«Global capital flows and financing constraints Ann E. Harrison a,b,*, Inessa Love c,1, Margaret S. McMillan d,2 a University of California, Berkeley, ...»
Journal of Development Economics 75 (2004) 269 – 301
Global capital flows and financing constraints
Ann E. Harrison a,b,*, Inessa Love c,1, Margaret S. McMillan d,2
University of California, Berkeley, 329 Giannini Hall, UC Berkeley, Berkeley, CA 94720-3310, USA
The World Bank, 1818 H St. NW MC3-300, Washington, DC 20433, USA
Department of Economics, Tufts University, USA
Received 1 April 2002; accepted 1 October 2003
Firms often cite financing constraints as one of their primary obstacles to investment. Global capital flows, by bringing in scarce capital, may ease host-country firms’ financing constraints.
However, if incoming foreign investors borrow heavily from domestic banks, multinational firms may exacerbate financing constraints by crowding host-country firms out of domestic capital markets. Combining a unique cross-country firm-level panel with time-series data on restrictions on international transactions and capital flows, we find that different measures of global flows are associated with a reduction in firm-level financing constraints. First, we show that one type of capital inflow—direct foreign investment (DFI)—is associated with a reduction in financing constraints.
Second, we show that restrictions on capital account transactions negatively affect firms’ financing constraints. We also show that DFI inflows are associated with lower sensitivity of investment to cash flow for firms without foreign assets and for domestically owned enterprises. Finally, the results indicate that these effects are stronger for low-income than for high-income regions.
D 2004 Published by Elsevier B.V.
Keywords: Capital flows; Financing constraints; Direct foreign investment Not all direct foreign investment around the world represents net capital flows. Often such investments are financed in local markets. Martin Feldstein (2000).
* Corresponding author. University of California, Berkeley, 329 Giannini Hall, UC Berkeley, Berkeley, CA 94720-3310, USA. Tel.: +1-510-643-9676.
E-mail addresses: firstname.lastname@example.org (A.E. Harrison), email@example.com (I. Love), firstname.lastname@example.org (M.S. McMillan).
1 Tel.: +1-202-458-0590.
2 Tel.: +1-617-627-3137.
0304-3878/$ - see front matter D 2004 Published by Elsevier B.V.
doi:10.1016/j.jdeveco.2003.10.002 270 A.E. Harrison et al. / Journal of Development Economics 75 (2004) 269–301 There is now broad agreement about the value of direct foreign investment, which brings not just capital but also technology and training. Joseph Stiglitz (1998).
1. Introduction Firms in developing countries typically cite financing constraints as one of their primary obstacles to investment. Some argue that countries should eliminate restrictions on international transactions and encourage incoming capital flows, especially direct foreign investment (DFI). DFI may ease these firms’ financing constraints by bringing in scarce capital. This is one reason why policy makers in developing countries have eased restrictions on inward DFI and in many instances provide special incentives for multinational firms. Yet if foreign firms borrow heavily from local banks, they may exacerbate domestic firms’ financing constraints by crowding them out of domestic capital markets. Foreign investors may borrow on domestic capital markets for a variety of reasons, including as a hedging device against exchange rate fluctuations or in response to artificially low domestic interest rates.3 Yet most observers assume that joint venture activity and acquisitions by multinationals are accompanied by significant capital inflows.4 Although we cannot measure the amount of local borrowing by multinationals, we can examine the impact of incoming DFI on firm investment behavior.5 There has been almost no previous research examining the impact of DFI on hostcountry firms’ financing constraints. One reason for the limited empirical evidence is the difficulty in obtaining detailed firm-level data across countries. In this paper, we combine firm-level panel data from Worldscope with cross-country time-series data on restrictions on international transactions and capital flows to test whether different measures of global flows are associated with a reduction in the sensitivity of firm-level investment to cash flow, which is consistent with a reduction in firm-level financing constraints. First, we test whether different types of capital inflows are associated with a reduction in financing constraints. Our main focus is DFI, but we also test for the effect of portfolio inflows and 3 In many developing countries, interest rates have historically been set at artificially low levels, leading to credit rationing in cases where the interest rate is set below the market clearing level.
4 For example, Stiglitz (1998) in an address to the Chicago Council on Foreign Relations argues that there is broad agreement about the fact that direct foreign investment brings additional capital. Feldstein (2000) argues that this is not necessarily the case. Helleiner (1988) in a survey for the Handbook of Development Economics suggests that it is unlikely that much new equity capital will result from expanded DFI flows.
5 More generally, there are different types of foreign direct investment. One type is a joint venture between a local company in need of capital and a foreign company. In this setup, the local company typically receives financing from the foreign company in the form of an equity injection. Clearly, this arrangement is expected to reduce the financing constraints of the local company. Another type of foreign direct investment is where a foreign company sets up a subsidiary. As the foreign company typically limits its loan exposure to the local subsidiary, the subsidiary will need to borrow to finance investments. The net effect on the financing constraints under this second type of foreign direct investment are therefore less clear. Our data on DFI inflows is aggregate, and thus, we cannot separate the two types of DFI. Therefore, our main results represent the ‘‘average’’ effect of DFI on the ‘‘average’’ firm in our sample. However, to get at the issue of which type of DFI is more prevalent, we do separate domestically owned firms from foreign-owned firms to test whether the ‘‘spillover’’ effects are positive or negative later in the paper.
A.E. Harrison et al. / Journal of Development Economics 75 (2004) 269–301 271 other flows such as commercial bank loans. We find that only DFI is associated with a reduction in financing constraints. Second, we test whether restrictions on capital movement affect firms’ financing constraints. Our results suggest that one type of capital control—restrictions on capital account transactions—negatively affects firms’ financing constraints. Finally, we show that DFI inflows are associated with less sensitivity of investment to cash flow for firms without foreign assets and for domestically owned enterprises. These results suggest that foreign inflows are associated with a reduction in firm-level credit constraints even for domestically owned enterprises. The results also indicate that these effects are stronger in low-income countries.6 Our work is related to the large body of literature on capital market imperfections and firm investment; an excellent survey of this literature is in Hubbard (1998). A number of papers have used the Euler equation methodology to estimate the effect of financing constraints on investment, with most studies concentrating on firms in developed countries. Surveys suggest that financing constraints are an even more important deterrent to investment in developing countries.7 Theoretically, capital market imperfections are likely to be more severe in these countries, which will result in stronger financing constraints due to unavailability of external financing.8 Most empirical evidence of financing constraints in developing countries comes from studies on individual countries, which are difficult to generalize.9 Research that links the level of financial development to financing constraints across countries includes Demirguc-Kunt and Maksimovic (1998), Rajan and Zingales (1998), and Love (2003). Demirguc-Kunt and Maksimovic (1998) finds that firms grow faster than they could have using only internally generated funds in more financially developed countries. Rajan and Zingales (1998) demonstrate that industries that require more external finance grow faster in more developed capital markets; and Love (2003) shows that firm’s investment is less sensitive to the availability of internal funds in more financially developed countries.
Recent evidence also links financial market liberalization to investment and financing constraints across countries. For example, Laeven (2003) finds that financial liberalization 6 Our results are in contrast to Harrison and McMillan (2001), who found that financing constraints of firms in Cote d’Ivoire were exacerbated by the presence of foreign firms, which borrowed heavily on domestic credit markets and crowded out local firms. However, that paper is quite different in two respects. First, it examines the impact of multinational firm borrowing on domestic firms’ behavior—this information is not available across countries. Second, it focuses on a very poor country with a variety of credit market imperfections, which drove foreign firms to borrow heavily from local banks. However, this current paper only includes two low-income countries, India and Pakistan, and it does not include any countries from Sub-Saharan Africa. This may be important because we would expect the domestic firms in the very poorest countries to be the most credit constrained, and at the same time, it is likely that governments in the poorest countries implement policies to help ease these constraints such as interest rate controls.
7 For example, in a recent survey of executives in 20 African countries, financing constraints were cited as a major obstacle to business expansion, see Africa Competitiveness Report (Harvard Institute for International Development and World Economic Forum, 1998). However, these surveys could overestimate the degree of constraints because they are typically administered by institutions in a position to make loans, such as the World Bank.
8 See, for example, Aghion et al. (1999) and Banerjee and Newman (1994).
9 See, for example, Jaramillo et al. (1996) for Ecuador; Harris et al. (1994) for Indonesia; Gelos and Werner (1999) for Mexico; Patillo (2000) for Ghana; Harrison and McMillan (2001) for Cote d’Ivoire; and Bigsten et al.
(2000) for several African countries.
272 A.E. Harrison et al. / Journal of Development Economics 75 (2004) 269–301 reduces firms financing constraints, especially for small firms. Galindo et al. (2001) find that financial reform has led to an increase in the efficiency with which investment funds are allocated. Bekaert et al. (2001) and Henry (2000) find that the cost of equity capital decreases significantly after financial liberalizations. In addition, Bekaert et al. (2001) find that equity market liberalizations increase real economic growth by approximately 1% per year. Yet none of these studies examine the impact of restrictions on international transactions or capital flows on firm-level financing constraints. This paper seeks to fill this gap.
To test whether capital inflows affect firm-level financing constraints, we use augmented investment Euler equations. We modify the investment model by introducing a constraint on external financing, which generates a shadow cost of external funds. This provides a theoretical justification for our measure of financing constraints. In the absence of financing constraints, investment should respond only to investment growth opportunities, which we control for with a measure of the marginal product of capital. Therefore, the availability of internal funds should not affect current investment. We interpret the sensitivity of investment to the availability of internal funds (measured by the stock of liquid assets) as a proxy for the degree of financing constraints. We find that firms in countries with greater DFI inflows have less investment-cash sensitivity, after controlling for other factors.
We also test for the impact of restrictions on international transactions on firm-level financing constraints. Lewis (1997) explores the relationship between income and consumption growth, using aggregate data in a cross-country framework. Using an Euler equation for consumption, she argues that the relationship between domestic income and consumption should be weak if individuals are not credit constrained. In particular, she shows that individuals are more credit constrained in countries with restrictions on international transactions. Our framework tests for the impact of restrictions on international transactions on firms (as opposed to individuals). Our results for firms support her results for individuals. Firms are more financially constrained in countries that impose controls on capital account transactions. Unlike Lewis (1997), however, we find that other types of controls—such as import surcharges or surrender requirements for exporters— have no impact on individual firm’s financing constraints.
An important question is which types of firms are most likely to benefit from capital inflows. Using data available both through Worldscope and from another database, Amadeus, we are able to identify two different types of firms in our data. First, we distinguish between domestically owned firms and firms with some foreign ownership.
Second, we distinguish between firms with foreign assets abroad (which are more likely to be multinational firms) and enterprises with no foreign assets. We find domestically owned firms are more constrained, on average, than firms with either foreign ownership or foreign assets. We also find that incoming DFI has a significant impact on investment-cash flow sensitivities for domestically owned firms and firms with no foreign assets. These results are consistent with the hypothesis that foreign investment is associated with a greater reduction in the credit constraints of firms which are less likely to have access to international capital markets. We argue that this is plausible because incoming foreign investment provides an additional source of capital, freeing up scarce domestic credit which can then be redirected towards domestic enterprises.