1. Adjustment to Target Capital, Finance, and Growth Elias Papaioannou European Central Bank March 2007 Antonio Ciccone UPF-ICREA

2. 2 Introduction Large literature finding an empirical link between financial deelopment and (subsequent) growth Cross-country work linking size of financial markets to (subsequent) growth (e.g. King and Levine, QJE 1993; Beck et al. JME 2000, JFE 2000) Cross-country before-after studies linking financial liberalization to growth (e.g. Henry JFE 2001; Bekaert et al., JFE 2005) Within country before-after banking deregulation studies, mainly in the US (review Strahan, 2003), but also France (Bertrand at el., JF 2006) and Italy (Guiso et al., QJE 2004) Introduction Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

3. 3 What are the channels through which finance impacts growth? —(I) Lowers cost of capital  investment (neoclassical view) —(II) Reallocates capital more quickly to where investment opportunities are (Bagehot, 1873; Schumpeter, 1911) HOW CAN WE TELL? Introduction Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

4. 4 -- Financial development  lowers cost of capital  investment Rajan and Zingales (1998): If that is the case, financial development should foster growth especially in capital intensive industries (neoclassical international specialization argument) Channel (I) Introduction Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

5. 5 Rajan and Zingales’ (ad-hoc) approach 1. Construct measure of EXTERNAL finance dependence industry i 2. Examine evidence for disproportionate industry growth effect of financial development (FD) Introduction Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

6. 6 Channel (II) -- Financial development  faster capital reallocation to industries with good growth opportunities Wurgler (2001), Fisman and Love (2004, 2007) 1. Construct measure of global growth opportunities of industry i 2. Examine evidence for disproportionate industry growth effect Introduction Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

7. 7 Suggestive reduced-form approach to answer important questions. But ad-hoc, which leads to key questions remaining unanswered. For example, -- is the non-robustness due to SALESGR being a less-than- perfect measure of investment opportunities? -- what is the role of measurement error introduced by using US proxies for global shifts? Channel (II) continued… Open Questions – Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

8. 8 THIS PAPER CONCEPTUAL -- Theoretical framework to study link between financial development, capital reallocation across industries, and growth (tailored to the data we have) This allows us to: -- Identify the problems of using US proxies for global industry characteristics -- Propose an approach to resolve these problems Main ESTIMATION result -- Industries with better (global) investment opportunities grow faster in countries with greater financial development Introduction Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

9. 9 Presentation Overview 1.Theoretical framework 2.Model estimation issues 1.Bias when employing US (or any other country) data to construct global industry characteristics 2.Dealing with measurement error (bias) 3.Data 4.Results 1.Using US-based proxy only 2.Accounting for measurement error 5.(IN)Sensitivity of estimation results 6.Summary Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Introduction

10. 10 Theoretical Framework Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth -- many open economies -- many industries, with country-specific varieties -- countries may differ in industry productivity (Ricardian element) and may face different demand for their varieties -- industry productivity and demand may shift globally; these shifts result in changes in the optimal amount of capital across industries -- countries may also differ in their level of financial development; lower development may slow down adjustment of capital to its target

11. 11 Theoretical Framework: Perfect Financial Markets Unexpected and anticipated productivity and demand shifts at the industry level Growth in the optimal capital stock (target capital) at the industry-country level Industry value added growth Frictionless Equilibrium (Perfect Capital Markets) Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

12. 12 Theoretical Framework: IMPerfect Financial Markets Unexpected and anticipated productivity and demand shifts at the industry level Growth of target capital at the industry-country level Industry value added growth Actual capital growth Financial UNDERDevelopment WEDGE Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

13. 13 Model Industries Countries Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

14. 14 Long-Run Equilibrium: Perfect Financial Markets Increases in target capital reflect anticipated future industry growth opportunities (due to technical change, demand shifts, and changing prices of international competitors) Target capital (no frictions) Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

15. 15 Financial UNDERDevelopment and Capital Adjustment 1 0 Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Financial Development

16. 16 Financial Underdevelopment and Value Added Growth Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

17. 17 Financial UNDERDevelopment and Growth 1  0 Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Financial Development

18. 18 Anticipated productivity shifts, demand shifts, and target capital growth Global industry investment opportunity Country effect Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth mean zero

19. 19 Estimating equations Growth Equation Industry US-based Proxy of Investment Opportunities Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

20. 20 Measurement error Scenario 2: Non-classical measurement error Scenario 1: Classical measurement error Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

21. 21 Non-classical measurement error: Extreme Example -- Countries with high financial development have idiosyncratics just like the US -- Countries with low financial development have idiosyncratics that are independent of the US

22. 22 Non-classical measurement error: True values True values 0 1 Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Financial Development

23. 23 True values 0 1 Least squares Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Financial Development Non-classical measurement error: Estimated values

24. 24 Combining classical and non-classical measurement error True values 0 1 Least squares Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Financial Development 1  Sign of least-squares bias unclear

25. 25 Data 1.Country-Industry level (from UNIDO) Value added growth in the 1980s 66-67 countries; 27-28 manufacturing industries (3 digit ISIC) 2.Country-level (various sources) FD: main measure is private credit to GDP Other control variables: GDP, institutions, human capital 3.Industry-level (NBER US manufacturing database) US industry capital growth Other proxies of industry growth opportunities used in the literature Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

26. 26 Least squares estimation: Basic Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

27. 27 Least squares estimation: With controls Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

28. 28 Least Squares: Opportunities and finance dependence Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Table II Rajan and Zingales (1998)

29. 29 IV approach to country-idiosyncratics Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Why is least squares biased? -- US capital growth mismeasures global growth opportunities -- US capital growth idiosyncratics may be correlated with idiosyncratics of financially developed countries (but not financially underdeveloped countries) Solution: Instrument US capital growth by a variable that does not reflect US idiosyncratics

30. 30 Instrument: Predicted US industry growth using industry-country growth outside of the US Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth 1 st step: Run the regression (without US data!) 2nd step: Obtain growth at US level of financial development

31. 31 Instrument Relevance: Predicted and Actual US Industry Growth slope=0.49 t-stat=3.54 Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

32. 32 Predicted and Actual US Industry Growth (Robust Estimation) slope=0.68 t-stat=4.71 Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

33. 33 Financial Development and Growth: Instrumental Variable Estimates Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Table III Mirror Table-Sensitivity LS estimate=0.3

34. 34 Comparisons Other Measures of Growth Opportunities Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Table IV

35. 35 Why are Results with US Sales Growth Weak? US industry sales growth= Capital growth [which depends on anticipated growth opportunities] + Unexpected shocks to productivity and demand But, not even the best financial systemn can reallocate capital in response to shocks that could not have been anticpated.

36. 36 Comparisons Other Measures of Growth Opportunities Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Table IV

37. 37 Comparisons Other Measures of Growth Opportunities Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Table IV

38. 38 Endogeneity of Financial Development and Measurement Error in US-based proxy of opportunities Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Table VII Sensitivity Analysis

39. 39 Sensitivity Analysis 1.Alternative measures of financial development Table 2.Other determinants of industry growth dynamics Table 3.Income differences (excl. low income countries) TableTable 4.Other measures of institutional quality and investment opportunities (legal inefficiency; property rights protection) TableTable 5.Further accounting for correlated industry shocks TableTable 6.State ownership of banks as a measure of financial underdevelopment Table Table Theoretical Framework – Estimation – Data – Results Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Sensitivity Analysis

40. 40 Summary 1.Theoretical framework linking global industry productivity and demand shifts, financial development and growth. 2.When using only US data to proxy global industry investment opportunities.  two countervailing measurement error biases 3.IV approach to account for country idiosyncratics Combine two noisy measures of global investment opportunities: –Actual capital growth in the US –Average non-US value added growth in a hypothetical country with well- developed capital markets 4. Main empirical finding: In countries with well-developed financial markets, industries with good investment opportunities grow faster Conclusion Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth

41. 41 Presentation Appendix Tables Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Appendix Tables

42. 42 Other Determinants of Industry Growth Dynamics Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Supplementary Appendix Table VI Appendix TablesSensitivity Analysis

43. 43 Other Measures of Financial Development Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Supplementary Appendix Table VII Appendix TablesSensitivity Analysis

44. 44 Accounting for Economic Development Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Table V Appendix TablesSensitivity Analysis

45. 45 Accounting for the Interaction between other Institutional Factors and Investment Opportunities Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Table VI Appendix TablesSensitivity Analysis

46. 46 Further Accounting for Correlated Industry Shocks Across Financially Developed Countries Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Analogous to Table III Appendix TablesSensitivity Analysis Mirror Table

47. 47 Financial Development - State Ownership of Banks Sensitivity Analysis Ciccone and Papaioannou: Adjustment to Target Capital, Finance, and Growth Appendix Tables