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The Allocation and Monitoring Role of Capital Markets: Theory and International Evidence

Author(s): Solomon Tadesse


Source: The Journal of Financial and Quantitative Analysis, Vol. 39, No. 4 (Dec., 2004), pp. 701
-730
Published by: University of Washington School of Business Administration
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ANALYSIS
ANDQUANTITATIVE
OF FINANCIAL
JOURNAL 2004
VOL.39, NO.4, DECEMBER
COPYRIGHT2004, SCHOOL OF BUSINESS ADMINISTRATION,UNIVERSITYOF WASHINGTON,SEATTLE,WA 98195

Roleof Capital
The Allocationand Monitoring
Evidence
Markets:Theoryand International
SolomonTadesse*

Abstract
Capitalmarkets of good
performtwodistinctfunctions:provisionof capitalandfacilitation
governancethroughinformation production andmonitoring.I arguethatthe governance
functionhas moreimpacton the efficiencywithwhichresourcesareutilizedwithinthe
firm.Basedon industry-leveldataacross38 countries,I presentevidencesuggestinga pos-
itiverelationbetweenmarket-based governanceandimprovements in industryefficiency.
Themeasuresof governance arealsopositivelycorrelatedwithproductivityimprovements
andgrowthin realoutput.Furthermore, whilegovernanceaffectsefficiency,the capital
provisionservicesinducetechnological change.Theevidenceunderscores theroleof cap-
italmarketsas a conduitof sociallyvaluablegovernanceservicesas distinctfromcapital
provision.

I. Introduction
Why do we observe differencesin economic performanceamong countries,
across industriesin the same economy, and across firms belonging to the same
industry?Whatis the role of the financialsystem in explainingcross-countryand
cross-industryvariationsin economic performance?While determinantsof cross-
countryeconomic growthhave been of greatinterestto developmenteconomists
and growth economic theory, the role of financial marketsand institutionshas
traditionallyreceivedvery little attention.Recent financeliteraturereportsstrong
relationsbetween indicatorsof financialdevelopmentandeconomic performance
in the real sector, indicating a positive role for capital marketsand institutions
(see, e.g., Levine (1998), Levine and Zervos (1998); and Rajan and Zingales
(1998)). Levine and Zervos (1998), for example, find a strong correlationbe-
tween financialdevelopmentand growthin per capitaGDP andproductivity.Yet,
*tadesse@sc.edu,Moore School of Business, Universityof South Carolina,Columbia,SC 29208.
I thankSteve Byers, JoshuaCoval, StijnClaessens, PaulMalatesta(the editor),MarcNerlove, Gordon
Phillips, RaghuramRajan, Lemma Senbet, Jeremy Stein, Alex Triantis,Haluk Unal, and an anony-
mous referee for comments and helpful suggestions. I thank seminar participantsat the 1998 Fi-
nancial ManagementAssociation meeting, the 1999 WesternFinance Association meeting, the 1999
AustralasianFinance and Banking Conference,the 2000 AmericanFinance Association meeting, the
2000 NationalTaiwanUniversityInternationalFinanceConference,the InternationalMonetaryFund,
Penn State University,and the University of South Carolina. I gratefully acknowledge financial sup-
port from the Center for InternationalBusiness Education and Research at the University of South
Carolina.
701
702 Journalof Financialand QuantitativeAnalysis

despite such progressin exploringthe finance-growthnexus, we are far from un-


derstandingthe exact mechanismsthroughwhichthe financialsystemcould affect
economic performancein the real sector. As Zingales (2003) notes, this lack of
understandinghas been one of the reasons why it has been so difficult to draw
policy conclusionsfromthe finance-growthliterature.Identifyingthe channelsof
influenceis also importantfor instilling confidencein the documentedfirst-order
relationsbetween financeand growthby strengtheningthe argumentfor causality
runningfrom the financialto the real sector.
This study utilizes a corporatefinanceframeworkto investigateempirically
the finance-growthlink by examiningpossible channelsthroughwhich financial
marketfunctions could influence economic performanceat the industrylevel. I
begin from the premise that financialmarketsand institutionsplay two critical
roles in an economy: allocation of risk capital throughsaving mobilizationand
risk pooling and sharing;and promotionof responsiblegovernanceand control
throughprovidingoutsideinvestorsa varietyof mechanismsfor monitoringinside
decision makers.In its allocationfunction,the financialsystem helps transferre-
sourcesfromindividualsaversto agentswho have managerialandentrepreneurial
talents with investmentopportunities,and providesfirms and investorswith risk
pooling and sharingfacilities. As its governancefunction, the financialsystem
provides monitoringand informationproductionservices that help mitigate the
variousagency problemsof the firm,resultingin betterprojectevaluationand se-
lection, even in the absenceof externalfinancialneed. While recognizingthe twin
roles of the financial system, modern corporatefinance theory emphasizes the
monitoringand informationproductionfunction;in contrast,the recent finance-
growth literaturefocuses on the capital mobilizationrole. Bridging the gap, I
arguethatthe two functionssystematicallyaffect differentsources of growth.
I postulate that economic performancein the real sector, for example, as
measuredby growthin output,y, is partlya function of the effectiveness of the
supportingfinancialsystem in deliveringgovernance,G, andcapitalallocation,A
functions,

(1) (1)y=g(A,G).
Part of the growth in output, y, is attributableto a mere change in the use of
constituentfactorsof production.The remainingis considereda resultof growth
in total factorproductivity,TFP, and generallyaccountsfor all changes in output
not accountedby growthin productioninputs. Denoting I to be growthin inputs.

(2) (2)y=I+TFP.

The recent literatureon the nexus between finance and growthexplores the role
of financial developmentin explaining variationsin output growth, y, and its
components I and TFP (see Levine (1997), (2003) for a review of this liter-
ature). Country-levelstudies of Levine (1998) and Levine and Zervos (1998),
industry-levelstudies of Rajanand Zingales (1998), and firm-level studies such
as Demirguc-Kuntand Maksimovic(1998) confirma strongpositive relationbe-
tween overallfinancialdevelopmentandy. Levine andZervos(1998) furtherdoc-
umentthatfinancialdevelopmentis stronglycorrelatedwith productivitygrowth,
Tadesse 703

TFP, establishingthe potentialrole of the financialsystem in explainingreal per-


formance.My papercomplementsand contributesto this literatureby identifying
specific channelsthroughwhich the financialsystem could affect economic per-
formancevia its twin functionsof governanceand allocation.First,I breakdown
TFP into two sources: efficiency improvementsand technologicalchange, TC. I
then extendthe extantempiricalevidence by showing how the A and G functions
of the financialsystem affect these primalsourcesof productivity.Finally,instead
of focusing on overallfinancialdevelopmentand its relationto growth,I focus on
how effectively financialsystems deliver on the G andA functions. I answerthe
following researchquestions. Which financialsystem productivitychannels (ef-
ficiency or TC) affect growth? Which capital marketfunction,A vs. G, matters
more for productivitygrowth?
I find that both G and A are significantdeterminantsof I and productivity.
Takentogether,however, G dominatesA in its impact on productivity.Further-
more, while G works to improveefficiency in promotingproductivitygrowth,A
appearsto have more impact on the TC componentof productivity.The correla-
tions betweenthe measuresof G andefficiency,andthe measuresof A and TC are
robustto an alternativemodel specificationin which I use legal and institutional
variablesthat are deemed to be more exogenous as instruments,indicatingthat
the relationsidentifiedcould be causal. The empiricalresults are also robustto
alternativedefinitionsof the focal constructsof efficiency and G, and alternative
specificationsof latentvariablesas randomor fixed effects.
The evidence suggests the following: i) The financialsystem positively af-
fects growthand productivityvia two channels-improving efficiencies and en-
ablingtechnologicalinventionsandinnovations;ii) while the governanceservices
of financialmarketshelp induce improvementsin efficiency, the allocation ser-
vices help acceleratetechnologicaladvances;and iii) while both G andA are de-
terminantsof productivity,the impactof G (via efficiency) dominatesthe impact
of A (via TC).
The evidenceunderscoresthe particularrole of the equitymarketas a conduit
of socially valuablegovernanceservices as distinct from capital provision. The
value of this service is economically large. An industryoperatingin a country
with a stock marketthatis one standarddeviationabovethe mean of the proxy for
G would have a growthratein real outputof 1.05%per annummore thanthatfor
the averageindustry.Cumulatingover the sample periodof 15 years, real output
for such an industrywould be about 17%higherat the end of the study period.
The rest of the paperis organizedas follows. Section II provides the theo-
retical frameworkand develops the hypothesesto be investigated. I describethe
data and methodologyin Section III. Sections IV and V examine the empirical
relationsbetweeneconomic performance,focusing on sourcesof productivityand
capitalmarketfunctions. Section VI summarizesthe results with policy implica-
tions.

II. TheoreticalFramework
and HypothesesDevelopment
Corporatefinancetheory suggests that the link between finance and invest-
ment at the micro level is a consequence of contractualimperfections. In fact,
704 Journalof Financialand QuantitativeAnalysis

financialmarketsand institutionsarise to mitigateproblemsof informationaland


transactionalfrictions. To that end, financial marketsand institutionsperform
variousfunctions. They aggregateand mobilize capital,providerisk pooling and
sharingservices, assess and select projects and managementthroughproducing
information,and monitorinside decision making. The degreeto which the finan-
cial system influenceseconomic performancein the real sector dependson how
effectively it carriesout both its A and G functions.

A. Governanceand EconomicPerformance:
The EconomicEfficiency
Channel

A primaryfunction of financial marketsis facilitating responsible gover-


nance within the firm. In a world of uncertaintyand incomplete contracting,
problemsof imperfectinformationandmoralhazardmay preventfirst-bestvalue-
maximizing investmentbehavior. Marketsand institutionsmitigate the conse-
quences of imperfect informationand moral hazardby producinginformation
and facilitatingmonitoring. The effectiveness with which marketsperformthis
governancefunction bears on a firm's economic efficiency in the sense that al-
leviation of the agency problemsengendersconvergenceof the firm's observed
economic behaviorto its optimum.Economic efficiency is broadlydefinedas the
degree to which observedeconomic behaviorconvergesto the optimal,given the
constraintsof the underlyingtechnology.1
As their vital role, financial marketsprocess information(see e.g., Gross-
man (1976)). Tradingamong marketparticipantsproduces informationthat is
conveyed throughprice signals. Informationis also generatedby financialinsti-
tutions(see e.g., Diamond(1984) andLelandandPyle (1977)). Insteadof traders
producinginformationthroughtradingandconveyingit via prices,bankshireloan
officers who produceinformationwhile evaluatingprojectsfor loan financing.
This informationproductionrole has consequencesthat have efficiency im-
plications. First, securityprices formedin financialmarketsconvey valuablein-
formationaboutthe profitabilityof currentinvestmentopportunitiesand thereby
guide managerialdecision making(see Dow and Gorton(1997), Bresnahan,Mil-
grom, and Paul (1992), and Titmanand Subrahmanyam(1999)). Second, based
on the information,bad firms, managementteams, or projects do not get fund-
ing, preventingwaste of resources.The informationproductionfunctionand firm
economic efficiencyarelinkedin thatmarketsandinstitutionsthatgeneratebetter
informationenable firmsto make betterdecisions.
In additionto informationproduction,marketsandinstitutionsfacilitatemon-
itoringof inside decision makers.First,marketsgenerateinformationto evaluate
the quality of past managerialdecisions (Kihlstromand Matthews(1990)). Sec-
ond, informationin stock prices allows effective managerialincentive schemes
(Holmstromand Tirole (1993)). Third,the threatof takeovervia capitalmarkets
mitigatesmanagerialinefficiencies (e.g., Scharfstein(1988)).
1Assuming cost minimization as a behavioral goal, for example, economic efficiency could be
operationalizedas observed total cost comparedto the optimal given the level of output and input
prices.
Tadesse 705

These forms of market-basedmonitoringdirectly enhance efficiency at the


firm-level. Managerialincentives that use informationin stock prices reduce
shirking,leading to the alignmentof managerialinterestto that of shareholders.
Inefficientmanagementis forced out throughthe mechanismof the marketfor
corporatecontrol. More importantly,the threatof takeoverinduces managerial
discipline,preventingmanagerialactions thatwaste firmresources.

B. Allocation TheTechnological
and EconomicPerformance: Change
Channel

A key functionof financialinstitutionsand marketsis to mobilize capitalto


its efficient use-the A function. Financial systems aggregatesmall savings of
numerousinvestorsfor use by agents with entrepreneurial talentswho need funds
for large scale capital investments. In so doing, they also provide investorsand
entrepreneurswith risk pooling and sharingfacilities.
The availability of capital and the ability of investors to share risk influ-
ence the degree of risk toleranceand the choice of technologies in an economy.
Througheasing the burdenof risk to capitalcontributorsand entrepreneurs,mar-
kets and institutionsenable the undertakingof risky technologicalinventionsand
innovations. This link between the allocation function and technological inno-
vations takes many forms. First, adoptionof technologies requireslarge sums
of capital that could easily be mobilized in well-developed financial systems.
Second, well-developed capital marketsand institutionsencourageadoptionof
long gestationproductivetechnologies throughreducinginvestors'liquidityrisks
(Bencivenga, Smith, and Starr(1995). Finally, by providinghedging and other
risk sharingpossibilities, financialmarketsand institutionspromoteassimilation
of specialized (vs. generalized),thus risky and yet productive,technologies (see,
e.g., Saint-Paul(1992)). The implicationis that, otherthings constant,countries
with a maturebankingsector and capital marketsshould achieve higher rates of
technologicalchange. This, in turn,translatesinto higherproductivityand, there-
fore, to largereconomic growth.
To sum up, how does the financialsystem affectreal economic performance?
I argue,as in equation(1), thathow much betteroff an economic unit will be, as
measuredby y, is partlydeterminedby the effectivenessof the financialsystem in
deliveringG andA. By decomposingy, as in equation(2), into I and TFP, it has
been shown (e.g., Levine and Zervos (1998)) that financialdevelopmentworks
throughproductivityimprovementsin affecting growth. TFP, however,may re-
sult from shifts in the underlyingtechnologyor improvementsin the efficiency of
the productionprocess. Thus, I denote 7 to be technologicalchange and E to be
changes in efficiency,

(3) TFP=T+E.

I arguethat while the degreeto which the financialsystem providesG affects the
rateof improvementsin the relative E with which the firmutilizes its resources,A
has an impacton the rate of T. In so doing, I trace the specific channelsthrough
706 Journalof Financialand QuantitativeAnalysis

which the financial system influences economic performance. My conceptual


model is, therefore,

(4) E=

T=(AG),

and
G0,a0.
A could also have an impacton E, as G does on 7t. However,the directionsof
the relationsdo not appearto be obvious a priori.Forexample,in an environment
of capital abundancevis-a-vis investmentopportunities,increasedA may lead
to overinvestment,suggesting a negative relation between A and k. Similarly,
whetherbetter governed(via marketsor otherwise) firms experiencefaster T is
an empiricalquestion. While the direct route from G to T may not be obvious,
Allen (1993) suggests a possible indirectlink wherebythe financialmarkets'role
as informationaggregator(part of G) could be more useful to industrieswith
complex decision environments,such as those characterizedby rapid 7t. Thus,
one would expect a positive correlationbetween T and the measureof G, but this
link does not indicatecausation.

III. Dataand Measurementof Proxies


To estimatethe measuresof economic performance,I use industry-levelpro-
ductiondata from the United Nations IndustrialStatisticsdatabasefor 10 manu-
facturingindustriesfor 38 countriesfrom 1980 to 1995. I use financialdevelop-
ment indicatorsto constructmeasuresof the A and G functions of the financial
system. These include stock marketcapitalization,value-traded,and turnoverra-
tio obtainedfrom the EmergingMarketsFact Book (variousissues) publishedby
the WorldBank, and size of the domestic credit and privatecredit sectors from
InternationalFinancial Statistics (IFS) publishedby the IMF. The stock market
datais availablein a systematicmannersince 1980, thuslimitingthe studyperiod.

A. Measurement
of CapitalMarketFunctions
Ideally, one would like to have a measure of the ability of firms to raise
capital to meet their financialneeds and to benefit from the related governance
services providedby financialsystems. I use measuresof financialsystem size as
proxies for A and measuresof financialmarketactivityas proxies for G.
Since A representsthe abilityof a country'sfinancialsystem to mobilize cap-
ital andenableparticipantsto pool and sharerisk, the larger,broader,anddeepera
country'sfinancialsystem, the moreeffectivelyit mobilizescapitalanddistributes
financialrisk. Hence, I use the sizes of a country'sequity and creditmarketsrel-
ative to its GDP as broadindicatorsof A. In so doing, I follow Levine andZervos
(1998), La Porta,Lopez-de-Silanes,Shleifer, and Vishny (1997), and Rajanand
Zingales (1998), who use size as measuresof financialdevelopment.The size of
Tadesse 707

equity marketsis representedby stock marketcapitalizationto GDP ratio (MKT-


CAP). The size of the credit sector is measured,alternatively,by i) the size of
total domesticcreditrelativeto GDP (BANK),and ii) the size of total creditto the
privatesector relativeto GDP (PRIVATE).While BANKis a broaderindicatorof
the depthof the creditsector,PRIVATEis a tightermeasureof the abilityof the in-
termediarysector in mobilizing capitalto the privatesector. As such, conditional
on findingrelations,PRIVATEis expectedto have a largercoefficient.
As a broad indicatorof the degree of governance services provided by a
country's financial system, I use a measure of the country's stock market ac-
tivity for which I use the ratio of total value of equity tradedto stock market
capitalization-turnoverratio (TURNOVER).Alternatively,for robustness,I use
the degree of accountingdisclosure,which reflectsthe extent of informationflow
and ease of monitoring.
There are strongtheoreticalreasons for using TURNOVERas a measureof
G. First, greatermarketliquidityimplies more andbetterinformation-prices re-
flect informationaboutthe firmand its investmentprospectsmore accurately.In-
creased marketactivity induces more informationacquisition,which, in turn,in-
creasesthe informationcontentof stockprices(see HolmstromandTirole(1993)).
The more shares of stock actively being tradedand the more liquid the market,
the easier it becomes for an informedpartyto make a good returnon investment
(Kyle (1984)). The resultantincreasedinformationflow into the marketimproves
the informationcontent of stock prices. Hence, a measureof marketliquidityis
an indicatorof the degree of informationaggregation.
Second, informativesecurityprices in liquid marketsfacilitatethe monitor-
ing2 management,as well as the implementationof incentive-basedcompensa-
of
tion designed to align management'sinterestswith those of shareholders.Incen-
tive contractsin the form of managerialoption and equity-relatedcompensations
are useful for reducingagency costs only to the extent that the underlyingequity
prices are informativeof firm performance.Holmstromand Tirole (1993) show
how liquidityvia increasedinformativenessof securityprices enhancesmonitor-
ing.
Third,greaterliquiditymakes it easier for active shareholdersto build posi-
tions so as to bring aboutchanges in corporatepolicies. Bhide (1993) arguesthat
more liquidity implies less monitoring,since shareholderscan dispose easily of
positions if they disagree with management'spolicies. On the otherhand,Maug
(1998) shows thatthe benefitsto shareholdersfrom buildingpositions and induc-
ing good governanceis so significantthat the impact of greatermarketliquidity
on effective monitoringis unambiguouslypositive.
Finally,the effective use of the secondaryequity marketsfor corporatecon-
trol activitiesrequiresthatthe marketbe liquid. Takeoversrequirea liquid capital
market-a marketwhere bidderscan access a vast amountof capitalon short no-
tice. Therefore,with liquid markets,investorswho want to acquirea firm can do
so.
Marketliquidity as a measureof governanceapplies only to stock markets.
Banks also providegovernanceservices both as informationproducersand dele-
2Effective monitoringand control could be exercised throughothermechanismssuch as via inter-
mediariesand boardeffectiveness, which may not be capturedby my proxy for governance.
708 Journalof Financialand QuantitativeAnalysis

gated monitors. However,the opaquenessof banks' dealings with their borrow-


ers makes it difficult to constructa comparableproxy for governance. Ideally,
one would like to have cross-countrydifferencesin loan rejections,corporatere-
structurings,boardactions, and other governanceactivities initiatedby banks to
representbankmonitoring.The cross-countrydifferencesin the size of the bank-
ing sector (measured,alternatively,by the variablesBANK and PRIVATE)may
pick up some of the differencesin the bankinggovernancerole. However,while
the size directly mirrorsthe ability of the sector to mobilize capital, size does
not translateinto good governance.Recent failuresin corporategovernancefrom
Japanto SoutheastAsia, despitelargebankingsectors,providea counterexample.
Similarly,it shouldbe notedthatdifferencesin the size of the stock marketacross
countriesas measuredby MKTCAPmight containinformationaboutdifferences
in governance.Yet, size againdoes not directlytranslateinto good governance.A
large marketwith many listed companiesthatrarelytrade,as is the case in many
emergingeconomies, does little to generateinformationandfacilitatemonitoring.
Table 1 presents a summaryof the measures of capital marketfunctions.
PanelA shows averagesof the variablesoverthe period 1980-1995 for each coun-
try. One can observe a numberof patterns. First, there is a wide variation. For
example, Germanyhas a turnoverratio of 1.0394 vis-a-vis Bangladesh's0.0327.
Second, stock marketsize does not necessarilycorrespondwith stock marketac-
tivity. For example, Chile has a relativelylarge stock market(MKTCAP0.4717)
andyet is one of the thinnest,with a turnoverof 0.0661. On the otherhand,Turkey
has one of the smallest markets(MKTCAPequals 0.0624) and is relativelybusy
(TURNOVER0.5041). Third, by all measures, developed countrieshave more
advancedfinancialsystems than emergingcountries. The correlations(in Table
2) between the log of real per capitaincome and proxy variablesare significantly
positive.
If we divide the countriesinto developed and emergingusing International
FinanceCorporation'sclassification,the distributionof countriesalong the spec-
trumof the financialvariablesis highly skewed in favorof developedeconomies.
For example, 32% of emergingand 0% of developedcountriesfall in the lowest
quartileof TURNOVER,and over 40% of emerging and only 5% of developed
economies fall in the bottomquartileof MKTCAP.Forty-fivepercentof emerg-
ing and 0% of developedeconomies belong to the bottomquartileon BANK. In
contrast,only 9% of emergingand 43 % of the advancedmarketsfall in the top
quartileof MKTCAP.

B. Measurement
of EconomicPerformance
An aggregateindex of improvementin an economic unit, extensively used
in the literature,is the growthrate in some measureof output. My measureof
aggregateperformanceis GV, the annualcompoundedgrowthrate in real value-
added. GV is an empiricalequivalentof y in equation(1). Outputgrowthcould be
a resultof eithergrowthin the componentfactorsof productionor improvements
in productivity.My second measureof aggregateperformanceis GP, the annual
compoundedgrowth rate in total factor productivity. GP operationalizes TFP
in equation(2). Furthermore,productivitygains in economic activities could be
Tadesse 709

causedby two differentfactors:adoptionof technologicalinnovationsin products


and processes (measuredby the rate of T), and improvementsin E, which reflect
the capacity of insider decision makersto improveproduction,given inputs and
availabletechnology.
I define E as the degree to which the firm's observedattainmentconverges
to its optimalbehavioralgoal, underconditionsof technologicaland marketcon-
straints.I operationalizeE using Farrell's(1957) concept of productionefficiency
and Leibenstein's(1966) economic efficiency. Productionefficiency reflects the
degree to which a producerachieves the maximumattainablequantityof output
for a given bundleof inputs. The optimumis in terms of productionpossibilities
and, as such, F is definedin referenceto the technicalrelationsbetween observed
and attainablequantities.
The optimumcan also be definedin terms of some behavioralgoal the pro-
duceris assumedto pursue,such as cost minimizationor profitmaximization.k
then refersto the degree to which that assumedobjectiveis achieved. In the cost
minimizationframework,an empirical measure of F would be the ratio of the
minimumattainablecost for a given level of outputto the actualcost incurredby
the producer,i.e., economic efficiency. A firm can achieve productionefficiency
by obtainingthe maximumoutputfor whateverbundleof inputsit chooses to em-
ploy. It may yet be inefficientif it purchaseswhat is not the best bundleof inputs
given the inputprices and theirmarginalproductivitiesin production.This latter
concept of efficiency is called price efficiency. Economic efficiency subsumes
both productionand price efficiencies.
Improvementsin a firm's productivityare not the result of efficiency gains
alone. They may arise from adoptionof technological innovationsin processes
and productsthat enable the firm to achieve higher productionquantitieswith
lower inputusage or equivalentlythe same level of outputat lower costs. While
efficiencyreflectsmanagerialactionsin referenceto a behavioralgoal, this source
of productivityreflects both the state of the availabletechnology and the ability
of firmsto acquirenew technologies in theirproductionprocesses.
Empirically,I measureproductionefficiency based on a stochasticproduc-
tion frontier,in which E is calculated as the proportionof actual output to the
maximally attainableone. The closer the actual is to the optimal level of out-
put, the more efficient the firm is. The empiricalmeasureof growthin efficiency
thus estimated is APRODEFF, the annualrate of improvementsin production
efficiency. APRODEFF is one of the empiricalproxies of growthin F in equa-
tion (4). I measureeconomic efficiency based on a stochasticcost frontieras the
proportionof the minimumattainablecost to actualcost. The resultantvariableis
AECONEFF,the annualrateof economic efficiency,and serves as the alternative
empiricalproxyfor F in equation(4). I measurethe effect of technicalprogressas
the shift in the productionfrontierover time holding inputquantitiesat the same
level, and the resultingvariable,TC, the annualrate of technologicalchange, is
my empiricalproxy for 7tin equation(4).
The Appendixprovidesdetails on the estimationof these variables.Tables 1
and 2 providea summary.Frompanel A of Table 1, thereis wide variationin the
estimatesacrosscountries.Growthis slower in advancedcountriesthanin emerg-
ing economies, as would be expected,reflectinginitial conditions.GV is strongly
710 Journalof Financialand QuantitativeAnalysis

Log
(per GDP) 9.704
9.856
5.234
9.791 7.711
9.899
6.086
7.096 9.963
8.968
5.780
6.315
9.287
9.757 7.008
9.966 8.527 7.730
9.632 7.975
9.786
9.444 7.524
5.794 6.566
8.690
9.422
6.496
9.344 7.880
6.984
9.654 7.876
9.949 page)
capita 10.085
10.081 10.179 10.123
next
on
in 0.043
0.038
0.034
0.032
0.029
0.026
0.061
0.050
0.061 0.045
0.042 0.054
0.051
0.040
0.037
0.051
0.046
0.123
0.055
0.026
0.043
0.055
0.057
0.068 0.043
0.043 0.051
0.058
0.048
0.037
0.045
0.079
0.040
0.046
0.044
0.039
0.047
0.071

Share(SHARE)
Industry (continued
Manufacturing

(TC)
0.023
0.0230.027
0.024
0.012
0.014
0.020
0.015
0.020
0.033
0.017
0.015
0.007
0.014
0.028
0.036
0.022
0.022
0.000
0.016
0.016
0.025
0.015
0.021
0.006
0.019
0.010
0.022
0.013
0.025 0.021
0.018
0.030 0.024
0.035 0.004
Change -0.011 -0.005
Technical

1980-1995
in
0.0007
0.0000 0.0120
0.0021
0.00140.00050.0018
0.0002 0.0043
0.0050 0.0054
0.0015
0.0016 0.0000
0.00050.0017
0.0009
0.00030.0003
0.0001
0.00140.0002
0.0004
from -0.0000-0.0015
-0.0000 -0.0002 -0.0027
-0.0027
-0.0003
-0.0045 -0.0008 -0.0087
-0.0006
-0.0002 -0.0019 -0.0006 -0.0037
Growth
Efficiency
Production
(APRODEFF)

Averages
in
0.0003
0.0017 0.00480.0009
0.00090.0016
0.0003
0.00220.0033 0.00020.00930.00000.00020.0011 0.0004
0.0040 0.0024
0.00080.0002
0.0001
0.00190.0010
0.0011
-0.0074
-0.0008
-0.0001 -0.0002 -0.0039
-0.0031
-0.0049
-0.0018
-0.0015 -0.0025
-0.0004 -0.0110 -0.0028 -0.0051 -0.0053
Efficiency
Growth
Economic
(AECONEFF)

Performance:
in
0.020
0.0280.003
0.019
0.038
0.0110.013
0.018 0.021
0.022
0.038
0.027
0.030 0.018 0.0490.007
0.019
0.009
0.016
0.009
0.024 0.0330.022
0.012
0.013
0.054
0.018
0.028
0.021
0.031
(PG) -0.064 -0.013
-0.018-0.021 -0.029
-0.049 -0.005
-0.032
1 Growth
Productivity
Economic
of
TABLE in
Value- 0.008
0.019
0.0450.030
0.053
0.039
0.029 0.000
0.029 0.025 0.089
0.022 0.171 0.0420.008
0.113
0.030
0.108 0.017 0.075 0.017
0.021 0.013
0.040
0.011
0.155
0.008
0.054
0.002
0.033 0.027
(GV) -0.001 -0.019
-0.015 -0.016
-0.002-0.118 -0.005
Added
Growth
Measures
Real

and

GDP 0.4930 0.3970


0.8656
0.1732
0.5021
0.5848
0.1587
0.4461
0.2618
0.7063
0.8856
0.24820.2655
0.26020.68541.0759
0.35910.6056
0.51550.6362
0.62190.1958
0.7700
0.43060.2771
0.51550.1020
0.2544
0.5543
0.7564
0.6928
0.2138
0.4552
0.1894
0.7901
0.6891
0.2271
0.1286
Private
Credit/
(PRIVATE)
Variables

Proxy
GDP 1.1361
0.6133
0.2976
0.9036
0.7692
0.2091
0.5763 0.5974
0.95321.1282
0.7882 0.5075
0.7134 1.2850
0.2557 1.2702
0.79390.8809
0.5470
0.6614
0.7274
0.35760.5030
0.96830.6211
0.5135
0.1606
0.34890.7614
0.98160.9965
0.41710.3672
0.76130.8814
0.8337
0.2965
0.2849
Credit/
Domestic(BANK)

Function
0.4712
0.0783
0.0158
0.2767
0.4687
0.4717
0.0725
0.2386
0.0442
0.1936
0.1995
0.08810.0669
0.14600.3208
0.1285
0.7859
0.5552
0.27101.2054
0.50510.1551
0.4485
0.42420.0945
0.1624 0.2419
0.0649 1.3511
0.09680.1966
0.1333
0.4141
0.0624
0.8100
0.6273
0.0717
0.1705
Stock
Market
Cap./GDP
(MKTCAP)
Financial

0.2923
0.4422
0.0327
0.1202
0.3084
0.0661
0.0863
0.0636
0.2086 1.0394
0.20190.12180.1855
0.42610.6492
0.2986
0.4329
0.1571
0.85020.2392
0.23630.5394
0.3656
0.18540.1413
0.3265 0.2161
0.16300.1537
0.3254
0.2695
0.0694
0.2984
0.5041
0.3783
0.5379
0.1275
0.0653
Ratio
Turnover Country
(TURNOVER)
by

Summary
A. Zealand
Lanka
Panel Bangladesh
Belgium
AustraliaCanada
Austria Chile
Colombia
Denmark
Egypt
Finland
Germany Indonesia
India
Greece Israel
Italy
JapanKorea
Kuwait
Jordan Mexico
Netherlands
New
Malaysia Norway
Pakistan
Peru Portugal
Philippines
Singapore
Spain U.K.
SriSweden U.S.
Turkey Zimbabwe
Venezuela
Tadesse 711

38 of to the
real
Log
(per GDP)
capita 8.4771.527
9.344
5.234
10.179
traded the
inter-bankdegree
estimates
value-added
themeasures
publicly dividing
in 0.116
0.041
0.028
0.056
0.029
0.050
0.015
0.021 0.067 3508
0.041 0.047
0.031
0.044
0.001 of real
0.326
in by
excluding change
Share(SHARE)
Industry value parameter
measures
Manufacturing on
Growth that
market calculated
institutions is
based
GDP.
0.022
0.023
0.019
0.021
0.008
0.026
0.017
0.014 0.016 3577
0.026 0.019
0.019
0.0130.056total by Technological
(TC) -0.029is efficiency
Change
Technical of
GDPdepository
computed
frontier.
divided
to and manufacturing
are cost
in
1980-1995 3272 32d) in
measure
0.0000
0.0014
0.00050.0010
0.00110.00110.0010 0.00035
-0.0008 -0.0008-0.0007 0.00008
0.0220.291 line
PRODEFF) -0.201 authority share
from Growth Efficiency
Production practice
efficiency
(IFS
(A capitalization
and best
sector output-related
Industry
monetarythe
market
in 3261
Averages 0.0010
0.00120.0003
0.00120.0000 the (1957)
from
-0.0008 -0.0011 -0.0010 -0.0008
-0.0001 -0.0001 0.0260.268 byprivate
0.00032
ECONEFF) -0.215Stock Productivity
GrowthEfficiency
Economic the technology.
(A held Farrell
year. a diverges
is
the against better
in of assets of
1980-1995.
Performance: 0.012 0.023
0.014
0.011
0.013
0.030
0.006
0.015 0.016 3272
0.014 0.0150.1800.950 of
0.016 industry
(PG) -1.076 end claims efficiency
Growth thesumof from an
Productivity adoption
at the to
is which
Economic
in to due
countries
Production
proportion
(continued) 0.0620.043 3301 0.2050.960 ratio38
1 of Value- 0.036
0.041
0.0140.037
0.041
0.006 0.026
0.027
(GV) -0.003 -0.008 -0.976 the cost)
Added GDP degree
is thedata.
Growth
Real capitalization
to of thetotal
cost in country.
GDP
TABLE marketto
credit
eachand the
Measures 3558
in
of
GDP 0.476
0.440
0.279 1.7600
0.021 measures
and Private
Credit/ stock credit decrease
(PRIVATE)
Domestic (orsector
total production
industries
to private
of 10 efficiency
year. output
3558
0.668
0.640
0.329 2.300
0.078 theindustry
Variables GDP
Credit/
(BANK) ratio
that
relative of of real
Domestic in
of manufacturing
The
year each Economic
Proxy GDPforpanel the
the GDP. of
3203
0.272
0.140
0.345 3.500 theby thefrontier.
0.001 increases
Stock
Market by on
Cap./GDP
(MKTCAP) during output
Function 311)313) 321)
314) 322)
351) 356)
355) 371)
382) divided
value-added real
divided
traded frontiers
production
represents
(ISIC
(ISIC
(ISIC
(ISIC (ISIC
(ISIC (ISIC
(ISIC
(ISIC
(ISIC 3420 32e) total
0.282
0.210
0.294 2.000 IFC real
0.005
in cost and the
Ratio equity
the
FinancialTurnover of by rate andefficient
by
time,
(TURNOVER) the
excluding
Sample value over
growth fromcountry
reported production
the
Industry 32a-32f frontier
Overall market
as in
by of
electrical lines diverges
total
year
is of IFS stochastic
compounded industry
except production
Summary chemicals
apparel steel Summary dev. ratio
end(i.e., industry
the
products
productsC. obs.
B. products at annual antheof
and of in
the
Food
Panel Beverages
Tobacco Industrial
Textiles Rubber
Wearing Iron
Plastic
Machinery,
No.Mean
Panel Median
Minimum
Maximum
Standard equityis cross-country
deposits
Turnover shift
which output
712 Journalof Financialand QuantitativeAnalysis

negatively correlatedwith per capita real GDP in Table 2. On the other hand,
GP is not related to a country's level of economic development. Productivity
growthin the U.S. (3.1%)compareswell with that of the Philippines(3.3%),the
highest being registeredby industriesin Korea(4.9%) and in Sri Lanka(5.4%).
More importantly,the growthrates in efficiency (AECONEF and APRODEFF)
are not relatedto a country'slevel of economic development.The growthratesin
economic efficiency and in productionefficiencies rangefrom 0.93% and 0.54%
in Korea to -0.74% in Bangladeshand -0.87% in Peru, respectively. Yet, an
advancedcountrylike the U.S. (0.11%) could have realized growthin economic
efficiencycomparableto thatfor Chile (0.09%)andColombia(0.09%). Industries
in richercountriesrealize higherratesof TC. TC is positively correlatedwith per
capita GDP (Table 2). This might reflect that richer countrieshave the where-
withal to supportadvancedR&D activities,which keep them in the technological
lead.

Governance,Allocation,and Economic
IV. Market-Based
Performance
Panel C of Table 1 summarizesboth the capital marketfunction variables
and the economic performancevariablesfor the entire sample of 3,605 industry
countryyears. There are wide variationsin realizedperformancemeasures. The
median industrygrowth rate in real value-addedis 2.6% for the entire sample.
The growth rate in economic efficiency has a median value of 0.032%, with a
range from -21.5% to 26.8%. The median growthrate in productionefficiency
is 0.008% with a range of -20.1% to 29.1%. The rate of technologicalchange
averages 1.9% per annum. The average industrycontributesabout 5% of the
manufacturingsector'stotal real value-addedor real output.
These variationsin performanceappearto be closely associated with vari-
ations in the measuresof capital marketfunctions across countries. Table 3 ex-
plores the relationsbetween the two sets of variablesfurtherby presentinga dif-
ference of means test of the performancemeasuresacross subsamplesformedon
the basis of rankingsin the finance variables. From panel A, more active equity
marketsare stronglyassociatedwith highergrowthratesin value-added,produc-
tivity, and efficiency. On the other hand, the size of equity marketsis weakly
relatedto growthratesin value-added,productivity,and efficiency (see panel B).
Better allocationby the credit sector is stronglyrelatedto productivitygains and
TC (panelsC and D).

A. FinancialSystem Functionsand Aggregate Measures of


Performance

I begin the analysisof the relationsbetween financialsystems and economic


performanceby examiningthe link between capital marketfunctionsand aggre-
gate measuresof industryperformance.This would facilitate a comparisonwith
the extantliterature.I use the growthratesin real value-addedandproductivityas
Tadesse 713

in
Share
Industry (SHARE)
Manufacturing
-0.270***

(TC)
Change
Technical 0.650***
-0.028

in

Growth
Efficiency
Economic
(AECONEFF)
0.037 0.048 0.043

in

Growth
Efficiency
Production
(APRODEFF) 0.895*** 0.052
-0.089** -0.050

in

(PG)
Growth 0.937***0.831** 0.006 0.008 0.033
Productivity

2 Matrix
Real
(GV)
in Value-
Added
Growth 0.901***0.899***0.740*** 0.063
TABLE -0.125*** -0.145***

Correlation
to

Sector
Private
Credit (PRIVATE) 0.043 0.083** 0.060 0.074 0.487*** 0.609***
-0.108**

Credit
(BANK)
Domestic 0.774***0.004 0.085** 0.046 0.049 0.465*** 0.500***
-0.061 respectively.

levels,
1%
Market
and
(MKTCAP)
Stock
Capitalization 0.242** 0.517***0.008 0.033 0.040 0.011 0.255*** 0.308***
-0.071 5%,

10%,
the
at
Ratio
Turnover
0.186***0.249*** 0.328***0.120***0.115***0.083** 0.140***0.357***
(TURNOVER) 0.236***
-0.031
significance

indicate
private real production
economic
share ***
to in addedin in in
market
capitalization
credit capitaand
manufacturing**,
(MKTCAP) sector
(BANK) (GV) productivity
value
(PRIVATE) (PG) efficiency
efficiency
(APRODEFF) change GDP ,
(TC) in (SHARE)
(AECONEFF)
Stock Domestic Credit Growth Growth Growth Growth TechnicalIndustryPer
714 Journalof Financialand QuantitativeAnalysis

TABLE 3
MeanDifferences
Inter-Quartile Performance
inIndustry

Bottom25%
vs. Top25%

Bottom Middle Top Wilcoxon


Variables 25% 50% 25% Test t-Test
PanelA. Rankingby StockMarketTurnover Ratio
Growthin realvalue-added 0.0240 0.0176 0.0468 -3.48*** -2.28**
Growthin realgross output 0.0330 0.0150 0.0443 1.87* -1.42
Growthin productivity 0.0073 0.0128 0.0268 -3.77*** -2.12**
Growthin productionefficiency -0.0002 0.0002 0.0013 -2.81*** -1.37
Growthin economicefficiency -0.0025 0.0001 0.0020 -4.21** -3.17***
Technicalchange 0.0133 0.0204 0.0246 -18.51** -20.7***
PanelB. Rankingby MarketCapitalization
Growthin realvalue-added 0.0237 0.0282 0.0334 -1.85* -0.89
Growthin realgross output 0.0307 0.0257 0.0303 -0.29 0.05
Growthin productivity 0.0096 0.0209 0.0141 -1.62 -0.46
Growthin productionefficiency -0.0006 0.001 -0.00006 -1.05 -0.43
Growthin economicefficiency -0.0030 0.0013 0.0004 -2.54** -2.28**
Technicalchange 0.0134 0.0203 0.0250 16.05** -18.04**
PanelC. Rankingby DomesticCreditto GDP
Growthin realvalue-added 0.0268 0.0287 0.0315 -0.24 -0.41
Growthin realgross output 0.0254 0.0287 0.0313 0.41 -0.64
Growthin productivity 0.0085 0.0151 0.0256 -2.82*** -1.67*
Growthin productionefficiency -0.0003 0.0007 0.0009 -1.21 -1.05
Growthin economicefficiency -0.0021 0.0009 0.0002 -2.57*** -1.59
Technicalchange 0.00118 0.0195 0.0252 20.5*** -23.1***
PanelD. Rankingby Creditto PrivateCreditto GDP
Growthin realvalue-added 0.0396 0.0240 0.0261 2.40** 1.19
Growthin realgross output 0.0376 0.0249 0.0260 2.72** 1.19
Growthin productivity 0.0166 0.0155 0.0164 -0.46 0.02
Growthin productionefficiency 0.0013 0.0002 0.0003 1.14 0.80
Growthin economicefficiency -0.0008 0.0004 -0.0001 0.11 -0.53
Technicalchange 0.0108 0.0207 0.0240 19.77** -21.9***
PanelE Rankingby Averageper CapitaGDP
Growthin realvalue-added 0.0427 0.0230 0.0209 2.89*** 2.05**
Growthin realgross output 0.0416 0.0253 0.0159 4.77** 2.97***
Growthin productivity 0.0086 0.0131 0.0232 -3.23*** -1.51
Growthin productionefficiency 0.0008 0.0002 0.0002 -1.04 0.52
Growthin economicefficiency -0.0015 0.0002 0.0007 -2.22* * -1.40
Technicalchange 0.0097 0.0198 0.0262 -26.4*** -31.6***
Thesample is classifiedintoquartilesbased on stock marketturnoverratio,marketcapitalization,domesticcredit,credit
to privatesector and average per capitaGDP,respectively,overthe period1980-1995. Turnover ratiois the valueof total
shares of stock tradeddividedby marketcapitalization.Stockmarketcapitalizationis the ratioof the totalmarketvalue
of publiclytradedequityto GDP. Domesticcreditis the sum of assets held by the monetaryauthorityand depository
excludinginter-bank
institutions transferdividedby GDP.Creditto privatesector equals claimsagainstthe privatesector
dividedby GDP.*, **,and ***indicatesignificanceat the 10%,5%,and 1%levels, respectively.

measuresof how well off an industryis. My empiricalmodel is a four-wayerror


component(randomeffects) of the following form,

(5)
GVcit=kFk+Zct+Ecit,

(6)
GPcit=k+

where and GPcit are, respectively,the annualcompoundedgrowthrates of


GVcit
real value-addedandtotalfactorproductivityof industryi in countryc overperiod
t. c = 1,..., C; i = 1,..., Ic; and, t= 1,..., Tci. is the kth financialfunction
Fkt
indicatorvariablefor countryc in period t. The financialfunction variablesare
TURNOVER,MKTCAP,BANK, and PRIVATE.The control variableZct repre-
Tadesse 715

sents the relativesignificanceof industryi in countryc duringperiod t. I use the


share of value-addedof the industryin the total value-addedof the manufactur-
ing sector of the country (SHARE). The model is a four-way errorcomponent
(randomeffects) specificationwith the following errorstructure,

(7) Ecit=c+Ti+At+vcit,

where

aciid(0,or),

qijiid(0,o2),

Attiid(0,0r), and

vcitr-iid(0,2)

and vcit are independentfrom each other and also independentof the
ac, Ti, At,
F and Z variablesin equations(5) and (6). ac is unobservabletime and industry
invariant,country-specificeffects; qi is unobservablecountryand time invariant
industryeffects; At representsunobservablecountryand industryinvarianttime
effects; and, vcit is a randomdisturbanceterm.
Hence, I controlfor country,industry,andtime heterogeneity,therebyavoid-
ing the risk of bias in my estimates.3Moreover,I treatthese latentcountry,indus-
try, and time effects as randomvariablesratherthanfixed parameters.4I estimate
the model by the method of maximumlikelihood (ML) underthe distributional
assumptionof normalityfor the errorcomponentsand the residual. The ML es-
timates are consistentand asymptoticallyefficient, and have a known asymptotic
samplinginformationmatrix.5
Table 4 presents the estimates of the empiricalmodel. From panel A, the
results indicate a very strong relationbetween the degree to which capital mar-
kets performtheirgovernancefunctionsandindustryaggregateperformance.The
coefficientestimatesof TURNOVER-the proxy for the governancefunction-is
positive (0.0570) and statisticallysignificantat 1%. Moreover,the contributions
of these services are economically significant.For example, using the coefficient
estimates, a one standarddeviation increase in TURNOVER(0.294) would in-

3The model rests on the premise that a sensible representationof relations among variables of
interest across diverse countries, industries,and time periods cannot explicitly captureall important
variables.These variablescould be simply too many to be included, since some may be unmeasurable
and others unobservable.
4For robustness,I also estimate the models in this section and the sections that follow as fixed
effects specifications. The results are qualitatively similar to the ones under the error components
specification.
5Alternativeestimation methods that include ANOVAtype, ML, restrictedmaximum likelihood
(REML),and MinimumQuadraticUnbiased Estimation(MINQUE)vary in the way the variancesof
the errorcomponentsare estimated. SimpleANOVAtype estimatesno longer apply for an unbalanced
panel with three errorcomponents. I use REML,a procedurein which variancecomponentsare esti-
matedbased on the portionof the likelihood function that depends on the errorcomponents In
a balanceddata,the REMLestimatorsof the variancecomponentsare identical to ANOVAestimators, alone.
which have optimal minimum variance properties. The results do not change when I estimate the
models by ML and by MINQUEprocedures.
716 Journalof Financialand QuantitativeAnalysis

crease the growthratein real value-addedof the averageindustryby about 1.68%


per annum.6

TABLE4
Performance
Aggregate and Functions
CapitalMarket
Dependent PanelA. PanelB.
Variable Growthin RealValue-Added Growthin RealGrossOutput
Independent
Variables I II Ill IV I II III IV

Turnover 0.0570*** 0.0358***


ratio (0.015) (0.012)
(TURNOVER)
Stockmarket 0.0161 0.0100
capitalization (0.016) (0.013)
(MKTCAP)
Domestic 0.0706*** 0.0854***
credit (0.021) (0.018)
(BANK)
Creditto private 0.0940*** 0.1049***
sector (0.024) (0.021)
(PRIVATE)
Industry'sshare 0.6178*** 0.6008*** 0.6159*** 0.6187*** 0.3830*** 0.3718*** 0.4085*** 0.4106***
in manufacturing (0.097) (0.098) (0.102) (0.102) (0.081) (0.080) (0.087) (0.087)
(SHARE)
ErrorComponents
0.0018*** 0.0013*** 0.0020*** 0.0015*** 0.0014*** 0.0011** 0.0019*** 0.0015***
a2
0.0007* 0.0007* 0.0006* 0.0006* 0.0005* 0.0004* 0.0004* 0.0004*
2
2 0.0008** 0.0009** 0.0009** 0.0009** 0.0006** 0.0007** 0.0005** 0.0006**
a2 0.0307*** 0.0317*** 0.0365*** 0.0366*** 0.0215*** 0.0213*** 0.0263*** 0.0263***
Theparameterestimatesare maximumlikelihoodestimatesof four-wayerrorcomponentmodelscontainingrandomcoun-
try,industry,and time effects. The dependentvariablesare the annualcompoundgrowthrate in the real value-added
and the annualcompoundgrowthratein the realgross outputforeach of the 10 industriesin 38 countriesforthe period
1980-1995. Turnoverratiois the value of totalshares of stocks tradeddividedby marketcapitalization.Stock market
capitalizationis the ratioof the totalmarketvalueof publiclytradedequityto GDP. Domesticcreditis the sum of assets
held by the monetaryauthorityand depositoryinstitutions excludinginter-bank transferdividedby GDP.Creditto private
sector equals claimsagainstthe privatesector dividedby GDP.Industrysharein manufacturing is calculatedby dividing
the realoutputof the industryinthe countryby the totalrealoutputof the manufacturingsectorof the country.Coefficients
of the interceptare not reported.Asymptoticstandarderrorsare given in parentheses.*, **,and ***indicatesignificance
at the 10%,5%,and 1%levels, respectively.

While MKTCAPis not significant,the variablesBANKandPRIVATE(prox-


ies for the allocationfunctionof creditmarkets)are positive and statisticallysig-
nificant. The largercoefficient on PRIVATEreflects the fact that the variableis
a tighter measure of capital mobilizationto the privatesector. A one standard
deviationincreasein the size of domestic credit (BANK)would increasethe GV
of the averageindustryby 2.32% per annum,the same orderof magnitudeas the
estimatesof the effect of bankdevelopmenton per capitaGDP (2.52%)in Levine
(1998). Note, however,thata one standarddeviation(0.329) increaseis approxi-
mately the differencein size of domestic creditbetween Indiaand the U.S.
Industriesthat account for a largerportionof the country'smanufacturing
have highergrowthrates, which may reflect the effects of other sources of com-
parativeadvantage(i.e., other than the financial system). Developed countries
have lower growthrates (the coefficient of log per capita GDP (not reported)is

6This is calculated by multiplying the coefficient estimate for TURNOVERfrom Table 4 (i.e.,
0.0570) by the standarddeviation of TURNOVER from Table 1 (i.e., 0.294).
Tadesse 717

significantlynegative)reflectingthe convergenceeffect.7 With respect to the la-


tent variables, overall the country,industry,and time effects are significant in
explaining variationsin industry growth (all errorcomponents are statistically
significant).Unobservablecountryfactorsappearto be relativelymore important
thanthe others.Forexample,based on Model I in Table4, the sum of variancesof
the errorcomponentsassociatedwith country,industry,time, and the noise term
amount to 0.0340. Country,industry,and time effects account for about 10%
(i.e., 0.0033) of the total unexplainedvariationsin industrygrowth,out of which
country-specific(but industryand time invariant)factors account for more than
50% (i.e., 0.0018).
Panel B, Table4 presentsthe relationsbetween capitalmarketfunctionsand
growthin real gross output(insteadof value-added).The results are qualitatively
similarto the value-addedregressions.
Table5 presentsthe relationsbetween PG, which is an amalgamof techno-
logical change and efficiency gains, and capitalmarketfunctions. TURNOVER-
the governanceproxy-has a statisticallypositive relationwith PG. On the other
hand, while PG is significantly related to the size of the credit sector (BANK
and PRIVATE),it is not relatedto MKTCAP.This is consistent with Levine and
Zervos (1998). The productivityconsequences of the G and A proxies are eco-
nomically very significant. To illustrate,considerMexico, which has an average
turnoverof 0.5394 (Table 1) and a productivitygrowth of 0.9% (Table 1). Us-
ing my estimates in Model I, if Mexico were able to increase marketactivity by
a mere 10%of the presentlevel, it would increase its rate of PG of the average
industryto about0.12% per annum.
Includingthe proxies in combination(Models V throughXII, in Table 5),
TURNOVERcarriesa strongpositive coefficient, whereasthe allocationproxies
(BANKand PRIVATE)lose their significance. In impactingproductivitygrowth,
G dominatesA. In Models VI, VIII, and X, TURNOVERwas interactedwith
MKTCAP,BANK, and PRIVATE,respectively,to assess if the productivityim-
pact of stock marketgovernancedependson the relativeimportanceof the credit
sector vis-a-vis the stock marketin capital provision. The interactionterms for
BANKand PRIVATEare negative and significant. The marginalproductivityef-
fect of market-basedgovernanceis lower in countrieswhere the credit sector is
dominantin capital provision. This might be because in such economies, much
of the governanceis undertakenby the credit sector as well. To the extent that
thereareoverlapsin the governanceservices providedthroughthe two media, the
more importantthe credit sector is as a conduitof capital,the lower the marginal
benefitof stock marketmonitoringwill be.

B. Governanceand EconomicPerformance:
The Efficiency
Channel
PG is an amalgamof effects of technologicalinnovationsand improvements
in efficiency.This section exploresin detailthe impactof capitalmarketfunctions
on efficiency growth.My hypothesisis thatfinancialmarkets,throughtheirinfor-
mation aggregationand monitoringfunction, induce economic efficiency within
7The results here and in the sections to follow are not sensitive to inclusion or exclusion of these
variables.
718 Journalof Financial
andQuantitative
Analysis

sum
XII factor output levels,
thevariable
Turnover
0.0335***
(0.011) (0.016) 0.2290***
(0.010) -0.0007 (0.070) 0.0007**
0.0257*** 1%
-0.0090 <0.0001 totalis The
<0.0001 real
in
and
total
credit
frontier.
GDP.
the5%,
XI growth
cost byby
0.0348***
(0.010) (0.009)(0.011) 0.2281** 0.0007**
(0.069)<0.0001 0.0257*** 10%,
-0.0087-0.0093 <0.0001 Domestic
annual the
divided
country
thestochasticat
is a GDP.the
X to in
0.0933*** 0.0222 0.2562***0.0001 0.0008** on sector
0.0266***
(0.025) (0.020)(0.038)
-0.0934** (0.072) <0.0001
variable
cost
equity significance
private
industry
thethe
IX tradedof indicate
0.0393*** 0.2525***0.00010.0008** minimum
0.0266***
dependent
(0.012) (0.017) (0.072) <0.0001
-0.0079 ***
against
The publiclyoutput
optimal
of and
real
the claims **,
*,
Vill effects.
to valuethe
0.1073***
(0.027) 0.0218 0.2495***0.0001
(0.028)(0.071)
(0.015) -0.079*** 0.0008**
0.0266***
<0.0001 time equals
cost
and market dividing
actualsector
by
parentheses.
VII of total in
0.0385***
(0.012) (0.013) 0.2539***0.0001
(0.072) 0.0008**
0.0266***the
Functions -0.0016 <0.0001 industry, private
of to
given
calculated
deviation
ratiois are
country,
of Credit
Market
VI the
0.0393***
(0.014)(0.015) 0.2245***
(0.034)(0.071) 0.0007**
0.0258***is errors
5 -0.0020 -0.0190 <0.0001
<0.0001 terms GDP.
random
in
Capital is by
manufacturing
V in standard
TABLE
and capitalization
divided
0.0344***
(0.010)(0.009) 0.2230***
(0.071) 0.0007**
0.0258***
containing
-0.0087 <0.0001
<0.0001 efficiency
share

modelsmarket Asymptotic
transfer
Growth
IV Industry
Economic
Stock
(0.015) 0.2619***
0.0426*** 0.0009**
(0.073)<0.0001 0.0300***
<0.0001 reported.
inter-bank
component model.
not
Productivity
Ill 1980-1995.are
error
0.0267** 0.2486*** 0.0009**
0.0300*** capitalization.
excluding
(0.012) (0.072)<0.0001
<0.0001 respective
period
four-way theintercept
of themarket
in
the
II forbyinstitutions
of
(0.010) 0.2458***
(0.073)0.00010.0008**
0.0272***
-0.0077 <0.0001 estimates variables
divided
countries
depository
other
38 Coefficients
I in traded
and
likelihoodtwo
0.0389***
(0.011) 0.2431**
(0.072)0.00010.0008**
0.0267***
the
stocksof country.
of authority
industries the
maximum of
10
are shares product
the
thesector
of monetary
manufacturing total
sector in of the
each by
estimates
Variable capitalization forvaluerepresents
ratio creditprivate share S<00001
2 held
market to the manufacturing
Components parameter is
(MKTCAP)
(TURNOVER) (BANK) (PRIVATE)(SHARE) assetsthe
CreditInteraction
StockDomestic
Turnover r2
Industry's
Error .2 The productivity
ratio
of interaction
of respectively.
Tadesse 719

the firm. I use a four-wayerrorcomponents(randomeffects) model of the fol-


lowing form,

(8)
AECONEFFcit=-o+S1

(9)
APRODEFFcit=/3o+:kFEct

where AECONEFF is the growth rate in the economic efficiency of industryi


of countryc in period t, and APRODEFF is the growthrate in the production
efficiency of industryi of countryc in period t. Fk is the kth financialfunction
variablefor countryc in periodt. The financefunctionvariablesare TURNOVER,
MKTCAP,BANK,and PRIVATE.The model is a four-wayrandomeffects model
with randomcountry,industry,and time effects as specifiedin equation(7).
Table6 reportsa very strongassociationbetweenthe degreeto which capital
marketsperformG andimprovementsin industryeconomic efficiency (AECON-
EFF). In Model I of Table6, TURNOVER-the governanceproxy-enters with
a positive coefficientthatis statisticallydifferentfrom zero. The relationbetween
MKTCAPand efficiency,while positive, lacks statisticalsignificance(Model II),
as does the relationbetween the size of the credit sector (BANKand PRIVATE)
and efficiency (Models III and IV).
Higher TURNOVERis also accompaniedby largerefficiency improvements
on the margin after controlling for the other financialproxies. In Model V in
Table 6, TURNOVERis positive (0.0057) and significantat the 1% level, while
MKTCAPis not differentfrom zero. Similarly,in Models VII and IX, which
include the proxies for capital mobilizationby the credit sector, TURNOVERis
positive (0.0063 and 0.0062) and significantat 1%. The coefficients on the other
variablesfall sharplyand remainstatisticallyinsignificant.For Models VIII and
X, where TURNOVERinteractswith BANK and PRIVATE,the interactionterm
is negative and significant,indicatingagain that the marginalefficiency effect of
market-basedgovernanceis lower in countrieswherethe creditsectoris the dom-
inant mediumfor capitalprovision. Finally,in Model XI, which includes BANK
and MKTCAP,the governanceproxy, is robustlypositive (0.0060, significantat
1%) and none of the other variablesare marginallysignificant. The same result
holds when I use PRIVATEin Model XII. Thus, controllingfor the allocation
services of both stock marketsand the credit sector,the proxy for the governance
functionof marketsadds value to efficiency growth.
The evidence is consistent with the hypothesis that the informationaggre-
gation and monitoringfunctionof marketsdeterminesthe relativeefficiency with
which firms utilize resources. Increases in my proxy for G raise industryeffi-
ciency aftercontrollingfor unobservablecountry,industry,time effects, and other
services providedby the financialsector.The contributionsof these services to in-
dustryeconomic efficiency areeconomicallylarge. Forexample,using the coeffi-
cient estimatesin Model I, Table6, a one standarddeviationincreasein the proxy
for the governancefunction (0.294) would increasethe growthrate in economic
efficiency of the averageindustryby about0.18%per annum.Accumulatingover
the 15 years of the sample period,the averageindustrywould be about3% more
720 Journalof Financialand QuantitativeAnalysis

1%
real
cost The
growthcredit
XII and
0.0057*** total
(0.002)
-0.0001 (0.003) 0.0245***
(0.002) -0.0005 (0.011)<0.001 0.0006*** GDP.
<0.001** bythe5%,
<0.001
stochastic
by
Domestic
a
compound 10%,
Xl on divided
GDP. the
0.0060***
(0.002)(0.002)(0.002) 0.0244***
(0.011)<0.001 0.0006*** to country
cost at
-0.0001-0.0023 <0.001 annual
<0.001** the
sector
the equityin
is
X minimum
private
significance
0.0152***
(0.004) 0.0038 0.0260**
0.0154***
(0.003)(0.006)
(0.011)<0.001 0.0006*** theindustry
traded
<0.001 variable
<0.001** the
optimalof
thepublicly indicate
against
of ***
IX from output
dependent
0.0062***
(0.002) (0.003) 0.0255**
(0.011)<0.001 0.0006*** claimsand
-0.0013 <0.001**
<0.001 value real
Thecost **,
the*,
equals
market
actual
VIII effects.
of total
0.0181***
(0.004) 0.0021
(0.002) -0.014*** 0.0251**
(0.004) 0.0006*** sector
(0.011)<0.001<0.001** dividing
<0.001 time the by
parentheses.
and of private
deviation in
Functions of ratio
to
VII given
the calculated
0.0063***
(0.002) -0.0020
(0.002) 0.0256***
(0.011)<0.001 0.0006***
industry,
is Credit
is are
<0.001**
<0.001 terms
Market in
is
GDP.
country, errors
VI by
Capital 0.0077***
0.0026
(0.002)
(0.002) 0.0226**
(0.005)
(0.011) 0.0006*** capitalization
manufacturing
6 -0.0077 <0.001<0.001**
<0.001 efficiency
random in standard
divided
and market
share
TABLE V Economic
transfer
0.0057*** 0.0221** 0.0006*** Stock
containing
(0.002) (0.002) (0.011)<0.001<0.001**
<0.001 Asymptotic
-0.0002
Efficiency Industry
modelsinter-bank
1980-1995. reported.
model.
IV
capitalization.
not
(0.002) 0.0289**
0.0038 (0.011)<0.001 0.0006***
<0.001**period
<0.001
Economic component are
excluding
in themarketrespective
forby the
error
III
0.0015 0.0283** 0.0006*** in intercept
(0.002) (0.011)<0.001 institutions
Growth <0.001** divided
<0.001 the
four-way
countries of
of
38traded variables
II in depository
0.0003
(0.002) 0.0243**
(0.011) 0.0006*** other
<0.001** and Coefficients
stocks
estimates
of two
industries
the
10 authority
of
I shares country.
likelihood
the
0.0061***
(0.002) 0.0236**
(0.011) 0.0006*** the
<0.001<0.001**of total of
<0.001
of product
each monetary
the
maximum the sector
forvalue
are by
the
is
held
represents
manufacturing efficiency
sector in ratio
estimates
Variable capitalization assetsmanufacturing
creditprivate share of the
ratio interaction
Turnover
market to Components sum of respectively.
economic
in
parameter
(TURNOVER) (BANK)
(MKTCAP) (PRIVATE)(SHARE) the
CreditInteraction
Stock Domestic
Turnover Industry's
A2 A32 2 The
Error rate is variable
frontier. levels,
output
Tadesse 721

efficient by the end of the study period, comparedto the actual 15 years median
of 0.032%.
The resultsbased on growthin productionefficiency (APRODEFF), the al-
ternativemeasureof efficiency,are presentedin Table7. In the individualregres-
sions, TURNOVERagain has a relativelylarge and positive effect on production
efficiency (0.004 and significantat 1%).MKTCAPhas no effect on productionef-
ficiency. On the otherhand,BANKandPRIVATEhave positive andsignificantco-
efficientsin the individualregressionsbutthey lose significanceonce TURNOVER
is controlledfor. The results from Models V to XII in Table7 are similarto the
results on economic efficiency (AECONEFF) in Table6.
In light of the structuraldifferencesbetween developedand emergingcoun-
tries discussed in Section III.A, I estimate equations(8) and (9) on the subsam-
ples of developed and emerging countriesseparately. The results (not reported)
are qualitativelysimilar to Tables 6 and 7 for the total sample. TURNOVER
is positively correlatedwith AECONEFF and none of the size variablesenter
the regressionswith statisticalsignificance. Raising TURNOVERalso increases
APRODEFF in both subsamples, while raising the size variables does not af-
fect APRODEFF. The consistency of the results across the sub-groupsprovides
additionalrobustness.

C. Allocation
andEconomicPerformance:
TheTechnological
Change
Channel
This section explores in detail the impactof capitalmarketfunctionson TC.
My hypothesisis thatthroughA the financialsystem enables firmsto adopttech-
nological innovationsand inventions.
Table 8 presentsthe results in which I regress industryTC on proxies of G
and A. In the individualregressions,TURNOVERfails to be statisticallysignifi-
cant. MKTCAPenterspositivelybutis significantonly at 10%. On the otherhand,
both BANK and PRIVATEcarry statisticallysignificantpositive coefficients, in-
dicating a strong relation between the degree to which the supportingfinancial
system provides allocation services and the rate of technological change attain-
able by industries. Raising the size of BANKby one standarddeviation (0.329)
increases the t of the average industryby about 0.07% per annum(double the
effect of MKTCAP).
In Model V of Table 8, where MKTCAPappearswith TURNOVER,both
variablesenter positively but both fail to be significant. In Models VI and VII,
where TURNOVERand MKTCAP are included, respectively, beside BANK,
TURNOVERand MKTCAPfail to be significant while BANK is robustly posi-
tive (0.0025 and 0.0026). Increasingthe size of domestic credit raises the rate
of TC even after controllingfor effects of equity markets. Similarly,the coeffi-
cients of PRIVATEare significantlypositive in Models VIII and IX. Finally, in
Models X and XI, where both TURNOVERand MKTCAPappearin additionto
BANK and PRIVATE,respectively,only the credit marketvariables(BANKand
PRIVATE)remainstatisticallysignificant.Controllingfor the governanceand al-
location services of the equity market,increasingA by the credit sector increases
the rate of TC.
722 Journalof Financialand QuantitativeAnalysis

theat
GDP. in
sector
XII growthto
0.0034***
(0.001)(0.001) 0.0008
(0.002) 0.0164"*
(0.008)<0.001* 0.0004***
stochastic
-0.0005 <0.001
<0.001* a
private
industry
significance
onequity
compound thethe
Xi of
traded indicate
output
0.0036***
(0.001)(0.001)(0.001) 0.0162*
(0.008)<0.001" 0.0004***
-0.0003-0.0007 <0.001 annual against
<0.001** ***
output
the publiclyand
is maximum real
of claims**,
X the*,
0.0099***
(0.004) 0.0018
(0.003) 0.0183**
(0.008)<0.001"
(0.005) 0.0004*** value
-0.0098** <0.001**
<0.001 optimal
variable equals
the dividing
marketby
Sector
from parentheses.
IX total in
dependent
0.0041***
(0.001) (0.002) 0.0178**
(0.008)<0.001* 0.0004***
-0.0014 <0.001
<0.001**
The thePrivate
output
of to calculated
given
is
" ratio are
actual
VIII of Credit
effects.
the
0.0120***
(0.003) 0.0020
(0.002) -0.009*** (0.008)0.001
0.0180**
(0.003) <0.001
0.0004***
time is
<0.001**
errors
GDP.
and bymanufacturing
deviation
Functions < of in standard
VII
0.0040***
(0.001) -0.0007
(0.002) 0.0180**
(0.008)<0.001 0.0004*** divided
capitalization
industry,
<0.001** terms share
<0.001
Market in
is Asymptotic
market
transfer
country, Industry
VI
Capital 0.0047***
0.0014
(0.002)
(0.002) 0.0149**
(0.008)
(0.004) 0.0004***Stock
-0.0045 <0.001<.
<0.001
<0.001** efficiencyreported.
7 random model.
inter-bank
and not
are
TABLE V Production
0.0035***
(0.001)(0.002) 0.0147**
(0.008)<0.001 containing
capitalization.
0.0004*** respective
excluding
-0.0002 <0.001**
<0.001
Efficiency theintercept
in
market
models the
1980-1995.
byinstitutions
of
IV
(0.002) 0.0215**
0.0041* (0.009)<0.001*. 0.0004***
<0.001**period variables
<0.001
Production divided
component
in the other
depository
Coefficients
fortraded
error two
III and
0.0028*
(0.002) 0.0204**
(0.009)<0.001 0.0004*** the
<0.001
<0.001** of country.
Growth stocks
four-way
countries the
of 38of authority
of
II in product
0.00002 0.0177** 0.0004*** sharesthesector
(0.001) (0.008) <0.001
<0.001*
<0.001**estimatesmonetary
total
industries
of the
10 by
I represents
thevalue
likelihood
0.0040***
(0.001) 0.0166**
(0.008)<0.001" 0.0004***
of held manufacturing
<0.001** the
<0.001
is the
each assets of
interaction
maximum
forratio respectively.
of
are
sum output
levels,
variable
manufacturing the real
Turnover
efficiency 1%
sector in is The
estimates total
capitalization and
Variable frontier.
GDP.
the
creditprivate share credit
ratio s byby5%,
production
market to Components parameterin 10%,
(TURNOVER)
(MKTCAP)
(BANK)(PRIVATE)(SHARE) 2 2 2
CreditInteraction
Stock Domestic
Turnover Error .77 o2
Industry' Therate Domestic
production
divided
country
the
Tadesse 723

thethe
in of
market
Xl
0.0007 0.0030***
0.0674*** change,
0.0007 (0.0006)
(0.0005) (0.0010)
(0.003) byinstitutions
<0.001"**<0.001**
<0.001**
<0.001*
variables
dividedCoefficients
other
depository
technological
X
0.0008 0.0024*** of traded
0.001**< two
0.0007
(0.0005) (0.0008) 0.0674***
(0.0006) (0.003) and
<0.001"**
<0.001**
<0.001*
rate the
country.
of the
thestocks of
< is of authority
IX
0.0008
(0.0006) 0.0030***0.0671***
(0.0010)(0.003) 0.001** product sector
<0.001***
<0.001** shares
<0.001*variable the
monetary
total
** the
< of
by
VIll dependentrepresents
manufacturing
0.0007
(0.0005) 0.0034***
0.0674***
(0.0009)(0.003) value
held
<0.001**
<0.001*The
<0.001** the
the
is of respectively.
assets
interaction
effects.
of levels,
ratio output
VII time sum 1%
0.0007
(0.0005) 0.0026***
(0.0008) 0.0674***
(0.003) real
<0.001**
<0.001*<0.001*
<0.001**and the
variable
and
Turnover
is Thetotal
5%,
Functions ** the
industry,
credit
GDP.
by10%,
VI
0.0008 0.0025***
(0.0008) 0.0671***
(0.006) (0.003)
by
<0.001***<0.001*
<0.001**
<0.001** 1980-1995. the
Market at
country, country
Domestic
divided
** period the
8 in
Capital
V theGDP.
random
0.0007 0.0009 0.0671*** to sectorsignificance
(0.0005)
(0.0006) (0.003)
<0.001** for
<0.001***
< <0.001**
and
TABLE industry
equity
private
containing the
theof indicate
countries
IV ***
Change 38traded
0.0023***
0.0660***
(0.0008)
(0.003) models
in and
<0.001** <0.001***against
<0.001**
<0.001** output
**,
publicly *,.
real
of claims
** the
industries
component
Ill 10value
0.0020***
(0.0007) 0.0660***
(0.003) error equals
Technological <0.001**
<0.001*<0.001***
<0.001** the dividing
of marketbyparentheses.
in
sector
** four-way
II of each
total
given
fortheprivate
0.0010*
(0.0006) 0.0667***
(0.003) are
<0.001** <0.001*of to calculated
<0.001**
<0.001**
is
estimates
frontier,
ratio errors
Credit
the
I is
0.0007 0.0671*** GDP.
(0.0005) (0.003) likelihood standard
<0.001** <0.001***
<0.001**
<0.001** bymanufacturing
production
the in
of
maximum divided
capitalization
share
Asymptotic
are
estimate
market
transfer
manufacturing on Industry
sectorin reported.
estimates
Stock
Variable capitalization not
share
creditprivate model.
basedinter-bank
ratio or2 are
market to Components parameter
(TURNOVER)
(MKTCAP)
(BANK)
(PRIVATE)
(SHARE) 2
Stock Domestic
Turnover o2
CreditIndustry's
Error o2 The respective
computed intercept
capitalization.
excluding
724 Journalof Financialand QuantitativeAnalysis

Industriesthat accountfor a largerportionof a country'smanufacturingre-


alize higher TC, which may reflect the effects of other sources of comparative
advantage. Also, not surprisingly,industriesin developed countries achieve a
higherrate of TC.
Given the differencesbetween developedand emergingcountriesdiscussed
in Section III.A, I estimatethe model on the subsamplesof developedand emerg-
ing countriesseparately.Again the results (not reported)are qualitativelysimilar
to those in Table8 for the total sample. IncreasingBANKor PRIVATE-the prox-
ies for A-increases TC in both subsamples,whereasTURNOVERandMKTCAP
do not explain variationin TC. As would be expected,the impactof mobilization
in emergingmarketsappearsto be largerthanthatin developedcountries.While
statisticallysignificant,the coefficientsfor BANKandPRIVATEin emergingmar-
kets (0.0048 and0.0087) arelargerthanthose for the developedcountries(0.0019
and 0.0020, respectively).
Overall,the results are consistentwith the hypotheses. First, industriesthat
are supportedby financial systems with greatercapital mobilizationability ex-
hibit faster rates of TC. This is true even after controllingfor G of the capi-
tal markets. Second, in its role as capital mobilizer,the credit sector appearsto
have strongerand largerimpacton TC than stock markets.The effects of BANK
and PRIVATEon TC remain significantlypositive even in models that include
MKTCAP. Third, the role of marketsas providersof G appearsto have little
impacton TC. TURNOVER invariablyfails to explaindifferencesin TC.

V. Robustness
Disclosureand Efficiency
A. Accounting

I use marketturnoveras my mainproxyfor informationproductionandmon-


itoring. An alternativeway to measurethe degreeof informationflow in a capital
marketis to look at the accountingstandardsthatdeterminethe amountandqual-
ity of disclosure by firms tradingin the market. I use an index of accounting
reportingqualityfor differentcountriesdevelopedby the Centerfor International
FinancialAnalysis and Research. The index rates the annualreportsof at least
three companies in each country based on the inclusion or omission of 90 re-
portableitems. The sample of companies used in each countryis designed to
representa cross-sectionof representativeindustries.The index can be viewed as
a measureof the degree of sophisticationand efficiency of the capital marketin
processinginformation.Also, moredisclosureas measuredby the index indicates
the availabilityof public informationthat might be associated with some of the
governancefunctionsof marketsI intendto measure.The index rangesfrom 0 to
90, the higherscore indicatingmore mandatedpublic disclosure. For my sample
(I have the index only for 31 countries),the range is from 24 to 83, the lowest
registeredby Egypt and the highestby Sweden. The U.S. scores 71 on this index.
More developed countries have higher accounting standards (correlation with log
per capita GDP is 0.56); yet, there are exceptions. The U.S. (71), Norway (74),
Canada (74), and Australia (75) score less than Malaysia (78); whereas the Philip-
Tadesse 725

pines (65) and Mexico (60) score as high as Italy (65), Japan(62), and Germany
(62).
Table 9 presents the results using this index, instead of TURNOVER,as a
proxy for G. G as measuredby the index of accountingqualityis stronglyrelated
with improvementsin economic as well as productionefficiency. The coefficient
estimates of the accountingqualityindex in panels A and B are positive (around
0.0001) and statistically significantat 5%. On the other hand, the index is not
importantin explaining differencesin TC (panel C). The index is also positive
and significanton the marginin Models II throughVI in which I control for the
capitalmobilizationproxies. Thus, aftercontrollingfor capitalprovisionin equity
markets(Models II and V of Table 9) and in credit markets(Models III, IV, V,
and VI), higheraccountingstandardqualityis relatedto largergains in efficiency.
Also, consistentwith the earlierresults,none of the proxies for allocationappear
to be associatedwith efficiency gains. Thus, market-basedgovernanceis strongly
related to firm efficiency, whether governanceis measuredin terms of level of
marketactivityor in termsof qualityof accountingdisclosure.

B. CausalityIssues

So far, I have examinedthe associationbetween economic performanceand


the degreeto which capitalmarketsdischargeG andA. I measurethe latterusing
variablesthatI assumeto be exogenous andpredetermined.It may be arguedthat
my proxies for capital marketfunctionsare not exogenous enough in that capital
marketdevelopmentmay simply be a leadingindicatorratherthana causal factor.
In an attemptto isolate the exogenous component of capital marketfunctions,
Table 10 uses two sets of variablesas instruments:indices of investor-protecting
legal codes and countryof legal origin. La Portaet al. (1997) arguesthat legal
protectionsand a country'slegal origin determinefinancialdevelopmentand that
these, in turn, are primarilydeterminedby a country's colonial history. Hence,
the two sets of variableswould be ideal instrumentsfor capital marketfunctions
in that while the variablesare strongly correlatedwith my proxies, they do not
directly correlatewith economic performance. Levine and Zervos (1998) use
these variablesas instrumentsfor financialdevelopment.
In Model I of Table 10, TURNOVERpredeterminedby the extent of legal
protectionaffordedto investorshas a positive, statisticallylargeimpacton growth
in economic efficiency (panel A), and on growthin productionefficiency (panel
B). The exogenous component of the governanceproxy is robustly positively
relatedto growthin economic and productionefficiency on the marginaftercon-
trollingfor stock marketsize andthe size of the creditsector.Similarly,the size of
the creditsectorpredeterminedby the extentof legal protectionis stronglyrelated
to TC (panel C). In Model II, the componentof the governanceproxy predeter-
mined by legal origin has a significantpositive impact on growth in economic
efficiency (panel A), and on growthin productionefficiency (panel B), as does
the allocation proxy on the rate of TC (panel C). Hence, the relations between
governanceand efficiency, and allocationand technologicalchange identifiedso
far are less likely to be explainedby endogeneity.
726 Journalof Financialand QuantitativeAnalysis

TABLE9
Disclosure
Accounting andEconomic
Performance
Variables I II III IV V VI
PanelA. DependentVariable:
Growthin EconomicEfficiency
Accountingstandardquality(x 100) 0.0113** 0.0099** 0.0108** 0.0113** 0.0093* 0.0100**
(0.005) (0.005) (0.005) (0.005) (0.005) (0.005)
Marketcapitalization (x 100) -0.0854 -0.0727 -0.1162
(MKTCAP) (0.152) (0.160) (0.166)
Domesticcredit(x 100) -0.0715 -0.0755
(BANK) (0.199) (0.183)
Creditto privatesector (x 100) -0.0031 0.0981
(PRIVATE) (0.249) (0.239)
IndustrySharein Manufacturing (x 100) 1.883* 1.849* 2.023** 2.032** 1.995** 2.017**
(SHARE) (0.989) (1.000) (0.997) (0.997) (1.008) (1.008)
PanelB. DependentVariable:Growthin ProductionEfficiency
Accountingstandardquality 0.0086** 0.0069** 0.0092** 0.0084** 0.0079** 0.0073**
( x 100) (0.004) (0.003) (0.004) (0.004) (0.003) (0.003)
Marketcapitalization (x 100) -0.0787 -0.1012 -0.1373
(MKTCAP) (0.107) (0.111) (0.118)
Domesticcredit(x 100) 0.0970 0.0888
(BANK) (0.047) (0.0125)
Creditto privatesector(x 100) 0.0720 0.1844
(PRIVATE) (0.186) (0.169)
Industryshare in manufacturing (x 100) 1.671* 1.607** 1.785** 1.782** 1.728** 1.745**
(SHARE) (0.759) (0.762) (0.765) (0.765) (0.767) (0.768)
PanelC. DependentVariable:Technological Change
Accountingstandardquality -0.0075 -0.0087 -0.0061 -0.0081 -0.0073 -0.0090
( x 100) (0.009) (0.009) (0.009) (0.009) (0.009) (0.009)
Marketcapitalization ( x 100) 0.1137* 0.0991 0.0959
(MKTCAP) (0.059) (0.060) (0.061)
Domesticcredit(x 100) 0.219*** 0.1840**
(BANK) (0.080) (0.085)
Creditto privatesector (x 100) 0.2710*** 0.2208**
(PRIVATE) (0.097) (0.104)
Industrysharein manufacturing (x 100) 7.104*** 7.154*** 7.123*** 7.121*** 7.170*** 7.167***
(SHARE) (0.323) (0.341) (0.325) (0.325) (0.342) (0.342)
Theparameterestimatesare maximumlikelihoodestimatesof four-wayerrorcomponentmodelscontainingrandomcoun-
try,industry,and timeeffects. Accountingstandardqualityis an indexof the qualityof companyfinancialdisclosureacross
countries.Stockmarketcapitalization is the ratioof the totalmarketvalueof publiclytradedequityto GDP.Domesticcredit
is the sum of assets held by the monetaryauthorityand depositoryinstitutionsexcludinginter-bank transferdividedby
GDP.Creditto privatesector equals claimsagainstthe privatesector dividedby GDP.Industryshareinmanufacturing is
calculatedby dividingthe realoutputof the industryin the countryby the totalrealoutputof the manufacturing sector of
the country.Coefficientsof the interceptare not reported.Asymptoticstandarderrorsare given in parentheses.*, **,and
***indicatesignificanceat the 10%,5%,and 1%levels, respectively.

VI. Conclusion
I examine the causal relationsbetween capital marketfunctions and firms'
real economic performancefocusing on the governanceroles of capitalmarkets.
I begin from a premise that financial marketsand institutionsplay two critical
roles in an economy: allocation of risk capital throughsaving mobilizationand
risk pooling and sharing(the allocationfunction);and promotionof responsible
governanceand control throughprovidingoutside investorsa varietyof mecha-
nisms for monitoringinside decision makers(the governancefunction). The pa-
per arguesthatthe two functionssystematicallyaffect differentsourcesof growth.
Specifically, I arguethat the governanceservices contributeto improvementsin
the relativeefficiency with which the firmutilizes its resources,while the alloca-
tion function allows firms to adopt new and costly technologies. In so doing, I
Tadesse 727

TABLE10
Market
Capital Functionsand EconomicPerformance:Instrumental
Variables

Variables 1 II
PanelA. DependentVariable:Growthin EconomicEfficiency
Turnover ratio 0.0187*** 0.0171**
(TURNOVER) (0.007) (0.009)
Marketcapitalization 0.0008 -0.0030
(MKTCAP) (0.004) (0.004)
Domesticcredit 0.0081 -0.0099
(BANK) (0.006) (0.009)
PanelB DependentVariable: Growthin ProductionEfficiency
Turnover ratio 0.0105** 0.0149*
(TURNOVER) (0.005) (0.008)
Marketcapitalization 0.0018 -0.0019
(MKTCAP) (0.003) (0.003)
Domesticcredit 0.0079 -0.0108
(BANK) (0.005) (0.008)
PanelC DependentVariable:TechnologicalChange
Turnover ratio 0.0096 0.0112
(TURNOVER) (0.012) (0.008)
Marketcapitalization 0.0179* -0.0019
(MKTCAP) (0.010) (0.005)
Domesticcredit 0.0371*** 0.0241***
(BANK) (0.009) (0.008)
Theparameterestimatesare maximumlikelihoodestimatesof four-wayerrorcomponentmodelscontainingrandomcoun-
try,industry,and timeeffects. InModelI,the instruments are an indexof shareholder'slegal rightsprovidedinthe country's
legal codes, an indexof legal rightsprotectingdebt holders,judicialefficiency,and an indexof ruleof lawfromLaPortaet
al. (1998). InModelII,the instrumentsare the originof a country'slegal system. Thelegal originvariablesincludedummy
variablesfor Englishorigin,Frenchorigin,Germanorigin,and ScandinavianoriginfromLa Portaet al. (1998). Industry
sharein manufacturing is calculatedby dividingthe realoutputof the industryinthe countryby the totalrealoutputof the
manufacturing sector of the country.Coefficientsof the interceptare not reported.Asymptoticstandarderrorsare given
in parentheses.*, **,and ***indicatesignificanceat the 10%,5%,and 1%levels, respectively.

trace the mechanismsthroughwhich financialdevelopmentinfluenceseconomic


growth.
Based on industry-leveldatafor 10 manufacturingindustriesacross38 coun-
tries from 1980-1995, I find evidence consistent with these hypotheses. First, I
find that both governanceand allocationare significantdeterminantsof real out-
put growth and productivity.Second, I reportthat the impact of governanceon
productivitydominatesthe impact of allocation. Third,I find that while gover-
nance works throughthe channel of improvingeconomic efficiency to promote
productivity,the allocationfunction affects the technologicalchange component
of productivity.
The findingof a strong associationbetween economic performanceand the
effectiveness of financialmarketssuggests the importanceof financialdevelop-
ment as a policy for acceleratingeconomic growth. It provides evidence that
financial sector policies that promote a financial market'sfunctionalcapacities
lead to betterreal economic performance.It points out the incompletenessof tra-
ditional developmentstrategiesthat exclusively focus on real sector reforms to
induce economic development.
Furthermore,throughlinking the multiple functionsof the financialsystem
to the primalsourcesof economic performance,the studyunderscoresthe impor-
tance of a functionalperspectivein guiding financialsector policies. The study
documentsthat the differentfunctions of the financialsystem play distinct roles
728 Journalof Financialand QuantitativeAnalysis

in the economic growthprocess. In particular,the governancefunctionpromotes


economic efficiency. The depthof the financialinfrastructureof an economy has
to be judged in terms of the effectiveness and efficiency with which it delivers
these multiplefunctions. A mere launchingof financialmarketsand institutions
is not sufficientfor acceleratinggrowth-theirefficientfunctioningalso matters.
The prevailingpolicy discussions of financial systems, particularlyin de-
veloping countries,have focused on their role in mobilizing savings for industri-
alization. Such emphasis on the capital provision role was inevitable given the
dominanteconomic thinkingon the subject,the McKinnon-Shaw(see McKinnon
(1973) and Shaw (1973)) paradigm,which views the financialsystem as a mere
conduitof capitalprovision.In this study,based on a corporatefinanceparadigm,
I attemptto show the shortcomingsof such a policy perspectiveby providingevi-
dence thatthe value of financialmarketslies in theirgovernanceservices thatare
distinctfrom capitalmobilization.

intoEfficiencyand
Appendix:Decompositionof Productivity
TechnicalChange
I assume that there exists an unobservablefunction, a productionfrontier,represent-
ing the maximum attainableoutput level for a given combinationof inputs. I represent
these best-practiceproductiontechnologies by a translogproductionfunctionof the form,8

(A-l)
lnyci(t)=o_o++jInxnci(t)+tt

0
0

where cci(t) = ac +r + v+i(t), x'ci(t)andxi(t) areproductioninputsj andk used in industry


i of country c during period t. The productioninputs are capital, K, and labor, L. The
variablet, an index of time, representsthe level of technology.pci(t) is a one-sidedrandom
variable and measures the degree of inefficiencyof industry i of country c in period t.
The specificationis a randomeffects model in which latent country and industryeffects
are specified as randomvariables. ac and 71iare the randomunobservablecountry- and
industry-specificeffects, respectively,and vci(t) is the usual white noise. The distributional
assumptionson the errorcomponentsare

(A-2) 0

and ~p(t)0,
pci(t)iid-half-normal0,cr)

Vei(t)iidN0,o,.
8My choiceof thisparticularfunctionalformis dictatedby its flexibilityreducingthechanceof
whenin facttheproblemis a poorfitto thedataof a morerestrictive
inefficiency
inferring form.More-
over,thereis evidencethatmanufacturing is non-homothetic
production andexhibitsscaleeconomies,
bothof whichareaccommodated in thetranslogform.
Tadesse 729

Fromequation(A-1), the estimateof the rateof technologicalchange, TC,for industryi in


countryc for period t is given by

(A-3)
TCcit

Using the predictedvalue of the inefficiency term (pci(t)) from equation (A-1), the
level of productionefficiency of industryi of countryc duringperiod t is

(A-4) PRODEFFcit=e-uci(t)
PRODEFF representsthe ratio of actual outputto the maximum attainableoutput if the
industrywere efficient, holding the technology (i.e., the productionfrontier)and the level
of input usage constant. Its value ranges from 0 to 1 (i.e., 100% efficient). Growthin
productionefficiency (APRODEFF) for industry i in country c over period (t) is then
given by

(A-5)
APRODEFF=0nPRODEFF

Using the productionfunction framework,this estimate only measures production


efficiency. It does not accountfor the possible errorof the firmin choosing an appropriate
input mix given relativeprices (i.e., price inefficiency). I estimate an economic efficiency
score that reflects both productionand price efficiencies based on the dual stochasticcost
frontier.9,10After estimatinga translogcost functionanalogousto equation(A-1), the level
of economic efficiency for industryi, in countryc, and in period t is

(A-6) ECONEFFci(t)=e-Oci(t)
where Oci(t) is a one-sided randomvariabledenoting the degree of economic inefficiency.
Equation(A-6) is the ratioof the minimumcost on the frontierto actualcost incurredand
ranges in value from 0 (inefficient) to 100% (efficient). Growthin economic efficiency
(AECONEFF) is then given by

(A-7)
AECONEFFci(t)=InECONEFFi-(t)

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