Finance and Growth:Evidence, Methodology and Channels Thorsten Beck
Finance and Growth • Theory ambiguous • Increases productivity • Depresses savings rates • Empirical question: Looking beyond correlation; how to overcome identification challenge? • Other issues: • Measuring finance • Data – from cross-country to firm/household-level • Looking at channels: • Understanding the mechanisms (differentiate among competing theories) • Additional insights into causality • Distributional impact of finance • Finance and Poverty Alleviation • Finance for Growth vs. Finance for All
This presentation • Finance and Growth – the identification challenge • Finance for Growth – the channels • Finance and Income Distribution • Finance for All?
Measuring finance • Functions of financial institutions/markets • Facilitating exchange of goods and services • Mobilizing and pooling savings • Assess projects and monitor entrepreneurs • Diversify and reduce liquidity and intertemporal risk • No data on functions • Focus on institutions and markets as proxies • Monetary aggregates, bank credit/deposits (IFS), stock market data • Bank level data • Firm-level data
Finance and Growth - basics • Unobserved/omitted variable bias Reverse causation Measurement bias
Finance and Growth – the identification challenge • Instrumental variable approach • Cross-country – historical and geographic experience as external instruments • Panel – internal instruments • Time-series approach: forecast capacity of finance for growth • Differences-in-differences approach: smoking gun • Firm-level evidence • Household-level evidence (more on this later)
Finance, Law, and Growth (1) • Cross-sectional IV regression, instrumenting for finance • Find instrument that (i) explains financial development, but is exogenous to it, (ii) explains growth only through finance • Legal origin: Common vs. Civil Law • Two-stage least square/GMM estimation • Specification tests: • 1st stage F-test • OIR test • Problems: • weak specification tests • Instrument for control variables • IV > OLS coefficient
Finance, Law, and Growth (2) • IV > OLS coefficient • Negative reverse causation? Unlikely • Omitted variable? Implausible • Measurement error in OLS? Ok • Legal origin correlated with omitted variable? Very likely (LLSV…)
Finance and Growth – Dynamic Panel Approach • Use of internal instruments – lagged values of explanatory variables • Difference estimator: Arrellano and Bond (1991): use past levels as IV for current differences • Weak, because • Lose cross-country dimension • Decreases signal-to-noise ratio • If persistent variables, past levels are weak instruments • System estimator; combines differences estimator with level regression that uses past differences as IV. • Problems: coefficients very sensitive to specification; overfit of first stage
Finance and Growth – Time Series Evidence • Forecast capacity of finance for GDP per capita – Granger causality • High-frequency data (annual) • Allows for heterogeneity across countries • Non-stationarity of finance and GDP per capita • Check for co-integration - comovement • Check for Granger causality
Finance and Growth – Differences in Differences (1) • Rajan and Zingales (1998): smoking gun approach: • Do industries more reliant on external finance (exogenous industry characteristics) grow faster in countries with higher levels of financial development? • Treatment/control groups • Challenge: are there inherent industry characteristics? • Reverse causation? • Clustering?
Finance and Growth – Differences-in-Differences (2) • Jaraytne and Strahan (1996) • Until mid-1970s most U.S. states restricted the ability of banks to freely branch within states and across states, reducing competition • Technological progress undermined these restrictions • From mid-1970s until 1994 (Riegle-Neal Act), most states did away within intra- and inter-state branch restrictions • Look at specific policy intervention • Reduce identification problem • Fewer concerns re: measurement error • Allows to assess channels
Finance and Growth – Differences-in-Differences (2) • Result of branch deregulation • Growth accelerated • Bank efficiency improved • Rate of new incorporations increased • Volatility decreased • Move towards efficient capital allocation • Problems/challenges: • Challenge: reverse causation (Kroszner and Strahan, 1996) • Challenge: cluster error terms within states (Bertrand et al.) • Problem: clustering of liberalization across regions (Huang, 2008)
Finance and Growth – Firm-level evidence • Demirguc-Kunt and Maksimovic (1998) • Firms grow faster than predicted by internal resources in countries with better finance • Beck, Demirguc-Kunt and Maksimovic (2005) • Firms’ growth rates are less affected by financing constraints in countries with better finance • Investment-cash flow correlation lower in countries with better finance (Laeven, 2004, Love, 2004)
Impact: finance promotes firm growth Proportion of firms that grow at rates requiring external finance 0.6 KOR JPN 0.5 THA SGP NOR MYS DEU DEU CAN MEX FIN AUT USA AUS ESP 0.4 NZL JOR CHE IND FRA ZWE NLD BEL GBR ITA 0.3 SWE PAK TUR 0.2 ZAF 0.0 0.5 1.0 1.5 Private credit / GDP
Finance and Growth – the channels • Allocation more than accumulation • Cross-country • Productivity growth vs. capital accumulation/savings • Capital reallocation • Differences-in-differences approach • Helps industries with more need of external finance • Helps industries with growth opportunities • Helps industries with higher shares of small firms • Effect seems largest for middle-income countries
Enterprise Credit, Household Credit and Economic Growth – Economic effect • Compare countries at 25th and 75th percentiles • Bank Credit to GDP • Pakistan vs. Thailand: 1.1% faster growth • Enterprise Credit to GDP • Poland vs. U.S. : 1.1% faster growth
Credit Composition and Growth - Interpretation • Only enterprise component of bank lending robustly linked to economic growth • Lending to households has no significant effect on growth (consistent with ambiguous effect predicted by theory) • Increasing importance of household credit in total credit in high-income countries explains why the impact of overall bank lending in these countries is insignificant.
Finance and Growth – Who benefits? • Pro-poor • Credit constraints are particularly binding for the poor (Banerjee and Newman,1993; Galor and Zeira, 1993; Aghion and Bolton, 1997) • Finance helps overcome barriers of indivisible investment (McKinnon, 1973) • Finance foster economy-wide openness and competition by facilitating entry (Rajan and Zingales, 2003) • Pro-rich: • Non-linear relationship (Greenwood and Jovanovic, 1993) • Credit is channeled to incumbent and connected and not to entrepreneurs with best opportunities (Lamoreaux, 1986; Haber, 1991)
Finance and Poverty Reduction Growth in poverty headcount 0.3 0.2 0.1 0 -0.1 -0.2 -0.3 -0.4 -2 -1 0 1 2 private credit
Finance and Income Inequality – Summary of cross-country work • Finance is pro-growth and pro-poor! • Robust to outliers, IV and GMM • Almost half of positive effect of financial development on income growth of poorest income quintile comes through income distribution effect • Important caveats: • Measurement • Identification • Channels
Finance and Income Distribution – exploiting U.S. branching deregulation • Deregulation at different times allows to exploit state-time-panel • Difference-in-difference estimation of relationship between branch deregulation and log(Gini) • Control for state and year dummies and time-variant state characteristics • 1977 to 2003 • Little concerns of endogeneity • Single policy change - reduce identification and comparability problems often associated with cross-country comparisons
Decomposition of Variance Non-wage income 33% Within unskilled 11% Total income 100% Within skilled 14% Wage income 67% Between skilled and unskilled 75%
Branch deregulation and income distribution – labor market channel • Labor market effect: Deregulation boosts labor demand primarily for the unskilled. • This increases the employment of less skilled workers, explaining reduction in wage income gap • Effect of branch deregulation goes through improved capital allocation and higher investment, not through expanding access to credit services • Effect of liberalization on income distribution NOT through: • Higher entrepreneurship • Human capital allocation
Finance, Income Inequality and Poverty Reduction • Finance reduces income inequality • Mechanism seems to work through better capital allocation and structural changes • U.S. evidence (see above) • General equilibrium models for Thailand suggests that financial development results in shifting labor from agriculture subsistence to formal sector, with repercussions for growth and income inequality (Gine and Townsend, 2004) • Access to credit for all? Microcredit? • Rigorous microcredit studies find mixed results on the impact of access to credit by the poor (Pitt and Khandker, 1998; Morduch, 1998; Khandker, 2003; Karlan and Zinman, 2006; Coleman, 1999) • Large share of microcredit used for consumption purposes • Credit for Growth; Basic financial services for all?
Finance and Growth – What have we learned? • Different methodologies and different aggregation levels show robust effect of finance on growth • Effect through allocation efficiency/productivity growth, less through savings/capital accumulation • Finance is pro-growth and pro-poor, but… • Effect is more on the intensive/qualitative margin than on the extensive margin
Finance and Growth – still more to learn • Advances on macroeconomic techniques (Rigobon: heterogeneity in structural shocks; GMM techniques) • Randomized experiments (household level; spill-over effects) • Look at specific policy interventions
References • Beck (2008): The Econometrics of Finance and Growth, Palgrave Handbook of Econometrics, Vol. 2, forthcoming • Beck, Buyukkarabacak, Neven and Valev (2008): Who Gets the Credit? And does it Matter? Household vs. Firm Lending across Countries, mimeo. • Beck, Demirguc-Kunt and Levine (2007): Finance, Inequality, and the Poor, Journal of Economic Growth 12, 27-49. • Beck, Levkov and Levine (2007): Big Bad Banks? The Impact of U.S. Branch Deregulation on Income Distribution, mimeo. Econ.worldbank.org/staff/tbeck