FIRM HETEROGENEITY, FINANCIAL DEVELOPMENT, FOREIGN DIRECT INVESTMENT, AND MONETARY POLICY

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1 IRM HETEROGENEITY, INNCIL EVELOMENT, OREIGN IRECT INVESTMENT, N MONETRY OLICY Inaugural-sseraon zur Erlangung des Grades ocor oeconomae publcae (r. oec. publ.) an der Ludwg-Maxmlans-Unversä München 20 vorgeleg von Jaru Zhang Referen: rof. r. Gerhard Illng Korreferen: rof. r. ala Marn romoonsabschlussberaung: 6. Ma 202

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3 To My arens

4 Conens cknowledgmens cronyms Chaper Inroducon. The Issue 2.2 Bref Survey of Leraure 6.3 Man Conrbuon 7 Chaper 2 Mulple Sources of nance, Margns of I, and ggregae Indusry roducvy 9 2. Inroducon The Model Closed Economy Open Economy 8

5 2.2.3 Complemenary and Subsuon Effecs ggregaon Concluson 30 ppendx.2. Numercal Examples Skech of General Equlbrum 40 Chaper 3 nancal Srucure, roducvy, and Rsk of I Inroducon The Model emand roducon No I I wh Bank nance I wh Bond nance Choce of nance ggregaon nancal Srucure of Sourcng Counry nancal Srucure and Rsk of I nancal Srucure and roducvy acs and Evdence 67

6 3.5 Concluson 72 ppendx.3. roofs Calculaon of nancal Srucure of I Calculaon of ggregae Rsk of I 78 Chaper 4 rm Heerogeney, Endogenous Enry and Ex, and Moneary olcy Inroducon The Model roducers Bankng Secor Households ggregaon Shocks and olcy nalyzng he Model New Keynesan hllps Curve and a new Tradeoff Calbraon and Impulse Responses Second Momen Concluson 09 ppendx

7 .4. ggregaon.4.2 Seady Sae Equaons Log-Lnearzed Sysem 6 References 7

8 Ls of gures 2. Complemenary Effec and Subsuon Effec Smulaon of rms Reserve for I Smulaon of Inensve Margn of I Smulaon of Exensve Margn of I Smulaon of rof of I Smulaon of Cuoff roducvy Gap nancal Srucure and Volaly of Ouward I roducon and nancng Choce nancng Cos and rm s roducvy Comparson of Expeced rof under fferen nance Segmenaon of rms n roducon and nancng The Effecs of an Increase n I Rsk roducvy srbuon and nancal Srucure The Evoluon of Number of I esnaons and roducvy 68

9 3.9 The Rsng verage Rsk per esnaon of I nancal Srucure and ggregae Rsk of I orfolo nancal Srucure and roducvy 7 4. Cyclcal Behavor of Enry and Ex Correlaon beween Enry(+k) and G(); Ex(+k) and G() Impulse Responses o a One ercen osve Technology Shock Impulse Responses o a One ercen Conraconary Money Supply Shock Smulaed Enry and Ex (H-lered Log-evaon rom Seady Sae) 09

10 Ls of Tables 3. Summery Sascs of Our aa Emprcal Esmaon of Volaly of I (nancal Srucure lays a Sgnfcan Role) enoaons of Varables n Emprcal nalyss Esmaon for Money Supply Shocks Momens for aa, Benchmark RBC model (Kng and Rebelo, 999), Blbe, Ghron and Melz (2007a) s model wh Endogenous Enry, and Our Model wh Boh Endogenous Enry and Ex 08

11 cknowledgmens rs and foremos I hank my supervsor rof. r. Gerhard Illng for hs connuous eachng, nsghful gudance, and encouragemen. urng my sudy a Unversy of Munch, he connuously suppored me and gave me nvaluable advce. I am also graeful o rof. r. ala Marn who made many nsghful commens on he hess and kndly agreed o serve as my second supervsor. Her connuous encouragemen s very mporan for my academc research as well as personal lfe. I hank rof. r. Uwe Sunde who rus me as hs eachng asssan for macroeconomcs (research) and compleed my dsseraon commee as he hrd examner. I exend my graude o my coauhor Le Hou, wh whom I had excng chas and debaes. I would lke o hank my curren and former colleagues a he Semnar for Macroeconomcs: esslava ndreeva, gnès Berprgl, Jn Cao, Sebasan Jauch, Sebasan Msso, Monque Newak, ngelka Sachs, Sebasan Wazka, and Mchael Zabel. They all helped he progress of my research and lvng n Munch. Specal hanks for r. Jn Cao who gave me grea help and nspraons n Munch. I am deeply ndebed o hm. I am also very graeful o rof. r. Kalna Manova, rof. r. Ganmarco Oavano, rof. r. Klaus Schmd, and rof. r. Monka Schnzer who gave me mporan commens on my hess. I also profed a lo from dscussons wh many oher colleagues. In parcular I wan o hank Werner Barhel, Chrsan Bauer, Susanne Hoffmann, arko Jus, Mchal Maška, Mchael Sez, Marn Spndler, Sebasan Srasser, ers Trepper, Rober Ulbrch, and Marn Waznger. To hese wonderful people I owe a deep sense of graude.

12 I sncerely hank Chna Scholarshp Councl and General Consulae of eople s Republc of Chna n Munch for her fnance and everyday suppor durng my sudy n Germany. arcularly I hank Jqang a and Jun Tan. I am also heavly ndebed o Munch Graduae School of Economcs, especally rof. Sven Rady, h.. (ormer recor), r. Slke Englmaer, Carna Legl, and Ines elger who offered generous helps durng my sudy. I also owe many hanks o Renmn Unversy of Chna where I ganed my earles knowledge of economcs. Mos specal hanks go o rof. r. Zhyong ong (Currenly n ekng Unversy) who s my menor and gave me remendous care and help. I also owe deep graude o rof. r. Rulong Yang (ean of School of Economcs, Remn Unversy of Chna), rof. r. Yuanchun Lu (Vce ean), rof. r. Gang Ln, rof. r. Zh Yang, rof. r. Ye an Zhou, rof. r. Yanbn Cheng, Yuan Ln, and Lng ang who helped me wh my early sudes n many ways. The happness of sudy back n Chna remnds me some of my bes frends: Qfan Wang, Mao Zang, and Xaomng Zhu. Mos chapers of he hess have been presened n dfferen semnars and conferences: CES (Chnese Economs Socey) annual conference 200, Chna Economcs nnual conference 200, Bennal Conference of Hong Kong Economc ssocaon 200, BGE workshop 20, GE (Globalzaon and Economc olcy, Nongham) conference 20, Bar Conference on Economcs of Global Ineracons 20, ETSG (European Trade Sudy Group) annual conference 20. I hank he parcpans for her consrucve commens ha sgnfcanly mproved he qualy of he hess. mong hem, rof. r. Spros Bougheas, r. Zhhong Yu, and Zheng Wang are hghly apprecaed. nally, my greaes graude goes o my parens and Q Lu. Ther love, undersandng and suppor are nvaluable o me! Jaru Zhang

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14 cronyms CES: CI: SGE: I: G: NV: I: RBC: T: ZC: Consan Elascy of Subsuon Consumer rce Index ynamc Sochasc General Equlbrum oregn rec Invesmen Gross omesc roduc Ne resen Value roducer rce Index Real Busness Cycles Toal acor roducvy Zero Cuoff rof

15 - - Chaper Inroducon

16 THE ISSUE The mpac of fnancal developmen (fnancal consran) on frms nernaonalzaon has recevng growng aenons among economss and polcy makers. s wdely beleved, beer access o exernal fnance faclaes global acves. In he recen fnancal crss, when cred suddenly dred ou, we dd observe sharp declne of global foregn drec nvesmen flow as well as rade. or nsance, as World Invesmen Repor 2009 ells, global I nflow fell 4% n 2008, amoun o.697 bllon dollar. Ths rggered ou he emergence of a huge body of leraure whch uses varous daa ses o re-emphasze he mporance of exernal fnance s avalably o mulnaonal frms. Neverheless, mos of hem focus on he sze effec of fnancal avalably whle neglec he srucure effec of fnancal developmen. One obvous fac s ha frms are heerogeneous, and hey reac o shocks and polces dfferenly. I s mporan o noce ha also durng he curren fnancal crss, a sgnfcan fracon of frms reallocae capal srucure and her sales reman unchanged or even expanded (repored by World Bank nancal Crss Survey, 200). Therefore, hs hess addresses he queson ha how heerogeneous frms behave dfferenly n erms of makng nvesmen decsons and choosng ypes of exernal fnance. Moreover, I exend he heerogeneous frms se-up no a dynamc sochasc general equlbrum model, embedded wh New Keynesan model feaures, o analyze he ransmsson of shocks and make mplcaons for polces. arcularly, n chaper 2, I sudy he mpac of fnancal developmen on foregn drec nvesmen wh mulple sources of exernal fnance. I s movaed drecly by he fac ha facng crunch of bank cred, no all he frms are lef helpless. Some less producve frms do suffer from less avalably of cred, ye a bunch of

17 - 3 - producve frms resor o alernave fnance, e.g., bond marke, o resore her nvesmen. s former charman of ederal Reserve Mr. Greenspan argues, he developmen of alernave fnancng channels helped o fll he fundng gap and sablze busness fnancng, alhough people wh dsagreemen pon ou ha he shorage of lqudy n one fnancal marke dres ou oher marke. The chaper 2 conrbues o he dscusson and nvesgaes frms choces among nernal fund, bank cred and bond marke cred n a very smple framework. rms are heerogeneous n producvy, hence he ably of generang prof from I. We fnd ha wh a cu of bank cred, producve frms swch o bond fnance o sablze he nvesmen. We call hs resul subsuon effec beween bank fnance and bond fnance, whch s emphaszed by Mr. Greenspan. However, he ncreased demand for bond fnance of hese producve frms bds up he bond rae, makng more expensve for ohers. s a consequence, less producve frms are forced o ex I marke. Ths s called complemenary effec beween bank and bond fnances n he sense ha a cu n bank cred s assocaed wh a hgher cos of bond cred. The rsng bond rae nduces he reallocaon of fnancal resources from less effcen frms owards more effcen ones and hus ncreases he aggregae ndusry producvy of he producng frms hrough a Melz-ype selecon effec. Connue wh hs work, I furher dscuss frms choces of dfferen sources of exernal fnance and he mpac of fnancal srucure on he performance of I n chaper 3. Ths research s movaed by wo observaons: frs, counres are dfferen n fnancal sysems. or example, as dscussed by ore and Uhlg (2005), Germany (or Japan) has a bank based fnancal sysem whle U.S (or U.K) has a marke-based sysem; and second, I flows from counres wh marke-based fnancal sysem are more volale relave o ha from counres wh bank-based sysem. s rsk s a man drvng force for volaly of nvesmen and a key deermnan for choosng capal srucure, I herefore explcly nvesgae he

18 - 4 - relaonshp beween fnancal srucure and he rsk of I. recsely, n chaper 3, I model frms choces of lenders when hey engage n I. They can choose ndrec fnance as borrowng from banks or drec fnance as ssung bond o bondholders. There are many dfferences beween drec fnance and ndrec fnance, as emphaszed by dfferen economss. or example, Russ and Valderrama (2009) argue ha he fxed cos of underwrng bond fnance s hgher han bank fnance whle he margnal cos s lower. Mos of ohers, agree on he characerscs of banks as cosly mddleman or delegaed monor compared o drec fnance (Holsrom and Trole, 997, ore and Uhlg, 2005, ec.). I ake Holsrom and Trole (997) s specfcaon n he model. arcularly, as I s rsky, frms wh lowes producves wll be unable o do I, and hose wh nermedae producves choose bank fnance whle hose mos producve frms use drec fnance. The paron of frms resuls from banks role as monor: on one hand, reduces he rsk (and he moral hazard problem) of I; on he oher hand, monor s cosly for frms. or less producve frms, fnance hrough banks s beer because hey are more fragle o rsk. However, hose mos producve frms wll fnd no aracve o hre an nermedary when fnancng he nvesmen. Based on frms choce of her lenders, he fnancal srucure of he economy s herefore calculaed as he rao of aggregaed bond fnance over aggregae bank fnance. We dscuss he relaonshps beween he fnancal srucure and rsk of I. Our model predcs ha, ceers parbus, f he rsk of desnaon counry s hgher, more frms use bank fnance relave o bond fnance. Moreover, n case of producvy growh, oher hngs equal, more frms wll use bond fnance and hey wll nves n rsker counres. The frs predcon exams he relaonshp beween fnancal srucure and expeced rsk of I; whle he second predcon exams he effec of producvy growh on boh fnancal srucure and rsk-akng of I.

19 - 5 - Boh predcons are suppored by our emprcal analyss. In parcular, we fnd ha hgher rao of bond fnance relave o bank fnance s assocaed wh hgher rsk of I per desnaon counry, whch s conssen wh Germany and U.S example. nally, I embed frm heerogeney and herefore her endogenous enry and ex no a SGE framework o analyze he ransmsson of shocks and dscuss moneary polcy n chaper 4. Ths work s srongly movaed by he facs ha enry s pro-cyclcal whle ex s couner-cyclcal, and hey are more volale han oupu (see fgure 4. and 4.2). Moreover, he enry and ex accoun sgnfcan share of oupu volaly, as suggesed by Broda and Wensen (200) ha n each un ncrease n oupu, 35% of whch comes from nroducon of new producs. Bernard, Reddng and Scho (200) also repor ha he value of newly nroduced producs accouns for 33.6% of oal oupu whle he value of desruced accouns for 30.4%. However, mos of he radonal SGE models assume consan number of producers, and he flucuaons of he economy n hese models smply reflec he reacons of producers nensve margn o shock,.e., producers reac by cung or ncreasng sales. These models do no capure he cyclcal behavor of enry and ex, and hey face a lo of well know challenges n predcng he mpulse responses of varables compared o wha daa suggess. or example, he couner-cyclcal behavor of markups wh pro-cyclcal behavor of prof ha are observed by daa can no be generaed by radon RBC models or New Keynesan models. Moreover, radonal RBC models depend heavly on he perssence of shocks o explan he observed perssence of oal facor producvy (T). In addon, n he second momen evaluaon, hese models generae oo smooh consumpon and labor and oo pro-cyclcaly of all he varables (oo hgh correlaon beween varables and oupu).

20 - 6 - By nroducng endogenous enry and ex n a New Keynesan framework, we are able o make subsanal mprovemens on he performance of he model n many aspecs. The aggregae oupu depends on number of producers, and we fnd a new mechansm of he ransmsson of shocks: hrough he dynamcs of frms. Moreover, n our model, he New Keynesan hllps curve has addonal radeoff for polcy makers such ha he number of producers has mpac on nflaon. Ths opens he door for opmal polcy analyss. We explcly dscuss he mplcaons of ou model n chaper 4..2 BRIE SURVEY O LITERTURE Snce Melz (2003) and Helpman e al. (2004), s wdely beleved and emprcally suppored (somehow) ha frm s producvy s a key deermnan for s nernaonalzaon. arcularly, Melz (2003) s he workhorse for analyzng nernaonal rade wh heerogeneous frms. Manova (2007) nroduces expor-orened bank cred and akes cred consran as anoher mporan deermnan for frms expor. Her research s followed by a growng emprcal analyss, such as Muuls (2008), Berman and Hercour (2008), ec. Buch e al. (2009) focus on he mpac of fnancal consran on I wh German frm level daa. Regardng he fnancal srucure, we focus on he srucure of prvae fnance and publc fnance,.e., he choces of lenders, alhough here s large body of leraure on frms choce beween equy and deb. Holsrom and Trole (997) model a moral hazard problem wh frms heerogeneous n nal wealh. They fnd a peckng order of he exernal fnance ha frms wh larges nal wealh can borrow from marke fnance whle hose wh nermedae nal wealh borrow from banks who monor he frms o reduce he moral hazard problem. ore and Uhlg (2005) dscuss he dfferences of fnancal sysem beween Europe and U.S,

21 - 7 - usng a model wh connuous level of shocks. nràs, e al. (2009) analyze he mpac of mperfec capal marke on I flows whch predcs ha he cos of fnancal conracng and weak nvesor proecon ncreases he relance on I flows. nally, regardng he SGE model wh endogenous enry and ex, Blbe, Ghron and Melz (2007a, 2007b) nroduced he endogenous enry bu assume a consan ex rae of frms. Ther models make some progress n brngng he dynamcs of frms no real busness cycle analyss and moneary polcy analyss. However, her models generae some couner-nuve mpulse responses, e.g., nflaon reacs posvely o an expansonary producvy shock. nd her models do no perform beer han radonal RBC models n erms of second momen. Neverheless, her models are mporan for undersandng he effec of endogenous enry, as a lo of auhors are emphaszng he mporance of frms dynamcs: Campbell (998), Jamovch and loeoo (2008) ec..3 MIN CONTRIBUTION Ths hess conrbues o he growng leraure on fnancal developmen and frms nernaonalzaon n respec o ha we are he frs o address he mpac of mulple sources of exernal fnance on frms I. We dscuss he selecon effec hrough fnancal marke such ha besdes he posve mpac of echnology spll over of mulnaonals on hos counres, I can brng producvy gans n sourcng counry hrough compeon n fnancal marke. Moreover, he hess s he earles research ha has close look a he rsk of I and lnks wh he fnancal srucure of he sourcng counres. We emphasze he mpac of he ype oher han avalably of exernal fnance on performance of I.

22 - 8 - Such an examnaon s mporan when we make polcy mplcaons on he developmen of ceran ype of fnancal sysem o faclae I. The sraegy of modelng frms heerogeney n connuous manner also brngs benef for addressng relaed quesons. Las bu no leas, hs hess proposes a SGE model wh endogenous enry and ex of frms. I s more close o he realy ha enry and ex exhb cyclcal behavors. Moreover, we subsanally mprove he performance of he model n erms of mpulse responses and second momen compared o radonal New Keynesan model as well as models wh only endogenous enry (Blbe, Ghron and Melz (2007a, 2007b)). nally, he model wh endogenous enry and ex fnds a new mechansm of ransmsson of shocks, whch opens he door for furher opmal polcy sudes.

23 - 9 - Chaper 2 Mulple Sources of nance, Margns of I, and ggregae Indusry roducvy

24 INTROUCTION n emergng body of leraure documens he mpac of fnancal developmen on faclang frm nernaonalzaon. Whle s funcon hrough provdng a larger scale of exernal fnance and relaxng frms fnancal consrans s wdely acceped, s no clear wheher he dversfcaon of fnancal channels and access o alernave fnance accompaned by fnancal developmen play a role. enon was drawn o he sgnfcance of mulple sources of fnancng by Charman lan Greenspan afer he san fnancal crss (Greenspan, 2000). He argued ha he developmen of alernave fnancng channels helped o fll he fundng gap and sablze busness fnancng, whch are especally mporan when eher banks or capal markes freeze up n a crss. ollowng hs argumen and movaed by he observaons of cred crunch and smulaneous drawdown n foregn drec nvesmen (henceforh I) n he recen fnancal crss, we address he queson of wheher he avalably of alernave fnancng sources could help reduce he sze of he collapse and nfluence welfare. Mulnaonal frms have beer access o mulple sources of fnance han her domescally orened peers. rsly, mulnaonal frms are usually large and producve ones (Helpman e al., 2004; Mayer and Oavano, 2007). Thus, hey have a beer chance of accessng marke fnance oher han bank borrowng (Canllo and Wrgh, 2000). Moreover, some frms can gan addonal fnancal suppor from busness parners or from he governmen n he form of rade cred or specal polcy loans. Secondly, mulnaonal frms have access o fnance from dfferen locaons. They can oban fnance from her paren counry, rase funds from her hos counry locally or n some cases explore lower-cos fnance on a worldwde bass (nras e al., 2009; Marn and Schnzer, 2006). Meanwhle, he nernal capal marke among he paren company and s foregn afflaes plays an mporan role

25 - - for mulnaonal frms. The allocaon of funds hrough he nernal capal marke exensvely subsues for exernal fnancng when he laer s cosly (esa e al., 2004). nally, frms end o keep a precauonary fund reserve o adap o poenal rsks and uncerany (Baes e al., 2009; Rddck and Whed, 2009), whch s parcularly he case for mulnaonal frms consderng he exra cos and hgher rsk n foregn operaons. Basng on a heerogeneous frm se-up, we model frms access o he nernal capal marke, bank fnance as well as bond fnance and nvesgae how frms adjusmen among mulple sources of fnance affecs her performance n foregn drec nvesmen and he aggregae ndusry producvy. We fnd ha gven exogenous conracon n he supply of bank fnance, frms wh dfferen producves reac dfferenly. Some less producve frms ex from he foregn marke due o less access o bank fnance and he unaffordable hgh cos of bond fnance as a resul of ougher compeon n he bond marke. In comparson, some relavely more producve frms can resor o bond fnance as compensaon for decreased bank fnance o susan her mulnaonal saus. The ncreased demand for bond fnance as a subsue for bank fnance by he survvng mulnaonals exacerbaes he compeon n he bond marke and bds up he bond reurn rae, whch rggers a Melz-ype selecon effec hrough he bond marke and brngs aggregae ndusry producvy gans. However, he dvesmen of hose falng I frms and hus her reduced bond fnancng demand mgae hs effec. The conrbuon of hs chaper s hreefold. rsly, complemens he quckly growng leraure on cred consran and frm nernaonalzaon by frsly proposng he mpac of alernave fnancng and dfferenang frm responses o he worsenng fnancal condon. Manova (2007) nroduces cred consran no Melz s (2003) research and argues ha cred consran resrcs frms

26 - 2 - parcpaon and performance n cross-border acvy. rnd e al. (2009), Berman and Hercour (2008), Buch e al. (2009), L and Yu (2009) and Muuls (2008) provde supporve evdence for hs argumen usng frm-level daa from dfferen counres. We reproduce hs resul ha bad cred condons mpede frms from engagng n I. urhermore, we show ha hs effec could be mgaed wh he exsence of alernave fnancng and could vary across frms wh dfferen producves. Compensaon from bond fnance and he reallocaon of he avalable funds sablze frm fnancng and faclae I. However, only he mos producve frms are able o ake advanage of mulple sources of fnance n smoohng foregn nvesmen. Secondly, hs chaper conrbues o he work on fnancal sysems by analyzng he complemenary and subsuon effecs of bank fnance and bond fnance. recsely, we fnd ha more producve frms use more alernave fnance as subsuon o reduce he rsk of cred shorage and rsk of nvesmen; hence he falure rae of frms I s endogenzed n our model. The less producve frms, on he conrary, beng unable o afford more expensve alernave fnance, wll choose o ex I marke facng cred crunch; hence we also observe complemenary effecs. In exsng leraure, aa e al. (999) and amond (99) documen he complemen of bank fnance o bond fnance by monorng. avs and Mayer (99) show ha he bank and bond markes can be alernaves o each oher bu hey are no perfec subsues. Sadenberg and Srahan (999) focus on he role of bank fnance n provdng a back-up source and lqudy nsurance for bond fnance agans marke shocks. The complemenary and subsuon effecs coexs n our model, whch vary across frms. lhough he subsuon of mulple sources of fnance could reduce he sensvy of I o adverse shocks, only a fracon of more producve frms benef from. The complemenary effec of bond fnance on bank fnance for hose less producve frms mples ha bond fnance canno fully

27 - 3 - subsue for bank fnance when he bankng secor faces a crss. In our model, s he hgher cos of bond fnance over bank fnance ha hnders less producve frms from employng alernave fnancng, hus leadng o he lmed subsuably beween he wo sources. Our resul suggess he mporance of reducng he cos of bond fnance and developng mul-layers of he fnancal sysem o sasfy he fnancng demand of varous frms, especally hose lower-qualy frms. Thrdly, we propose I-nduced aggregae producvy gans for he paren counry hrough he selecon effec n he capal marke. lhough he queson of wheher I benefs s hos counry n producvy hrough echnology spllover o local frms s wdely dscussed (ken and Harrson, 999; Bzer and Görg, 2005; Haskel e al., 2002; Javorck, 2004; Keller and Yeaple, 2003), he mpac of I on he paren counry s rarely consdered. Compared wh oelsberghel and Lchenberg (200), who presen evdence ha a counry gans from ouward I hrough echnology sourcng, we show ha I could brng aggregae producvy gans for he paren counry hrough he reallocaon of fnancal resources owards more producve frms. The ougher compeon n he bond marke nduced by he large I fnancng demand selecs he leas producve frms ou of producon and enhances he aggregae producvy. However, hs effec s dampened due o frms adjusmen among mulple sources of fnance. Ths chaper s organzed as follows: secon 2.2 sars wh he model n a closed economy as a benchmark case. fer ha, we nroduce mulple sources of fnance n an open economy seng, allowng frms o go abroad where he neracon of bank fnance and bond fnance and s mpac on he margns of I are nvesgaed. Secon 2.3 characerzes he general equlbrum and dscusses he aggregae oucome on ndusry producvy. Secon 2.4 concludes.

28 THE MOEL Consder a world wh wo counres. We call one counry he home (domesc) counry and he oher he hos (foregn) counry for I. There s a connuum of frms, ndexed by, producng dfferenaed varees n each counry. rm s born wh nal nernal fund N, whch s a random number from a common dsrbuon ( N ). fer payng an enry cos of f e (f e <N ), he frm draws producvy from a common dsrbuon g() (Melz, 2003). Wh he knowledge of s own producvy, he frm makes he nvesng decson among hree poenal opons: () purchasng corporae bonds B ; (2) nvesng n domesc producon,.e. producng and sellng a dsnc produc n he home counry, he oupu beng denoed by q ; (3) engagng n I,.e. producng and sellng n he hos counry, he oupu beng denoed by q. Noe ha he subscrp denoes varables for domesc producon whereas denoes hose for foregn producon; hese apply o he whole chaper. There s a perfec bond marke n he economy n whch frms can eher buy or ssue bonds, B beng posve or negave accordngly. Upon a draw of very low producvy, producng s no as profable as buyng bonds. The frm herefore nvess all s nernal funds n bond holdngs o acheve a safe reurn. Upon a draw of hgh producvy, on he conrary, he frm wll produce. If s nernal fund s no enough o pay he producon cos, he frm wll rase he workng capal by ssung corporae bonds hrough bond markes. There s no fxed cos for he frm o nves n he bond marke. In conras, f he frm engages n producon, regardless of wheher s domesc producon or I, mus pay a fxed overhead cos f o se up he facory. In addon, here s an exra

29 - 5 - fxed cos C for I. f and C are measured n labor uns CLOSE ECONOMY Ths subsecon provdes he closed economy case as a benchmark n whch frms only serve he domesc marke and oban exernal fnance merely by ssung corporae bonds emand The uly funcon of a represenave consumer s U q d where he se represens he mass of avalable varees and denoes he elascy of subsuon beween any wo varees. efnng he aggregae good QU wh he aggregae prce p d and solvng he expendure mnmzaon problem of he consumer, we have he demand funcon for every varey. q Q (2.) p roducon Each frm produces a dsnc varey and s oupu for he domesc marke s denoed as q. Labor s he only npu. efne he cos funcon for producng q as: l q f (2.2) where f0 s he fxed cos for producon, whch s he same for any sngle frm. s he frm-specfc producvy. The domesc nomnal wage s denoed as w. ssume ha labor mus be prepad.

30 Bond Marke ssume ha he bond marke s perfec n he sense ha s compeve and here s no nformaon asymmery, and he equlbrum bond rae s r. rms can nves her nernal funds n buyng a bond and acheve a reurn rae of +r. In comparson, frms for whch he domesc producon s confned by lmed nernal funds can also ssue bonds a he rae of +r. In he general equlbrum seng, he bond reurn rae r s deermned by he condon ha here s no aggregae ne demand for bonds. or a sngle frm, however, r s gven rms Opmal ecson In a closed economy, frm allocaes s own dsposable nernal fund afer enry cos s pad beween bond holdng B and domesc producon q (f produces) and maxmzes he oal prof from he nvesmen porfolo. rm solves max p, B p q w l rb s.. w l B N f ; (2.); (2.2) e where p s he produc prce n he home counry. We have: p w r (2.3) q w r Q (2.4) l w r Q f (2.5) Bond holdngs B can be calculaed from he budge consran. B N f e w w Q f r (2.6)

31 - 7 - roposon 2. (composon of prcng under lmed nernal funds): Boh he fnancng cos (bond rae r) and he labor cos (wage rae w over frm-specfc producvy ) compose he produc prce. Oher hngs beng equal, he hgher r, hgher w or lower, he hgher he produc prce and he lower he oupu. In our seng, he derved prce p consss of hree pars: labor cos w /, markup /() and an addonal par +r, where +r reflecs he exra exernal fnancng cos. If a frm does no have suffcen nernal funds for producon, ssues a bond wh a cos of +r o rase workng capal. Therefore, he lmed nernal fund se-up resuls n a hgher prce and lower oupu compared o radonal se-up (e.g., Melz 2003). To focus on he dscusson on producvy n hs chaper, we do no model frm heerogeney n erms of nernal fund N, hough he effec of N on frm fnancng and producon works hrough aggregaon. If all he frms have more nernal funds (N ncreases), hey wll ssue fewer (or hold more) bonds, hence he bond demand ncreases relave o he supply and he bond reurn rae r declnes. Oher hngs beng equal, he decreased fnancng cos resuls n a lower prce and he supply of each varey wll ncrease Cuoff roducvy for omesc roducon s n Melz (2003), a frm s prof from domesc producon depends on s producvy. The less producve he frm s, he less prof earns from producon. Therefore, only hose frms wh producves above a ceran hreshold wll produce because of he exsence of ousde opon. In our model, safe reurn rae from bond marke s he ousde opon, and frms compare he profs from producon and hose from nvesng all her nernal funds n purchasng bonds and choose o produce f and only f he former s greaer han he laer; herefore, he cuoff producvy for domesc producon s deermned by equaon (2.7) below:

32 - 8 - p q e w l rb r N f (2.7) Usng (2.3), (2.4), (2.5) and he bndng budge consran, we have w r Q f (2.8) roposon 2.2 (cuoff producvy for domesc producon): The cuoff producvy for domesc producon s hgher wh a hgher fxed producon cos f, hgher labor wage w or hgher fnancng cos r. f and w measure he real cos whle r measures he fnancal cos of producon. Inuvely, proposon 2.2 says ha hgher cos requres hgher producvy for frms o be able o produce. The shapes of he ncreasng relaonshps depend on elascy of subsuon ε. or example, when ε s less han 2, he cuoff producvy s convex n f, whle when ε s larger han 2, s concave n f. s for he mpac of he frm s nernal fund, only works hrough he bond marke n aggregaon. s we dscussed n proposon 2., frms bond holdng ncreases wh her nernal funds. More aggregae nernal funds could pull down he bond rae and resul n a lower cuoff producvy. However, n paral equlbrum, he bond rae s exogenous for a sngle frm. Therefore, he nernal fund s no drecly relaed o he frm-level cuoff producvy OEN ECONOMY In hs subsecon, we consder he case of an open economy n he sense ha frms are neresed n producng domescally as well as expandng producon o a foregn counry by means of I. Meanwhle, we nroduce gong-abroad-orened bank cred as alernave fnancng and reconsder he above frm s nvesmen porfolo decson. The cuoff producvy for a frm o become a mulnaonal s

33 - 9 - also derved. Moreover, he neracon of borrowng from a bank and ssung corporae bonds and he overall effec of mulple sources of fnance are dscussed emand or smplcy and whou loss of generaly, we assume he aggregae prce ndex and aggregae goods ndex n he hos counry are he same as hose n he home counry, and are denoed agan as and Q, respecvely. We mpose furher he assumpon ha when he economy shfs from auarky o openness, and Q wll no change. In oher words, he new varees comng n as he resul of openness wll no affec he aggregae ndces. The demand funcon for each varey n he hos counry s gven by: q Q p (2.9) roducon ssume frm s producvy splls over o s foregn afflae and produces n he foregn counry wh he same producvy as n he home counry bu has o shoulder an exra fxed cos C o carry ou I. Ths foregn expanson-nduced fxed cos ncludes he expenses for buldng up foregn afflaes and dsrbuon channels, collecng nformaon abou he foregn marke and foregn regulaons, ec. Regardless of he form of such a cos, s ndependen of he frm s oupu and mus be pad before he frm s revenue n he foregn marke s generaed. Ths cos C s assumed o be unceran for he frm a he momen when a frm arranges s nvesmen porfolo. The dsrbuon of C s common knowledge and he I decson s made based on frm s expecaon for C. C s revealed when he frm ses foo on he foregn land. I s successful (hence I prof s receved) only f C s fully covered. In an open economy, he domesc producon funcon s he same as equaon (2.2),

34 whereas he producon funcon for I s gven as: l q f C (2.0) where q and l are respecvely oupu and labor npu n he foregn counry. Here assume ha he exra fxed cos C follows a concave dsrbuon f(c ) wh suppor [0, ]. The f(c ) has he cumulave dsrbuon (C ) Gong-broad-Orened Loans and robably of I Success To cover C, he frm can oban fnance from banks. ssume ha a gong-abroadorened bank loan s avalable for all I frms. Such loans am o release frms fnancal consrans due o he subsanal upfron coss of I and are herefore assumed o be used only o shoulder C. Collaeral s requred by banks. rm pledges a fracon, (0,], of he overhead fxed cos f as collaeral o oban a bank loan of he amoun of f, where s he mulpler over he collaeral. Here we use μ o measure he avalably of exernal bank cred, whch s an ndcaor of counry-specfc fnancal developmen. The hgher μ mples beer access o bank cred and beer fnancal developmen of a counry. or smplcy, we furher assume ha borrowng from banks s cosless as bankers are compeve and have no access o he bond marke. Moreover, o guaranee he suffcency of funds o cover C and hus he success of I, frms may keep some reserve funds besdes he bank borrowng f o pay he exra fxed cos. could be a fracon of he nernal fund or fnanced from he bond marke. Therefore, before C s revealed, he frm has +f prepared. Hence, he probably of he I s success s rob(c +f)=(+f), whch s he endogenous decson of frms. s we shall see, for I frms, he more producve By hs assumpon, we rule ou he case ha frms use hs loan o pay for domesc producon so ha we can oban resuls n an open economy ha are comparable o hose n a closed economy and focus on he effec of he bank loan on frms fnancng sraegy and I decsons.

35 - 2 - he frm s, he larger s kep and he more lkely ha he I wll be successful. Our model hus s relaed o he observaon ha producve mulnaonal frms ssue corporae bonds o rase capal for I snce he profs from I are suffcenly large and hey have hgher ncenve o guaranee he success rms Opmal ecson rm maxmzes he expeced oal prof from bond holdng, domesc producon and I. p p,, B,max w l E[ ] p q w s.. e l p q w l f rb w l C B N f ; (2.); (2.2); (2.9); (2.0); Noe ha he prof from I s mulpled by he probably of s success. lso noe ha n he budge consran, C s covered by and f. enong he expeced value of C as C, we have: p w r (2.) p w r f (2.2) B e l C N f w l w (2.3) and s deermned by: p q w l f f r (2.4) Equaons (2.) (2.4) characerze he opmal choces of an I frm. We can compare he prces n he home counry and he hos counry by comparng (2.) and (2.2), nocng ha (+f). The prce for he domesc marke has he same expresson as ha n he closed economy benchmark (equaon (2.3) n secon ), whch means ha frms do no change her prcng sraegy for he home marke when hey sar foregn

36 busness. Neverheless, he acual nomnal value of he domesc prce may be dfferen. When he economy shfs from auarky o openness, frms of hgh producvy adjus her nvesmen porfolos: purchase fewer bonds (or ssue more bonds) and allocae funds o I. The adjusmen, as wll be dscussed n aggregaon n secon 2.3, nduces a ougher compeon n he bond marke and drves he bond reurn rae up. Hence, he acual prce n he home marke under an open economy seng wll be hgher han n a closed economy, alhough hey share he same mahemacal expresson. s he reserve fund s endogenously deermned by frms, he probably of successful I s also endogenzed. Hence we have a look a wha affec he choce of he reserve fund. n mplc soluon of s gven by equaon (2.4). The smulaon resuls are provded n ppendx 2. (where proposons 2.3 o 2.6 are also smulaed). We have he followng proposon: roposon 2.3 (reserve fund for I): Gven ha a frm manans I, s reserve fund for I s hgher wh hgher producvy, lower cred access, lower producon fxed cos f or lower bond fnancng cos r. The relaonshp beween and suggess a frm s subsuon n mulple sources of fnance. When bank cred s gher, a frm ncreases as he alernave source o cover C, so ha can manan I. Ths fndng supplemens he exsng leraure n whch frms are lef helpless bu ex producon when bank cred s gh (Buch e al., 2009; Manova, 2007). In our model, however, frms can resor o alernave fnance and keep producon unaffeced. Noe ha borrowng from a bank has no cos bu has a cos of (+r), because s rased eher from nernal funds or from he bond marke. If he bond reurn rae s

37 hgher, s more aracve o buy bonds raher han producng, hence he frm wll cu. s for he negave relaonshp beween fxed cos f and, works n wo ways. On one hand, f s a real cos of I. The hgher he cos s, he less ncenve here s for frms o underake I, and hence he smaller he reserve fund frms keep for I projecs. On he oher hand, f could be used as collaeral: frms can oban greaer bank loans agans a larger f, so hey could reduce he amoun of he reserve fund. n mporan fndng s ha more producve frms keep more reserve funds and hus have a hgher probably of success n producng abroad. s I s more profable wh hgher producvy, hose frms have ncenves o guaranee he I s success. Ths resul dffers from he prevous leraure, n whch he probably of success or he probably of frms defaul s assumed o be exogenous and ndependen of frm producvy (e.g. Buch e al., 2009; Manova, 2007). In L and Yu (2009), more producve frms have a hgher probably of success bu such a relaonshp s ex ane gven whou a mcro foundaon. In our model, however, he probably s frm-specfc and frms hemselves choose how much o nves o ncrease he probably of success. roposon 2.4 (nensve margn of I): The more producve a frm s (hgher ), he larger s s afflae sale. The sale s also larger f he wage cos w s lower or he bond fnancng cos r s lower. If a frm can manan I afer a cred crunch 2 (decrease n cred mulpler ), rases workng capal from ssung bonds and keeps s afflae sale unaffeced. The frs hree argumens on, w and r are nuve and easly verfed hrough 2 We wll dscuss he condon for frms o manan I n secon

38 equaon (2.2). Hgher producvy or a lower cos, eher he wage cos or he fnancal cos, resuls n more oupu and sales. However, he change n bank cred avalably rggers frms adjusmen o her fnancng sraegy and affecs afflae sales ndrecly. In paral equlbrum, when bank cred suddenly becomes gh, frms rase more funds from he bond marke o subsue for bank cred n order o keep her workng capal. In our model, when decreases such ha borrowngs from banks are less, and f a frm can manan I, wll ncrease (proposon 2.3) o keep he probably of he I s success. Therefore, accordng o equaon (2.2), as long as he bond reurn rae does no change n paral equlbrum, he afflae sale q wll no be affeced. Ths resul s conssen wh he evdence ha durng he recen fnancal crss, a non-neglgble fracon of frms reallocae more funds o fnance workng capal and her sales reman unchanged or even expand, especally n domesc-orened or non-radable secors (World Bank nancal Crss Survey 200; 200 Survey on Curren Condons and Inenon of Oubound Invesmen by Chnese Enerprses) Cuoff roducvy for I To see how producve should a frm be o be profable o do I, we calculae he cuoff producvy for I by equaon (2.5), he LHS of whch s he prof when he frm engages n domesc producon as well as I whle he RHS s he prof when he frm merely serves he domesc marke. The frm wll expand producon o he foregn counry f and only f s oal prof s hgher han ha from only servng he domesc marke. p q pq wl f rb pq wl rb w l (2.5) B comes from (2.3) and B comes from (2.6). Then we derve he expresson of cuoff producvy for I:

39 w r / C r Q r f / w (2.6) f where denoes (+f). roposon 2.5 (exensve margn of I): The cuoff producvy for I s lower when frms face beer access o cred (hgher cred mulpler ), lower bond fnancng cos r, lower producon fxed cos f or C, and lower labor wage w. The expeced prof of underakng I s larger wh a hgher. Wh he suppor of beer avalably of bank cred, more frms are able o go abroad. Meanwhle, he nduced hgher expeced profs make I more aracve o frms. Ths resul mples ha beer cred condons as a resul of he fnancal developmen n a counry play a posve role n faclang frm nernaonalzaon. On he conrary, varous coss, such as he labor wage, overhead cos and fnancal cos, mpede frms from gong abroad. Moreover, we have a look a he dfference beween he cuoff producvy for I and ha for domesc producon n order o nvesgae he queson wheher I frms are necessarly more producve han domesc frms. We have he followng proposon: roposon 2.6 (cuoff gap): The gap beween he cuoff producvy for I and he cuoff for domesc producon ( ) s lower facng lower bond rae r, larger cred mulpler and lower expeced fxed cos C. Comparng equaon (2.6) wh equaon (2.8), and knowng ha (+f), we mmedaely conclude ha. ue o he exsence of exra fxed coss, frms requre hgher producvy o aan posve profs from I. The wo cuoffs are

40 equal f and only f C 0. In hs case, he probably of a successful I s and frms wll no keep any as s no necessary and s cosly. roposon 2.6 saes ha a beer cred condon (hgher ) or lower bond fnancng cos (lower r) can reduce he producvy requremen for I and promoe domesc frms growh no mulnaonals. Noe ha when facng a lower bond reurn rae r, boh cuoffs decrease, whle ha for I declnes faser, ndcang he hgher sensvy of I o fnancng condons compared wh domesc producon Complemenary and Subsuon of Mulple Sources of nance I frms have access o wo exernal sources of fnance,.e. borrowng from banks and ssung corporae bonds. When facng a bank cred shock, frms adjus her fnancng sraegy and fund allocaon among nvesmen projecs bu frms wh dfferen producves reac dfferenly. Take a bad cred shock as an example. When bank cred suddenly becomes gh,.e. suddenly decreases, hen ncreases (proposon 2.5) and hence some relavely less producve I frms are forced o ex. s a resul of whdrawng capal from I, hese frms ssue fewer bonds. In hs case, deerorave bank cred resuls n shrnkng bond ssuance, whch we call he complemenary effec of bond ssung and bank borrowng. In conras, however, hose frms ha are producve enough o manan I under a worse cred condon ssue more bonds as a subsuon for reduced bank cred and keep he workng capal for foregn producon unchanged (proposon 2.3 and 2.4), whch we call he subsuon effec of bond ssung and bank borrowng. or he exsence of he possbly o ssue bonds as an alernave form of fnance, frms do no necessarly experence producon conracon when facng cred ghness, whch mples he sgnfcance of mulple sources of fnance n smoohng nvesmen.

41 gure 2. depcs nuvely he change n wh decreased (from o ) and he dfferenaon of frms n fnancng. s we menoned above, only hose frms wh producves ha are hgher han he cuoff producvy for I keep reserve fund. The more producve he frm s, he more rases (proposon 2.3). Therefore, s 0 for he frms wh producves lower han (), and jumps o posve a he cuoff value () and keeps ncreasng wh afer ha. < Complemenary: falng frms do no hold Subsuon: survvng frms hold more 0 () ( ) gure 2.: Complemenary effec and subsuon effec acng a bank cred shock ( decreases o ), he cuoff of carryng ou I ncreases from () o ( ). The frms wh producves n beween ex from I and hence do no reserve anymore, whle hose frms wh producvy hgher han ( ) manan I and rase more from ssung bonds. s he adjusmen of respondng o he aleraon of he bank cred condon s hrough bond fnance, gure 2. shows he complemenary and subsuon effec of bond fnance and bank fnance.

42 GGREGTION 2.3. CHRCTERIZTION O EQUILIBRIUM IN N OEN ECONOMY In an open economy, saonary general equlbrum s characerzed as follows: () here s an aggregae cuoff producvy for domesc producon, whch s deermned by equalzng he prof from purely holdng bonds and ha from producng domescally; (2) here s an aggregae cuoff producvy for I, whch s deermned by equalzng he oal prof from engagng n domesc producon as well as I wh ha from merely domesc producon; (3) a mass M of ncumben frms s paroned no hree groups n erms of producvy. rms wh producvy hgher han rms wh producvy lower han produce domescally as well as abroad. do no produce bu nves n purchasng bonds. rms wh producvy n beween produce and serve he domesc marke; (4) a frm s enry decson s made by equalzng he presen value of he expeced average prof flows of all ypes of frms and he sunk cos for enry f e ; (5) n each perod, a mass M e of new enrans replaces he mass of M of ncumben frms ha ex, where s he probably of beng h by he forced-ex shock; (6) produc markes clear such ha he consumers demand s me by he frms supply; (7) he labor marke clears o deermne he wage w (we assume he nelasc supply of labor L); (8) he bond marke clears n a sense ha here s no aggregae ne demand for bonds, where he bond rae r s deermned; (9) he resource consran s sasfed such ha he oal ncome equals he oal expendure. The dervaon of he general equlbrum s gven n ppendx THE COMLEMENTRY N SUBSTITUTION EECTS REVISITE

43 s we dscussed above, when an adverse shock on bank cred occurs, he complemenary effec mples ha frms dves from I and purchase more bonds, whereas he subsuon effec means ha frms ssue more bonds o fnance I. In general equlbrum, he complemenary effec and subsuon effec nfluence he equlbrum n he bond marke and hus he bond rae opposely. The overall oucome s a resul of he relave scale of he wo effecs, whch furher reles on he dsrbuon of frm producvy and he severy of shocks on bank cred. In a counry where he frm dsrbuon skews owards hgh producvy, facng he same conraconary bank cred shock, more frms wll susan I and he subsuon effec wll be domnan. s a resul, he bond rae wll ncrease, and vce versa. Moreover, when facng a more severe adverse shock, more frms ex from I and ransfer nernal fund o purchase bonds. On he oher hand, he survvors n I wll ssue more bonds o compensae for he reduced bank fnance. Consequenly, boh he complemenary effec and he subsuon effec are sronger and he overall effec s ambguous SELECTION EECT IN THE BON MRKET N GGREGTE INUSTRY ROUCTIVITY When an economy opens, hose producve frms ha go abroad wll ssue more bonds from he paren counry o fnance foregn producon. The ncreased demand n he bond marke wll bd up he bond reurn rae and hus ncrease he fnancng cos for all he producng frms, eher I or non-i frms. acng a hgher fnancng cos, he leas producve producng frms are forced o ex from producon and become bond holders. Thus, he aggregae producvy of producng frms ncreases. Therefore, ouward I rggers he selecon effec

44 hrough he bond marke and brngs aggregae ndusry producvy gans for he paren counry. s was prevously dscussed n Secon 2.3.2, a shock o he bank cred supply can also nfluence he bond reurn rae and hence furher he aggregae producvy gans. However, wheher he change n bank cred condons wll nensfy or weaken such gans reles on he relave mporance of he above complemenary effec and subsuon effec. s a response o an adverse shock o bank fnance, he rsng bond rae as a resul of he subsuon effec wll shuffle he deck and wash ou less producve frms. However, he exsence of he complemenary effec pulls down he bond rae and mgaes hs selecon. 2.4 CONCLUSION Ths chaper nroduces he nernal fund, bank fnance and bond fnance no a heerogeneous frm se-up and analyzes frms adjusmen among mulple sources of fnance and s mpac on he performance of I and he aggregae ndusry producvy. We show ha wh access o he bond marke as an alernave source of fnancng, frms sufferng from bank lendng ghness could sablze her fnancng and manan I. However, only he more producve frms benef from he subsuon of bond fnance for bank fnance. In comparson, he less effcen frms could no afford he hgher cos of bond fnance due o he ncreased compeon n he bond marke when economy opens, and hus ex from producon. Therefore, he rsng bond rae nduces he reallocaon of fnancal resources from less effcen frms owards more effcen ones and hus ncreases he aggregae ndusry producvy of he producng frms. Neverheless, he

45 - 3 - decreased fnancng demand of dvesng frms helps o pull down he bond rae and hus weakens he above effec. Our resuls sugges he mporance of he dversfcaon of fnancal channels and sgnfcance of he avalably of alernave fnancng n smoohng foregn drec nvesmen, whch s parcularly mporan for low-qualy frms. Moreover, he selecon hrough he bond marke mples he role of he capal marke n reshufflng frms, whch also proposes a mechansm of I-nduced welfare change for paren counres. To focus on he role of alernave fnancng n sablzng nvesmen, we dd no dscuss he dfference beween bank fnance and bond fnance n hs chaper. However, modelng her dfferences n resrucurng, monorng and screenng wll help us o undersand beer he lmed subsuably of he wo sources of fnance and mgh generae more fruful resuls. Moreover, modelng he fnancng sources of bank secors and nvesgang he co-movemen of he bank secor and he bond marke consue anoher drecon for fuure research. In addon, relaxng he perfec compeon assumpon for he bond marke and nroducng a frm-specfc bond rae are also neresng exensons. Ths s wha I do n he nex chaper of he hess.

46 ENIX 2.: NUMERICL SIMULTIONS O ROOSITIONS roposons 2. and 2.2 are sraghforward, so here we only provde he smulaon resuls for proposons 2.3, 2.4, 2.5 and 2.6. srbuon of he fxed cos for I: ssume C follows areo dsrbuon k x b x C x r (.2.) wh he suppor of [b,], where b and k are parameers of he dsrbuon. The probably densy funcon of C s herefore gven by k k k x b x k x kb x f (.2.2) enoe he mean of C as c, hen k kb C E c..2.. Smulaon of roposon 2.3 The opmal reserve fund for an I frm s gven by equaon (2.4): r f f l w q p By nserng equaons (2.9), (2.0), (2.2), (.2.) and (.2.2) no equaon (2.4) we oban equaon.2.3 for he smulaon. r f b f k c f w f b r Q f b r w k k k / / (.2.3) gures depc he change n wh, r, f and, respecvely. arameer values

47 gure.2..: r 0. 05, 0. 5, f 0, 2, w, 0, Q 0, 0.5, b k 3, c gure.2..2:. 4, 0. 5, f 0, 2, w, 0, Q 0, 0.5, b k 3, c gure.2..3: r 0. 05,. 4, 0. 5, 2, w, 0, Q 0, 0.5, b k 3, c gure.2..4: r 0. 05,. 4, f 0, 2, w, 0, Q 0, 0.5, b k 3, c g..2.. g g g Smulaon of roposon 2.4

48 We derve he soluon for q (.2.4) by nserng equaon (2.2) and he dsrbuon of C no equaon (2.9), where varable s deermned by equaon (.2.3). q w Q r b f k (.2.4) gures show he change n q wh r, w, and, respecvely. arameer values gure.2.2.:. 4, 0. 5, w, 2, f 0, 0, Q 0, 0.5, b k 3, c gure.2.2.2: r 0. 05,. 4, 0. 5, 2, f 0, 0, Q 0, 0.5, b k 3, c gure.2.2.3: r 0. 05,. 4, w, 2, f 0, 0, Q 0, 0.5, b k 3, c gure.2.2.4: r 0. 05, 0. 5, w, 2, f 0, 0, Q 0, 0.5, b k 3, c 4. 5.

49 g g g g Smulaon of roposon 2.5 Inserng k f b no equaon (2.6), we oban equaon (.2.5) for smulaon relang o. Varable n equaon (.2.5) s deermned by equaon (.2.3) n whch akes he value of. Hence he resul s he soluon o he smulaneous equaons (.2.3) and (.2.5). f r f b w r c f b f b r w Q f k k k (.2.5)

50 The oal prof of I frms s rb f l w q p l w q p (.2.6). Inserng he opmal soluons of frms prof maxmzaon problem gven by equaons (2.), (2.2), (2.9), (2.0), (2.), (2.2) and (2.3) no (.2.6) and rearrangng, we oban he fnal smulaon equaon for. f Q r w w r Q r w k k e f b Q f b r w c w f N r c f Q f b r w w r f b k k (.2.7) Varable n equaon (.2.7) s deermned by equaon (.2.3). gures show he change of wh, r, f and w, respecvely. gure depcs he ncreasng relaonshp of wh. arameer values gure.3.: r, 0 f, w, 2, 5 0., 0, 0 Q, 0.5, 3 k b, 5 4. c.

51 gure.3.2:. 4, f 0, w, 2, 0. 5, 0, Q 0, 0.5, b k 3, c gure.3.3: r 0. 05,. 4, w, 2, 0. 5, 0, Q 0, 0.5, b k 3, c gure.3.4: r 0. 05, f 0,. 4, 2, 0. 5, 0, Q 0, 0.5, b k 3, c gure.3.5: r 0. 05, f 0, 2, 0. 5, 0, Q 0, 0. 5, b k 3, c 4. 5, w w, f 0, N 500. e g g g g

52 Smulaon of roposon 2.6 g g g g The smulaon equaon for s derved by equaon (.2.5) mnus equaon (2.8). gures descrbe he change n he cuoff gap wh r,, and c, respecvely. Noe ha gven k, he relaonshp of and c s ndrecly represened by he change n wh b. arameer values gure.4.:. 4, f 0, 2, 0. 5, 0, Q 0, 0. 5, b k 3, c 4. 5, w w.

53 gure.4.2: r 0. 05, f 0, 2, 0. 5, 0, Q 0, 0. 5, b k 3, c 4. 5, w w. gure.4.3: r 0. 05,. 4, 2, 0. 5, 0, Q 0, 0. 5, k 3, w w.

54 ENIX 2.2: SKETCH O THE GENERL EQUILIBRIUM IN N OEN ECONOMY ollowng Melz (2003), we assume ha here s an unlmed number of prospecve frms wang o ener our model. Each frm was born wh an nal fund N. To ener, hey frs have o pay enry cos f e wh her nal fund o draw her own producves from a common dsrbuon g(). g() s areo dsrbuon wh cumulave densy funcon G() and he suppor of [b,] (Helpman e al., 2004). rms wh hgh producvy produce, among whch he hgher ones also engage n I, whle hose wh low producvy hold bonds only. ll he frms face a consan probably of forced ex n each perod. The forced ex frms can pay f e o draw new producvy agan. enoaons of endogenous varables: M number of ncumben frms; M e number of new enrans n each perod; average prof across all ypes of frms; cuoff producvy for domesc producon; prce ndex; Q aggregae goods; w wage; and r bond rae. cuoff producvy for I; The seady-sae equlbrum s characerzed by he followng equaons. Zero cuoff prof for domesc producon: w r Q f (.2.8) Zero cuoff prof for I:

55 - 4 - / / f r w r C r w Q f (.2.9) Expeced average prof: d u G d u G G f N r G e (.2.0) where rb wl q p, rb f wl q p wl q p ree enry condon: f e (.2.) rm enry equals frm ex: M e M (.2.2) Labor marke clearng condon: d u l G M G L d u l G M d u l G M (.2.3) where L s he exogenous oal supply of he economy, and labor demands for domesc producon and I are gven by: f Q r w l and c f Q f r w l Bond marke clearng condon: f e N MG 0 d u B G M d u B G M G (.2.4)

56 where B N f wl and B N f wl wl c e e rce ndex: M G G p u d M G p u d M G p u d (.2.5) Resource consran: N f M Q wl (.2.6) e e We hus have 9 equlbrum condons as well as 9 unknowns. In equaon (.2.8) (.2.6), u g f and u 0 f. G u G g G f and u 0 f. b G g k b and s an mplc funcon of, whch s deermned by equaon (2.4): p q w l f f r. k k

57 Chaper 3 nancal Srucure, roducvy, and Rsk of oregn rec Invesmen

58 INTROUCTION Rsk s an mporan elemen n he heory of capal srucure. rms have ncenves o reduce he coss assocaed wh varous rsks by adjusng her capal srucure (esa e al. 2008). Meanwhle, rsk s a key drvng force for he volaly of nvesmens and reurns, whch s parcularly he case for I comparng o domesc nvesmen. When comparng he I performances n counres wh dfferen fnancal sysems, we fnd ha ouward I flows from counres wh he marke-based fnancal sysem lke U.S. and U.K. are more volale han hose from counres wh bank-based fnancal sysem lke Germany and Japan (see gure 3.). Hence n hs chaper, we nvesgae he queson ha facng busness rsks n foregn drec nvesmen, how mulnaonal frms choose her sources of fnancng and wheher fnancal srucure nfluences he volaly of foregn drec nvesmen. nswerng hs queson wll llumnae he poenal lnk of fnancal sysem and volaly of I, and furher provde polcy mplcaons abou how o srucure he fnancal sysem o sablze I and asss frms nernaonalzaon Japan Uned Kngdom Uned Saes Germany gure 3. nancal Srucure and Volaly of Ouward I Noe: Ths graph shows he annual ouward I flow (devaons from rend) of Japan, Uned Kngdom, Uned Saes and Germany over Sandard devaon: Japan 8.7; Uned Kngdom 72.; Uned Saes 68.6; and Germany The daa s n bllons of US dollars a curren prces and curren exchange raes. aa source: UNCT.

59 In hs chaper, we develop a paral equlbrum model based on nformaon asymmery. The hdden nformaon s he producvy shock, whch happens when frms engage n I. frm eners he model wh a gven amoun of nal wealh as nernal fund and draws s producvy. fer knowng s own producvy, he frm makes wo decsons, one s on wheher nvesng abroad or no and he oher s on he mean of fnancng f does nves. There are wo ypes of exernal fnance: borrowng from bank or ssung corporae bonds from a group of bondholders. The producvy shock of I s ex ane unknown o all he pares (eher banks, bondholders or frms), and s only freely observable by he frm ex pos. However, banks are wllng o spend some resources o monor he rsk and convey he nformaon o he borrowng frms afer hey pay an nformaon acquson fee (ore and Uhlg 2005). The role of he banks as delegaed monors s also assumed by amond (984), Holsröm and Trole (997), ec. The underlnng movaon for banks o acvely parcpae n monorng nvesmen s her prvae relaonshp wh he lenders. Therefore, bankng fnance s usually he pror choce for less producve frms or frms wh hgh agency cos. The bondholders, n conras, have no ncenve o do so snce he rsk s shared by each ndvdual holder. Therefore, he cos of fnancng wh bond s lower due o he monor cos assocaed wh banks. However, bond fnancng faces addonal rsk n he sense ha under fnancal dsress, frms are compleely lqudzed and lef wh nohng. arcularly, f a frm borrows from a bank, can be old abou he nformaon of poenal rsk before makng producon decson. If he bank ells ha a good shock wll happen, he frm wll engage n I and ge posve prof; whle f a bad shock s comng such ha I s no profable, he frm has he opon o absan from I ral. Thus, when frms choose bank fnancng, hey pay an exra fee o proec

60 hemselves from he rsk of producvy shock. In conras, f he frm uses bond fnancng, saves he nformaon acquson fee bu expose self o he rsk. When facng a good shock, he frm ges posve ne prof from I absracng a fxed repaymen o bondholders. However, could happen ha he frm s no able o repay he bondholders when sufferng from a bad shock. In hs case, he frm defauls and ges nohng whereas he bondholders compleely seze all he generaed revenues of he frm. The frs resul ha our model delvers s frms paron n fnancng n erms of producvy. Those frms ryng o do I bu wh relavely low producves use bank fnance o reveal he nformaon on producvy shock ex ane o reduce he poenal rsks, and hs s smlar o purchasng nsurance. In comparson, hose frms wh hgh producves and hus able o counerwegh bad producvy shocks prefer o skp he cosly mddleman and ssue bond drecly. Secondly, he varance of producvy shocks (he ndcaor of rsks) also mpacs frms fnancng choces. rms nvesng n low-rsk hos counres prefer bond fnance snce n hs case he nsurance from banks s no worhwhle. By conras, frms who engage n I n more rsky locaons are more lkely o use bank fnance. Ths resul lnks he fnancal srucure of I sourcng counry wh he characerscs of s hos counres as well as he volaly of s I flows. Hgher rao of bond fnance relave o bank fnance s assocaed wh safer and less volale foregn nvesmen. Thrdly, he relave cos of bank fnance and bond fnance maers for frms fnancng decson. Inuvely, frms are nclned o use relavely cheaper fnance. Ths chaper conrbues o he rare research on he mpac of fnancal developmen

61 on I. Wha dsngushes us s he nvesgaon on he srucure effec of fnancal developmen. Besdes reproducng he resuls ha reducon of fnancng cos faclaes I as dscussed n exsng leraures, we se up a lnk beween fnancal srucure and I locaons as well as volales based on he fac ha foregn nvesmen faces sgnfcan rsks and frms have ncenve o reduce such rsks by choosng dfferen fnancng nsrumens. By dong so, we sugges a new drecon of polcy on reformng he srucure of fnancal sysems o promoe frms nernaonalzaon. I also conrbues o a huge body of capal srucure leraure n he followng wo aspecs: frs, we use producvy as a reference o segmen frms n he choce of fnancng. We argue ha producvy, besdes leverage, sze or cash flow focused n prevous leraures, could be a key ndcaor for frm s profably and defaul probably, and affec s fnancng choces. Second, we ncorporae produc marke no a fnancal srucure model. Insead of calculang reurn of nvesmen as n pror sudes, we derve frms prcng and he revenues generaed n produc marke such ha he mpac of fnancng on he nensve margn of I s dscussed. In addon, we nroduce he connuous sochasc saes o calculae he cuoff producves and derve he aggregaed resuls for he whole economy. The remander of hs chaper s organzed as follows. Secon 3.2 derves he model and frm-level predcons. Secon 3.3 derves he aggregaon resuls and dscusses he relaonshps beween fnancal srucure, producvy and I rsks. Secon 3.4 provdes some facs and evdences. Secon 3.5 concludes. 3.2 THE MOEL Consder a world wh wo counres, one home counry and one poenal hos

62 counry for I. We focus on he behavor of frms from home counry. connuum of frms s born wh nernal fund n, and hey are heerogeneous n erms of producvy. ollowng Melz (2003), we assume ha frm draws s dosyncrac producvy from a common dsrbuon G( ). fer he producvy s revealed, he frm decdes wheher o engage n I or no. If does no nves n foregn counry, he frm can nves all s funds n a safe asse o ge gross reurn of Rn where R s he exogenous safe reurn rae n he economy. Insead, f he frm decdes o carry ou I, faces a producvy shock 2, whch brngs uncerany for he I revenue. The propery of he shock wll be specfed n deals when we nroduce producon. ssume ha labor s he only npu n producon, whch mus be prepad. lso assume ha frms nernal funds are no enough o fully fnance he producon, hence hey need o borrow. There are wo ypes of exernal credors: one s banks and he oher s a group of bondholders. Boh of hem have access o he safe reurn R, bu hey dffer n he followng aspecs: s he delegaed monor of nvesors (amond, 984), banks are wllng o collec nformaon on nvesmen projecs of her borrowers. In our model, we assume ha banks spend resources o acqure nformaon abou he producvy shock 2. Then condonal on he nformaon obaned, banks offer frms he opon o ge loans and do I or absan from I and keep her nal wealh. However, he reduced uncerany comes a a cos, namely ha an nformaon acquson fee s pad by frms o banks, whch s assumed o be a share of he nernal fund: n. When we look a he daa laer n secon 3.4, parcularly when we examne he relaonshp beween fnancal srucure and average rsk of I per desnaon counry, we exend he model o mulple hos counres seng.

63 In comparson, he bondholders also offer he frms opons o oban funds, bu here s no ex ane nformaon acquson abou he rsk of I. Ths assumpon can be jusfed by he dea ha here mgh be free-rdng problems among bondholders snce he rsk s shared. s a consequence, bond fnance saves he nermedary cos bu s a more rsky choce because n a suaon of fnancal dsress (a very low 2 s realzed), frms wll be fully lqudzed by bondholders and compleely lose her nal wealh. Inuvely, frms ha have bad draws of nal producves earn no more prof n I wh eher ype of exernal fnance han he safe reurn, and hese frms mmedaely choose no I opon. rms wh nermedae producves go o banks and spend some nal wealh o buy secury as hey are more lkely o suffer from fnancal dsress even under he same rsk. Those mos producve frms would raher skp he cosly mddleman and ssue fnance from bondholders drecly. The srucure s summarzed n gure 3.2: No I: prof S =( R-)n 2- Gve up: prof =(R-)(-)n 2 rm, n, I wh 2-2 Bank nance I: prof 2 3 I wh 3- Bond nance 3-2 efaul: prof B2 =-n Repay: prof B2 gure 3.2 roducon and nancng Choces

64 emand The uly funcon of a represenave household n hos counry s: U q d where he se denoes he mass of avalable varees and denoes he elascy of subsuon beween any wo varees. efnng he aggregae good QU wh aggregae prce p d and solvng he expendure mnmzaon problem of he consumer, we have he demand funcon for every varey : q p Q (3.) roducon Each frm produces a dsnc varey n I, and labor s he only npu. The cos funcon s gven as: l q 2 f (3.2) where l s he labor npu, q oupu and f he fxed cos for producon (measured n uns of labor). The labor wage s normalzed o. 2 s he producvy shock comng from a dsrbuon ( 2 ). has a non-negave suppor and whou loss of generaly, we assume E[ 2 ]=. ollowng Bernanke, Gerler and Glchrs (999) s proof for he neror soluon, we also requre ha he hazard rae of ( 2 ) s non decreasng n 2 :

65 - 5 - where h 2 d 2 2 h We ake unform dsrbuon as an example. 2 C, C, C 2 2C The mean of ( 2 ) s and he varance s (/3)C 2. Ths varance, ndcaed by parameer C, s he measure of he poenal rsk of I No I The frm s unlucky o draw a very low producvy such ha I s no profable. In hs case, he frm chooses roue and deposs all s nernal fund o ge a safe reurn Rn. The prof of hs roue s S =(R-)n I wh Bank nance The frm has an nermedae producvy such ha could make more prof n I han ha from roue. I has an addonal rsk 2 due o, for example, unancpaed nsuon or polcy change or sysemac rsk n foregn economy. s we menoned above, when a frm goes o a bank, he bank s wllng o spend resources on monorng he producvy shocks. or smplcy, we assume ha bank monorng s so effcen such ha he uncerany n I could be compleely elmnaed 2. The bank hen conveys he nformaon abou 2 o he borrower, allowng he frm o decde wheher o connue wh I or absan from. However, he frm has o pay a fee for he monorng. Here we assume he nformaon acquson fee s a fxed share of s nernal fund. enoe he share for 2 Relaxng such assumpon does no change our resuls. Wha we are emphaszng s he role of banks monor compared o bond fnance.

66 he fee as so ha afer he paymen, he frm has dsposable fund (-)n lef. Banks have access o he safe reurn rae R and hey are perfecly compeve bsan from I If s old ha a bad shock wll happen,.e., 2 s below some hreshold value, he frm wll absan from I and nves s remanng nernal funds o ge he safe reurn. In hs case, he frm ends up wh he prof n roue 2-: R n (3.3) Engage n I If s old ha a good shock wll happen,.e., 2 s above a ceran hreshold value and I s profable, he frm wll engage n I and end up n roue 2-2. fer payng he nformaon acquson fee, he frm needs o borrow: X l n (3.4) s here s no uncerany for bank fnance anymore, he parcpaon consran of banks s gven by: M RX (3.5) where M denoes he amoun of repaymen. The prof of he frm n roue 2-2 s: p q l X M The frm maxmzes 2 subjeced o he demand (3.), echnology (3.2), borrowng (3.4) and repaymen (3.5), whch gves he opmal prce: p R (3.6) 2 The prce s composed wh markup and margnal cos where R s fnancng cos and labor wage s normalzed o. The opmal oupu, labor npu, borrowng and

67 repaymen can be calculaed wh hs prce Expeced rof of Roue 2 The expeced prof of roue 2 depends on boh payoffs n sub-roue 2- and 2-2 and he correspondng probably of endng up wh each roue. rms wh dfferen nal producves have he dfferen correspondng probables. recsely, frm choose sub-roue 2-2 nsead of 2- f and only f: 2 whch gves a hreshold value of he producvy shock 2 : 2 Q f R (3.7) The frm wll acually do I only f he realzaon of 2, old by he bank, s greaer han 2,. Noe ha 2 s nverse n, whch mples ha more producve frms are able o bear worse shocks and hus more lkely o engage n I. In our example dsrbuon of 2, we requre ha 2 [-C, +C]. ccordngly, we derve he range of from (3.7) and defne he lower and upper bound of as L and H respecvely. L f C Q R f C Q R H or a frm wh nal producvy < L, even he bes shock 2 =+C can no brng prof n I, hence he frm wll defnely end up wh roue 2-. On he conrary, f s nal producvy > H, hen even he wors shock 2 =-C can no sop he frm from dong I (end up wh roue 2-2). Only hose frms whose producves are beween L and H mgh end up wh eher roue 2- or 2-2.

68 Therefore he ex ane expeced prof of roue 2 s derved n he followng hree cases: E C C C C d d d H H L L f f f Subsung and 2 by prevous resuls, and usng he unform dsrbuon of, we have: E Rf n R Rf C C n R n R H H L L f f f (3.8) where R C QR C 2, 2 2 R Q f C Rf R C QR C C 2 3 are posve consans ha deermne he slope of he expeced prof as a funcon of nal producvy Cuoff roducvy of Roue 2 The frm wll choose roue 2 raher han roue f and only f he expeced prof of roue 2 s larger han ha of roue : S E (3.9)

69 When condon (3.9) s bndng, a unque cuoff producvy s deermned. rms wh nal producvy < wll no do I wh bank fnance consderng a hgh probably of falng besdes he nformaon acquson fee charged by banks. Therefore, we have he followng proposon: roposon 3.: he cuoff producvy for frms o do I wh bank fnance s ncreasng wh he bank cos and frm sze n. roof: see ppendx.3. s he share of frm s nal wealh ha s pad for monorng. hgher means a hgher cos for bank fnance, whch leads o a hgher hreshold for frms o access bank loans. Moreover, he cuoff s ncreasng wh frm sze n snce larger frms pay hgher nformaon fee n wh a gven. Therefore, bank fnance s less aracve for larger frms. Ths resul s conssen wh he one delvered by capal srucure leraure (Canllo& Wrgh, 2000). roposon 3.2: he cuoff producvy for frms o do I wh bank fnance s decreasng wh he uncerany n foregn nvesmen C. roof: see ppendx.3.. When a frm goes o a bank, pays a fee o elmnae he uncerany n fuure nvesmen, whch s smlar o purchasng nsurance wh a fxed paymen. If he nvesmen s no rsky (lower C and lower varance of 2 ), s no worh for he fxed fees. Hence gong o banks s a less aracve choce; on he oher hand, f he nvesmen s rsky, (hgher C and hgher varance of 2 ), s more worhwhle o pay a fxed fee o reduce he rsk n foregn producon.

70 I wh Bond nance large number of bondholders provde drec fnance for frms. They have no ncenve o monor he rsk of I as a resul of free rdng problem. Therefore, f frms borrow from bondholders, hey save he nermedaon cos bu keep unknown ex ane abou he poenal shocks. When a frm draws a hgh producvy such ha feels confden o overcome possble bad shocks, would raher borrow from bondholders drecly. rms are assumed o be rsk-neural and he opmal lendng conrac s smlar o deb conrac where frms ake all he rsk. The frm and bondholders negoae he amoun of lendng and correspondng repaymen. The producvy shock s realzed afer conducng producon and s only observable by he frm. If he prof afer repaymen o bondholders s non-negave, he frm repays he borrowng and collecs he remaned prof. Oherwse, he frm defauls and s revenue from I s compleely lqudzed and aken by bondholders. Smlar o banks, bondholders also have access o he safe reurn rae R and hey are perfecly compeve Opmal Conrac wh Bond nance s labor mus be prepad, he frm wh decdes how much labor l o hre for I ex ane. ccordng o he cos funcon (3.2), wh npu l, he acual oupu of I wll be: q ~ l f (3.0) 2 nd he frm s expecaon of oupu (ex ane arge oupu) s: Thus, we have q l f E q ~ (3.)

71 ~ (3.2) q 2q and he acual prce (ex pos realzed prce) s gven by he nverse demand funcon (3.): where p denoes he ex ane arge prce. ~ Q ~ p2 q p (3.3) To fnance I, he frm needs o borrow X B l n (3.4) enoe he repaymen as M B, whch s negoaed by he frm and bondholders. Then he acual prof of he frm afer repaymen o bondholders s gven by: ~ p q~ l X M (3.5) B B B The frm wll repay M B f and only f B 0. The opmal lendng conrac specfes borrowng X B and repaymen M B and he payoffs are dsrbued accordng o he followng plan: If B 0, he frm ges B and bondholders ge M B. If B <0, he frm defauls and ge 0 whle bondholders ge lqudzed value of I oal revenue. Noe ha B = 0 deermnes a hreshold level of shock 2 B shown n expresson (3.6) such ha f he frm encouners a shock 2 < 2 B, wll defaul. B 2 M p B n q (3.6)

72 The hreshold level of shock B 2 depends on he repaymen, frm nal wealh as well as arge prce and oupu, whch are furher posvely deermned by he frm s nal producvy. Hence B 2 s decreasng wh, mplyng ha he more producve frms are less lkely o defaul. Smlarly, we requre B 2 [-C, +C], whch gves some parons on. nalogous o he case n bank fnance, f B 2 >+C,.e., s below some ceran level B L, hs frm wll defaul even f has he bes producvy shock when he frm borrows from bondholders; on he oher hand, f B 2 <-C,.e., s above some level B H, hs frm wll never defaul even f encouners he wors shock. Only hose frms whose producves are beween B L and B H have boh possbles. If 2 B [-C, +C], he expeced prof of I wh bond fnance s: C ~ p q~ n M B B Bd 2 E (3.7) 2 The parcpaon consran of bondholders s gven by: C M B B 2 d ~ p q~ 2 nd 2 RX B (3.8) B 2 C Maxmzng (3.7) subjec o (3.8) gves he ex ane arge prce of I p R (3.9) and he opmal amoun of lendng: X B Q R f n (3.20) where C C 2C 2

73 Compared o (3.6), he opmal prce ncludes an exra cos / nduced by poenal rsk. Noe ha s decreasng n C, meanng ha a hgher poenal rsk resuls n a hgher prce. Meanwhle, he opmal repaymen s gven by: M B p q 2 C 2C2 Rl R n 3 p q n (3.2) Hence he repaymen rae on bond fnance s: R M / X (3.22) B B B roposon 3.3: he repaymen rae on bond fnance R B s decreasng n producvy, and ncreasng n I rsk C. roof: see ppendx.3.. Comparng o he consan cos of bank fnance (fxed monor cos as well as fxed margnal cos), he cos of bond fnance s frm-specfc, whch s ncreasng wh frm s defaul probably and hus decreasng wh frms own producvy (See gure 3.3). When I s more rsky (hgher C), he frm has a hgher defaul probably, herefore bondholders charge a hgher bond rae. On he oher hand, f he frm has a hgher producvy, s less lkely o defaul facng he same rsk, hus s repaymen rae s lower.

74 Cos Cos of Bank nance Cos of Bond nance gure 3.3 nancng Cos and rm s roducvy Expeced rof of Bond nance The expeced prof n roue 3 s gven by equaon (3.7) f [B L, B H ]. Moreover, f <B L, regardless of how hgh 2 s, he frm wll defaul. If >B H, he frm wll never defaul and bondholders charge he repaymen rae R B =R. The resul s summarzed by equaon (3.23): n E B R n Rf B R n Rf B 2 f f f B L B L B B H H (3.23) where B B 2 QR R are posve consans ha deermne he slope of he expeced prof of bond fnance The Choce beween Bank nance and Bond nance Based on he resuls derved above, we summarze he relaonshps beween

75 - 6 - expeced profs and frm s nal producvy n roue (green dashed lne), 2 (red curve) and 3 (black curve) n gure 3.4. E[] E[ B ] E[ ] (R-)n (R-)(-)n S -n L B L B gure 3.4 Comparsons of Expeced rofs Three hngs are worh menonng n hs fgure. rs, f producvy s suffcenly low (lower han ), he prof of I ral wh eher bank fnance or bond fnance s lower han safe reurn S due o he monor cos and exsence of rsk respecvely. When <B L, frms usng bond fnance wll lose all her nal wealh n because of he lqudaon under defaul. These can be seen from he equaons (3.8) and (3.23). Second, when producvy s above ceran value ( L and B L for bank fnance and bond fnance respecvely), he expeced profs wh boh bank fnance and bond fnance are ncreasng wh producvy and ha wh bond fnance E[ B ] ncreases faser. Ths s because he cos of bank fnance s consan whle he cos of bond fnance s decreasng wh producvy, as fgure 3.3 shows. Noe ha B L needs no o be hgher han L. or example, B L < L when C=0,.e., here s no rsk assocaed wh I. In hs case, no frm uses bank fnance. We rule ou hs unneresng case by assumng a ceran level of rsk.

76 Thrd, frms make her decsons on producon and fnancng choce by comparng he expeced profs of each roue. nally, frms are segmened no hree ypes by he wo cuoff producves and B. Those frms whose nal producves are below wll no engage n I bu ge safe reurn as n roue. Those whose producves are beween and B borrow from banks and do I rals snce he expeced prof s hgher han safe reurn (red curve s above he green dashed lne). nd hose whose producves are hgher han B borrow from bondholders and engage n I as now he black curve s above he red curve. 3.3 GGREGTION fer specfyng frm-level decsons, we now aggregae over ndvdual frms o form counry-wde predcons and ake hem o he daa n nex secon nancal Srucure of I Sourcng Counry In he economy, a connuum of frms (he oal number s normalzed o ) draws producvy from a common dsrbuon G( ). enoe he number of frms who do no engage n I, borrow from banks and borrow from bondholders on he aggregae level as N S, N and N B respecvely. Then we have N S B S N N N, N G, B G G, N G B (3.24) B We defne he fnancal srucure of he economy as he rao of oal bond fnance over oal bank fnance: BON BNK T nsr (3.25) T

77 To calculae he fnancal srucure, we negrae frms borrowngs from banks and from bondholders respecvely based on her producves. rs we derve he oal amoun of bank fnance. Noe ha no all he frms whose producves are beween and B borrow from banks. Some of hem, upon wh a bad luck of producvy shock, absan from I and do no borrow (roue 2-). Only hose frms wh producvy shock 2 > 2 wll borrow X. s X s gven by (3.4), whch furher depends on he realzaon of producvy shock 2, we have he ex pos amoun of borrowng (subsung he labor demand by he opmal prce (3.6) and he correspondng demand (3.)): X R 2 f n Hence he ex ane condonal expeced amoun of borrowng from banks by frm wh producvy s gven by: E X C d R f n By negraon on, he oal amoun borrowed from banks (expeced value) s 2 gven by: BNK T dg B N E[ X ][ (3.26) 2 ] where 2 s gven by (3.7), and -( 2 ) s he probably of borrowng. Smlarly, he oal amoun borrowed from bondholders s where X B s gven by (3.20). BON B T N X BdG B (3.27) s we can see from (3.26) and (3.27), he aggregae fnancal srucure depends on he wo cuoff producves and B as well as he dsrbuon of G( ), whch s nuvely depced n gure 3.5. Gven dsrbuon of nal producvy G( ), he aggregae fnancal srucure s deermned by he relave poson of he wo

78 cuoffs, snce he negraon s smply he area beween he dsrbuon and he horzonal axs. roducvy srbuon G( ) No I Bank nance, I B Bond nance, I gure 3.5: Segmenaon of rms n roducon and nancng nancal Srucure and Rsk of I ccordng o he above argumen, he aggregae fnancal srucure depends on he cuoff producves for bank fnance and bond fnance. Therefore, we derve he relaonshp beween I rsk and fnancal srucure by examnng he mpac of rsks on wo cuoff producves. Noe ha s calculaed by equalzng E[ ] and S whle B s derved by equalzng E[ ] and E[ B ] (see gure 3.4). We have he followng lemma: Lemma 3.: f C, n he expresson for he expeced prof from bank fnance (3.8), s ncreasng n C, 2 s decreasng n C and 3 s ncreasng n C. In he expresson for he expeced prof from bond fnance (3.23), B and B 2 are decreasng n C. roof: see ppendx.3.. Lemma says ha wh a hgher rsk of I (hgher C), he slope of E[ ] as a funcon of nal producvy s seeper whle he slope of E[ B ] s flaer (see respecvely he expressons (3.8) and (3.23)). Therefore wh a hgher rsk, gure 3.4

79 changes o gure 3.6. E[] E[ B ] E[ B ] E[ ] (R-)n (R-)(-)n B B S -n gure 3.6 The Effecs of an Increase n I Rsk When he rsk s hgher, bank fnance becomes more aracve snce bank monorng largely reduces he uncerany and he expeced prof of bank fnance s herefore hgher, resulng n a lower cuoff. On he conrary, bond fnance s more expensve as bondholders charge hgher rsk premums. In comparson o bank fnance, an ncrease n rsk resuls n a much hgher cuoff B. Ths resul s drven by he slopes change of expeced profs of boh ypes of fnancng and s ndependen of he nal posons of he wo curves. We herefore make he followng proposon: roposon 3.4: oher hngs equal, he hgher rsk of I, he lower fnancal srucure of he economy. roof: by gure 3.6 and Lemma.

80 nancal Srucure and roducvy s Helpman e al. (2004), we assume frms producves n an economy follow areo dsrbuon. Comparng he dsrbuon of G( ) and G( ) n gure 3.7, we see ha he average producvy of G( ) s hgher han G( ). Meanwhle, fxng he wo cuoffs and B, more frms use bond fnance n he economy wh G( ). Hence we expec a hgher fnancal srucure under G( ) han G( ). G( ) G( ) No I Bank nance B Bond nance gure 3.7 roducvy srbuon and nancal Srucure roposon 3.5: oher hngs equal, he hgher producvy of he home economy, he more bond fnance relave o bank fnance s used. Wh proposon 3.5, we exend our dscusson o mulple desnaon counres case. ssumng counry-specfc rsk C, s easly o conclude a peckng order of I desnaons, ha s, frms sar I n counres wh lower rsks and hen go furher o counres wh hgher rsks. The more producve he frm s, he more desnaons can nves and hence he average rsk per desnaon s ncreasng. On aggregae level, wh he ncrease of producvy, a counry nvess n more desnaons, whch brng hgher rsks. We hus observe a posve relaonshp beween he fnancal srucure (bond fnance over bank fnance) and he rsk of I. Imporanly, he rsk of I n curren dscusson s he average rsk per desnaon raher han he rsk of one parcular desnaon. Hence hs resul does no

81 conradc proposon 3.4. Ineresngly, boh proposon 3.4 and 3.5 are suppored by our emprcal analyss, wh rsk measured respecvely by per-porfolo and per-desnaon counry. 3.4 CTS N EVIENCE 3.4. aa In he secon, we examne he relaonshp of fnancal srucure wh producvy, ouward I performance a aggregae counry level usng he panel daa ncludng 24 counres (usrala, usra, Belgum, Canada, Czech Republc, enmark, nland, rance, Germany, Greece, Hungary, Iceland, Ireland, Ialy, Japan, Korea Republc, Neherlands, Norway, orugal, Span, Sweden, Swzerland, Uned Kngdom, Uned Saes) over perod. The share of ouward I flow of he 24 counres n he oal world amouns o 80% n ll he relevan varables are summarzed n Table 3.. Table 3. Summary Sascs Varables Label Obs. Mean Sd. ev. Mn Max S I nancal Srucure rod roducvy gg.rsk ggregae Rsk of I orfolo I Vol. I Volaly Nr.of es. Number of Toal esnaons ve_rsk_per_es. verage Rsk per esnaon Noe: nancal srucure s measured as he rao of bond fnance over bank fnance.

82 roducvy s measured by G per hour. ggregae rsk s he grade for desnaon counry rsk weghed by s share n a sourcng counry s oal ouward I flow. I volaly s he absolue value of devaon from rend (H-lered). Number of desnaons s couned by auhors. verage rsk per desnaon s he sum-up rsk of all desnaon counres dvded by he number of desnaons. Rsk daa s from Euromoney Counry Rsk aase. We ake he reverse of he orgnal daa, herefore, n hs chaper, hgher value ndcaes hgher rsk. Orgnal daa for calculang fnancal srucure s from Beck (200). The daa of I flows s from UNCT daase. ll oher daa are from OEC aase. or he calculaon of fnancal srucure and aggregae rsk see he appendx roducvy and Locaon eckng Order of I Evdence : Counres end o nves n more desnaons over me and he average rsk per desnaon of ouward I ncreases. 3 gure 3.8 The Evoluon of Number of esnaons and roducvy. aa source: OEC. 3 lernavely, we ake he dsance beween I sourcng counry and s desnaon counry no accoun and calculae he average rsk per dsance, and we fnd smlar paern, namely, wh he ncrease of he oal dsance of all desnaons, he average rsk per dsance ncrease as well.

83 Wh he producvy growng over me, counres nves n more foregn desnaons. s depcng n gure 3.8, producvy and number of I desnaons of a counry are ncreasng smulaneously. They are sgnfcanly posvely correlaed excep for usra, Canada, Czech Republc, Norway, and Span. The correlaon coeffcen s hgher han 0.9 for Belgum, nland, rance, Greece, Ireland, Ialy, Korea, and Sweden. The average correlaon of he 24 counres s 0.6. Wh nvesng n more desnaon counres, he average rsk per desnaon s ncreasng (see gure 3.9), whch mples a peckng order of counres n choosng I desnaons from low rsk counres o hgh rsk counres. gure 3.9 The Rsng verage Rsk per esnaon of I

84 ggregae Rsk and nancal Srucure of I rom he orgnal counry-par I daa, we fnd ha he amoun of nvesmen vares across desnaons ha have dfferen level of rsks. I sourcng counry adjuss s nvesmen n each desnaon o reduce he aggregae rsk of he porfolo. We herefore defne he aggregae rsk of I as he weghed rsk of all he desnaons by he share of ouward I flow o each desnaon n he oal amoun ouward I flow. When lnkng o he fnancal srucure of he sourcng counry, we have he followng observaon: Evdence 2: The hgher I aggregae rsk, he less bond fnance relave o bank fnance s exploed. s our model predcs, facng hgher rsk n foregn nvesmen, bank fnance s more preferred. In realy, he sourcng counry dvess from more rsky counry and nvess more n safer locaons. In aggregaon across all he desnaons, he negave relaonshp beween aggregae rsk and fnancal srucure rao holds (see fgure 3.0). gure 3.0 nancal Srucure and ggregae Rsk of I orfolo Noe: Ths graph shows he relaonshp beween a counry s fnancal srucure for I and

85 - 7 - s aggregae rsk of I locaon porfolo. The aggregae rsk s he grade for desnaon counry rsk weghed by s share n a sourcng counry s oal ouward I flow. I s he pooled daa for 24 I sourcng counres over Number of observaon = 377. corr.= -0.29, coeff. = nancal Srucure and roducvy The mpac of producvy on fnancal srucure works n wo ways. When he producvy dsrbuon skews owards hgher producvy, more frms wll use bond fnance, leadng o a hgher rao of bond fnance over bank fnance. Neverheless, as evdence shows, more frms wll ap more rsky counres and n ha case bank fnance s more preferred by some frms o reduce uncerany. The daa shows a posve relaon beween producvy and fnancal srucure of I, meanng he frs effec domnaes he second one. gure 3. nancal Srucure and roducvy Noe: Ths graph shows he relaonshp beween a counry s fnancal srucure for I and s producvy. nancal srucure s measured as he rao of bond fnance over bank fnance. The x-axs gves he G per hour as a counry-level measuremen of producvy. I s he pooled daa for 24 counres over Number of observaon = 388, coeff. =