Does Financial Liberalization Improve the Allocation of Investment?: Micro Evidence from Developing Countries

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1 Iner-American Developmen Bank Banco Ineramericano de Desarrollo (BID) Research deparmen Deparameno de invesigación Working Paper #7 Does Financial Liberalizaion Improve he Allocaion of Invesmen?: Micro Evidence from Developing Counries by Aruro Galindo* Fabio Schianarelli** Andrew Weiss*** *Iner-American Developmen Bank **Boson College ***Boson Universiy April 2002

2 Caaloging-in-Publicaion daa provided by he Iner-American Developmen Bank Felipe Herrera Library Galindo, Aruro. Does financial liberalizaion improve he allocaion of invesmen? : micro evidence from developing counries / by Aruro Galindo, Fabio Schianarelli, Andrew Weiss. p. cm. (Research Deparmen Working paper series ; 7) Includes bibliographical references.. Asse allocaion--developing counries. 2. Invesmens--Developing counries. 3. Finance--Developing counries. I. Schianarelli, Fabio. II. Weiss, Andrew. III. Iner-American Developmen Bank. Research Dep. IV. Tile. V. Series G dc Iner-American Developmen Bank 300 New York Avenue, N.W. Washingon, D.C

3 The views and inerpreaions in his documen are hose of he auhors and should no be aribued o he Iner-American Developmen Bank, or o any individual acing on is behalf. The Research Deparmen (RES) produces he Lain American Economic Policies Newsleer, as well as working papers and books, on diverse economic issues. To obain a complee lis of RES publicaions, and read or download hem please visi our web sie a: hp:// 3

4 Absrac Has financial liberalizaion improved he efficiency wih which invesmen funds are allocaed o compeing uses? In his paper, we address his quesion using firm-level panel daa from 2 developing counries. We develop a summary index of he efficiency of invesmen allocaion ha measures wheher, and o wha exen, invesmen funds are going o firms wih a higher marginal reurn o capial. We hen examine he relaionship beween his index and various measures of financial liberalizaion. The resuls sugges ha in he majoriy of cases financial reform has led o an increase in he efficiency wih which invesmen funds are allocaed. * * We are graeful o paricipans a seminars a he World Bank, NBER Summer Insiue, NEUDC Conference, and Universiy of Bergamo for heir commens. In paricular we hank G. Anderson, T. Beck, G. Caprio Jr., L. Klapper, R. Levine, E.Lora, J. Minnier, N. Loayza, and D. Rodrik for useful suggesions and help wih he daa.

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6 . Inroducion Since he mid-980s several developing counries have liberalized heir financial sysems. This liberalizaion has been characerized by greaer scope graned o marke forces in he deerminaion of ineres raes and in he allocaion of credi. One crucial quesion ha needs o be addressed is wheher he financial reforms ha have been implemened have led o an improvemen in he allocaion of resources. I is curious ha while governmens were moving away from sae conrol oward a free marke orienaion, economiss were focusing heir research effors on he negaive consequences caused by informaional imperfecions in a marke sysem. Financial liberalizaion in general involves replacing one deeply flawed sysem, characerized by heavy governmen inervenion, wih anoher sysem wih differen flaws. Wheher hese changes will improve he allocaion of savings and invesmen is fundamenally an empirical quesion. Several sudies based on cross-counry aggregae daa find evidence of posiive effecs of various measures of financial developmen on growh. Noe ha financial liberalizaion ends o be accompanied by an improvemen in various measures of financial deph. A he same ime, here is no evidence ha financial reform increases privae savings. Acually, in some counries he effec may even be significanly negaive. 2 All his herefore suggess ha, herefore, if here is a beneficial effec of financial reform on growh, his is no likely o go hrough is effec on he quaniy of saving. Moreover, cross-counry growh regressions also reveal ha measures of financial developmen do no have a significan impac on he quaniy of invesmen, bu hey posiively and significanly affec measures of oal facor produciviy growh. 3 So, if financial liberalizaion has a posiive effec on growh, he mos imporan channel is likely o be o be he Mos of he sudies are based on cross-secional growh regressions (see, for insance, King and Levine, 993; Levine, 997; and Levine and Zervos, 998), while ohers on pooled ime series-cross secional counry level daa (see Beck, Levine and Loayza, 999). See also Bekaer, Harvey and Lundblad (200) for evidence of a posiive effec of sock marke liberalizaion on growh. For a differen approach see Rajan and Zingales (998) who rely on indusry-level daa o show ha indusries wih he greaer need of exernal finance, grow faser in more financially developed counries. Alernaively, Demirguc-Kun and Maksimovic (998) show ha firms grow a a faser rae, relaive o a benchmark growh rae ha would hold in he absence of exernal finance, in counries wih a more developed financial sysem. 2 See Bandiera, Caprio, Honohan and Schianarelli (999). 3 See Beck, Levine and Loayza, 999.

7 effec of financial reform on he efficiency wih which invesmen is allocaed across firms and across secors. There is very lile micro evidence on he effec of financial liberalizaion on he efficiency of resource allocaion. 5 Using a panel of Ecuadorian firms during he 980s, Jaramillo, Schianarelli and Weiss (992) find ha here was an increase in he flow of credi accruing o echnically more efficien firms afer liberalizaion, conrolling for oher firms characerisics. Technical efficiency is calculaed using panel daa esimaes of a Cobb-Douglas producion funcion. Similar resuls are also obained by Siregar (992) for Indonesian esablishmens in he 980s. Oher papers based on firm level daa address he relaed bu disinc quesion of wheher financial consrains have been relaxed following financial liberalizaion (or financial developmen) and find ha in mos, bu no all cases, smaller firms have improved heir access o exernal resources following financial reform. However, i is no obvious, wihou furher consideraion, wha effec a relaxaion of financial consrains for small firms has on he efficiency of resource allocaion. Using indusry-level daa, Wurgler (2000) provides evidence ha, in counries wih more developed financial sysems, he rae of growh in invesmen is more closely associaed wih conemporaneous growh in value added. In he sudy, counry-level financial developmen is measured by he average size of credi and equiy markes relaive o GDP. More specifically, counries wih more developed financial sysems boh increase invesmen more in heir growing indusries and decrease invesmen more in heir declining indusries. The emphasis of ha paper is on cross-counry variaion in ime invarian measures of financial developmen and no on he changes resuling from he process of financial reform. Finally, oher papers (see Cho, 988, for Korea) have focused on he change in he variance of expeced marginal reurns o capial across indusries, as measured by an indusry specific user cos of capial, before and afer liberalizaion. A decrease in he variance is inerpreed as suggesing ha liberalizaion faciliaes he process by which flows of capial equae reurns. Financial liberalizaion may have also conribued o faser echnological progress. See King and Levine (993). 5 See Schianarelli, Aiyas, Caprio e al. (99) for a more deailed review. See also Aiyas, Caprio and Hanson (99) and Fry (995) for a comprehensive review of financial liberalizaion. This is he case for Indonesia in he 980s (see Harris, Schianarelli and Siregar, 99), bu no for Ecuador (see Jaramillo, Schianarelli and Weiss, 99). See also Gelos and Werner (999) for Mexico and Gallego and Loayza (2000) for Chile. See also Love (2000) and Laeven (2000) for micro evidence for several counries. The former focuses on financial developmen, he laer on financial reform 7

8 Alhough hese approaches provide useful insighs on some of he consequences of financial developmen or of financial reform in differen counries, hey do no address direcly and comprehensively he quesion of wheher financial liberalizaion has resuled in a more efficien allocaion of invesmen funds in developing counries. In his paper, we invesigae wheher financial liberalizaion has increased he share of invesmen going o firms wih a higher marginal reurn o capial. To his end we develop a summary index of he efficiency of allocaion of invesmen. The index compares differen measures of he marginal reurns of invesmen summed across firms in each wih he hypoheical reurns in a benchmark economy where invesmen funds had been allocaed o firms in proporion o heir share of capial in he economy. To implemen his approach, we use firm-level panel daa panel daa from 2 developing counries: Argenina, Brazil, Chile, India, Indonesia, Korea, Malaysia, Mexico, Pakisan, Philippines, Taiwan, and Thailand. We discuss a lengh he simplifying assumpions needed o consruc he index, as well as is poenial drawbacks. We hen relae his index wih differen measures of financial liberalizaion based on a careful reconsrucion of he iming of liberalizaion measures along several dimensions of financial developmen (see Laeven, 2000). The mehods used range from ocular economerics o panel esimaion, using he counry- specific measures of our efficiency index. We also conrol for oher poenial deerminans of changes in he efficiency of resource allocaion, such as rade liberalizaion and macroeconomic/financial shocks. Finally we allow he coefficien of financial reform o differ wih counry specific characerisics. The resuls sugges ha financial liberalizaion in he majoriy of cases leads o an improvemen in resource allocaion, alhough here are ineresing excepions. Panel esimaion suggess ha on average here is a significan posiive associaion beween measures of liberalizaion and our index, which is robus o he inclusion of oher conrols. The economeric evidence on he deerminans of cross-counry differences in he efficacy of financial reform is less clear-cu. The srucure of he paper is as follows. In Secion 2, we discuss he consrucion of he index of efficiency we propose. In Secion 3 we describe he panel daa se we use, we calculae he index for 2 developing counries, and we provide descripive and economeric evidence on 8

9 he relaionship beween he index and various measures of financial liberalizaion. Secion concludes. 2. Measuring he Efficiency in he Allocaion of Invesmen In assessing he effec of financial liberalizaion we wan o see wheher i succeeds in direcing resources owards hose uses wih higher marginal reurns. This is he concep of efficiency we focus on. In order o develop a synheic measure of efficiency in he allocaion of invesmen, we firs need o measure he marginal reurn o invesmen. Our index approach measures marginal reurns eiher by he sales o capial raio or by he raio of operaing profis o capial. The former is appropriae if he producion funcion is Cobb-Douglas in capial, labor and maerials. In his case he marginal reurn o capial is proporional o he sales o capial raio. The consan of proporionaliy equals he produc beween he elasiciy of oupu wih respec o capial and he inverse of one plus he markup of prices over marginal coss. 7 The operaing profi-based measure is an appropriae proxy for he marginal reurn o capial under a generic consan reurn o scale producion funcion and perfec compeiion in he oupu marke. We hen esimae he oal reurn on invesmen for each firm by muliplying he firm s invesmen in a paricular by one of our measures of he firm s marginal reurn o invesmen. We sum he oal reurn o invesmen for each firm across all firms o obain an esimae of he oal reurn o invesmen for he economy in a paricular. To measure he efficiency of he allocaion of invesmen in a, each of our esimaes of he oal reurn on invesmen mus be compared o a benchmark. The benchmark we use is an esimae of oal reurn if invesmen funds had been allocaed o firms in proporion o heir share of capial in he economy. In every case we use he same esimaes of he marginal produc of capial for each firm o esimae acual reurns, and reurns for he benchmark allocaion. We divide our measure of oal reurn acually achieved by his benchmark o obain a measure of he efficiency wih which invesmen funds were allocaed in each. This approach generaes wo differen measures of he efficiency of he allocaion of invesmen funds: one where sales per uni of capial is used as a measure of he marginal produc of invesmen, he oher where operaing profis per uni of capial is used as he 7 See Abel and Blanchard (98) and Gilchris and Himmelberg (998) for deails. 9

10 appropriae measure. Le us assume ha invesmen becomes producive wih a one period delay. Moreover, le us use an individual firm s capial sock a he beginning of, as a fracion of oal capial for all firms a he beginning of he same, o measure he proporion of invesmen funds ha he firm would receive if invesmen funds were assigned in he same proporion as in he pas. The wo versions of our index for are: EI S = i i S K i, Si, + I i K i, + + K i, T K i, +, I T () or: EI π = i π i, + I i i K i, + π i, + K i, T K K i, +, I T (2) where S i denoes firm i sales a ime, of period capial. T I and π i operaing profis, I i invesmen, and K i, beginning T K represen, insead, aggregae invesmen and aggregae capial a ime, respecively. Noe ha each uni of invesmen in increases he capial sock, and hence generaes a reurn, in +. There are a se of reasons ha make he sales-based index preferable o he profi-based index. Firs and foremos, sales are probably measured more accuraely han operaing profis in balance shees. Calculaion of he laer requires a valuaion of cos of goods sold, and hence of changes in invenories of raw maerials, which is a ricky exercise, paricularly in inflaionary environmens. Second, he sales-based measure allows for a deparure from perfec compeiion. However, he markup of prices over marginal coss is allowed o vary over ime bu no across firms, and he deparure comes a he cos of making a parameric (Cobb-Douglas) assumpion abou he producion funcion. There is a hird poenial problem wih he profi-based measure of efficiency. Due o unionizaion or efficiency wage consideraions, workers may be paid more han he reservaion wage for heir jobs. To he exen ha he reallocaion of capial induces a 0

11 reallocaion of labor, our profi measure may underesimae he gain in oal surplus generaed by such a reallocaion. A final problem wih using operaing profis as a measure of he reurn o capial is ha operaing profis are correlaed wih cash flow. Prior o financial liberalizaion, he correlaion beween cash flow and invesmen may be higher han afer liberalizaion. Thus we would expec he operaing profi measure of he efficiency of he allocaion of invesmen migh be biased in favor of he pre-liberalizaion periods. In fac, he previous lieraure in his field ends o find ha financing consrains are relaxed for small esablishmens afer financial liberalizaion. For medium and large esablishmens here is no significan change in he severiy of consrains. However, if in spie of all his, we find ha our profi-based measure of efficiency increases afer financial reform, his is a srong indicaion ha here has been an improvemen in he allocaion of resources. Boh measures of efficiency in he allocaion of invesmen funds have common poenial drawbacks. Firs, we make he implici assumpion ha he same marginal reurn o capial applies for he same firm in a given o all unis of invesmen. Second, we have so far ignored adjusmen coss of invesmen. Given our procedure for compuing he efficiency of he allocaion of invesmen funds, allocaive efficiency would be greaes if he firm wih he highes raio of operaing profis or value added o capial were o ge all he invesmen funds available for a given. However, he discrepancy due o omiing adjusmen coss may no be large. For insance, if adjusmen coss are inernal and addiive, and ake he form 2 ( b 2) ( I K ) K, he omied erm is ( b 2) ( I K ) 2, which should be relaively small for a large range of realisic values of he invesmen rae. 8 A hird drawback is he implici assumpion ha marke prices reflec he social value of oupus and inpus. Presumably, here were social, poliical or even economic reasons for why governmens favored paricular indusries or regions prior o liberalizaion. Tha bias in he allocaion of invesmen funds could have been (second bes) socially efficien given oher disorions in he economy. For insance, if favored indusries were producing expors, and if he currency was overvalued, hen he domesic marke price of heir oupus would undersae he rue value of heir producs (correc valuaions would use he shadow price of foreign currency).

12 Using he wrong exchange rae would lead he privae reurn on invesmen in he expor secor o be less han he social reurn. Therefore favoring expor indusries whose privae reurns are relaively low could acually increase he social produciviy of invesmen. Similarly, governmen policies ha encouraged invesmen wih posiive spillovers and discouraged invesmen wih negaive spillovers would enhance social efficiency. Finally, governmens may wan o favor paricular regions in order o improve iner-regional income disribuion. Programs of direced credi migh be more efficien means of aiding hose regions han would oher programs inended o reduce iner-regional income dispariies such as ax holidays for invesmens in economically depressed regions. Those ax exempions encourage verically inegraed firms o use ransfer prices o move profis ino he subsidized region. In general programs of direced credi may be a second-bes soluion o problems for which he firs-bes soluion is no poliically feasible. A fourh problem involves inerpreing differences in he allocaion of capial. In equilibrium, he marginal produc of capial of a perfecly efficien economy would be he same in all firms. Consequenly, random allocaions of capial would do as well as any oher allocaion. No banking sysem could do beer. This would be a serious problem if we were looking a he resuls of a financial liberalizaion ha had been in effec for many s. However, we are observing he allocaion of capial for he s immediaely following he implemenaion of financial liberalizaion. For financial liberalizaion o evenually resul in an equalizaion of he reurns o capial across firms, i mus have redireced invesmen funds oward he firms where he marginal produc of capial was highes. This reallocaion of invesmen is precisely wha we are seeking o measure. In addiion, even a cursory look a he daa suggess ha here are grea differences in he marginal revenue produc of capial across firms. There is also a se of problems inroduced by measuremen error of he capial sock. I is very difficul o ge good measures of he marke value of capial. Firms reporing large levels of capial are likely o have less capial han hey acually repor, and firms reporing low levels of capial are likely o have more capial. These measuremen errors bias our measures of he reurn o capial in favor of firms ha repor low levels of capial and agains firms reporing high levels 8 See, for insance, Abel and Blanchard (98), foonoe 5. 2

13 of capial. However, i is difficul o know wheher financial liberalizaion direcs he flow of invesmen funds in favor of or agains firms wih posiive or negaive reporing errors. As a resul, i is no possible o deermine a priori he sign of he bias his causes in he measuremen of efficiency. 3. Empirical Resuls Has financial reform lead o an improvemen in he allocaion of resources as measured by our index? In order o answer his quesion we need firm level panel daa o consruc he index, and we need o be more precise in defining he evoluion of financial reform. Afer providing some background on he daa used, we will presen a se of empirical resuls ha provide some answers o our cenral quesion. 3. The Daa Our empirical invesigaion is based on firm level panel daa for 2 developing counries ha have inroduced various measures of financial reform over he las several s: Argenina, Brazil, India, Indonesia, Korea, Malaysia, Mexico, Pakisan, Philippines, Taiwan, and Thailand. The source of he firm level informaion is he Worldscope daabase, which provides balance shee informaion on publicly raded firms. The advanage of his daa se is he cross-counry comparabiliy of he accouning informaion. The obvious drawback is he absence of informaion on non-publicly raded firms, which are on average smaller. Anoher limiaion is ha prior o he 990s, very lile daa is available for he subse of counries of ineres o us. 9 We use an unbalanced panel, bu we require a leas hree consecuive s of observaion on each firm, and a minimum of fifeen observaions (firms) for each counry-. Moreover we have deleed ouliers following he crieria summarized in he Daa Appendix. Descripive saisics for he main variables of ineres are presened in Table A, while he oal number of firms available for each counry is repored in Table A2. We will rely on differen measures of liberalizaion. They are all based on analysis of he iming of he inroducion of various aspecs of financial reform as discussed in Laeven (2000). Laeven provides a daing of ineres rae deregulaion, reducion of enry barriers, reducion of 3

14 reserve requiremens, reducion of credi conrols, privaizaion of sae banks, and srenghening of prudenial regulaion. These measures focus on he banking secors and correspond o he classificaion also used in Bandiera, Caprio, Honohan and Schianarelli (2000) for a smaller subse of counries. 0 Assume we associae a dummy equal o one (zero) wih he s characerized by he more (less) liberalized regime. A firs cardinal measure of liberalizaion is obained by summing he six dummies (so ha he index varies beween zero and six). We will denoe his measure by fli. Anoher measure is mean o disinguish in a discree fashion counry-s characerized by a more or less fully liberalized regime, versus one sill characerized by many resricions. As in Laeven (2000) we will divide observaions depending upon wheher he overall index is less han five, versus equal o five or six. This yields a pariion of he s ha is similar o he one proposed by Williamson and Mahar (998). We will denoe his dummy by Libdummy. In addiion, we consruc a dummy variable, denoed by Libdummy2, ha equals one he following he removal of he main resricions on ineres raes and credi allocaion (he laer in he form of direced credi or credi ceilings). This final measure enables us o focus on he aspecs of financial liberalizaion ha are more likely o affec he allocaion of invesmen funds. Since in all bu wo counries he removal of ineres rae conrols precedes or is conemporaneous wih he removal of conrols on credi flows, a dummy mean o capure only he laer aspec would be almos idenical o Libdummy2. Finally, noe ha all hese measures of liberalizaion focus on financial inermediaries. All he counries in our sample have also inroduced changes designed o promoe he developmen of sock markes. However, sock marke liberalizaion akes place in mos counries a he end of he 980s and in he remaining counries in he very early 990s, while our firm-level daa se is basically limied o he 990s. This is one of he reasons we have focused on he liberalizaion measures regarding financial inermediaries. Furher invesigaion of he role of sock marke developmen requires firm-level daa for he 980s as well, and his is lef for fuure research 9 Alhough for some counries daa are available also for he second half of he 980s, he number of firms included is very small. 0 Bandiera, Caprio, Honohan and Schianarelli (2000) also include informaion on securiies marke developmens and inernaional financial liberalizaion.

15 3.2. Descripive Evidence In his secion we will presen descripive evidence on he effec of financial liberalizaion on he allocaion of invesmen. We sar by ploing in Figure (a hrough m) our efficiency index for sales, S EI, agains he financial liberalizaion index, fli. The verical line in he graphs represens he in which boh ineres rae and credi conrols were removed. This exercise in ocular economerics reveals some very ineresing paerns. Firs, for a subse of counries, Brazil, Chile, India, Pakisan and Thailand, here is a clear and posiive associaion beween S EI and fli, suggesing ha financial liberalizaion is associaed wih an improvemen in he allocaion of resources. One cavea is in order for Chile: by he beginning of he 990s many aspecs of financial reforms had already been implemened, so ha he mos informaive experimen would have been o analyze he behavior of he efficiency index over he 980s. I is ineresing o noe ha he value of he index in Chile, a counry wih one of he mos liberalized financial sysems, ends o be higher han for he oher counries. For anoher group of counries, here is also evidence of an improvemen of he efficiency index following he inroducion of liberalizaion measures. This is rue for Argenina, Korea and Mexico. For insance, in Korea he index is below one (indicaing an efficiency in invesmen allocaion acually worse han one based purely on size) in he iniial s and increases above one wih he inroducion of liberalizaion measures. However, in all hese cases, here are significan reversals in he improvemen around periods of financial and currency crisis: 995 for Argenina, 998 for Korea and 99 and 998 for Mexico, and 998 for Brazil. Finally, for a subse of counries, such as Indonesia, Malaysia, and he Philippines, he index shows no clear rend, while i is decreasing over ime for Taiwan. The efficiency index based on profis, π EI, pains a picure largely similar o he one for S EI. Brazil, Chile India, Pakisan and Thailand are he counries for which one observes he clearer improvemens. However, now π EI decreases over ime for Argenina and here is a Schianarelli and Weiss, wih Siregar, in preliminary pas research using a similar mehodology o he one proposed in his paper, found ha financial liberalizaion did no have a posiive effec on he efficiency of he allocaion of invesmen in Indonesia in he 980s. There are several reasons ha could accoun for hese resuls for Indonesia. For insance, Indonesian conglomeraes, many owned by ehnic Chinese enrepreneurs, already had access o overseas capial markes, which may have allowed hem o circumven he problems of a resriced 5

16 worsening of he allocaion of resources around periods of financial/currency crises in Mexico and Korea. Again, no clear paern emerges for Indonesia, Malaysia, and Philippines, while he index shows a decrease in he laer s for Taiwan. The overall paern described above is confirmed and made more quaniaively precise by comparing he mean value of he index over sub-periods, defined as pre- and posliberalizaion. The resuls are repored in Table (in par for S EI and in par 2 for π EI ). In he firs se of columns we use Libdummy o divide he 990s i.e., he pre-liberalizaion (posliberalizaion) period is he one for which he value of he overall index is less han five (equal o five or more). In he second se of columns, we use Libdummy2, so ha he pre-liberalizaion period is he one up o and including he in which boh ineres rae and credi conrols are removed. Looking a he sales-based index, using Libdummy, here are large and posiive increases in is mean value in he pos-reform period in six counries (Argenina, Brazil, India, Pakisan, Thailand and Korea). In hree cases (Malaysia, Mexico and he Philippines) he means are virually unchanged. In one case (Taiwan) one observes a decrease. When he ineres rae and credi conrol dummy is used o pariion he period, one observes an increase in he mean value of he efficiency index for Argenina, Brazil, India, Mexico and Pakisan, while here is basically no change for Korea. Noe ha for some counries, such as Chile, he difference in mean is no available, since he major changes in he financial deregulaion process had already occurred by he beginning of he 990s. These resuls are srongly supporive of an improvemen in he allocaion of resources, for he majoriy of counries, afer financial reform. The resuls for he profi-based index confirm his overall paern bu are no as srong as he sales-based resuls. For insance, using Libdummy2, one observes an improvemen in Brazil, Mexico, Pakisan and Thailand, bu he increase is smaller han before. Moreover, he profi-based index for India does no reveal any noiceable change in efficiency Economeric Evidence We now provide more formal economeric evidence on he effec of financial liberalizaion on he efficiency of resource allocaion by uilizing he enire panel of firm- observaions. More specifically, we regress our efficiency index on differen measures of liberalizaion, allowing for domesic financial sysem. This may conribue o explain why inernal financial liberalizaion has no generaed

17 counry-specific consans. Resuls are repored in Table 2. In Par, column I, we regress on he Laeven (2000) index. The resuls are very supporive of he idea ha financial liberalizaion leads o an improvemen in resource allocaion: he coefficien of he liberalizaion index is posiive and significan a he 5 percen level. Moreover, he quaniaive effecs are quie large: he coefficien esimae sugges ha going from a financially repressed index (fli = 0) o a fully liberalized sysem (fli = ) leads o an increase in S EI S EI of 9.8 percen. 2 In column II and III, he explanaory variables are Libdummy and Libdummy2, respecively. The coefficiens on he liberalizaion dummies are posiive and significan a he percen level. Again he effecs are quaniaively significan. For insance, he efficiency index increases by.5 percen when ineres rae and credi conrols are relaxed. Table 2, Par 2 conains he resuls for he profi-based measure of efficiency, π EI. The resuls coninue o sugges ha financial liberalizaion improves efficiency, bu he effec is no as srong and precisely esimaed as he one observed using he sales based measure, EI. The coefficiens of he liberalizaion dummies are always posiive, bu somewha smaller now. The coefficiens of fli - and Libdummy2 are now significan a he 5 percen and percen level, respecively, while he one for Libdummy2 is no significan. Sill, he resuls in column I imply ha going from a compleely repressed sysem o a fully liberalized one leads o a sizeable increase in efficiency of 2. percen. One may legiimaely wonder wheher wha we are capuring in hese regressions is no only he effec of financial reform, bu also he effec of oher liberalizaion measures, such as rade liberalizaion or changes in macroeconomic condiions. Acually, i is no obvious a priori how rade liberalizaion should affec our paricular measure of efficiency. Moreover, he main seps in rade liberalizaion were underaken before he period we use for esimaion. 3 In many counries, however, a decrease in rade barriers coninues during he 990s, and in a leas one counry (India), rade liberalizaion was accompanied by inernal indusrial deregulaion, which can have a posiive effec on he efficiency of resource allocaion. In order o address hese S large gains. 2 If we include in he calculaion of he liberalizaion index also a dummy for sock marke liberalizaion, he resuls are virually unchanged. The coefficien of he liberalizaion remains significan and virually unchanged. 7

18 issues, we reurn o he full sample and we add o each specificaion he mean ariff rae as a measure of he degree of rade barriers. The resuls for S EI are repored in Table 3. Is coefficien is negaive, bu no significan. Mos imporanly, from our poin of view, he coefficiens on wo of he hree proxies for financial reform (fli - and Libdummy2) remain posiive and saisically significan, alhough heir magniude is now a bi smaller. In order o check he robusness of our resuls o he inclusion of oher explanaory variables, we have conduced four oher experimens (see Table 3 again). Firs, we have included in he panel regression changes in he real exchange rae (an increase denoes an appreciaion). These variables may capure general macro insabiliy and he effecs of financial and currency crisis ha have occurred during he 990s. Moreover, since he real exchange rae is correlaed wih changes in he relaive price of radables versus non-radables, i conrols for changes in markups ha may occur unevenly in he radable and non-radable secors. Second, we have used a differen and possibly more specific measure of he exisence of speculaive pressure ha has resuled in currency crises in he las decade. This variable is he average of he percenage change in he nominal exchange rae, in reserves and in he ineres rae (see Eichengreen, Rose and Wyplosz, 995, and Sachs, Tornell and Velasco, 99). Third, we have included as an addiional regressor he inflaion rae as a general proxy for macroeconomic insabiliy. During periods of macroeconomic insabiliy i may be more difficul o idenify where good invesmen opporuniies are, and his may adversely affec he efficiency of allocaion of invesmen funds. Finally, we include GDP growh in he equaion o conrol for he effec of business cycles on he efficiency of resource allocaion. I is no clear wha he sign of he GDP growh coefficien should be. For insance, during a recession credi risk increases and banks may become more careful in selecing he projecs o be financed. A he same ime uncerainy may be greaer during a recession, making i more difficul o idenify good invesmen opporuniies. The crucial resul here is ha financial liberalizaion coninues o exer a significan effec on he sales-based index of efficiency. Across all specificaions, he coefficiens of all he proxies for financial liberalizaion remain significan a leas a he 5 percen level in all cases 3 For a review of empirical evidence of he effec of rade liberalizaion on growh see Edwards (993). For more recen analysis, see Sachs and Warner (995), Edwards (998) and Rodríguez and Rodrik (200). See also Lora (997) for a discussion on rade liberalizaion in Lain America. 8

19 bu wo. Of he four addiional variables, he coefficiens on wo of hem (he measure of speculaive pressure and he inflaion rae) are negaive and significan, while hose of he remaining wo (real appreciaion and GDP growh) are insignifican. This suggess ha macroeconomic insabiliy and financial crises are associaed wih a worsening of he allocaion of resources. The robusness of he link beween allocaive efficiency and financial liberalizaion, when we use he sales based measure of efficiency, does no carry over o he profi-based measure of efficiency. More specifically, addiion o he basic specificaion of he mean ariff rae, of real depreciaion, of he measure of speculaive pressure, of he inflaion rae or of GDP growh, leaves he coefficien of he proxies for financial liberalizaion posiive bu insignifican a convenional levels. 5 However, he problems associaed wih he profi-based measure of efficiency sugges ha more aenion should be given o he resuls derived from he sales-based index. I is worh assessing he robusness of he resuls in oher dimensions, such as esimaion mehods, and he definiion of he capial sock. In evaluaing he effec of financial liberalizaion one may wan o aribue more weigh o hose observaions in he counry- efficiency index, when he laer is based on a larger number of firm-level observaions, since in his case efficiency is measured more accuraely. This could be achieved by weighing each counry- observaion of he variables included in he regression by he square roo of he number of firmlevel observaions available in each in each counry. However, his means aribuing, de faco, greaer weigh o larger counries. In Table we repor he resuls for he weighed leas square regressions for S EI. Our conclusion is largely unchanged, wih he variables capuring liberalizaion exering a posiive and significan effec on he value of he efficiency index. Moreover, one may wonder wheher he resuls obained so far are robus o changes in he definiion of he capial sock. In Table 5 we repor he regression resuls for S EI, for a definiion of he capial sock, idenical o he one used in Love (2000). In his case beginning of period capial is measured as end of period capial minus invesmen plus depreciaion. As Love See Beaudry, Caglayan and Schianarelli (200) for an analysis of he effecs of moneary uncerainy on he allocaion of invesmen, using a differen approach. 5 Of he addiional variables, inflaion, he average ariff and he speculaive pressure measure remain significan and have negaive signs. Resuls are available from he auhors upon reques. 9

20 suggess, his measure may be a beer measure in hose s in which firms undergo mergers or acquisiions. However, i may exacerbae measuremen problems in s in which firms are allowed o revalue heir capial sock in order o ake accoun of inflaion. Alhough he coefficiens end o be somewha smaller, hey remain significan for all he hree measures of financial liberalizaion a leas a he 5 percen level, independenly from wheher one weighs he observaions. The fundamenal conclusions we have reached so far are, herefore, robus o changes in he definiion of he capial sock. A very ineresing quesion one may ask is wheher he changes in he efficiency index are due o an inra or iner-secoral reallocaion of invesmen, ha is a reallocaion of invesmen funds beween firms in he same secor or in differen secors. Our daa se includes publicly raded firms in agriculure, mineral indusries, consrucion, manufacuring, ransporaion, communicaion and uiliies, wholesale and reail rade. Unforunaely he coverage a he secoral level is quie spoy and makes comparisons across ime or counries a very dubious exercise. Even for manufacuring, here is no enough informaion for some counries and s o make he consrucion of he efficiency index meaningful. The invesigaion of his issue, herefore, will have o be posponed unil daa ses ha are richer, and wih more exensive coverage han he one used here, become available o researchers. Finally, he descripive evidence presened in Table suggess ha counry-level changes in he mean value of he efficiency index beween he pre and pos- liberalizaion period differs across counries. This could occur for many reasons. Firs, facors besides financial liberalizaion affec he efficiency of resource allocaions. Second, he inensiy of he liberalizaion measures may differ across counries, and his is no fully capured by our index. Third, he effec of financial liberalizaion may differ depending upon iniial condiions, upon oher liberalizaion measures, and upon he macro conex and he general insiuional environmen in which i akes place. The resuls presened in Table have already suggesed ha measures of speculaive pressure and of macro insabiliy (such as he inflaion rae) have an independen adverse effec on he allocaion of invesmen. We have also experimened wih ineracing all he addiional variables included in Table 3 (average ariffs, change in he real exchange rae, speculaive pressure, inflaion, and GDP growh) wih our measures of financial reform, bu he ineracion 20

21 erms are never significan. We have also experimened wih inroducing ineracions of he liberalizaion measures wih measures of dispersion of he macro variables over he period used for esimaion. Again we have no had much success. Moreover, we have invesigaed wheher he effeciveness of financial reform depends upon iniial condiions and oher variables ha reflec insiuional qualiy and poliical sabiliy. For insance, one may hink ha he effec of financial reform may be more beneficial in counries wih a well-developed legal sysem ha affords beer proecion o credior righs. For his reason we have ineraced our liberalizaion measures wih he iniial level of financial developmen, iniial GDP per capia, and several insiuional variables, such as rule of law, credior righs, risk of expropriaion, risk of conrac repudiaion, efficiency of he judiciary, counry of origin of he legal sysem, qualiy of accouning sandards, measures of supervisory power and qualiy, corrupion, and poliical risk. 7 Again, i is difficul o find saisically significan differences in he financial liberalizaion coefficiens, due probably o he limied number of counries in our sample. The only saisically significan ineracion is he one wih he measure of official supervisory power over financial inermediaries from Barh, Caprio and Levine (200a). 8 Resuls are repored in Table. A greaer degree of supervisory power is associaed wih a sronger effec of financial liberalizaion, and he differences are economically significan. A low levels of supervision he effec of financial liberalizaion is basically zero, while i becomes large and posiive a mean levels of supervision (or higher). Finally, we also repor he regression resuls when he effec of financial reform is allowed o differ beween counries wih legal sysems based on he English sysem and hose based on oher sysems. The coefficien of financial liberalizaion is wice as large for he former and more precisely deermined (0.03 versus 0.022, wih a -raio equal o 2.39 and., respecively). This is consisen wih he conenion ha proecion of invesors righs ends o be beer in he English common law sysem (see La Pora, Lopez de Silanes, On he issue of he sequencing of reforms see, for insance, McKinnon (99). See also Area, Eichengreen and Wyplosz (200) for growh regression resuls. 7 See La Pora, Lopez de Silanes, Shleifer and Vishny (997 and 998) on he relaionship beween insiuions and finance. Noe ha all he insiuional variables we use are counry specific, bu ime invarian, and ha all our regressions conain counry-specific consans. 8 The daa in Barh, Caprio and Levine (200a) reflec he siuaion a he end of he 990s. The measure of official supervisory power varies in our sample beween nine and fifeen. See also Barh, Caprio and Levine (200b) for an analysis of he effecs of regulaion and supervision. 2

22 Shleifer and Vishny, 998). However, one canno rejec he hypohesis ha he wo coefficiens are idenical. This is also he case when more direc measures of propery righ proecion, credior righ proecion, ec. are used.. Conclusions The resuls presened in his paper provide empirical suppor for he idea ha financial liberalizaion has led o an improvemen in he efficiency wih which invesmen funds have been allocaed. Boh he informal ocular economeric exercise and he comparison of mean values of our efficiency index in he pre- and pos- liberalizaion regimes suggess ha he index has improved for many (alhough no for all) counries, following he inroducion of financial reform. Moreover, he economeric resuls on he panel of counry-s observaions srongly suppors a posiive, significan and sizeable effec of financial liberalizaion on he efficiency wih which invesmen funds are allocaed. These conclusions hold for differen measures of marginal reurns and financial liberalizaion, alhough hey are sronger when reurns are assumed o be proporional o he sales o capial raio. Moreover, he resuls for he sales-based index are robus o he inclusion of oher poenial deerminans of he efficiency of resource allocaion, such as rade liberalizaion, and macro or financial sabiliy. We have also found evidence ha here is a negaive relaionship beween efficiency of invesmen allocaion, on he one hand, and inflaion and speculaive pressure, on he oher. There is also evidence ha is efficacy is enhanced by greaer official supervisory power, and some indicaion ha he effecs may be greaer in counries whose legal sysem is based on English common law. However, he saisical significance of he ineracion erms wih various measure of insiuional qualiy ends o be weak Obviously more works needs o be done. Exending he number of developing counries included in he analysis would obviously be useful. Moreover, one could gain addiional insighs on his issue by conducing a similar analysis on larger daa ses for individual counries ha also conain observaions on smaller esablishmens. The use of larger daa ses would allow one o assess more fully wheher he improvemen in he efficiency in he allocaion of invesmen funds is due o an inra-indusry or iner-indusry reallocaion. The main difficuly in pursuing hese exensions is he lack of good qualiy, firm level daa, over long enough periods. Sill, he 22

23 evidence presened here provides he firs comprehensive micro-based answer concerning he effec of financial liberalizaion on he allocaion of invesmen in developing counries. 23

24 DATA APPENDIX Variable Definiions Firm-Level Variables K : Beginning of period capial sock, measured as he lagged value of end of period value of propery plan and equipmen, ne of depreciaion. I : Capial expendiure. S : Gross sales and oher operaing revenue during he period, less discouns, reurns and allowances. cogs : cos of goods sold. π : operaing profis = S - cogs. Counry level variables fli : Financial liberalizaion index, based on Laeven (2000); see Table his Appendix and Annex. I is calculaed as he sum of zero-one dummies represening six dimensions of liberalizaion (ineres rae deregulaion, reducion of enry barriers, reducion of reserve requiremens, reducion of credi conrols, privaizaion of sae banks, srenghening of prudenial regulaion). One (zero) denoes he pos (pre) reform regime. libdummy: A dummy variable ha equals one (zero), when fli equals or exceeds five (is less han five). libdummy2: A dummy variable ha equals one in he following he inroducion of ineres rae liberalizaion and he removal of credi conrols. I is zero oherwise. 2

25 Average Tariff: Unweighed average of ariff raes. Source: World Bank, World Developmen Indicaors. Real exchange rae: domesic prices divided by US prices muliplied by he exchange rae (in unis of domesic currency per US Dollar). Source: Inernaional Financial Saisics. Inflaion: log (+CPI inflaion rae). Source: Inernaional Financial Saisics. Real GDP Growh: Real GDP growh rae. Source: World Developmen Indicaors. Supervision: Measure of official supervisory power. Source: Barh, Caprio and Levine (200a). Speculaive pressure: Average of exchange rae depreciaion, real ineres rae variaion and he negaive of he variaion in inernaional reserves. Source: Eichengreen, Rose and Wyplosz (995) and Sachs, Tornell and Velasco (99). 25

26 Sample Selecion Crieria We deleed he following observaions: Financial secor firms, ha is firms wih SIC codes 0 and higher. Years wih fewer han 5 firms Firms wih fewer han 3 s of observaions. Observaions wihou invesmen, capial sock, profis or sales daa. Observaions wih I 0 Observaions wih S/K 0 Observaions wih K 0 Observaions wih cos of goods sold 0 Observaions where S/K >20 Observaions where Cos of goods sold > 20 Observaions where I/K > 2.5 Observaions where Profis/K > 5 Table A. Descripive Saisics Variable Observaions Mean Median Sd.Dev Min Max I/K S/K Profis/K

27 Table A2. Number of Firms, by Counry Counry Toal Non - Manufacuring financial Firms a Firms b Argenina 0 3 Brazil 20 Chile India Indonesia 5 9 Korea Malaysia Mexico 7 55 Pakisan Philippines 7 7 Taiwan Thailand 8 39 Noes: a Toal number of firms excluding hose wih SIC codes greaer han 0. b Firms wih SIC codes beween 20 and

28 References Abel, A.B., and O.J. Blanchard. 98. The Presen Value of Profis and Cyclical Movemens in Invesmen. Economerica 5(2): Area, C., B. Eichengreen, and C. Wyplosz When Does Capial Accoun Liberalizaion Help More Than Hurs? CEPR Discussion Paper No London, Unied Kingdom: Cenre for Economic Policy Research. Aiyas, I., G. Caprio, Jr., and J.H. Hanson. 99. An Overview of Financial Reform Episodes. In: G. Caprio Jr., I. Aiyas and J.H. Hanson, ediors. Financial Reform: Theory and Experience. Cambridge, Unied Kingdom: Cambridge Universiy Press. Bandiera, O., G. Caprio, Jr. P. Honohan, F. Schianarelli Does Financial Reform Raise or Reduce Saving? Review of Economics and Saisics 82(2): Barh, J.R., G. Caprio, Jr. and R. Levine. 200a. The Regulaion and Supervision of Banks Around he World: A New Daabase. Washingon, DC, Unied Saes: World Bank. Mimeographed documen b. Bank Regulaion and Supervision: Wha Works Bes? Washingon, DC, Unied Saes: World Bank. Beaudry, P., M. Caglayan, and F. Schianarelli Moneary Insabiliy, he Predicabiliy of Prices and he Allocaion of Invesmen: An Empirical Invesigaion using UK Panel Daa. American Economic Review 9(3): 8-2. Beck, T., R. Levine, and N. Loayza Finance and he Sources of Growh. Journal of Financial Economics 58: Beck, T., G. Clarke, A. Groff e al New Tools and New Tess in Comparaive Poliical Economy: The Daabase of Poliical Insiuions. Policy Research Working Paper Washingon, DC, Unied Saes: World Bank. Bekaer, G., C.H. Harvey and C. Lundblad Does Financial Liberalizaion Spur Growh? Durham, Unied Saes: Duke Universiy. Mimeographed documen. Cho, Y The Effec of Financial Liberalizaion on he Efficiency of Credi Allocaion: Some Evidence for Korea. Journal of Developmen Economics 29: 0-0. Demirguc-Kun, A., and V. Maksimovic Law, Finance, and Firm Growh. Journal of Finance 53():

29 Eichengreen, B., A. Rose and C. Wyplosz Exchange Marke Mayhem: he Anecedens and Afermah of Speculaive Aacks. Economic Policy 2: Edwards, S Openness, Trade Liberalizaion, and Growh in Developing Counries. Journal of Economic Lieraure 3(3): Openness, Produciviy and Growh: Wha Do We Really Know? Economic Journal 08: Fry, M.J Money, Ineres, and Banking in Economic Developmen. The John Hopkins Universiy Press. Gallego, F., and N. Loayza Financial Srucure in Chile: Macroeconomic Developmens and Microeconomic Effecs. Saniago, Chile: Cenral Bank of Chile. Manuscrip. Gelos, G., and A. Werner Financial Liberalizaion, Credi Consrains, and Collaeral: Invesmen in he Mexican Manufacuring Secor. IMF Working Paper 99/25. Washingon, DC, Unied Saes: Inernaional Moneary Fund. Gilchris, S., and C.P. Himmelberg Invesmen, Fundamenals and Finance. In: B.S. Bernanke and J. Roemberg, ediors. NBER Macroeconomics Annual. Cambridge, Unied Saes: MIT Press. Harris, J., F. Schianarelli and M. Siregar. 99. The Effec of Financial Liberalizaion on Firms Capial Srucure and Invesmen Decisions: Evidence from a Panel of Indonesian Manufacuring Esablishmens, World Bank Economic Review 8(): 7-7. Jaramillo, F., F. Schianarelli, and A. Weiss The Effec of Financial Liberalizaion on he Allocaion of Credi: Panel Daa Evidence for Ecuador. Policy Research Working Papers WPS 092. Washingon, DC, Unied Saes: World Bank Capial Marke Imperfecions Before and Afer Financial Liberalizaion: An Euler Equaion Approach o Panel Daa for Ecuadorian Firms. Journal of Developmen Economics 5: King, R., and R. Levine Finance and Growh: Schumpeer May Be Righ. Quarerly Journal of Economics 08: Laeven, L Does Financial Liberalizaion Reduce Financial Consrains? Washingon, DC, Unied Saes: World Bank. 29

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