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Adjustment to Target Capital, Finance, and Growth

Adjustment to Target Capital, Finance, and Growth. Antonio Ciccone UPF-ICREA. Elias Papaioannou European Central Bank. March 2007. Introduction. Introduction. Large literature finding an empirical link between financial deelopment and (subsequent) growth

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Adjustment to Target Capital, Finance, and Growth

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

  2. Introduction 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) Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

  3. Introduction Introduction 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? Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

  4. Introduction Channel (I) -- 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) Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

  5. Introduction 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) Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

  6. Introduction 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 Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

  7. Open Questions–Theoretical Framework– Estimation – Data – Results Channel (II) continued… 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? Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

  8. Introduction 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 Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

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

  10. Theoretical Framework– Estimation – Data – Results Theoretical Framework -- 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 Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

  11. Theoretical Framework– Estimation – Data – Results 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 Frictionless Equilibrium (Perfect Capital Markets) Industry value added growth Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  29. Theoretical Framework – Estimation – Data – Results IV approach to country-idiosyncratics 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 Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

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

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

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

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

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

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

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

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

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

  40. Conclusion Summary • Theoretical framework linking global industry productivity and demand shifts, financial development and growth. • When using only US data to proxy global industry investment opportunities. two countervailing measurement error biases • 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 Ciccone and Papaioannou:Adjustment to Target Capital, Finance, and Growth

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

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

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

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

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

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

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

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