Adjustment to Target Capital, Finance, and Growth Elias Papaioannou European Central Bank March 2007 Antonio Ciccone UPF-ICREA

Adjustment to Target Capital, Finance, and Growth

Elias Papaioannou

European Central Bank

March 2007

Antonio Ciccone

UPF-ICREA

2

Introduction

Large literature finding an empirical link between financial deelopment and (subsequent) growth

Cross-country work linking size of financial markets to (subsequent) growth

(e.g. King and Levine, QJE 1993; Beck et al. JME 2000, JFE 2000)

Cross-country before-after studies linking financial liberalization to growth (e.g.

Henry JFE 2001; Bekaert et al., JFE 2005)

Within country before-after banking deregulation studies, mainly in the US

(review Strahan, 2003), but also France (Bertrand at el., JF 2006) and Italy

(Guiso et al., QJE 2004)

Introduction

Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

3

What are the channels through which finance impacts growth?

— (I) Lowers cost of capital investment (neoclassical view)

— (II) Reallocates capital more quickly to where investment opportunities are (Bagehot, 1873; Schumpeter, 1911)

HOW CAN WE TELL?

Introduction

Introduction


4

-- Financial development lowers cost of capital investment

Rajan and Zingales (1998): If that is the case, financial development should foster growth especially in capital intensive industries (neoclassical international specialization argument)

Channel (I)

Introduction


5

Rajan and Zingales’ (ad-hoc) approach

1. Construct measure of EXTERNAL finance dependence industry i

2. Examine evidence for disproportionate industry growth effect of financial development (FD)

,

( , )

- - i US c

Growth industry country

Industry effects Country effects EXTFIN FD

, ,,

,

i US i USi i US

i US

I CASHFLOWEXTFIN EXTFIN

I

Introduction


6

Channel (II)

-- Financial development faster capital reallocation to industries with good growth opportunities

Wurgler (2001), Fisman and Love (2004, 2007)

1. Construct measure of global growth opportunities of industry i

2. Examine evidence for disproportionate industry growth effect

, , ,i c i US c i US cGrowth CE IE OPPORT FD EXTFIN FD

, ,i i US i USOPPORT OPPORT SALESGR

Introduction


7

Suggestive reduced-form approach to answer important questions.

But ad-hoc, which leads to key questions remaining unanswered. For example,

-- is the non-robustness due to SALESGR being a less-than-perfect measure of investment opportunities?

-- what is the role of measurement error introduced by using US proxies for global shifts?

Channel (II) continued…

Open Questions – Theoretical Framework – Estimation – Data – Results


8

THIS PAPER

CONCEPTUAL-- Theoretical framework to study link between financial

development, capital reallocation across industries, and growth (tailored to the data we have)

This allows us to:-- Identify the problems of using US proxies for global industry

characteristics-- Propose an approach to resolve these problems

Main ESTIMATION result-- Industries with better (global) investment opportunities grow

faster in countries with greater financial development

Introduction


9

Presentation Overview

1. Theoretical framework

2. Model estimation issues

1. Bias when employing US (or any other country) data to construct global industry characteristics

2. Dealing with measurement error (bias)

3. Data

4. Results

1. Using US-based proxy only

2. Accounting for measurement error

5. (IN)Sensitivity of estimation results

6. Summary


Introduction

10

Theoretical Framework

Theoretical Framework – Estimation – Data – Results


-- many open economies

-- many industries, with country-specific varieties

-- countries may differ in industry productivity (Ricardian element) and may face different demand for their varieties

-- industry productivity and demand may shift globally; these shifts result in changes in the optimal amount of capital across industries

-- countries may also differ in their level of financial development; lower development may slow down adjustment of capital to its target

11

Theoretical Framework: Perfect Financial Markets

Unexpected and anticipated

productivity and demand shifts

at the industry level

Growth in the optimal capital stock (target capital) at the industry-country

level

Industry value added growth

Frictionless Equilibrium (Perfect Capital Markets)



12

Theoretical Framework: IMPerfect Financial Markets

Unexpected and anticipated

productivity and demand shifts

at the industry level

Growth of target capital at the industry-country level

Industry value added growthActual capital growth

Financial

UNDERDevelopment

WEDGE



13

Model

, ,

, , , ,

1

1, ,

0 0

(1 )11

, , (1 ), , , , , ,

, 0

, , , , , ,

Preferences

ln 0 1

Demand

Supply

i c t

i c t i c t

I C

t i c t

Ci c t

i c t t i c t i c ti t

i c t i c t i c t

U x B dc di

px B M P p B dc

P

Z A K

IndustriesCountries



14

Long-Run Equilibrium: Perfect Financial Markets

, , , , , ,

* * *, ,

, ,

*, , , , , , , , , ,

1* 1, , , , , ,

,

or

ln ln ln Country-effect ln

i c t i c t i c t

ti c t t

i c t

i c i c T i c T i c S i c S i c

ti c t t i c t i c t t

i t

rA p r p MC

A

Y p Z p Z K

rK M B A r

P

Increases in target capital reflect anticipated future industry growth opportunities (due to technical change, demand shifts, and changing prices of international competitors)

Target capital (no frictions)



15

Financial UNDERDevelopment and Capital Adjustment

c

*,ln i cK

*, ,ln 1 ln 0 1i c c i c cK K

,ln i cK

1

0



Financial Development

16

Financial Underdevelopment and Value Added Growth

* *, , , ,

*, ,

Price adjustment:

ln (1 ) ln ln ln

Value added and target capital growth:

ln 1 ln

i c i c i c i c

i c c i c

p K K MC

Y K



17

Financial UNDERDevelopment and Growth

c

*,ln i cK

,ln i cY

1

0




18

Anticipated productivity shifts, demand shifts, and target capital growth

, , , ,

* * *, ,

ln ; ln

ln ln ln

i c c i i c i c c i i c

i c c i i c

A a a a B b b b

K K K

Global industry investment

opportunityCountry effect



mean zero

mean zero

19

Estimating equations

*, ,

* * *, , ,

(1) ln Country-effects [(1 ) ] ln

(2) ln ln ln ln

i c c i i c

i US i US US i i US

Y K

K K K K

Growth Equation

Industry US-based Proxy of Investment Opportunities



20

Measurement error

, ,

, ,

and are independent

and more strongly correlated with each other

when , have similar financial development

i c i US

i c i q

c q

Scenario 2: Non-classical measurement error

Scenario 1: Classical measurement error



21

Non-classical measurement error: Extreme Example

-- Countries with high financial development have idiosyncratics

just like the US

-- Countries with low financial development have idiosyncratics

that are independent of the US

22

Non-classical measurement error: True values

[(1 ) ]HIGH

LOW 1HIGH

[(1 ) ]LOW

True values

0

1




23

[(1 ) ]HIGH

LOW HIGH

[(1 ) ]LOW

True values

0

1

Least squares




Non-classical measurement error: Estimated values

24

Combining classical and non-classical measurement error

True values

0

1

Least squares



Financial Development 1

Sign of least-squares bias unclear

25

Data

1. Country-Industry level (from UNIDO)• Value added growth in the 1980s

• 66-67 countries; 27-28 manufacturing industries (3 digit ISIC)

2. Country-level (various sources)• FD: main measure is private credit to GDP

• Other control variables: GDP, institutions, human capital

3. Industry-level (NBER US manufacturing database)• US industry capital growth

• Other proxies of industry growth opportunities used in the literature



26

Least squares estimation: Basic

, ,ln Country-effects Industry-effects lni c c i USY FD K



27

Least squares estimation: With controls

, , ,ln CE IE lni c c i US c i USY FD K FD EXTFIN



28

Least Squares: Opportunities and finance dependence

OLS Robust OLS Robust(1) (2) (3) (4)

Finance X Investment Opportunities 0.3183 0.2927 0.2905 0.2261[FD X CAPGR ] (3.08) (4.47) (2.34) (3.22)

Finance X External Finance Dependence 0.0109 0.0146[FD X EXTFIN ] (1.28) (3.09)

Industry Share in Total Manufacturing -0.1955 -0.0803[SHARE80i,c ] (3.79) (3.47)

adj. R-squared 0.284 0.299Countries 67 67 66 66Observations 1607 1607 1589 1589Country Fixed-Effects Yes Yes Yes YesIndustry Fixed-Effects Yes Yes Yes Yes

External Finance



Tab

le IIT

able II

Rajan and Z

ingales (1998)

29

IV approach to country-idiosyncratics

, , ,ln Country-effects Industry-effects lni c c i US i cY FD K u



Why is least squares biased?

-- US capital growth mismeasures global growth opportunities

-- US capital growth idiosyncratics may be correlated with idiosyncratics of financially developed countries (but not financially underdeveloped countries)

Solution:

Instrument US capital growth by a variable that does not reflect US idiosyncratics

30

Instrument: Predicted US industry growth using industry-country growth outside of the US



,

,

ln Country-effect

ln

i c i i c

PREDICTED EST ESTi US i i US

Y FD

Y FD

1st step: Run the regression (without US data!)

2nd step: Obtain growth at US level of financial development

31

Instrument Relevance: Predicted and Actual US Industry Growth

slope=0.49

t-stat=3.54



382

331

372

314

354

324

351

361

323

341

369

381

313

384

321

371

342

383

311

385

356

353

332

355

352

390322

362

-.02

0.0

2.0

4.0

6C

apit

al G

row

th in

the

Uni

ted

Stat

es (

CA

PG

R)

0 .02 .04 .06 .08 .1Industry value added growth at the US level of financial development,

predicted using data on all countries except the US (predictions based on OLS)

32

Predicted and Actual US Industry Growth (Robust Estimation)

slope=0.68

t-stat=4.71



382

331

372

314

354

324

351

361

323

341

369

381

313

384

321

371

342

383

311

385

356

353

332

355

352

390322

362

-.04

-.02

0.0

2.0

4.0

6C

apit

al G

row

th in

the

Uni

ted

Stat

es (

CA

PG

R)

0 .02 .04 .06 .08 .1Industry value added growth at the US level of financial development,

predicted using data on all countries except the US (predictions based on a robust regression)

33

Financial Development and Growth:Instrumental Variable Estimates

IV IV-R

(1) (2)

Finance X Investment Opportunities 1.1683 0.6872[FD X CAPGR ] (4.01) (3.72)

Countries 67 67Observations 1607 1607Industry Fixed-Effects Yes YesCountry Fixed-Effects Yes Yes



Tab

le IIIT

able III

Mirror Table-Sensitivity

LS estimate=0.3

34

Comparisons Other Measures of Growth Opportunities



Tab

le IVT

able IV

Investment Opportunities Proxy:

IV IV

(1) (2) (3) (4) (5) (6)

Finance X Sales Growth -0.1523 0.1779 1.0567[FD X SALESGR ] (0.93) (1.85) (3.76)

Finance X Value Added Growth -0.0579 0.1689 0.9032[FD X VAGR ] (0.46) (1.97) (3.81)


adj. R-squared 0.284 0.281 0.284 0.282Countries 67 67 67 67 67 67Observations 1607 1607 1607 1607 1607 1607Industry Fixed-Effects Yes Yes Yes Yes Yes YesCountry Fixed-Effects Yes Yes Yes Yes Yes Yes

OLS

Sales Growth [SALESGR ] Value Added Growth

OLS

35

Why are Results with US Sales Growth Weak?

US industry sales growth=

Capital growth [which depends on anticipated growth opportunities]

+Unexpected shocks to productivity and demand

But, not even the best financial systemn can reallocate capital in response to shocks that could not have been anticpated.

36




Tab

le IVT

able IV


IV IV

(1) (2) (3) (4) (5) (6)





OLS


OLS

37




Tab

le IVT

able IV


IV IV

(1) (2) (3) (4) (5) (6)





OLS


OLS

38

Endogeneity of Financial Development and Measurement Error in US-based proxy of opportunities

Instrumental Variable Technique FULL (Double) IV FULL (Double) IV-R(1) (2)


Countries 67 67Observations 1607 1607Industry Fixed-Effects Yes YesCountry Fixed-Effects Yes Yes



Tab

le VII

Tab

le VII

Sensitivity Analysis

39


1. Alternative measures of financial development Table

2. Other determinants of industry growth dynamics Table

3. Income differences (excl. low income countries) Table 4. Other measures of institutional quality and investment opportunities

(legal inefficiency; property rights protection) Table 5. Further accounting for correlated industry shocks Table 6. State ownership of banks as a measure of financial underdevelopment

Table




40

Summary

1. Theoretical framework linking global industry productivity and demand shifts, financial development and growth.

2. When using only US data to proxy global industry investment opportunities. two countervailing measurement error biases

3. IV approach to account for country idiosyncratics

Combine two noisy measures of global investment opportunities:

– Actual capital growth in the US

– Average non-US value added growth in a hypothetical country with well-developed capital markets

4. Main empirical finding: In countries with well-developed financial markets, industries with good investment opportunities grow faster

Conclusion


41

Presentation Appendix Tables


Appendix Tables

42

Other Determinants of Industry Growth Dynamics

OLS Robust OLS Robust OLS Robust

(1) (2) (3) (4) (5) (6)

Finance X Invest. Opport. 0.3877 0.3471 0.3828 0.3666 0.3529 0.3223[FD X CAPGR ] (3.72) (5.26) (3.51) (5.41) (3.39) (4.79)

Property Rights X Intangibility -0.0007 0.0001[PROP X INTANG ] (0.41) (0.94)

Finance X Intangibility -0.0036 -0.0018[FD X INTANG ] (1.65) (1.04)

Schooling Interaction 0.0020 0.0009[SCH X HCINT ] (2.06) (1.90)

adj. R-squared 0.343 0.461 0.299 0.450 0.312 0.459Countries 64 64 66 66 62 62Observations 1589 1589 1589 1589 1534 1534Industry Fixed-Effects Yes Yes Yes Yes Yes YesCountry Fixed-Effects Yes Yes Yes Yes Yes Yes

Claessens-Laeven (2003) Braun (2003) Ciccone-Papaioannou


Su

pp

lemen

tary Ap

pen

dix T

able V

IS

up

plem

entary A

pp

end

ix Tab

le VI

Appendix TablesSensitivity Analysis

43

Other Measures of Financial Development

Financial Development MeasureOLS Robust OLS Robust OLS Robust(1) (2) (3) (4) (5) (6)

Finance X Investment Opportunities 0.2798 0.2731 0.2402 0.1474 0.4294 0.2566[FD X CAPGR ] (2.63) (3.64) (3.95) (3.82) (3.80) (3.90)

adj. R-squared 0.282 0.441 0.303 0.478 0.304 0.477Countries 67 67 44 44 44 44Observations 1607 1607 1119 1119 1119 1119Industry Fixed-Effects Yes Yes Yes Yes Yes YesCountry Fixed-Effects Yes Yes Yes Yes Yes Yes

BANKCR MCAP TF


Su

pp

lemen

tary Ap

pen

dix T

able V

IIS

up

plem

entary A

pp

end

ix Tab

le VII


44

Accounting for Economic Development

OLS IV OLS IV(1) (2) (3) (4)

Finance X Investment Opportunities 0.2662 0.7840 0.3063 0.8990[FD X CAPGR ] (2.49) (3.21) (3.10) (4.38)

Income X Investment Opportunities 0.0680 0.3612[Y X CAPGR ] (0.89) (2.02)

adj. R-squared 0.284 0.321Countries 67 67 54 54Observations 1607 1607 1335 1335Industry Fixed-Effects Yes Yes Yes YesCountry Fixed-Effects Yes Yes Yes Yes

All countries No Low Income


Tab

le VT

able V


45

Accounting for the Interaction between other Institutional Factors and Investment Opportunities

(1) (2) (3) (4) (5) (6) (7) (8)

Finance X Invest. Opport. 0.3193 1.0782 0.2906 0.9893[FD X CAPGR ] (2.66) (3.47) (2.72) (3.96)

Law X Invest. Opport. -0.1891 -0.0472 -0.4760 0.0040[LAWINEF X CAPGR ] (2.40) (0.52) (3.06) (0.02)

Property X Invest. Opport. 0.1805 0.0925 0.4020 0.0985[PROP X CAPGR ] (2.63) (1.31) (1.96) (0.51)

adj. R-squared 0.307 0.311 0.283 0.286Countries 58 58 58 58 65 65 65 65Observations 1481 1453 1481 1453 1572 1572 1572 1572Industry Fixed-Effects Yes Yes Yes Yes Yes Yes Yes YesCountry Fixed-Effects Yes Yes Yes Yes Yes Yes Yes Yes

OLS IV OLS IV

Legal System Inefficiency (LAWINEFF ) Property Rights (PROP )


Tab

le VI

Tab

le VI


46

Further Accounting for Correlated Industry Shocks Across Financially Developed Countries


An

alogous to T

able III

An

alogous to T

able III


IV IV-R

(1) (2)


Countries 67 67Observations 1607 1607Industry and Country Fixed-Effects Yes Yes

First Stage

Predicted Investment Opportunities 0.3088 0.5392(2.99) (5.15)

R-squared 0.24 0.449F-score 8.95 26.54Observations (Industries) 28 28

Mirror Table

47

(1) (2) (1) (2)

-0.6506 -0.4781 -0.5675 -0.2261(3.76) (2.79) (3.14) (3.22)

0.1782 0.1166(2.46) (1.03)

adj. R-squared 0.3586 0.3536 0.383 0.384Countries 55 55 47 47Observations 1434 1434 1243 1243Country Fixed-Effects Yes Yes Yes YesIndustry Fixed-Effects Yes Yes Yes Yes

All Countries

Country State Ownership of Banks X Investment Opportunities

Excl. Low Income

Country Income X Investment Opportunities

Financial Development - State Ownership of Banks



Appendix Tables

Documents

Adjustment to Target Capital, Finance, and Growth Elias Papaioannou European Central Bank March 2007 Antonio Ciccone UPF-ICREA