to McMillan and Woodruff (2002), partly in order to be comparable. The caveats about omitted variables and reverse causality thus apply to this study as well.<sup>12</sup>

# **The Mechanisms of Property Rights Effects**

Several recent firm-level studies reveal specific mechanisms through which property rights affect firm performance. First, in a sample of 30 developed and developing countries, the protection of property rights, as measured at the country level, is associated with a better availability of external finance (Demirguc-Kunt and Maksimovic 1998).<sup>13</sup> When property rights are well protected, information disclosure about firm performance and fund uses are more adequate, banks are therefore more likely to make loans, shareholders are more willing to invest, and abuse of company funds is more likely to be detected and punished. Similarly, when the court system functions well, creditors are more likely to get their loans back when firms underperform and declare bankruptcies, and are therefore more willing to lend.

A better protection of property rights also leads to a better asset allocation. Claessens and Laeven (2003), using cross-country firm-level data, find that industrial sectors that use relatively more intangible assets (as proxied by the importance of intangible assets for the corresponding industry in the U.S.) develop faster in countries with better protection of property rights.<sup>14</sup> They also confirm that the protection of property rights boosts the return to investments in intangible assets. Their results are more convincing than many existing studies in that they control for both country and industry fixed effects, therefore holding constant all factors that are country- and industry-specific. Why does property rights protection lead to a better asset allocation? Without a proper protection of intellectual property rights, firms fear expropriation of investment in intellectual property and intangible assets. They then invest more in tangible assets, which are less subject to government expropriations since the resale value upon exit would be higher for tangible assets than for intangible assets. The extra reliance on property rights protection for intangible-asset-intensive industries

> 12 Similarly, using the World Bank investment climate survey, Lu et al. (2008) find that better institutions (i.e., property rights protection and contract enforcement) facilitate firm growth in China. This is true even after they instrument institutions with city population density in 1918–19 and whether the city was administered by the British in the late Qing Dynasty.  While this study strengthens the finding about the importance of institutions for firm growth, its instruments are not fully convincing—one can imagine that the historical variables might affect firm growth via routes other than institutions, for instance, through better infrastructure.

> 13 A caveat for this study is that other country-level variables related to property rights can account for the correlation between the measures of property rights and the access to external finance.

> 14 The property rights measures are broad cross-country indicators (such as those from ICRG, the Heritage Foundation, the U.S. Trade Representative, and so on).

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