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by Matías Braun and Claudio Raddatz
No. 2, September 2004 - December 2004
Motivation for
the Research
It has been extensively documented that the level of financial development,
however measured, varies greatly across countries. However, the ranking of countries
varies through time. Our theories of financial development need to explain both
the relatively high persistence in degree of financial depth as shown in key
indicators and the non-trivial changes in the ranking across countries at different
moments in time. Existing theories—which rely on stable and largely predetermined
institutional features—successful as they are in explaining the cross-sectional
variation, are challenged when applied to the time-series dimension of the data.
Research Approach
This paper builds on the premise that
a well-developed financial system enhances competition in
the industrial sector by allowing easier entry.
The authors document this fact by showing that both aggregate manufacturing-sector
price-cost margins and average firm size—representing
measures of incumbents’ rents or the inverse of the degree of competition in
an industry—are significantly negatively correlated with financial development
across countries. They show, however, that there is important heterogeneity in
the impact of financial development on these measures across industries.
The
authors split industries into two equal-sized groups, according to whether
the benefits of easier access to external finance outweigh
the costs of increased
competition, and call them the promoters and opponents of financial development,
positing that the relative strength of each group determines the equilibrium
level of financial system sophistication. Absent significant perturbations
to this political economy equilibrium, they do not expect
significant changes in
financial development.
Trade liberalization is a perturbation to the relatively
high persistence of private credit. The paper uses an event study and regression
analysis to study the change induced by trade liberalization in the relative
strength of promoters across 41 trade-liberalizing countries to see whether
this is a good predictor of subsequent financial development.
Key Findings
- The change in the relative
strength of promoters induced by trade liberalization is
a very
good predictor of subsequent financial development.
- Evidence suggests
that the relation between changes in relative strength of promoters
and subsequent
financial development is mediated by policy adjustments—especially
adjustments to
policies that induce change in the financial sector—made in the five-year
period following trade
liberalization.
- By overcoming informational and agency problems,
a well-functioning financial system can foster growth through two
main channels: by increasing resources
available for investment and by better allocating these scarce
funds. The results provide some indication that it is allocation
that is
the more affected.
- The effects of trade liberalization are particularly
strong in countries with relatively high levels of governance,
suggesting
that incumbents resort
to this costly but more subtle way of restricting entry when
the degree of governance would make it difficult to obtain
more blatant
forms
of anti-competitive measures
from politicians.
Implications
Although deep institutional reasons
play a role, to an important extent countries have the level
of financial development they
choose. Policy convergence to best-practice standards is not
likely to
happen automatically unless the political-economic conditions
for such a change are
present.
Policies that on average have a liberalizing effect
on markets are not by themselves enough to guarantee
their extension
to the
financial system. They
can even worsen the situation. In this context, understanding
the interrelation between sectoral reforms and
adjusting the timing
accordingly seems
of first-order importance. Full text of Working
Paper 04-3 
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