Finance and Growth: Evidence, Methodology and Channels

1
Finance and GrowthEvidence, Methodology and
Channels

• Thorsten Beck

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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

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This presentation

• Finance and Growth the identification challenge
• Finance for Growth the channels
• Finance and Income Distribution
• Finance for All?

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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

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Finance and Growth - basics

• Unobserved/omitted variable bias Reverse
  causation Measurement bias

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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)

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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 gt OLS coefficient

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Finance, Law, and Growth (2)

• IV gt OLS coefficient
• Negative reverse causation? Unlikely
• Omitted variable? Implausible
• Measurement error in OLS? Ok
• Legal origin correlated with omitted variable?
  Very likely (LLSV)

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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

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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

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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?

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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

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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)

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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)

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Impact finance promotes firm growth
Proportion of firms that grow at rates requiring
external finance
0.6
KOR
JPN
0.5
SGP
THA
NOR
DEU
MYS
DEU
CAN
FIN
MEX
AUT
USA
AUS
ESP
JOR
NZL
0.4
CHE
FRA
IND
ZWE
NLD
BEL
GBR
ITA
0.3
SWE
PAK
TUR
0.2
ZAF
0.0
0.5
1.0
1.5
Private credit / GDP
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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

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(No Transcript)
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Finance and Growth Household vs. Enterprise
Credit
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Enterprise Credit, Household Credit and Economic
Growth
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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

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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.

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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)

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Finance and income share of poorest income
quintile
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Finance and change in Gini
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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
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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

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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

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The effect of branch deregulation on income
inequality
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Decomposition of Variance
Non-wage income 33
Within unskilled 11
Total income 100
Within skilled 14
Wage income 67
Between skilled and unskilled 75
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Branch deregulation and the labor market
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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

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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?

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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

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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

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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