Firm Productivity, innovation and Financial Development

[Acknowledgment]We are grateful to Christopher Kilby, Saul Lizondo, Chris Papageorgiou, the Strategy, Policy, and Review Departments' Low-Income Countries group, the Africa Department's Macro Modeling, Debt, and Growth Network, and two anonymous referees for useful comments and suggestions. Kersting gratefully acknowledges financial support by the Center for Global Leadership at the Villanova School of Business.1. IntroductionEconomists still struggle to explain the large differences in output per worker across countries. The view that these differences are mostly the result of variations in investment rates has now largely been abandoned, as cross-country evidence suggests that total factor productivity (TFP) rather than capital accumulation accounts for observed per capita income differences (Hall and Jones 1999). The largely unexplained cross-country differences in TFP led to Prescott's (1998) call for a "theory of TFP." In response, barriers to innovation, imitation, and adoption (e.g., Parente and Prescott 2000) and institutions (e.g., Acemoglu and Johnson 2005) have often been offered as explanations for low TFP in poorer countries. The global crisis and the resulting uncertainty have reinforced concerns about growth prospects in many low-income countries. After a decade of almost-universally solid growth performance, the medium-term outlook for many low-income countries appears increasingly uncertain. At the same time, the growth potential in many countries with low TFP remains dim, even beyond the full conclusion of this crisis.If TFP drives growth, its determinants are the key to development prospects in low-income countries. Some country-specific direct determinants of TFP--geography, history, or institutions such as the prevalent legal system--are fixed or slow-moving, and the degree to which policy can influence these conditions is limited. Others, such as innovation or the level of financial development, can respond to both foreign and domestic forces--external shocks, globalization, or government policy. In this view, TFP is not primarily the result of the endowment of a country, but instead a direct result of purposeful actions by economic agents, and as such can be influenced by policy.Innovation activity leads to technological progress in two distinct ways. Purposeful research and development can result in the invention of completely new products and processes. This kind of innovative activity moves the global technological frontier and still mainly occurs in developed countries. However, innovation also consists of the adoption and adaptation of existing technology, which can close the gap between countries converging toward the global technological frontier and those on the leading edge, pushing the world frontier. Innovation shares a strong connection with the provision of financial services. Invention and adoption of technology are costly and risky activities, which require financing. It is therefore natural to study the impact of a country's financial development on TFP via the innovation channel.1In this article, we follow that agenda in two separate steps. (i) How do firm-specific actions--in particular, innovation--affect firm productivity? (ii) What is the role of a country's level of development (both financial and general) in facilitating higher productivity? Using firm-level data taken from the Enterprise Surveys covering over 14,000 firms in 63 countries, we first establish a connection between a firm's innovative activities and its productivity. We control for country, industry, and firm-specific factors. The countries in our data include low-, middle-, and high-income countries, while the firms span all sizes, with a focus on small- and medium-sized enterprises (SME). Innovation is defined broadly as the introduction of new production processes or product lines, so that it includes the adaptation of existing technology. We find that, other things being equal, firms that have introduced a new process or product are more productive. …