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«Financial Dependence and Industry Growth in Europe: Better Banks and Higher Productivity Research Memorandum GD-100 Inklaar, Robert and Michael ...»

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University of Groningen Groningen Growth and

Development Centre

Financial Dependence and Industry Growth in

Europe: Better Banks and Higher Productivity

Research Memorandum GD-100

Inklaar, Robert and Michael Koetter



Financial dependence and industry growth in Europe:

Better banks and higher productivity Robert Inklaar and Michael Koetter University of Groningen April 2008 Abstract Financial development stimulates growth, in particular in industries dependent on external finance. In this paper we show that more efficient banks are particularly important in stimulating both output and productivity growth, while traditional volume measures of finance are much less important for productivity growth. For this we exploit firm-level information to measure the dependence of industries on external finance and the efficiency of intermediaries. Our results are in line with Schumpeter’s (1912) contention that bankers provide resources to the most deserving entrepreneurs.

Within the EU-25, growth gains are concentrated in the new member states.

Inklaar: R.C.Inklaar@rug.nl; Koetter: M.Koetter@rug.nl. This paper is written as part of the “EU KLEMS project on Growth and Productivity in the European Union”. This project is funded by the European Commission, Research Directorate General as part of the 6th Framework Programme, Priority 8, “Policy Support and Anticipating Scientific and Technological Needs”. Michael Koetter acknowledges financial support from the Netherlands Organization for Scientific Research NWO. We would like to thank seminar participants at the University of Groningen and the European Central Bank for helpful comments and suggestions. Any remaining errors are, of course, our own.

1 Introduction 1.

Most economists would agree that a better developed financial system is beneficial for economic growth (Levine, 2005). The seminal contribution of Rajan and Zingales (1998) strengthened this notion by alleviating concerns of reverse causality.1 They exploit cross-industry differences in dependence on external finance to identify the growth effects of international differences in financial development for a heterogeneous sample of countries. But sampling such different countries might lead to biased results.2 Furthermore, financial development is measured by volumes of financial funds intermediated, which may be poor proxies of theoretical priors (Levine, 2005). Also, the channel through which economic growth is affected is not clear. Finally, financial dependence is measured with the assumption that the U.S. is the benchmark financial system for the rest of the world.3 In this paper we extend the Rajan and Zingales (1998) results for 25 countries of the European Union (EU), a particularly policy-relevant sample given the efforts to construct a single European market for financial services.4 We cover the period 1994-2004 and address three questions, namely how measurement of financial development can be improved; whether financial development stimulates factor accumulation or productivity growth; and whether EU countries benefit uniformly from financial development.5 Our results corroborate and extend the findings of Rajan and Zingales (1998). Both bank cost and profit efficiency scores are economically and statistically significant factors in spurring economic activity and they facilitate both output and productivity growth. In contrast, traditional volume measures of financial development are much less important in stimulating productivity growth in particular. Within the EU, the growth gains from financial development are concentrated in the new member states that acceded to the EU in 2004.

The first question we address is which aspects of the financial system are of key importance for growth. Theory suggests that better financial development reduces the negative effects of information asymmetries, thereby facilitating the flow of funds from savers to borrowers. However, most empirical studies rely on measures of private credit or stock market capitalization as a percentage of GDP.6 But such volume proxies may increase for other reasons than more efficient financial systems, for instance due to an inflating stock market bubble.

We use instead banks’ relative ability to channel financial funds efficiently from savers to investors as additional indicators of financial development in a country. We estimate cost and profit efficiency of European banks relative to the best-practice frontier with a latent-class stochastic frontier model. For instance, a cost efficiency score measures to what extent a bank uses resources, such as deposits and labour, in optimal proportions to provide financial services at the lowest possible cost.7 1 See Robinson (1952) for an early critique that financial services and products depend on rather than ignite economic activity. Likewise, Levine et al. (2000) discuss methods to address econometric endogeneity aspects, which, however, are different from the inherent reverse causality concerns voiced by Robison.

2 See e.g. Manning (2003), Rioja and Valev (2004) and Guiso et al., (2004).

3 See Furstenberg and von Kalkreuth (2006) for a critical discussion of this assumption.

4 We cover the countries that were member of the European Union before the accession of Bulgaria and Romania in January 2007.

5 For other studies focusing on Europe specifically, see e.g. Fernández de Guevara and Maudos (2007), Romero-Ávila (2007) and Hartmann, Heider, Papaioannou and Lo Duca (2007).

6 These two measures are used very often, see also Beck et al. (2000b) for a host of other financial volume measures; Rajan and Zingales (1998) on accounting standards; Wurgler (2000) on the investment elasticity of output as a measure of allocative efficiency of capital; La-Porta et al. (1997, 1998) on legal origins as an underlying determinant of financial development; de Serres et al. (2006) and Romero-Ávila (2007) on the regulatory framework as a feature of financial development; and Hartmann et al. (2007) on a diverse collection of financial system indicators.

7 See e.g. Berger and Humphrey (1997) for more on such measures.

2 While a handful of studies investigate the relation between bank efficiency and economic growth at the country or regional level, this is the first study to use industry data, and hence avoid many endogeneity concerns.8 We hypothesize that relative efficiency scores are informative in addition to the conventional volume measures since they emphasize the quality of financial institutions.

Efficiency measures are by no means a perfect reflection of financial development. But they constitute in our view an important additional quality dimension next to the quantity channel.

Our results confirm previous studies that deeper credit and capital markets spur growth. In addition, we find that both quality proxies, bank cost and profit efficiency, exert an independent as well as statistically and economically significant growth impetus. Hence, it is not only the quantity of financial funds, but also the quality of intermediation that spurs growth.

The second question is how growth is stimulated by a well-developed financial system.

Schumpeter (1912) conjectured that bankers and other intermediaries allocate funds to the best firms and most promising entrepreneurs. This should not only increase the overall flow of funds but in particular the allocation of funds to more productive firms, thereby ultimately fostering growth. Better financial development can therefore lead to both higher factor accumulation and higher multifactor productivity growth, the growth in output that cannot be accounted for by the growth in labour and capital. We are not able to test this directly at the industry level since we lack data on multifactor productivity growth for a number of European countries, but we argue our two-part test achieves the same result. First, we eliminate growth of employment as a source of growth by using labour productivity growth instead of output growth as the dependent variable. Second, we use investment growth as a dependent variable to test whether financial development stimulates capital accumulation.

We find that financial development can explain differences in labour productivity growth but not in investment growth. This leads us to conclude that financial development has a positive effect on multifactor productivity growth. Our findings are broadly in with the cross-country literature, which tends to find more support for an effect of financial development on productivity growth than on investment.9 Carlin and Mayer (2003) also tried to explain investment at the industry level and found similarly insignificant results.

Finally, most finance-growth studies aim to maximize country coverage. While this is useful for some applications, it is less helpful in formulating policy recommendations. A study focusing on European countries can illuminate the gains from moving to a single, best-practice financial system in Europe. While the EU still does not constitute a harmonised market for financial services, efforts in this direction have long been underway.10 Our analysis for 25 EU countries for the period 1994-2004 should be useful in this policy endeavour and supplement the insights on the gains from policy harmonisation of Romero-Ávila (2007). We find that most of the gains in growth from financial development over this period were concentrated in the 10 new member states, which are characterized by lower average levels of financial development.11 8 See Berger et al. (2004) for a cross-country application and Lucchetti et al. (2001) for a regional study.

9 See e.g. King and Levine (1993a, b), Benhabib and Spiegel (2000) and Beck et al. (2000a).

10 See e.g. Romero-Ávila (2007).

11 This is in line with Manning (2003), who finds that the Rajan and Zingales (1998) results are much weaker for OECD countries.

–  –  –

2. Methodology A key challenge in establishing the effect from increased financial development on economic growth is the potential for reverse causality, i.e. the possibility that finance follows growth. We adopt the method first used by Rajan and Zingales (1998) because it does not only address the econometric aspect of endogeneity.12 They hypothesize that if financial development in a country improves, industries that are more reliant on external finance would benefit most. This led to the following

estimating equation:

Δ ln Vij = α 1 S ij + β1 DEPi × FD j + ε 1.

(1) In equation (1) growth of real value added V of industry i in country j is explained by the initial share of that industry in overall value added S and the interaction between financial dependence DEP of that industry and financial development FD of that country. Growth, financial dependence and financial development are all averaged over a decade and country and industry fixed effects are also included. The key identifying assumption of Rajan and Zingales (1998) is that the financial dependence of US firms is an ‘inherent’ characteristic of the industry and relevant for other countries too.13 How to empirically implement these concepts will be discussed in the next section. Our main methodological innovation will be to test how financial development affects the sources of value added growth at the industry level. In a standard growth accounting framework,14 output grows either

because of growth in inputs or growth in productivity:

Δ ln V = sΔ ln L + (1 − s )Δ ln K + Δ ln Z, (2) where L is labour input, K is capital input, s is the share of labour compensation in output and Z is multifactor productivity (MFP).15 This equation implies that if in equation (1) is positive, this could be because financial development enables greater labour input, capital input, productivity growth or a combination of the three.

A finding that financial development stimulates productivity growth would be of particular interest since this would imply that financial development not only affects the overall flow of funds, indicated by faster factor accumulation, but also how well those funds are used. The theoretical literature has advanced numerous explanations for this. For example, King and Levine (1993b) build a model where financial development increases the speed of innovation by improving the return to innovation; Almeida and Wolfenzon (2005) show how financial development can stimulate intermediaries to invest in higher-return/higher-risk projects and Aghion, Angletos, Bannerjee and Manova (2007) show how financial development can stimulate long-run investments in, for example, 12 A comprehensive review of various methods used in the literature is Levine (2005).

13 This assumption has been questioned (Furstenberg and Kalckreuth, 2006) and we return to some of these criticisms in the data section below. However, this is not the focus of our paper and we mostly follow the literature. In the robustness analysis, we also use a measure of growth opportunities as in Fisman and Love (2007).

14 See e.g. Jorgenson, Ho and Stiroh (2005) or Timmer, O’Mahony and van Ark (2007a).

15 In the most basic set-up, labour and capital are homogenous inputs. Labour is often measured as the total number of workers or hours worked and capital is estimated by cumulating overall investment. In more sophisticated work, different types of workers and capital are distinguished.

4 research and development by protecting against liquidity risk. The implications of these theories differ at the micro-level, but they all imply that improved financial development stimulates industry productivity growth.

Ideally, we would run separate regressions for each of these three sources of output growth, but data limitations preclude this. For quite a number of the new member states from Central and Eastern Europe, long time series of investment data are not available for reliable estimates of capital stocks.16 However, sufficient investment data are available to test whether investment is influenced by financial development. So in addition to equation (1), we will estimate two further equations with labour

productivity growth and investment growth as dependent variables:

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