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«Abstract This paper studies how the financial development in a country influences firms’ financing and growth decisions. We first document ...»

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Firm Dynamics and Financial Development∗

Cristina Arellano Yan Bai

University of Minnesota and Arizona State University

Federal Reserve Bank of Minneapolis

Jing Zhang

University of Michigan

September 2008


This paper studies how the financial development in a country influences firms’ financing and

growth decisions. We first document empirically the debt financing and growth patterns of

firms with a large and comprehensive dataset from 22 European countries. We find that in economies with worse financial development, small firms grow disproportionately faster than large firms yet have lower leverage ratios, than those in more financially developed countries.

We build a dynamic model where firms’ dynamics are linked to financial institutions. We find that financial considerations can rationalize quantitatively the difference in growth rates between firms of different sizes across countries.

This version is preliminary. Arellano: arellano@econ.umn.edu; Bai: yan.bai@asu.edu; Zhang:

jzhang@umich.edu. We thank V. V. Chari, James Hines, Chris House, Patrick Kehoe, Narayana Kocher- lakota, Ed Prescott, Vincenzo Quadrini, and Richard Rogerson for useful comments and suggestions. We thank Katya Kartashova and Jacek Rothert for excellent research assistance.

1 Introduction Do small and large firms grow at different rates across countries? Are growth rate differences linked to different debt financing behavior? This paper documents that small firms grow disproportionately faster than large firms in less financially developed countries. In these countries, small firms also finance their assets with disproportionately less debt than large firms. We then develop a model to study and quantify these findings where firm dynamics are linked to financial decisions. We find that financial development can go a long way in rationalizing the difference in growth rates across firms of different sizes across countries.

Theoretical models of firm dynamics have shown that financing restrictions can have a real impact on firm size and growth.1 These theories largely predict that small firms grow faster than large firms because they are the ones for which financing frictions are the more severe. But if financial considerations matter for firm dynamics, examining firm growth and debt financing across countries that differ in their financial institutions can prove useful in evaluating the implications of these theories. Hence, in this paper we use firm level data on debt financing and firm growth across many countries to evaluate and quantify the impact of financial development on firms’ behavior.

In the empirical part of the paper, we document the growth and financing patterns of firms using a large and comprehensive firm level database from 22 European countries. We focus on the relative growth and financing behavior of firms of different sizes across countries with varying financial development. First, we find that small firms grow faster than large firms.

And that this difference is stronger in countries that are less financially developed as indicated by the ratios of private credit to GDP and the availability of credit information of consumers.

Second, small firms in more financially developed countries use more debt financing than large firms relative to those in less financially developed countries. Importantly, these findings are robust to controlling for country, industry or age specific characteristics. To the best of our knowledge, this work is the first to document these relations for comprehensive firm level datasets that include a large number of small private firms across many countries.2 The paper then develops a dynamic model of firms’ growth and debt financing to evaluate and quantify the mechanisms by which financial development interacts with firms decisions.

1 See for example Cooley and Quadrini (2001), Albuquerque and Hopehayn (2004), and De Marzo and Fishman (2006) among others.

2 The negative relation between size and growth has been documented for U.S. firms in Rossi-Hansberg and Wright (2005) and Klette and Kortum (2004).

2 The framework is a stochastic dynamic model of heterogeneous firms that builds on Cooley and Quadrini (2001). In our model, debt is constrained by the likelihood of default, which varies across heterogeneous firms and economies with different financial development.

Creditors offer firms defaultable debt contracts but have to pay a fixed cost to obtain credit information when issuing any loan. Differences in these credit costs across economies proxy for differences in financial institutions across countries.

Given the set of loans available, firms’ choices over new borrowing depend on their loans due, output, investment needs, and precautionary incentives to self-insure for the future.

Firms who have received a sequence of bad shocks are small and face very restricted loan opportunities. These firms are very sensitive to good shocks, because they can use the additional output to decrease their debt and increase their capital. Firms’ sensitivity to shocks is more amplified with more severe financial restrictions. And in economies with high credit costs, the set of loans available are limited throughout, but disproportionately for the small firms. Hence, in less financially developed economies, small firms portray simultaneously disproportionately low debt to asset ratios and high growth rates.

We use the firm level data of Bulgaria and the United Kingdom to calibrate our model such that we match the financial structure observed in the cross section of firms in each country. We choose these countries as representative countries with weak and strong financial development. We show that our model can deliver the relationship between sales growth rate and firm size observed in the data in both countries. For Bulgaria, we calibrate the leverage ratios of firms as in the data; for small firms in the first asset quintile to be 0.45 and for the mean size firm to be 0.53. The model then delivers the observed sales growth differences of 0.77 for the small firms and 0.40 for the large firms, which matches the data counterpart of 0.73 versus 0.39. For the United Kingdom, we do a similar exercise. We calibrate the leverage ratios of firms as in the data; for small firms in the first asset quintile to be equal to 1.18 while and for the mean size firm to be equal to 0.84. The model generates a growth rate of small firms equal to 0.17 while 0.08 for large firms, which are in line with the data counterparts of 0.23 and 0.05 for small and large firms respectively. Hence, we conclude that financial considerations are important determinants of the differential growth rates observed across firms of different sizes.

We also perform the comparative static of changing the degree of financial development in our model economies. In particular, we decrease the credit costs in Bulgaria to the British level. We find that following this experiment, the difference in growth rates between the smallest and largest firms decrease from 37 percentage points to 18 percentage points. Lower credit costs also increase the difference in leverage ratios from -21 percentage points to 9 3 percentage points. Thus, our model is fully consistent with the evidence that in economies with better financial development the difference in growth rates of small versus large firms is lower yet the difference in leverage ratios of small versus large firms is bigger.

Changing credit costs also has a level effect for the overall average debt financing and for the output of the small firms. In this experiment, the average debt to asset ratio increases from 0.60 to 0.73 and the output of the small firms increase by 19%. However, we find that although financial development appear as a major determinant for the differential relation of firms size with growth and leverage across countries, the overall average growth rate and size of firms are driven by other factors such as the productivity process for firms.

Related Literature

The paper is related to the literature that studies the implications of financial frictions and agency problem for the dynamics and sizes of firms. Our model is closest to Cooley and Quadrini (2001) who develop a model where financing restrictions arise from limited commitment in debt contracts and show that these frictions can deliver quantitatively large differences in the growth rate of small versus large firms. However, we concentrate on how the degree of financial development across countries can help explain the differential financing and growth patterns of small firms. Moreover, contrary to Cooley and Quadrini’s model, our model does not impose an upper bound on the level of liquid assets, which limits the precautionary motive for debt use. In addition, we use firm level data to discipline the extent to which financial considerations impacts growth rates. Our paper is also related to Albuquerque and Hopenhayn (2004) who focus on the effects of enforcement problems and solve for the optimal state contingent contract. Our environment is different from theirs in that we consider an incomplete set of assets. Incomplete markets allow for firms in the model with a history of bad shock to decrease their value while increasing debt holdings through time and allow precautionary savings to play a role.

Clementi and Hopenhayn (2006) and Quadrini (2004) study financial constraints that arise due to informational asymmetries between the lender and the entrepreneur and show that moral hazard considerations can rationalize borrowing constraints, which makes investment sensitive to cash flows. They show that information asymmetries can also provide a rationale for the relation between growth and size. De Marzo and Fishman (2007) study the effects on investment within a large set of agency problems between equity and debt holders. They find that the positive relation between investment and current and past cash flows is robust to a large class of optimal contracting models that feature informational asymmetries. Moreover, they find that leverage ratios are larger for small firms. Our model generates a similar 4 dependency of investment to cash flow due to imperfections in financial markets; however, our model provides a rationale for why small firms can have higher or lower leverage ratios relative to large firms depending on the degree of financial development.

The paper is also related to a vast literature on the optimal capital structure of firms in corporate finance, which is motivated by the classic Modigliani-Miller irrelevance propositions.3 Among various strands of theories on capital structures, our model falls into the dynamic trade-off theory. Two close works in this strand of literature are Hennessy and Whited (2005) and Miao (2005). Hennessy and Whited (2005) develop a dynamic trade-off model with the presence of taxes and financial distress costs. They model corporate taxes to be progressive which induces larger firms to use debt more because they face higher tax rates. Interestingly, this theory is at odds with the data in the United Kingdom where corporate taxes are progressive, yet the relation between size and leverage is negative. Miao (2005) develops a model where firms choose debt and exit decisions to optimally respond to stochastic productivities. However, the debt decision is static as all firms choose only the same perpetuity level of debt when they enter. In his model, small firms with low productivity shocks have higher leverage ratios because their equity value is small. In our paper, the firm’s debt decision is dynamic, firms can choose to exit, and the interest on debt is time varying, reflecting endogenous default probabilities. In addition, our framework rationalizes that small firms can have smaller debt to asset ratios because debt is more constrained for them given their higher default probabilities.

2 Empirical Facts In this section, we study the empirical relation of firm size with debt financing and growth across countries. Contrary to other studies on growth and financing that have analyzed individual countries or only the public firms, our work documents these relations for comprehensive firm level datasets that include a large number of small private firms across many countries. We find that these relations vary systematically with the degree of financial development across countries as follows. First, in countries with stronger financial development, small firms use more debt financing than large firms relative to those in countries with weaker financial development. Second, small firms tend to grow faster than large firms in all countries, but by more in countries with weaker financial development.

We first describe the firm-level database, Amadeus, which we use for the analysis of firms in 22 European countries. We then highlight our findings with two example countries: the 3 See Harris and Raviv (1991) for a comprehensive review.

5 United Kingdom and Bulgaria. The United Kingdom is much more financially developed than Bulgaria. Relative to large firms, small firms use more debt financing in the UK, but less in Bulgaria. Small firms grow faster than large firms in both countries, but by more in Bulgaria than in the UK. We then present our main empirical findings regarding the debt financing and growth patterns of firms in 22 European countries that vary in their financial development.

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