can survive in environments where laws are poorly drafted and contracts not enforced. The relationship is largely self-governing; parties intent on maintaining their reputations honor the spirit of agreements (often in the absence of any written contract) in order to ensure a steady flow of future business within the same network of firms. By contrast, the prompt and unbiased enforcement of contracts by courts is a pre- condition for the viability of a market-based system. Moreover, since contracts are typically hard to write with the wealth of detail necessary to fully govern transactions, it is important that the law offer a helping hand. We discuss in and Zingales (2000) how the law, especially a common law tradition, can help.7 Another distinction between the two systems is the relative importance of transparency. systems require transparency as a guarantee of protection. In the words of Franklin , Sunlight is said to be the best of disinfectants; electric light the most efficient policemen. 8 By contrast, relationship based systems are designed to preserve opacity, which has the effect of protecting the relationships from the threat of competition. This probably explains the negative correlation between accounting standards and the size of the banking sector that we noted earlier. 2.1An Example: Credit Before going further, let us consider the example of a transaction – the extension of credit – in each of the two systems. In a relationship based system, a bank will have close ties with a potential borrowing firm, perhaps because of frequent past contacts or because of ownership links. In assessing the borrowing needs of the firm and its ability to pay interest and principal, the bank will consider not only the firm's current debt-servicing capability, but also its long-term ability to repay, and the various non-contractual levers the bank can push to extract repayment.9 7See La Porta, et al. (1997). 8In , The Transformation of Wall Street, , 1995, p. 9For example, the bank may refuse to extend a blanket guarantee to the firms other creditors, refuse to provide new financing or even take a piece of it, etc. , Industrial Structure, and Growth Volym D:27 The interest rate charged will be repeatedly negotiated over time, and may not have a direct relationship to the intrinsic risk of the project. In an arm's-length system, by contrast, the firm will be able to tap a wider circle of potential lenders because there will be more widespread financial information about it. The loan will be contracted for a specific period, and the interest rate will be a competitive one that will compensate the lender for time and the risk of that particular loan. Limitations on competition in a relationship system do not just give the financier power, but also strengthen his incentive to co-operate with the borrower. Studies of Japanese keiretsus show that the main banks went out of their way to help financially distressed borrowers. For example, not only effectively guaranteed 's debts when it got into trouble after the first oil shock, but also orchestrated a rescue, in part by exhorting employees within its keiretsu to buy cars.10 Sumitomo's incentive to help would have been considerably weaker if had had the option of giving the lion's share of its business, once it emerged from distress, to some other bank. As this example suggests, the effective limitations on outside competition imposed by the keiretsu system enable lenders to internalize a greater share of the benefits accruing to the borrowers than is possible in an arm's-length, competitive banking environment. The absence of competition and disclosure in a relationship based system imply that there are really no price signals to guide decisions. Unlike an arm's-length system, where a number of competitive lenders can give a borrowing firm independent assessments of the costs of undertaking a project, the cost a borrower faces in the relationship based system is simply what the relationship lender and the borrower negotiate. Since there can be substantial value created in the relationship, and the negotiation and allocation of this surplus is a function of each party's power, the effective cost of financing can deviate substantially from the true risk-adjusted cost. 2.2Do relationship based systems always lead to worse investment decisions? But is this necessarily a bad thing? Are lending and investment decisions always inefficient if the cost of funds differs from their true cost? Are there no redeeming features of a relationship based system? The answer to all these questions is no. In the real world with all its imperfections, 10 See Hoshi, et al. (1990a). Volym D:28 Supplement 23 an imperfect cost of funds can sometimes produce the right investment decisions. For instance, consider our previous example of a firm in distress. Taking into consideration all the value that the firm adds to society – to workers, , and local governments as well as shareholders – the company may be worth saving. But, in the short run, the true cost of funding may far exceed what the firm can pay without creating further investment distortions.11 And in the competitive arm's-length system, a lender may not be able to recoup or internalize enough of the firm's value in the long run to be able to offer it subsidized financing in the short run. So the firm is much less likely to be bailed out in the competitive, arm's-length system. By contrast, a lender in a relationship based system, confident in the strength of the relationship (and the protection it affords from competition), can offer a below-market rate in the short run and then recoup its losses with an above-market rate over the long run when the firm is healthy and can afford high payouts. In sum, relationship banks can be viewed as using their monopoly power to charge above-market rates in normal circumstances in return for an implicit agreement to provide below-market financing when their borrowers get into trouble. and (1995) provide evidence of the existence of such relationship lending practices even in the U.S. In examining bank loans to small businesses in different banking markets throughout the U.S., 12 their study finds that in concentrated markets (those where most of the lending is done by a handful of banks) – which are likely to be more relationship-oriented for the reasons discussed earlier – more credit is available to young firms than in more competitive banking markets. To the extent young firms are more credit rationed, as many have suggested, the evidence suggests that the relationship based system does a better job of ensuring that value-adding projects get funded. The study also finds that the interest rates charged to younger firms are, on average, lower in concentrated markets than in competitive markets, with the effect reversing for older firms. This suggests that banks in concentrated markets can offer more credit on economic terms because their relationships allow intertemporal cross-subsidies – that is, below-market rates for younger firms that are compensated for by above-market rates for more mature firms that have a higher ability to 11For example, too high an interest rate could lead the firm to take riskier, negative NPV, projects, see and Meckling (1976). 12The idea of distinct banking markets makes sense in this case because small firms rarely do business with a bank outside their local banking market; the median borrower in the above cited study is only two miles from its bank.