Financial Dependence and Growth- Raghuram G.

Rajan; Luigi Zingales (1998)

Pre and Post 2008 crisis 1929, 1997, 2008 and dotcom crisis Pre-crisis gains in all the crisis were
wiped off in the crisis

Financial Capitalism- how many and how large financial services are required?
&
Manufacturing Capitalism

Hence, Finance is a lubricant and not a machine for growth

Also, absence of financial markets will hamper economic growth, and presence of one may not lead to
growth.

We ask whether industrial sectors that are relatively more in need of external finance develop
disproportionately faster in countries with more-developed financial markets. We find this to be true in
a large sample of countries over the 1980's.

Other studies
1. Joseph A. Schumpeter (1911), emphasizes the positive influence of the development of a country’s
financial sector on the level and the rate of growth of its per capita income.
2. Raymond W. Goldsmith (1969 p. 48) concludes that "a rough parallelism can be observed between
economic and financial development if periods of several decades are considered."

Limitations of literature: It shows only correlation/ speculation/ indication

1. First, both financial development and growth could be driven by a common omitted variable such as
the propensity of households in the economy to save. Since endogenous savings (in certain models of
growth) affects the long-run growth rate of the economy, it may not be surprising that growth and initial
financial development are correlated.
2. Second, financial development-typically measured by the level of credit and the size of the stock market -
may predict economic growth simply because financial markets anticipate future growth; the stock
market capitalizes the present value of growth opportunities, while financial institutions lend more if they
think sectors will grow.
3. It is difficult to interpret observed correlations in cross-country regressions in a causal sense.
4. Problem with the traditional methodology is that explanatory variables are multi collinear and are
measured with error

Specifically, theorists argue that financial markets and institutions help a firm overcome problems of
moral hazard and adverse selection, thus reducing the firm's cost of raising money from outsiders. So
financial development should disproportionately help firms (or industries) typically dependent on
external finance for their growth. Such a finding could be the "smoking gun" in the debate about
causality. There are two virtues to this simple test. First, it looks for evidence of a specific mechanism by
which finance affects growth, thus providing a stronger test of causality. Second, it can correct for fixed
country (and industry) effects.

Ceteris paribus, an industry such as Drugs and Pharmaceuticals, which requires a lot of external funding,
should develop relatively faster than Tobacco, which requires little external finance, in countries that are
more financially developed. Examples:
1. Malaysia, which was the most financially developed by our measures, Drugs and Pharmaceuticals
grew at a 4 percent higher annual real rate over the 1980's than Tobacco (the growth rate for each
industry is adjusted for the worldwide growth rate of that industry).
2. Korea, which was moderately financially developed, Drugs grew at a 3 percent higher rate than
Tobacco.
3. Chile, which was in the lowest quartile of financial development, Drugs grew at a 2.5-percent lower
rate than Tobacco.
So financial development seems to affect relative growth rates of industries in the way predicted

Hypothesis- Industries that are more dependent on external financing will have relatively higher growth rates
in countries that have more developed financial markets.
Financial industry Gestation or Technology
Model-
Growth j,k = Constant + B1 ... m * Country Indicators + Bm+1 ....n * Industry Indicators + Bn+1 * (Industry j's
share of manufacturing in country k in 1980) + Bn+2 * (External Dependence of industry j * Financial
Development of country k) + Ej,k Interaction variables

A Measure of Dependence on External Finance

Data on the actual use of external financing is typically not available. But even if it were, it would not be
useable because it would reflect the equilibrium between the demand for external funds and its supply.
Since the latter is precisely what we are attempting to test for, this information is contaminated.

We assume that there is a technological reason why some industries depend more on external finance than
others. To the extent that the initial project scale, the gestation period, the cash harvest period, and the
requirement for continuing investment differ substantially between industries, this is indeed plausible.

If Pharmaceuticals require a larger initial scale and have a higher gestation period before cash flows are har-
vested than the Textile industry in the United States, it also requires a larger initial scale and has a higher
gestation period in Korea.

Hence the proxy are: tech advancement and gestation period

Finance External Finance Internal Finance

Gestation High Low
Technology High Low
Comparative Advantage New entrants Incumbents

Is the Dependence of U.S. Firms a Good Proxy? Much of our analysis rests on dependence of U.S. firms on
external finance being a good proxy for the demand for external funds in other countries

1. A steady-state equilibrium there will not be much need for external funds
2. Even if the new investment opportunities generated by these worldwide shocks differ across
countries, the amount of cash flow produced by existing firms in a certain industry is likely to be
similar across countries.
3. One might argue that the stage of the product life cycle that U.S. firms are in is likely to be different
from that of foreign firms
4. We only have a noisy measure of the need for funds creates a bias against finding any interaction
between dependence and financial development.

Measures of Financial Development- it is a latent construct (not-observable)

Financial development should measure the ease with which borrowers and savers can be brought together,
and once together, the confidence they have in one another. It is also related to the variety of intermediaries
and markets available, the efficiency with which they perform the evaluation, monitoring, certification,
communication and distribution functions, and the legal and regulatory framework assuring
performance. The 4 measure are:
1. The ratio of domestic credit plus stock market capitalization to GDP. We call this the capitalization
ratio. Why this- (Unlike domestic credit, stock market capitalization does not reflect the amount of
funding actually obtained by issuers. Instead, it reflects a composite of retained earnings, the
investing public's perception of the corporate sector's growth prospects, and actual equity issuances.
 Initial public offerings and secondary offerings is more suitable for our purpose. Unfortunately,
these data are not widely available)
2. Accounting standards in a country- It reflect the potential for obtaining finance rather than the
actual finance raised (easier to raise finance). If the accounting standards are poor, institutions will
invest because they have information and bargaining power.
3. Domestic credit to private sector over GDP- size and % of GDP
a. Country internally finances itself
b. Investors invest in domestic companies
c. Investors are confident in the companies
4. Per Capita Income-
a. Marginal propensity to save
b. Crowding-out effect (William Easterly et al. 1993) - firstly liquid assets, than returns are wiped
off, so new avenues in financial assets.

Limitations
Other Explanations: Reverse Causality
An alternative explanation of the development of financial markets is that they arise to accommodate the
financing needs of finance-hungry industries. Suppose there are some underlying country-specific factors
or endowments (such as natural resources) that favour certain industries (such as Mining) that happen to
be finance hungry. Then, countries abundant in these factors should experience higher growth rates in
financially dependent industries and as a result should develop a strong financial market. But the authors
have taken only manufacturing industries, so this may not happen.

Conclusion
1. Financial development has a substantial supportive influence on the rate of economic growth and
this works, at least partly, by reducing the cost of external finance to financially dependent firms.
Financial development may play a particularly beneficial role in the rise of new firms. If these firms
are disproportionately the source of ideas, financial development can enhance innovation, and thus
enhance growth in indirect ways.
2. In the context of the literature on financial constraints, this paper provides fresh evidence that
financial market imperfections have an impact on investment and growth
3. In the context of the trade literature, the findings suggest a potential explanation for the pattern of
industry specialization across countries. To the extent that financial market development (or the
lack thereof) is determined by historical accident or government regulation, the existence of a well-
developed market in a certain country represents a source of comparative advantage for that country
in industries that are more dependent on external finance. Similarly, the costs imposed by a lack of
financial development will favour incumbent firms over new entrants. It also helps in determining
the size composition and concentration of an industry.