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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
(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
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
A. Governanceand EconomicPerformance:
The EconomicEfficiency
Channel
B. Allocation TheTechnological
and EconomicPerformance: Change
Channel
(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
(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.
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
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
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
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).
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%
(5)
GVcit=kFk+Zct+Ecit,
(6)
GPcit=k+
(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
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
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
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
(8)
AECONEFFcit=-o+S1
(9)
APRODEFFcit=/3o+:kFEct
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
V. Robustness
Disclosureand Efficiency
A. Accounting
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
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.
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
(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
(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
(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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