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American Economic Association
Financial Dependence and Growth
Author(s): Raghuram G. Rajan and Luigi Zingales
Source: The American Economic Review, Vol. 88, No. 3 (Jun., 1998), pp. 559-586
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/116849
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FinancialDependence and Growth
By RAGHURAM G. RAJAN AND LUIGI ZINGALES*

This paper examines whetherfinancial developmentfacilitates economic growth by scrutinizing one rationale for such a relationship: thatfinancial development reduces the costs of external finance to firms. Specifically, we ask whether in-dustrial sectors that are relatively more in need of externalfinance develop disproportionately faster in countries with more-developedfinancial markets. We find this to be true in a large sample of countries over the 1980's. We show this result is unlikely to be driven by omitted variables, outliers, or reverse causality.
(JEL 04, F3, G1)
A large literature,dating at least as far back as Joseph A. Schumpeter ( 1911 ), emphasizes the positive influence of the development of a country's financial sector on the level and the rate of growth of its per capita income. The argumentessentially is that the services the financial sector provides-of reallocating capital to the highest value use without substantial risk of loss through moral hazard, adverse selection, or transactionscosts-are an essential catalyst of economic growth. Empirical work seems consistent with this argument. For example, on the basis of data from 35 countries between 1860 and 1963, Raymond W.
Goldsmith (1969 p. 48) concludes that "a rough parallelism can be observed between economic and financial development if periods of several decades are considered." Nevertheless, studies such as these simply suggest correlation. As Goldsmith puts it: "There is no possibility, however, of establishing with confidence the direction of the causal mechanism,
i.e., of deciding whether financial factors were responsible for the acceleration of economic

* GraduateSchool of Business, University of Chicago,
1101 E. 58th St., Chicago, IL 60637. We thank George
Benston, Marco Da Rin, Eugene Fama, Peter Klenow,
Krishna Kumar, Ross Levine, Jonathan Macy, Colin
Mayer, Canice Prendergast, Andres Rodriguez-Clare,
David Scharfstein, Robert Vishny, and two anonymous referees for valuable comments. Jayanta Sen, Dmitrii
Kachintsev, and Alfred Shang provided excellent research assistance. A preliminary study was supported by the
World Bank. We gratefully acknowledge financialsupport from NSF GrantNo. SBR-9423645.

development or whether financial development reflected economic growth whose mainsprings must be sought elsewhere." While
Goldsmith is agnostic, other economists have expressed downright skepticism that financial development is anything but a sideshow to economic development. Joan Robinson (1952
p. 86) is representative of such a viewpoint when she claims "where enterprise leads, finance follows."
In an important recent paper, Robert G.
King and Ross Levine (1993a) investigate the causality problem following a post hoc, ergo propter hoc approach.They show that the predeterrninedcomponent of financial development is a good predictor of growth over the next 10 to 30 years. However, the skeptic could still offer a numberof argumentsagainst attributingcausality. First, both financial development and growth could be driven by a common omitted variable such as the propensity of households in the economy to save. Since endogenous savings (in certain models of growth) affects the long-run growth rate of the economy, it may not be surprising that growth and initial financial development are correlated. This argument is also hard to refute with simple cross-country regressions. In the absence of a well-accepted theory of growth, the list of potential omitted variables that financial-sector development might be a proxy for is large, and the explanatory variables to include a matter of conjecture.
Second, financial development-typically measured by the level of credit and the size of

559

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560

THE AMERICANECONOMICREVIEW

the stock market -may predict economic growth simply because financial markets anticipatefuturegrowth; the stock marketcapitalizes the present value of growth opportunities, while financial institutions lend more if they think sectors will grow. Thus financial development may simply be a leading indicator ratherthan a causal factor.
One way to make progress on causality is to focus on the details of theoretical mechanisms through which financial development affects economic growth, and document their working. Our paper is an attempt to do this.
Specifically, theorists argue that financialmarkets and institutions help a firm overcome problems of moral hazard and adverse selection, thus reducing the firm's cost of raising money from outsiders. So financial development should disproportionatelyhelp firms (or industries) typically dependent on external finance for their growth. Such a finding could be the "smoking gun" in the debate about causality. There are two virtues to this simple test. First, it looks for evidence of a specific mechanism by which finance affects growth, thus providing a strongertest of causality. Second, it can correct for fixed country (and industry) effects. Though its contribution depends on how reasonable our microeconomic assumptions are, it is less dependent on a specific macroeconomic model of growth.
We construct the test as follows. We identify an industry's need for externalfinance (the difference between investments and cash generated from operations) from data on U.S. firms. Under the assumption that capital markets in the United States, especially for the large listed firms we analyze, are relatively frictionless, this method allows us to identify an industry's technological demand for external financing. Under the further assumption that such a technological demand carries over to other countries, we examine whether industries that are more dependent on external financing grow relatively faster in countries that, a priori, are more financially developed.
This would imply that, ceteris paribus, an industry such as Drugs and Pharmaceuticals, which requires a lot of external funding, should develop relatively faster than Tobacco, which requires little external finance, in countries that are more financially developed. Con-

JUNE 1998

sider, for instance, Malaysia, Korea, and
Chile, which are moderate-income, fastgrowing, countries that differ considerably in their financial development. Consistent with our hypothesis, in Malaysia, which was the most financially developed by our measures,
Drugs and Pharmaceuticals grew at a 4percent higher annualreal rate over the 1980's than Tobacco (the growth rate for each industry is adjusted for the worldwide growth rate of that industry). In Korea, which was moderately financially developed, Drugs grew at a
3-percent higher rate than Tobacco. In Chile, which was in the lowest quartile of financial development, Drugs grew at a 2.5-percent lower rate than Tobacco. So financial development seems to affect relative growth rates of industries in the way predicted. We establish this result more systematically for a large cross section of industries and countries in the body of the paper.
Delving deeper into the components of growth, industry growth can be decomposed into the growth in the number of establishments and the growth in the average size of existing establishments. New establishments are more likely to be new firms, which depend more on external finance than established firms. So the growth of the number of establishments in industries dependent on external finance should be particularly sensitive to financial development. This is indeed the case.
Our estimates suggest that financial development has almost twice the economic effect on the growth of the number of establishmentsas it has on the growth of the average size of establishments. This suggests that an additional indirect channel throughwhich financial development could influence growth is by disproportionately improving the prospects of young firms. If these are typically innovators, they make possible Schumpeterian"waves of creative destruction" that would not even get initiated in countries with less-developed markets. Let us be careful about what we find, and about what we have little to say. Our findings suggest that the ex ante development of financial markets facilitates the ex post growth of sectors dependent on external finance. This implies that the link between financial development and growth identified elsewhere may

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VOL. 88 NO. 3

RAJANAND ZINGALES:FINANCIALDEPENDENCE AND GROWTH

stem, at least in part, from a channel identified by the theory: financial markets and institutions reduce the cost of external finance for firms. Of course, our analysis suggests only that financialdevelopment liberates firmsfrom the drudgeryof generating funds internally. It is ultimately the availability of profitable investment opportunitiesthat drives growth, and we have little to say about where these come from. In the imagery of Rondo Cameron( 1967
p. 2), we find evidence consistent with finance as a lubricant, essential no doubt, but not a substitute for the machine.
Our paper relates closely to three recent papers that attempt to establish the direction of causation of the finance-growth correlation. Asli Demirgiiq-Kunt and Vojislav
Maksimovic ( 1996) also use micro-datato develop a test of the influence of financial development on growth. Using firm-level data, they estimate the proportion of firms whose rate of growth exceeds the growth that could have been supported only by internal resources. They then run a cross-countryregression and find that this proportionis positively related to the stock market turnover and to a measure of law enforcement. There are two essential differences from our paper. First, their estimate of the internal growth rate of a firm is dependent on the firm's characteristics.
While it is potentially more accurate than our measure of external dependence, it is also more endogenous. Second, they focus on between-country differences in the spirit of traditional cross-country regressions, while our focus is on within-country, betweenindustrydifferences. The latteris an important innovation in this paper.
Jith Jayaratneand Philip E. Strahan(1996) examine the liberalization of the banking sector in different states in the United States in recent years and show that this had a positive influence on a state's growth. Our attempt to correct for fixed effects is similar to theirs.
They use differences in growth rates across the temporal shock of liberalization while we use differences between industries within a country to do so. Since they focus on a very nice natural experiment to provide identification, their methodology may be harder to apply to different countries or different questions. But the more importantdifference is that we focus

561

on providing evidence for a microeconomic channel through which finance is supposed to work rather than examining, as they do, the broader correlation between finance and growth. Finally, Levine and Sarah Zervos (1998) study whether stock markets and banks promote economic growth. They find that measures of market liquidity are strongly related to growth, capital accumulation, and productivity, while surprisingly, more traditional measures of development such as stock market size are not as robustly corTelated.They also find that bank lending to the private sector has a strong independent effect on growth. They focus on a richer set of measures of financial development and growth than we do, but their cross-country regression methodology is also more traditional. The two studies should be viewed as complementary--theirs providing information on a broader set of conrelations, while ours details a mechanism.
In this paper, we start by describing the theoretical underpinningsof our work in Section I and then our measure of external dependence in Section II. In Section III, we present our data on financial development, country characteristics, and industry growth. In Section IV we set up our main test and discuss the results. We explore other tests and the robustness of our findings in Section V. Section VI concludes. I. Theoretical and Underpinnings tiie Basic Test
A. Theoretical Underpinnings
There has been extensive theoretical work on the relationship between financial development and economic growth. Economists have emphasized the role of financial development in better identifying investment opportunities, reducing investment in liquid but unproductive assets, mobilizing savings, boosting technological innovation, and improving risk taking.' All these activities can

'Apart from the papers discussed below, see Valerie
R. Bencivenga and Bruce D. Smith (1991), Gilles SaintPaul ( 1992), King and Levine ( 1993b), MauriceObstfeld
(1994), and John H. Boyd and Smith (1996).

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THE AMERICANECONOMICREVIEW

lead to greater economic growth. We do not have the space to go into all these theories [ see
Levine ( 1997) for a comprehensive recent survey] so we content ourselves with outlining the essential theoretical underpinningsfor our test. Jeremy Greenwood and Boyan Jovanovic
(1990) develop a model where the extent of financial intermediationand economic growth are endogenously determined. In their model, financial intermediaries can invest more productively than individuals because of theirbetter ability to identify investment opportunities.
So financial intermediation promotes growth because it allows a higher rate of returnto be earned on capital, and growth in turnprovides the means to implement costly financial structures. Equivalently, the model could be recast to show that financial development reduces the cost of raising funds from sources external to the firm relative to the cost of internally generated cash flows. Externalfunds are generally thought to be costlier because outsiders have less control over the borrower's actions (see, for example, Michael C. Jensen and William
R. Meckling, 1976) or because they know less about what the borrowerwill do with the funds
(see Joseph E. Stiglitz and Andrew Weiss,
1981; Stewart C. Myers and Nicholas S.
Majluf, 1984). Financial development, in the form of better accounting and disclosure rules, and better corporategovernance throughinstitutions, will reduce the wedge between the cost of internaland externalfunds and enhance growth, especially for firms that are most reliant on external financing.2
A second issue is how financial development takes place. Some economists take the

2 In Greenwood and Jovanovic (1990), there are no moral hazard or asymmetric information problems at the level of the entrepreneur.The intermediary simply provides information about economywide trends that the entrepreneur cannot figure out for himself, enabling the entrepreneurto invest his own funds more productively.
An equivalent formulationis to distinguish between savers and entrepreneurs.Absent financial development, savers can invest directly only in safe, low-return, governmentsponsored projects, while financial development can reduce adverse selection, enabling savers to invest in risky
(but often more productive) entrepreneurs.

JIJNE 1998

development of the financial market as exogenous to the model arguing that "differences in the extent of financial markets across countries seem to depend primarily on legislation and government regulation" (Bencivenga and
Smith, 1991 p. 207). By contrast, Greenwood and Jovanovic (1990) have a "once-and-forall" lump-sum cost of development and development is endogenous to their framework.
From the perspective of our paper, it really does not matter whether legal and political or economic forces are responsible for financial development. Our focus is on whether the predetermined level of financial development affects growth. All we need for the stock of financial development to mattereven when development is endogenous is that there be a cost to development (as in Greenwood and
Jovanovic) or that financial development cannot happen instantaneously (as in reputational models of financial development such as
Douglas W. Diamond, 1989). Either assumption seems plausible.
If financial development cannot take place at low cost and on the fly, the above theories would suggest that the a priori existence of a well-developed financial market should disproportionately improve the ex post growth rates of industries that are technologically more dependent on external funds.
B. The Basic Test
The most disaggregated comprehensive data on growth that we have for countries is at the industry level (data at the firm level, if available, is typically limited to large listed firms). Our hypothesis is that industries that are more dependent on external financing will have relatively higher growth rates in countries that have more developed financial markets. Therefore, the dependent variable is the average annual real growth rate of value added in industry j in country k over the period
1980-1990. If we can measure industry j's dependence on external finance and country k's financial development, then after correcting for country and industry effects we must find that the coefficient estimate for the interaction between dependence and development is positive.

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RAJANAND ZINGALES:FINANCIALDEPENDENCE AND GROWTH

VOL. 88 NO. 3

The most effective way of correcting for country and industry characteristics is to use indicator variables, one for each country and industry. Only additional explanatory variables that vary both with industry and country need be included. These are industryj's share in country k of total value added in manufacturing in 1980 and the primary variable of interest, the interaction between industry j 's dependence on external financing and financial market development in country k.
The model we want to estimate is then
(1) Growth3,k
=

Constant + #I3.. n 'Country Indicators
++

1n

... .n

+ fin + I

IndustryIndicators

(Industryj's share of

manufacturingin countryk in 1980)
+

n + *(External
2?

Dependence of

industryj] Financial Development of countryk) +

ej,k

Of course, in order to estimate the model, we need appropriatemeasures of financial development and external dependence. This is what we will examine shortly.
Before proceeding, we point out that our study has one importantadvantageover recent cross-country empirical studies of growth.3
That advantage is simply that we make predictions about within-country differences between industries based on an interaction between a country and industrycharacteristic.
Therefore, we can correct for country and industry characteristics in ways that previous studies were unable to correct for, and will be less subject to criticism about an omitted variable bias or model specification.
3 See, for example, Roger Kormendi and Philip
Meguire (1985), Robert J. Barro (1991), Levine and
David Renelt (1992), N. Gregory Mankiw et al. (1992),
King and Levine (1993a), and Demirgui-Kunt and
Maksimovic (1996).

563

II. A Measure of Dependence on External Finance

A. The Proxy for Dependence
Data on the actual use of external financing is typically not available. But even if it were, it would not be useable because it would reflect the equilibrium between the demand for external funds and its supply. Since the latter is precisely what we are attemptingto test for, this information is contaminated. Moreover, we are not aware of systematic studies of the external financing needs of different industries, either cross-sectionally or over time.4
We, therefore, have to find some other way of identifying an industry's dependence on external financing. We assume that there is a technological reason why some industries depend more on external finance than others. To the extent that the initial project scale, the gestation period, the cash harvest period, and the requirement for continuing investment differ substantiallybetween industries, this is indeed plausible. Furthermore,we assume that these technological differences persist across countries, so that we can use an industry's dependence on external funds as identified in the
United States as a measure of its dependence in other countries. While there are enormnous differences in local conditions between countries, all we really need is that statements of the following sort hold: If Pharmaceuticalsrequire a larger initial scale and have a higher gestation period before cash flows are harvested than the Textile industry in the United
States, it also requires a larger initial scale and has a higher gestation period in Korea.
B. How the Proxy Is Calculated
We start by computing the external financing needs of U.S. companies over the 1980's.
We use data from Standardand Poor's Compustat (1994) for this. Compustat does not contain a representativesample of U.S. firms, because it is limited to publicly traded firms, which are relatively large. Nevertheless, we

4Colin Mayer ( 1990) does look at external financing, but largely at the country level.

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564

THE AMERICANECONOMICREVIEW

regard this as an advantage for two reasons.
First, in a perfect capital market the supply of funds to firms is perfectly elastic at the proper risk-adjustedrate. In such a market the actual amount of external funds raised by a firm equals its desired amount. In other words, in such an idealized setting, the identification problem does not exist. But capital marketsin the United States are among the most advanced in the world, and large publicly traded firms typically face the least frictions in accessing finance. Thus the amount of external finance used by large firms in the United States is likely to be a relatively pure measureof their demand for external finance.5
A second reason for using a database on listed firms is that disclosure requirementsimply that the data on financing are comprehensive. For most of the paper, we will take the amount of external finance used by U.S. firms in an industry as a proxy for the desired amount foreign firms in the same industry would have liked to raise had their financial marketsbeen more developed.
Next, we have to define precisely what we mean by external and internal finance. We are interested in the amount of desired investment that cannot be financed through internal cash flows generated by the same business. Therefore, a firm's dependence on external finance is defined as capital expenditures (Compustat
# 128) minus cash flow from operations divided by capital expenditures. Cash flow from operations is broadly defined as the sum of cash flow from operations (Compustat # 110) plus decreases in inventories, decreases in receivables, and increases in payables.i Note that this definition includes changes in the nonfinancial components of net working cap-

5Even if capital markets are imperfect so that the supply is not perfectly elastic, this methodology provides a reasonable measure of the relative demand for funds provided the elasticity of the supply curve does not change substantially in the cross section. By contrast, in a very imperfect capital market, the relative amount of funds raised may be a function not only of the demand for funds but also of factors that affect supply, such as the availability of collateral.
6 This item is only defined for cash flow statements with format codes 1, 2, or 3. For format code 7 we construct it as the sum of items # 123, 125, 126, 106, 213,
217.

JUNE 1998

ital as part of funds from operations. In fact, in certain businesses these represent major sources (or uses) of funds that help a firm avoid (or force it to tap) external sources of funds.7 Similarly, the dependence on external equity finance is defined as the ratio of the net amount of 9quity issues ( Compustat# 108 minus Compustat# 115 ) to capital expenditures.
Finally, the investment intensity is the ratio of capital expenditure to net property plant and equipment (Compustat # 8).
To make these measures comparable with the industry-level data we have for other countries, we have to choose how to aggregate these ratios over time and across companies.
We sum the firm's use of external finance over the 1980's and then divide by the sum of capital expenditure over the 1980's to get the firm's dependence on external finance in the
1980's. This smooths temporal fluctuations and reduces the effects of outliers. To summarize ratios across firms, however, we use the industry median. We do this to prevent large firms from swamping the information from small firms; for instance, we know that
IBM's free cash flow does not alleviate possible cash flow shortages of small computer firms. C. External Dependence for Different Industries
In Table 1 we tabulateby InternationalStandard IndustrialClassification (ISIC) code the fraction of investments U.S. firms financedexternally (first column) and the level of capital expendituresdivided by net propertyplant and equipment (second column). We restrict our attentionto those manufacturingindustriesfor which we have value-added data from the

7 It could be argued that interfirm trade credit should be viewed as a component of external financing. It is unclear how much of trade credit is used to reduce transactions costs and how much is used for financing. Much trade credit is granted routinely and repaid promptly and usually net tradecredit for a firm (accounts receivable less payabies) is small (see Mitchell A. Petersen and Rajan,
1997). This may be why trade credit is typically treated as part of operations in capital budgeting exercises. We adhere to this tradition.

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565

Much of our analysis rests on dependence of U.S. firms on external finance being a good proxy for the demand for external funds in

other countries. We think this is reasonablefor four reasons.
First, in a steady-stateequilibriumtherewill not be much need for external funds, as Figure
1 shows. Therefore, much of the demand for external funds is likely to arise as a result of technological shocks that raise an industry's investment opportunitiesbeyond what internal funds can support. To the extent these shocks are worldwide, the need for funds of U.S. firms represents a good proxy.'
Second, even if the new investment opportunities generated by these worldwide shocks differ across countries, the amount of cash flow produced by existing firms in a certain industryis likely to be similar across countries.
In fact, most of the determinants of ratio of cash flow to capital are likely to be similar worldwide: the level of demand for a certain product, its stage in the life cycle, and its cash harvest period. For this reason, we make sure that our results hold even when we use the amount of internally generated cash, rather than the difference between investments and internally generatedfunds. 'Wealso check that the results hold when we use dependence as measured in Canada, a country which has well-developed capital marketsbut a very different banking system and industry concentration than the United States. Unfortunately, we do not have access to flow-offunds data from any other countries, so we cannot venture further afield, but this methodology could, in principle, be used with dependence measured in any country with well-functioning capital markets.
Third, one might argue that the stage of the product life cycle that U.S. firms are in is likely to be different from that of foreign firns.
Given that our sample is biased toward developing countries, one might think that the U.S. industry in the 1970's might be a better proxy for the position of developing countries in a product life cycle. For this reason, we also explore the robustnessof our resultsto measuring

' We required that there be more than one observation in the industryfor this variableto be computed. Even with this weak requirementwe do not have data for some industries. Most notably there are insufficient young firns in the Tobacco industry.

'This amounts to saying that if the invention of personal computers increased the demand for external funds in the U.S. Computer industry, it is likely to increase the need for funds in the Computerindustryin other countries as well.

United Nations Statistical Division (1993).
Drugs and Pharmaceuticalsemerge as the industrythat uses the most external finance, with
Plastics and Computing following close behind. Tobacco, on the other hand, generates the most excess cash flow and has negative external funding needs.
It is common wisdom in the corporate finance literature (though we were hardpressed to find formal empirical studies of this phenomenon) that there is a life cycle in the pattem of financing for firms; firms are more dependent on external financing early in their life than later. Figure 1 supports the common wisdom. It plots the median financing and investment needs across U.S. firms as a function of the number of years since the initial public offering (IPO). Not surprisingly, in the year of the IPO, firms raise a substantial amount of external funds (especially equity). More interestingly, this conto on a smaller scale-up tinues-albeit approximately the tenth year. After that period, net equity issues go to zero and the usage of external finance fluctuates aroundzero.
In the third and fourth columns of Table 1, we reportthe external dependence and capital expenditures for mature companies (firms that were listed for more than ten years), while the fifth and sixth columns are for young companies (firms that were listed for less than ten years).' This pattern appears to be fairly standard across different industries, though there are exceptions. All this suggests that very young firms are more dependent on external finance than older firms. This fact will provide an additional test of our hypothesis. D. Is the Dependence of U.S. Firms a Good Proxy?

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THE AMERICANECONOMICREVIEW

566
TABLE 1-PATTERN

OF EXTERNAL FINANCING AND INVESTMENT ACROSS INDUSTRIES
IN THE UNITED STATES DURING THE 1980's

All companies
ISIC
code

Industrialsectors

JUNE 1998

Mature companies

Young companies

External
Capital
Capital
External
Capital
External
dependence expenditures dependence expenditures dependence expenditures

314

Tobacco

-0.45

0.23

--0.38

0.24

361

Pottery

-0.15

0.20

0.16

0.41

-0.41

0.13

323

Leather

-0.14

0.21

-1.33

0.27

-1.53

0.16

3211

Spinning

-0.09

0.16

-0.04

0.19

324

Footwear

-0.08

0.25

-0.57

0.23

0.65

0.26

372

Nonferrous metal

0.01

0.22

0.21

0.46

0.24

322

Apparel

0.03

0.31

-0.02

0.27

0.27

0.37

353

Petroleum refineries

0.04

0.22

-0.02

0.22

0.85

0.28

369

Nonmetal products

0.06

0.21

313

Beverages

0.08

0.26

371

Iron and steel

0.09

0.18

311

Food products

0.14

0.26

3411

Pulp, paper

0.15

0.20

3513

Synthetic resins

0.16

0.30

341

Paper and products

0.18

0.24

342

Printing and publishing

0.20

0.39

352

Other chemicals

0.22

0.31

355

Rubberproducts

0.23

0.28

332

Furniture

0.24

0.25

381

Metal products

0.24

Basic excluding fertilizers

331

0.07

0.15

0.22

-0.03

0.26

0.28

0.63

0.26

0.16

0.26

0.19

0.25

0.66

0.33

0.21

0.22

0.20

0.20

0.79

0.45

0.10

0.23

0.57

0.29

0.14

0.33

0.60

0.41

-0.18

0.25

1.35

0.46

-0.12

0.21

0.50

0.32

0.33

0.17

0.68

0.29

0.29

0.04

0.25

0.87

0.34

0.25

0.30

0.08

0.24

0.79

0.29

Wood products

0.28

0.26

0.25

0.23

0.34

0.40

384

Transportation equipment 0.31

0.31

0.16

0.28

0.58

0.31

354

Petroleum and coal products 0.33

0.23

0.16

0.26

Motor vehicle

0.39

0.32

0.11l

0.33

0.76

0.32

321

Textile

0.40

0.25

0.14

0.24

0.66

0.26

382

Machinery

0.45

0.29

0.22

0.25

0.75

0.33

Ship

0.46

0.43

0.04

0.34

1.05

0.56

3511

3843

3841

-0.15
0.09
-0.05
0.13
-0.23

-0.26

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0.22

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RAJANAND ZINGALES:FINANCIALDEPENDENCE AND GROWTH
TABLE

1-Continued.

All companies
ISIC
code

Industrialsectors
Other industries

0.47

0.37

362

Glass

0.53

0.28

383

Electric machinery

0.77

385

Professional goods

3832
3825

3522

Mature companies

Young companies

External
External
Capital
Capital
External
Capital
dependence expenditures dependence expenditures dependence expenditures

390

356

567

-0.05

0.28

0.80

0.49

0.03

0.28

1.52

0.33

0.38

0.23

0.29

1.22

0.46

0.96

0.45

0.19

0.33

1.63

0.52

Radio

1.04

0.42

0.39

0.30

1.35

0.48

Office and computing

1.06

0.60

0.26

0.38

1.16

0.64

Plastic products

1.14

0.44

--

1.14

0.48

Drugs

1.49

0.44

0.03

2.06

0.47

0.32

Notes: This table reports the median level of external financing and capital expenditure for ISIC industries during the
1980's. External dependence is the fraction of capital expenditures not financed with cash flow from operations. Cash flow from operations is broadly defined as the sum of Compustat funds from operations (item #110), decreases in inventories, decreases in receivables, and increases in payables. Capital expenditures are the ratio of capital expenditures to net propertyplan and equipment. Maturecompanies are firms that have been public for at least ten years; correspondingly, young companies are firms that went public less than ten years ago. The year of going public is the first year in which a company starts to be traded on the NYSE, AMEX, or NASDAQ. All companies is the union of rnatureand young firms plus firms for which the year of going public could not be determined (firms already traded on NASDAQ in 1972). All the information is obtained from the flow-of-funds data in Compustat, except for the SIC code which is obtained from the Center for Research on Securities Prices and then matched with the ISIC code.

the dependence of U.S. firms in the 1970's ratherthan in the 1980's. We also distinguish between dependence as measured for young firms in the United States (less than ten years from listing) and dependence for old firms
(more than ten years from listing).
Last but not least, that we only have a noisy measure of the need for funds creates a bias against finding any interactionbetween dependence and financial development.

A. Data on Industries

tional SIC code. In order to obtain the amount of external finance used by the industry in the
United States, we matched ISIC codes with
SIC codes.'0 Typically, the three-digit ISIC codes correspond to two-digit SIC codes, while the four-digit ISIC codes correspond to three-digit SIC codes. In order to reduce the dependence on country-specific factors like natural resources, we confine our analysis to manufacturingfirms (U.S. SIC 2000--3999).
We would like data on as many countries as possible. The binding constraint is the availability of measures of financial development
(specifically the availability of data on

Data on value added and gross fixed capital formationfor each industryin each countryare obtained from the Industrial Statistics Yearbook database put together by the United
Nations Statistical Division (1993). We checked the data for inconsistencies, changes in classification of sectors, and changes in units. The U.N. data is classified by Interna-

0
Not all the ISIC sectors for which the Industrial Statistics Yearbookreports data on value added are mutually exclusive. For example, Drugs (3522) is a subsector of other Chemicals (352). In these cases, the values of the broadersectors are net of the values of the subsectors that are separately reported. We follow this convention both for the data value added and for the financial data from
Compustat.

III. Data

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568

THE AMERICANECONOMICREVIEW

JUNE 1998

2-

_______________

1.5-

0.54

0~~~~~

-0.5

-1
0

4

8

12

#ears

16

20

24

since the IPO

Equity
FinancingL~External Finance E
FIGURE

1.

28

~Investments

LIFE CYCLE OF EXTERNAL FINANCING AND INVESTMENTS

Notes: This graph plots the median level of external financing, equity financing, and investments in the United States across three-digit SIC industries as a function of the number of years since the IPO. External finance is the amount of capital expenditures not financed with cash flow from operations, reduction in inventories, or decreases in trade credit.
Equity finance is the net amount of funds raised through equity issues divided by the amount of investments. Investment is the ratio of capital expenditures to net property,plant, and equipment.The IPO year is defined as the first year in which a company starts to be traded on the NYSE, AMEX, or NASDAQ. All the information is obtained from the flowof-funds data in Compustat,except for the SIC code which is from the Center for Research on Securities Prices.

accounting standards). Since we also wanted data on equity market capitalization, we started with the 55 countries from the International Finance Corporation's (IFC' s)
Emerging Stock Markets Factbook. We dropped countries like Kuwait that did not report a stock marketcapitalizationuntil the latter half of the 1980's. We could not use Hong
Kong and Taiwan because data on these countries are not present in the International
Money
Fund's (IMF's) International Financial Statistics (IFS) volumes. We also dropped countries for which we did not have data from the
Industrial Statistics Yearbookdatabase that is separatedby at least five years (notably, Swit-

zerland). Finally, Thailand is dropped because the U.N. notes that data from year to year are not comparable. The United States is excluded from the analysis because it is our benchmark. This leaves us with the 41 countries in Table 2.
We want to see if financially dependent industries are likely to be better off in countries with well-developed financial sectors. The availability of finance affects not just investment but also the ability to finance operations and sales through working capital. Therefore, the most appropriatemeasure of an industry being "better off " is the growth in value added for that industry, i.e., the change in the

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VOL 88 NO. 3

RAJANAND ZINGALES:FINANCIALDEPENDENCE AND GROWTH

log of real value added in that industry between 1980 and 1990. Real value added in
1990 is obtained by deflating value added by the Producer Price Index (PPI). For highinflation countries, spurious differences in value added may be obtained simply because the U.N. data are measured at a different point from the PPI. So, instead, we determine the effective deflator by dividing the growth in nominal value added for the entire manufacturing sector in the U.N. databaseby the index of industrial production (which measures the real growth rate in industrial production) obtained from the IFS statistics.
B. Data on Countries
The Gross Domestic Product, the Producer
Price Index, the exchange rate, and the Index of IndustrialProduction are all obtained from
InternationalFinancial Statistics publishedby the InternationalMonetary Fund. Whenever a particularseries is not available, we use close substitutes -for instance, the Wholesale Price
Index if the ProducerPrice Index is not available. Data on a country's human capital (average years of schooling in population over
25) is obtained from the Barro-Leefiles downloaded from the National Bureau of Economic
Research web site (see Barro and Jong Wha
Lee, 1993).
C. Measures of Financial Development
Ideally, financial development should measure the ease with which borrowersand savers can be broughttogether, and once together,the confidence they have in one another. Thus financial development should be related to the variety of intermediaries and markets available, the efficiency with which they perform the evaluation, monitoring, certification,communication and distributionfunctions, and the legal and regulatory framework assuring performance. Since there is little agreement on how these are appropriately measured, and even less data available, we will have to make do with crude proxies even though they may miss many of the aspects we think vital to a modem financial system.
The first measure of financial development we use is fairly traditional-the ratio of do-

569

mestic credit plus stock market capitalization to GDP. We call this the capitalization ratio.
We obtain stock market capitalization for all countries listed in the Emerging Stock Markets
Factbook published by the International Finance Corporation,which contains data on developed countries also.'" Domestic credit is obtained from the IMF's International Financial Statistics. Specifically, it is the sum of IFS lines 32a through 32f and excluding 32e. Finally, domestic credit allocated to the private sector is IFS line 32d.
Despite the virtue of tradition,there are concerns with this measure. Unlike domestic credit, stock marketcapitalizationdoes not reflect the amount of funding actually obtained by issuers. Instead, it reflects a composite of retained earnings, the investing public's perception of the corporatesector's growth prospects, and actual equity issuances. One could argue that the amountof money raised through initial public offerings and secondary offerings is more suitable for our purpose. Unfortunately, these data are not widely available.
At the same time, one cannot dismiss the capitalization measure in favor of actual financing too easily. The net amount raised from U.S. equity markets by large firms was negative in the 1980's (see, for example, Rajan and
Zingales, 1995). So the actual amount raised may underestimatethe importanceof the stock market's role in providing price information and liquidity to investors. Market capitalization may be a bettermeasure of the importance of the stock market in this respect. Since we are unsure about whethermarketcapitalization is a reasonable proxy, we will check that the results are robust to redefining the capitalization ratio as the ratio of domestic credit to the private sector to GDP.
The second proxy for finarncial development we use is the accounting standardsin a country. Unlike our first measure, accounting

" Stock marketcapitalizationis measured at the end of the earliest year in the 1980's for which it is available, while Gross Domestic Productmay value flows throughthe year. This may be a problemin high-inflationcountries.We thereforemeasureGDP as the GDP in constantprices multiplied by the ProducerPrice Index where the base year for both series is five years before the year of interest.

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570

THE AMERICANECONOMICREVIEW
TABLE 2-FINANCIAL

Country
Bangladesh

Accounting standards JUNE 1998

DEVELOPMENT ACROSS COUNTRIES

Kenya

Domestic credit to private sector over GDP

0.20

0.07

121

0.28

-

Total capitalization over GDP

0.20

417

Per capita income (dollars)

Morocco

-

0.41

0.16

807

Sri Lanka

-

0.44

0.21

252

0.53

0.25

290

Pakistan
Costa Rica

-

0.53

0.26

2,155

Zimbabwe

-

1.01

0.30

441

1.16

0.54

1,109

Jordan
Egypt

24

0.74

0.21

563

Portugal

36

0.82

0.52

2,301

Peru

38

0.28

0.11

842

Venezuela

40

0.34

0.30

3,975

Colombia

50

0.21

0.14

1,150

Turkey

51

0.35

0.14

1,081

Chile

52

0.74

0.36

2,531

Brazil

54

0.33

0.23

1,650

Austria

54

1.00

0.77

9,554

Greece

55

0.74

0.44

3,814

India

57

0.50

0.24

240

Mexico

60

0.39

0.16

2,651

Belgium

61

0.65

0.29

11,226

Denmark

62

0.56

0.42

12,188

Germany

62

1.08

0.78

12,345

Italy

62

0.98

0.42

6,460

Korea

62

0.63

0.50

1,407

Netherlands

64

0.91

0.60

11,155

Spain

64

1.02

0.76

5,087

Israel

64

1.18

0.67

3,573

Philippines

65

0.46

0.28

729

Japan

65

1.31

0.86

9,912

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TABLE

571

2-Continued.

Accounting standards Total capitalization over GDP

Domestic credit to private sector over GDP

Per capita income (dollars)

France

69

0.70

0.54

11,337

New Zealand

70

0.59

0.19

7,490

South Africa

70

1.51

0.26

2,899

Norway

74

0.63

0.34

13,430

Canada

74

0.98

0.45

10,486

Australia

75

0.82

0.28

9,866

Malaysia

76

1.19

0.48

1,683

Finland

77

0.52

0.48

10,181

U.K.

78

0.78

0.25

9,600

Singapore

78

1.96

0.57

4,661

Sweden

83

0.79

0.42

14,368

Country

Notes: Accounting standards is an index developed by the Center for InternationalFinancial Analysis and Research ranking the amount of disclosure in annual company reports in each country. Total capitalization to GDP is the ratio of the sum of equity market capitalization (as reportedby the IFC) and domestic credit (IFS lines 32a-32f but not 32e) to
GDP. Domestic credit to the private sector is IFS line 32d. Per capita income in 1980 is in dollars and is from the IFS.

standardsreflect the potential for obtaining finance rather than the actual finance raised.
Specifically, the higher the standardsof financial disclosure in a country, the easier it will be for firms to raise funds from a wider circle of investors. The Center for InternationalFinancial Analysis and Research (CIFAR) creates an index for different countries by rating the annual reports of at least three firms in every country on the inclusion or omission of
90 items. Thus each country obtains a score out of 90 with a higher number indicating more disclosure. The Center for International
Financial Analysis and Research, which produces this data, started analyzing balance sheets from 1983 onwards. However, its first comprehensive survey dates from 1990. We will use the accounting standardsas measured in this study in much of the paper. The date of the survey raises concerns about endogeneity, but we believe such concerns are small to begin with, and can easily be addressed. First, accounting standardsdo not change much over

time. In 1995, the CIFAR published a study examining how accounting standards had changed since 1983. This study estimated the standardsin 1983 and 1990 based on a subset of annualreports, and for a subset of countries that are in the comprehensive 1990 survey.
The study finds the mean accounting standards for countries sampled both in 1983 and 1990 is the same at 65. The Wilcoxon signed rank test for equality of distributionsfails to reject the equality of the distribution of accounting standardsacross countries in the two years. Finally, the correlation between the accounting standardsin 1983 and 1990 is 0.75.12 Nevertheless, we will instrument accounting standards with variables that predate the period of growth at which we are looking. Also, we will use the 1983 data to see that the results hold

12
1he regression estimates are riot sensitive to dropping the few countries such as Denmark and Spain that changed accounting standardssubstantially.

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JUNE 1998

THE AMERICANECONOMICREVIEW

572

TABLE
3-SUMMARYSTATISTICS
A: Summary Statistics
Maximum

Number of observations -0.447

1.000

1242

0.071

-0.414

0.759

1073

0.026

0.094

-0.536

0.410

1070

0.016

0.009

0.021

0.000

0.224

1217

Log per capita income in 1980 in dollars

7.870

7.971

1.344

4.793

9.573

41

Average years of schooling

5.900

5.442

2.829

1.681

12.141

41

External finance dependence (all firms)

0.319

0.231

0.319

-0.451

1.492

36

External finance dependence (old firms)

0.010

0.075

0.302

-1.330

0.394

35

External finance dependence (young firms)

0.675

0.673

0.643

-1.535

2.058

34

External finance dependence (1970's)

0.078

0.073

0.188

-0.450

0.542

35

External finance dependence (Canadianfirms)

0.427

0.384

0.767

-0.802

3.512

27

Cash flow generated

0.173

0.198

0.112

-0.217

0.331

36

Investment intensity

0.298

0.278

0.095

0.161

0.600

36

Total capitalization over GDP

0.738

0.696

0.375

0.199

1.962

41

Domestic credit to private sector over GDP

0.377

0.302

0.201

0.069

0.856

41

Accounting standards

61.324

62.000

13.238

24.000

83.000

34

Accounting standards(1983)

65.393

68.500

11.426

39.000

81.000

28

Standard deviation Minimum

Variable

Mean

Median

Industry's real growth

0.034

0.029

0.099

Industry's growth in number of firms

0.012

0.007

Industry's growth in average firms' size

0.022

Industry's share of total value added

B: CorrelationBetween Measures of External Dependence
All
External finance dependence (all firms)
External finance dependence (old firms)

Old

Young

1970's

Cash flow Investment

1.00
0.46

1.00

-

-

-

-

-

-

-

-

-

(0.01)

External finance dependence (young firms)
External finance dependence (1970's)
Cash flow generated
Investment intensity
External finance dependence (Canadianfirms)

0.72
(0.00)

0.48
(0.00)

1.00

0.63
(0.00)

0.42
(0.01)

0.48
(0.00)

1.00
-

-0.91
(0.00)

-0.37
(0.03)

-0.55
(0.00)

-0.50
(0.00)

1.00

0.81
(0.00)

0.28
(0. 10)

0.64
(0.00)

0.63
(0.00)

-0.60
(0.00)

1.00

0.77
(0.00)

0.36
(0.07)

0.58
(0.00)

0.37
(0.07)

-0.78
(0.00)

0.55
(0.00)

-

-

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RAJANAND ZINGALES:FINANCIALDEPENDENCE AND GROWTH
TABLE

573

3-Continued.

C: CorrelationBetween Measures of Financial Development
Total
capitalization

Market capitalization Domestic credit to private sector

Accounting standards Accounting standards 1983

Market capitalization over GDP

0.79
(0.00)

Domestic credit to private sector over GDP

0.67
(0.00)

0.21
(0.18)

1.00

Accounting standards

0.41
(0.02)

0.45
(0.01)

0.25
(0.17)

1.00

Accounting standards(1983)

0.27
(0.17)

0.39
(0.05)

-0.14
(0.50)

0.68
(0.00)

1.00

Per capita income

0.26
(0.09)

0.04
(0.80)

0.48
(0.00)

0.56
(0.00)

0.28
(0.16)

Notes: Industryreal growth is the annualcompounded growth rate in real value added for the period 1980-1990 for each
ISIC industry in each country. The growth in the number of firms is the difference between the log of number of endingperiod firms and the log of number of beginning-period firms. The average size of firms in the industry is obtained by dividing the value added in the industry by the number of firms, and the growth in average size is obtained again as a difference in logs. The industry's share of total value added is computed dividing the 1980 value added of the industry by the total value added in manufacturingthat year. External dependence is the median fraction of capital expenditures not financed with cash flow from operations for each industry. Cash flow from operations is broadly defined as the sum of Compustat funds from operations (items #110), decreases in inventories, decreases in receivables, and increases in payables. External dependence has been constructedusing Compustatfirms between 1980 and 1990, except for Canada where we use Global Vantage (Standard& Poor's, 1993) data between 1982 and 1990. Accounting standardsis an index
Financial Analysis and Research rankingthe amountof disclosure of companies' developed by the Centerfor International annual reports in each country. In Panels B and C the p-values are reportedin parentheses.

in the subset of countries for which it is available. Both our measuresof financialdevelopment, accounting standards and the capitalization ratio, are tabulatedfor the different countries
(see Table 2). While more-developed countries have better accounting standards, there are exceptions. For instance, Malaysia scores as high as Australia or Canada, while
Belgium and Germany are in the same league as Korea, the Philippines, or Mexico.
Portugal has among the worst accounting standards. Before we go to the summarystatistics, note that for a country's financial development to have any effect on industrial growth in that country we have to assume that firms finance themselves largely in their own country. In other words, only if world capital markets are not perfectly integratedcan domestic financial development affect a country's growth. There

is a wealth of evidence documenting the existence of frictions in internationalcapital markets: the extremely high correlationbetween a country's savings and its investments (Martin
Feldstein and Charles Horioka, 1980), the strong home bias in portfolio investments
(Kenneth R. French and James M. Poterba,
1991), and cross-country differences in expected returns(Geert Bekaert and Cambell R.
Harvey, 1995). We have little else to say about this assumptionother than noting that its failure would weaken the power of our test but not necessarily bias our findings.
Summary statistics and correlations are in
Table 3. A number of correlations are noteworthy. First, the financial sector is more developed in richer countries. The correlationof per capita income in 1980 with accounting standards and total capitalization is 0.56 and
0.26 (significant at the 1-percent and 10percent level, respectively).

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574

THE AMERICANECONOMICREVIEW

Second, the correlation between our capitalization measure of financial development and accounting standardsis 0.41 (significant at the 5-percent level for the 33 countries for which we have both data). However, the correlations between accounting standards and the components of capitalization differ. Accounting standardsare stronglycorrelatedwith equity market capitalization (correlation =
0.45, significant at the 1-percentlevel) but not with domestic credit (correlation = 0.25, not significant). Domestic credit is credit offered by depository institutionsand the centralbank.
One explanation of the low correlation is perhaps that institutions rely on their own private investigations, and credit from them is little affected by accounting standards. Another possible explanation is that when accounting standards are low, only institutions offer credit. But even though institutions benefit from improvements in accounting standards, other sources of finance become available, and firms substitute away from their traditional sources. We cannot distinguish between these explanations. It will suffice for our purpose that the overall availability of finance, whatever its source, increases with financial development. IV. Financial Dependence and Growth

A. Results From the Basic Regression
1. Varying Measures of Financial Development.-Table 4 reportsthe estimates of our basic specification (1) obtained by using various measures of financial development. Since the specification controls for country-specific effects and industry-specific effects, the only effects that are identified are those relative to variables that vary both cross countries and cross industries.Thus, Table 4 reportsonly the coefficient of the industry's share of total value added at the beginning of the sample and the coefficient of the interaction between external dependence and different measures of financial development.1"Since we use U.S.

'" The dependent variable is the average real growth rate over the period 1980-1990. For some countries,how-

JUNE 1998

data to identify the extermaldependence, we drop the United States in all regressions.
We start with total capitalization as the proxy for development. As can be seen in the first column of Table 49 the coefficient estiis positive and mate for the interaction te statistically significant at the 1-percent level
(throughout the paper, the reported standard errors are robust to heteroskedasticity) 14
The interactionterm is akin to a second derivative. One way to get a sense of its magnitude is as follows. The industry at the 75th percentile of dependence (high dependence) is Machinery. The industry at the 25th percentile (low dependence) is Beverages. The country at the 75th percentile of development as measured by capitalization is Italy, while the country at the 25th percentile is the Philippines. We set the industry's initial share of manufacturing at its overall mean. The coefficient estimate then predicts that Machinery should grow 1.3 percent faster than Beverages annually, and in real terns, in Italy as compared to the Philippines. For comparison, the real annual growth rate is, on average, 3.4 percent per year. So a differential of 1.3 percent is a large number.
For each specification, we compute a similar number which is reportedas the differential in real growth rate in the last row of each table.
Of course, the countries at the 75th and 25th percentile vary with the measure of development, as do the industries at the 75th and 25th percentile with the measure of dependence.
The rest of the columns of the table include different measures of development. We inever, data availability limits the period. For no country do we have data separatedby less than five years. A potential concern is that we measure growth in value added rather than growth in output. Unfortunately,we do not have data for the latter. While we may not capture increases in productivity fully, we see no obvious way in which this should bias our results.
14 We reduce the impact of outliers by constraining growth between -1 and +1. Three observations are affected. The coefficient estimates for the interaction coefficient are higher and still significant when we do not do this, though the explanatory power of the regression is lower. We also reestimatethe same specification afterwinsorizing the 1-percent and 5-percent tails of the growth rate distribution obtaining virtually identical results (except that the explanatory power of the regression is still higher). This content downloaded from 14.139.224.146 on Mon, 06 Jul 2015 21:29:52 UTC
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575

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VOL. 88 NO. 3

TABLE 4-INDUSTRY

GROWTH AND VARIOUS MEASURES OF DEVELOPMENT

Financial development measured as
Total
capitalization

Variable
Industry's share of total value added in manufacturingin
1980
Interaction(external dependence x total capitalization) Bank debt Accounting standards Accounting standards in 1983

Accounting standardsand capitalization

Instrumental variables -0.912
(0.246)

-0.899
(0.245)

-0.643
(0.204)

-0.587
(0.223)

-0.443
(0.135)

-0.648
(0.203)

0.012
(0.014)

--

0.069
(0.023)

-

-

-

0.118
(0.037)

Interaction(external dependence x domestic credit to private sector)
Interaction(external
dependence X accounting standards) -

-

-

Interaction(external dependence x accounting standards1983) 0.155
(0.034)

-

-

-

0.099
(0.036)

0.133
(0.034)

0.165
(0.044)

-_

R2

0.290

0.290

0.346

0.239

0.419

0.346

Number of observations

1217

1217

1067

855

1042

1067

1.3

1.1

0.9

0.4

1.3

1.0

Differential in real growth rate Notes: The dependent variable is the annual compounded growth rate in real value added for the period 1980-- 1990 for each ISIC industry in each country. Externaldependence is the fraction of capital expendituresnot financed with internal funds for U.S. firms in the same industrybetween 1980-1990. The interactionvariable is the product of external dependence and financial development. Financial development is total capitalization in the first column, domestic credit to the private sector over GDP in the second column, accounting standardsin 1990 in the thirdcolumn, and accounting standards in 1983 in the fourth column. The sixth column is estimated with instrumentalvariables. Both the coefficient estimate for the interactionterm and the standarderrorwhen accounting standardsis the measure of development are multiplied by 100. The differential in real growth rate measures (in percentage terms) how much faster an industry at the 75th percentile level of external dependence grows with respect to an industry at the 25th percentile level when it is located in a country at the 75th percentile of financial development rather than in one at the 25th percentile. All regressions include both country and industry fixed effects (coefficient estimates not reported). Heteroskedasticity robust standard errors are reportedin parentheses.

clude domestic credit to the private sector in the second column, accounting standards in the third column, and accounting standards from the 1983 subsample in the fourthcolumn
(for ease of presentation,accounting standards have been divided by 100 in the estimation).
The coefficients are uniformly significant at the 1-percent level. The econoinic magnitudes-as measured by the differential in growth rates-are also similar except when development is measured by accounting stan-

dards in 1983. The magnitude in column four falls to approximately half of its level otherwise. The explanation for this fall is, perhaps, that the 1983 subsample, being based on just a few companies for each country, introduces significant measurementerror.15
'" When we instrument this measure (see next paragraph), the coefficient estimate goes up by 50 percent, suggesting the coefficient estimate is biased downwards by measurementerror.

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576

THE AMERICANECONOMICREVIEW

In the fifth column, we include both total capitalization and accounting standards. The coefficient for total capitalization is no longer different from zero and its magnitude falls to one-fifth of its level in the firstcolumn. Similar results are obtained when we replace total capitalization by domestic credit to the private sector (coefficients not reported). This suggests that accounting standardscapturethe informationabout development that is contained in the capitalizationmeasures. For this reason, we will use accounting standardsas our measure of development in the rest of the paper.
The reader should be assured, however, that the results are qualitatively similar when capitalization measures of development are used.
Because of potential concerns about endogeneity, we will, however, instrument accounting standards with predetermined institutional variables. Rafael La Porta et al.
(1996) suggest that the origin of a country's legal system has an effect on the development of a domestic capital market and on the nature of the accounting system. Countriescolonized by the British, in particular,tend to have sophisticated accounting standardswhile countries influenced by the French tend to have poor standards.This suggests using the colonial origin of a country's legal system (indicators for whether it is British, French,
German, or Scandinavian) as reported in La
Porta et al. as one instrument.Also, countries differ in the extent to which laws are enforced.
So we use an index for the efficiency and integrity of the legal system produced by Business InternationalCorporation(a country-risk rating agency) as another instrument. As the sixth column of Table 4 shows, the fundamental interactionbecomes even stronger in magnitude when we estimate it using instrumental variables. Before going further, consider the actual
(ratherthan estimated) effects of development on the growth of specific industries. In Table
5, we summarize for the three least-dependent and three most-dependentindustries,the residual growth rate obtained after partialling out industry and country effects. The patternis remarkable. For countries below the median in accounting standards,the residual growth rate of the three least-dependent industries is positive, while the residual growth rate of the

JUNE 1998

TABLE 5-EFFECT
OF FINANCIAL DEVELOPMENT ON
ACTUAL GROWTH RATES IN DIFFERENT INDUSTRIES

Countries below
Countries above the median in the median in accounting standards accounting standards
Least financially dependent industries
Tobacco

0.53

-0.60

Pottery

0.25

-0.30

Leather

0.77

-0.77

Most financially dependent industries
Drug

-1.11

1.30

Plastics

-0.21

0.21

Computers

-2.00

1.80

Notes: This table reportsthe mean residual growth rate (in percentage terms) obtained after regressing the annual compoundedgrowth rate in real value added for the period
1980-1990 on industry and country dummies.

three most-dependent industries is negative.
The pattern reverses for countries above the median. Clearly, this suggests no single country or industry drives our results and the realized differential in growth rates is systematic and large.
2. VaryingMeasures of Dependence. -We now check that our measure of dependence is, indeed, reasonable. We do this in two ways.
First, we check that past financing in a country is related to the external dependence of industries in the country. Second, we check that our result is robust to different measures of dependence. Total capitalization is a (crude) measure of how much finance has been raised in the past in the country. If external dependence is a proxy for an industry's technological need for external finance outside the United States, then countries more specialized in externally dependent industries should have higher capitalization. We calculate the weighted average dependence for each country by multiplying an industry's dependence on external finance by the fraction that the industry contributesto value added in the manufacturing sector in
1980. We then regress total capitalization

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RAJANAND ZINGALES:FINANCIALDEPENDENCE AND GROWTH

against weighted average dependence for the
41 countries in the sample. Weighted average dependence is strongly positively correlated with capitalization in 1980 (,6 = 2.89, t =
3.06). This suggests that our measure of dependence in the United States is related to the external financing used by industry in other countries.16 Next, in Table 6 we check that the results are robust to using the external dependence measuredfor the sample of young firms. Since
Figure 1 suggests that most of the demand for external funds is expressed early on in the life of a company, it may be legitimate to expect this to be a better measure of an industry's financial needs. Regardless of how we measure financial development, the interactioneffect is positive and statistically significant at the 10-percent level or better, and at the 5percent level when we use instrumented accounting standards. The magnitude of the coefficient, however, is smaller (roughly a third of the one estimated in Table 4). In part, this reflects the higher level of the external finance raised by young companies. But even when we take this into account (see last row of the table), a difference, albeit smaller, persists. One possible explanation for this result is that young firms are not as importantas mature firms in influencing the growth of the industry. We shall returnto this issue in Section
V, subsection A.
In Table 7, we undertakefurtherrobustness checks on our measure of external dependence. While we vary the measure of external dependence, we maintain as a measure of financial development a country's accounting standards,instrumentedas above.
In the first column, external dependence is calculated restricting the sample only to mature firms (listed for more than ten years) in the United States. Our interaction variable is positive and statistically significant and the estimated differential growth rate (0.9 percent) is similar to that for the entire sample.
Next, we check whether there is persistence in dependence.If the patternof financingin the
United States in the 1980's is very different

16 Of course, this raises the possibility of reverse causality which we will address later.

577

from the patternin the 19709s, it would be unreasonable to expect dependence to carty any informationfor other countries (especially developing countries that may use older technologies). The raw correlation between an industry'sdemandfor external financingin the
1980's and its demand in the 1970's is 0.63.
The coefficient estimate when dependence is measuredby the demandfor externalfinancing in the 1970's is statisticallysignificant,and the estimateddifferentialgrowthrateis 0.9 percent.
Finally, it may be that our results derive from the peculiarities of the United States over the 1980's. Our method should work so long as we measure dependence in a country where financial constraints are thought to be small
(so that we measure demand not supply). The only other country we have detailed data on flow of funds for is Canada. Canada is very different from the United States along important dimensions. Its banking system is more concentrated as is corporate ownership, and the composition of its industries is different.
Nevertheless, the correlation between dependence measured in the United States and dependence measured in Canada is 0.77. As the third column of Table 7 shows, the coefficient estimate when dependence is measured using
Canadian data is highly significant. What is especially interesting both in this table and
Table 4 is that the economic magnitude of the interaction effect is generally similar despite variation in the measure of dependence and development used.
V. OtherTests
A. Decomposition of Sources of Growth
An industry can grow because new establishments are added to the industry or because existing establishmentsgrow in size. The U.N. database also reports the nurnberof establishments in an industry.'7In our sample, it turns

i An establishment is defined as a "unit which engages, under a single ownership or control, in one, or predominantly one, kind of activity at a single location."
(Industrial Statistics Yearbookp. 4). This definition may not coincide with the legal boundaries of the firm, but is the only one available for such a large cross section of countries. This content downloaded from 14.139.224.146 on Mon, 06 Jul 2015 21:29:52 UTC
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THE AMERICANECONOMICREVIEW

578

JUNE 1998

TABLE 0-INDUSTRY GROWTHAND VARIOUSMEASURESOF DEVELOPMENT
USING EXTERNAL
DEPENDENCE
MEASUREDFORYOUNG FIRMS

Financial development measured as
Total
capitalization

Variable
Industry's share of total value added in manufacturingin
1980
Interaction(external dependence x total capitalization) Bank debt -0.911
(0.287)

-0.904
(0.286)

0.034
(0.019)

Interaction(external dependence x accounting standards) Interaction(external dependence x accounting standards1983) Accounting standardsand capitalization

-0.568
(0.234)

-0.616
(0.252)

-0.293
(0.149)

-

-

-

-

Instrumental variables -0.004
(0.008)

0.046
(0.021)

-

Accounting standards in 1983

-

0.021
(0.012)

Interaction(external dependence x domestic credit to private sector)

Accounting standards -

-

-

0.045
(0.022)

0.058
(0.028)

0.415

0.340

984

1008

0.1

0.5

0.038
(0.019)

R2

0.283

0.283

0.341

0.236

Number of observations

1150

1150

1008

808

Differential in real growth rate

0.6

0.5

0.4

-0.571
(0.233)

0.2

Notes: The dependent variable is the annual compounded growth rate in real value added for the period 1980-1990 for each ISIC industryin each country. Externaldependence is the fraction of capital expendituresnot financed with internal funds between 1980-1990 for U.S. firms which went public in the previous ten years belonging to the same industry.
The interactionvariable is the product of external dependence and financial development. Financial development is total capitalization in the first column, domestic credit to the private sector over GDP in the second column, accounting standardsin 1990 in the third column, and accounting standardsin 1983 in the fourth column. The sixth column is estimated with instrumentalvariables. Both the coefficient estimate for the interactionterm and the standarderrorwhen accounting standardsis the measure of development are multiplied by 100. The differential in real growth rate measures
(in percentage terms) how much faster an industry at the 75th percentile level of external dependence grows with respect to an industry at the 25th percentile level when it is located in a country at the 75th percentile of financial development rather than in one at the 25th percentile. All regressions include both country and industry fixed effects (coefficient estimates not reported).Heteroskedasticityrobust standarderrorsare reportedin parentheses.

out that two-thirds of the growth is spurredby an increase in the average size of establishments, while the remaining third is accounted for by an increase in the number of establishments. The growth in the number of establishments is the log of the number of ending-period establishments less the log of the number of establishments in the beginning of period. The average size of establishments in the industry is obtained by dividing the value added in the industry by the number of

establishments, and the growth in average size is obtained again as a difference in logs.
Although the definition of establishments provided by the Industrial Statistics Yearbook does not coincide with the legal definition of a firm, there are three reasons why it is interesting to decompose the effect of financial development in its effect on the growth in the number of establishments and growth in the size of the existing establishments.First, since this statistic is often compiled by a different

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TABLE 7-INDUSTRY

579

GROWTH AND VARIOUS MEASURES OF EXTERNAL DEPENDENCE

External dependence measured using
Old firms

Firms in 1970's

Canadianfirms

Industry's share of total value added in manufacturingin 1980

-0.625
(0.204)

-0.620
(0.205)

-0.610
(0.235)

Interaction(external dependence x accounting standards)

0.253
(0.063)

0.315
(0.127)

0.065
(0.023)

R2

0.336

0.334

0.343

Number of observations

1035

1035

802

Differential in real growth rate

0.9

0.9

0.8

Variable

Notes: The dependent variable is the annual compounded growth rate in real value added for the period 1980-1990 for each ISIC industryin each country. Externaldependence is the fraction of capital expendituresnot financed with internal funds by firms in the same industry during the 1980's. In the first column this ratio is computed only for companies that have been public for at least ten years. In the second column it is computed for U.S. firms during the 1970's. In the third column it is computed for Canadianfirms during the 1980's. Also in the thirdcolumn, data on U.S. industriesare included while data on Canadianindustries are dropped. The differential in real growth rate measures (in percentage terms) how much faster an industry at the 75th percentile level of external dependence grows with respect to an industry at the 25th percentile level when it is located in a country at the 75th percentile of financial development ratherthan in one at the
25th percentile. All regressions are estimated using instrumentalvariables and include both country and industry fixed effects (coefficient estimates not reported).Heteroskedasticityrobust standarderrors are reportedin parenthesis.

body in a country from the one that produces the value-added data, this test provides an independent check on our results.'8 Second, the creation of new establishments is more likely to require external funds, while the expansion of existing establishmentscan also use internal funds. Thus, the effect of financial development should be more pronounced for the first than for the second. Finally, the growth in the number of establishments is more likely to be generated by new firms than the growth in the size of the existing establishments. Thus, the growth in the numberof establishmentsshould be more sensitive to the external dependence measured using young firms in the United
States.
We then estimate the basic regression with growth in number of establishments and growth in average size as dependentvariables.
As Table 8 indicates, the interaction variable is statistically significantonly when explaining
18 The disadvantage is that the industry classification used by the body compiling the number of firms may differ from the industryclassification used by the body compiling value-added data, resulting in an increase in noise.

the growth in the number of establishments.
More important,the differentialin growth rate suggested by the estimate is twice as large in the second column (the regression with growth in numbers as the dependent variable) as in the first column (the regression with growth in average size as the dependent variable). This finding that the development of financial markets has a disproportionalimpact on the growth of new establishments is suggestive. Financial development could indirectly influence growth by allowing new ideas to develop and challenge existing ones, much as
Schumpeter argued.
Recall that in the previous section, we found that the dependence of youing firms was of lower importance (both statistical and economic) than the dependence of mature firms in explaining the relative growth of industries.
One explanation is that the dependence of young firms in the United States is an accurate measure of the needs of new firms in that industry elsewhere, but only a noisy measure of the dependence of all firms. This seems to be the case. When dependence is measured for

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580

THE AMERICANECONOMICREVIEW
TABLE 8-GROWTH

JUNE 1998

IN AVERAGE SIZE AND NUMBER OF ESTABLISHMENTS

External dependence measured using
All firms

Variable

Growth average size

Industry's share of total value added in manufacturingin 1980
Interaction(external dependence x accounting standards)

Young firms

Growth number Growth average size

-0.620
(0.217)

-0.312
(0.154)

0.051
(0.043)

R2

Mature firms

Growth number Growth average size

Growth number -0.635
(0.256)

-0.252
(0.179)

-0.624
(0.220)

--0.282
(0.152)

0.115
(0.037)

-0.021
(0.029)

0.078
(0.024)

0.125
(0.055)

0.131
(0.041)

0.498

0.314

0.500

0.302

0.492

0.310

Number of observations

951

975

899

922

923

947

Differential in real growth rate

0.3

0.7

-0.2

0.6

0.4

0.4

Notes: The average size of establishments in the industry is obtained by dividing the value added in the industry by the numberof establishments, and the growth in average size is obtained as a difference in logs between average size in 1990 and average size in 1980. The growth in the numberof establishmentsis the log of the numberof establishmentsin 1990 less the log of the number of establishments in 1980. The differential in real growth rate measures (in percentage terms) how much faster an industry at the 75th percentile level of external dependence grows with respect to an industry at the
25th percentile level when it is located in a country at the 75th percentile of financial development ratherthan in one at the 25th percentile. All regressions are estimated using instrumentalvariables and include both country and industryfixed effects (coefficient estimates not reported). Heteroskedasticityrobust standarderrors are reportedin parentheses.

young firms, the interaction coefficient has a positive, statistically significant effect on the growth in the number of establishments, but a negative (and statistically insignificant) effect on the growth of the average size of existing establishments (third and fourth columns); when dependence is measured for mature firms, the interactioncoefficient has a positive, statistically significant effect on both.
Since most of growth in value added is generated by an increase in the average size of existing establishments, the most appropriate measure of external dependence seems to be one that includes both the needs of new firms as well as the needs of existing firms. This is why in the rest of the paper we will use external dependence measured across all firms.
B. Is the Interaction a Proxy for Other Variables?
Do external dependence or financial development proxy for something else? In principle, there is a long list of sources of comparative advantage that may dictate the presence, ab-

sence, or growth of industriesin a country.Our results, though, cannot be explained unless the dependence of industries on this source of comparative advantage is strongly correlated with their dependence on external funding and financial development is a good proxy for the source of comparative advantage. We rule out two such possibilities below.
Industries that are highly dependent on external finance-for example, Drugs and Pharalso be dependent on maceuticals-could human capital inputs. To the extent that financial market development and the availability of human capital are correlated, the observed interaction between external dependence and financial development may proxy for the interaction between human capital dependence and the availability of trained human capital.
To check this, we include in the basic regression an interaction between the industry's dependence on external finance and a measure of the country's stock of human capital (average years of schooling in population over the age of 25). If the conjecture is true, the coefficient of the financial development interaction term

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AND GROWTH
RAJANAND ZINGALES:FINANCIALDEPENVDENCE

581

TABLE 9-ROBUSTNESS CHECKS

Variable

Human capital Economic development Above median Below median Industry's share of total value added in manufacturingin 1980

-0.386
(0.137)

-0.422
(0.134)

-0.437
(0.178)

-6.079
(1.932)

0.191
(0.072)

0.149
(0.055)

0.161
(0.065)

0.161
(0.066)

Interaction(external dependence x accounting standards)
Interaction2 (external dependence x average years of schooling)

-0.002
(0.003)

0.000
(0.005)

Interaction3 (external dependence x log of per capita income in
1980)

-

-

-

R2

0.413

0.418

0.548

0.390

Number of observations

1006

1042

522

545

1.0

0.9

0.9

1.0

Differential in real growth rate

Notes: The dependent variable is the annual compounded growth rate in real value added for the period 1980-1990 for each ISIC industry in each country. The first column adds to the basic specification the interaction between external dependence and a country's human capital. The second column adds to the basic specification the interaction between external dependence and a country's level of economic development (log per capita income). The third column estimates the basic specification for industries that in 1980 were above the median industry in terms of the fraction they accounted for of value added in the manufacturingsector. The fourth column estimates the basic specification for industiies that in
1980 were below the median industry in terms of the fraction they accounted for of value added in the manufacturing sector. The differential in real growth rate measures (in percentage terms) how much faster an industry at the 75th percentile level of external dependence grows with respect to an industry at the 25th percentile level when it is located in a country at the 75th percentile of financial development ratherthan in one at the 25th percentile. All regressions are estimated using instrumental variables and include both country and industry fixed effects (coefficient estimates not reported). Heteroskedasticityrobust standarderrors are reportedin parentheses.

should fall substantially.As the coefficient estimates in the first column of Table 9 show, the coefficient on the humancapitalinteraction term is small and not statistically significant, while the financial development interactionincreases somewhat. This suggests that financial dependence is not a proxy for the industry's dependence on human capital.
Another possibility is that lower dependence on external financing in the United
States simply reflects the greater maturity of the industry. An influential view of the development process is that as technologies mature, industries using those technologies migrate from developed economies to developing economies (see, for example, Rudiger
Dornbusch et al., 1977). Since developing countries are more likely to have underdeveloped financial markets, the interaction effect we document may simply reflect the stronger

growth of mature technologies in underdeveloped countries.
We alreadyhave results suggesting this cannot be the entire explanation. The interaction effect is present even when dependence is measured only for young firms in the United
States. Furthermore,we can test if financial development is really a proxy for economic development in the regression. We include in the basic regression the interaction between the industry's dependence on external finance and the log per capita GDP for the country, in addition to our usual interactionterm. As seen in the second column of Table 9, the coefficient of the interaction termifalls from 0.165
(in the basic regression) to 0.149 but is still statistically and economically significant. The interaction between financial dependence and log per capita income is close to zero and not significant. The results do not suggest financial

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582

THE AMERICANECONOMICREVIEW

dependence is a proxy for technological maturity. C. Other Explanations: Reverse Causality
Thus far, we have taken the state of financial markets as predeterminedand exogenous. An alternative explanation of the development of financial markets is that they arise to accommodate the financing needs of finance-hungry industries. The argument is as follows. Suppose there are some underlying country-specific factors or endowments (such as natural resources) that favor certain industries (such as Mining) that happen to be finance hungry. Then, countries abundantin these factors should experience higher growth rates in financially a resultdependent industries and-as should develop a strong financial market. If these factors persist, then growth rates in financially dependentsectors will persist and we will observe the significant interaction effect.
But here it will result from omitted factors than any beneficial effect of finance.
On the one hand, the lack of persistence in country growth over periods of decades (see
William Easterly et al., 1993) and the low correlation of sectoral growth across decades (see
Peter Klenow, 1995) suggest that this should not be a majorconcernm the other hand, our
On
finding that capitalization is higher when the weighted average dependence of industries in the country is high indicates the argument is not implausible.
The results we already have should reduce concerns about reverse causality. By restricting the sample to manufacturing firms, we have reduced the influence of availability of natural resources. More important, the measure of financial development we use -accounting standards-is instrumented with predeterminedvariables that are unlikely to be correlated with omitted factors driving the growth of industries dependent on external finance. In fact, it should be less correlatedwith past financing than the capitalizationmeasure, yet it explains future relative growth rates better. However, we can also test the argument more directly. If an industry has a substantial presence in a particular country, it is logical

JUNE 1998

that the country has the necessary resources and talents for the industry. So by further restricting the sample to industries that are above the median size in the country in 1980, we reduce the problem of differences in growth stemming from differences in endowment. When we estimate the regression with this smaller sample (third column of
Table 9), the interaction coefficient is virtually unchanged.
One way to make sense of all our findings without reverse causality driving the results is that financial markets and institutions may develop to meet the needs of one set of industries, but then facilitate the growth of another younger group of industries. Alfred D.
Chandler, Jr. (1977) suggests this is, in fact, what happened in the United States. The financial sector, especially investment banks and the corporate bond market, developed to meet the financing needs of railroads in the mid-nineteenth century. The financial infrastructure was, therefore, ready to meet the financing needs of industrial firms as they started growing in the latter half of the nineteenth century. Similarly, Goldsmith (1985 p.
2) based on a study of the balance sheets of
20 countries writes: "The creation of a modem financial superstructure,not in its details but in its essentials, was generally accomplished at a fairly early stage of a country's economic development."
Again, we can test this possibility more directly. We estimate the effect of financial development only for industries that are small to start out with, and are unlikely to be responsible for the state of development of the financial markets. So we estimate the basic regression for industriesthat in 1980 were less than the median size in their respective countries. The coefficient of the interaction term is again unchanged (see column four of Table 9) even for these industries for which the economy' s financial development is largely predetermined.We conclude that reverse causality is unlikely to explain our results.
D. Other Explanations: Investment and Cost of Capital
Investment opportunitiesin different industries may be very different. For instance, the

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RAJANAND ZINGALES:FINANCIALDEPENDENCE AND GROWTH
TABIE

10-CASH

583

FLOW AND INVESTMENTS

Cash flow intensiveness Variable
Industry's share of total value added in manufacturingin 1980
Interaction(internalcash flow x financial development)

Investment intensiveness Both

Both measured for 1980

-0.588
(0.201)

-0.653
(0.205)

-0.639
(0.205)

-0.639
(0.207)

-0.261
(0.196)

-0.595
(0.295)

0.623
(0.221)

0.443
(0.283)

0.800
(0.299)
0.344

0.482
(0.153)

Interaction2 (investment intensiveness x accounting standards)
R2

0.343

0.345

0.345

Number of observations

1067

1067

1067

Differential in real growth rate

-0.7

1.4

0.5

1035
1.6

Notes: The dependent variable is the annual compounded growth rate in real value added for the period 1980- 1990 for each ISIC industry in each country. Internalcash flow is the ratio of cash flow from operations broadly defined (see text) to net property plant and equipment for U.S. firms in the same industry. Investment intensity is the ratio of capital expenditures to propertyplant and equipment for U.S. firms in the same industry. The fourth column uses the cash flow intensity and the investment intensity measured for the year 1980. The differential in real growth rate measures (in percentage terms) how much faster an industry at the 75th percentile level of external dependence grows with respect to an industry at the 25th percentile level when it is located in a country at the 75th percentile of financial development rather than in one at the 25th percentile. All regressions are estimated using instrumental variables and include both country and industry fixed effects (coefficient estimates not reported). Heteroskedasticityrobust standarderrors are reported in parentheses.

Tobacco industry in the United States uses negative external finance (see Table 1) partly because investment opportunities in the Tobacco industry are small relative to the cash flows the industrygenerates. It may be thatour measure of dependence on external finance proxies primarily for the investment intensity of a particularindustry. Furthermore,the development of the financial sector may proxy for the overall cost of capital in that country
(rather than the cost of external funds). The interactioneffect then indicates that capital intensive firms grow faster in an environment with a lower cost of capital. Though this is a legitimate channel throughwhich the financial sector influences growth, we are also interested in a different channel where the reduction in the incremental cost of external funds facilitates growth.
If investmentintensitywere all thatmattered, and external finance and internalfinance were equally costly, the cash internallygeneratedby industrieswould be irrelevantin countriesthat aremorefinanciallydeveloped.All thatmattered would be the size of the required investmentand the cost of capital. By contrast, if there is a wedge between the cost of internaland external financewhich narrowsas the financialsectordevelops, industriesgeneratinglots of internal cash should grow relativelyfasterin countrieswith a poorly developed financial sector. As indicated in the first column of Table 10, they do. This is consistent with financialdevelopmentreducing the cost of external finance. Of course, as is to be expected with both the "cost of capital" and
"cost of externalcapital" hypotheses,industries thatinvest a lot also grow fasterin countrieswith more-developed financialmarkets(second column). Unfortunately, when both interactions are introducedin the same regression, the coefficients are measuredvery impreciselybecause of multicollinearity(cash flow intensity and investnent intensity have a correlationof 0.73); so neither is statistically different from zero.
However, the coefficient on cash flows is still negative and sizeable (accounting for a real growth rate differentialof about0.4 percentper year). Multicollinearity results from our aggregating cash flows and investments over a

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584

THE AMERICANECONOMICREVIEW

decade."9
Therefore, we estimate the same regression using a measure of cash flow intensity and investment intensity measuredfor just one year (rather than an entire decade). In the fourth column we report the estimates obtained by using the 1980 measuresof cash flow and investment. Both the cash flow intensity and the investment intensity are statistically significant at the 5-percent level. We estimated
(but do not report) the same regression using a 1985 measure and a 1990 measure. In both cases the results are similar and both coefficients are statistically significant at the 5percent level.
VI. Conclusion
We develop a new methodology in this paper to investigate whether financial-sectordevelopment has an influence on industrial growth. In doing so, we partially circumvent some of the problems with the existing crosscountry methodology highlighted by Mankiw
(1995). First, it is difficult to interpret observed correlations in cross-country regressions in a causal sense. Here, we push the causality debate one step furtherby finding evidence for a channel through which finance theoreticallyinfluences growth. Also, since we have multiple observations per country, we can examine situations where the direction of causality is least likely to be reversed. A second problem with the traditionalmethodology is that explanatoryvariables are multicollinear and are measured with error.The combination of these two problems may cause a variable to appear significant when it is merely a proxy for some other variable measured with error.
As a result, observed correlationscan be misleading. By looking at interactioneffects (with country and industryindicators) ratherthandirect effects, we reduce the numberof variables that we rely on, as well as the range of possible alternative explanations. Third, there is the problem of limited degrees of freedom-there

" Early investments will generate later cash flows resulting in the correlation.Aggregating over a decade, however, will still give a reasonable estimate of the average demand for external funds even though it tells us less about the components.

JUNE 1998

are fewer than 200 countries on which the myriad theories have to be tested. Our approach partially alleviates this problem by exploiting within-country variation in the data.
Our methodology, may have wider applications, such as testing the existence of channels through which human capital can affect growth. Apart from its methodological contribution, this paper's findings may bear on three different areas of current research. First, they suggest that financial development has a substantial supportiveinfluence on the rate of economic growth and this works, at least partly, by reducing the cost of external finance to financially dependent firms. We should add that there is no contradictionwhen the lack of persistence of economic growth (Easterly et al.,
1993) is set against the persistence of financial development. Otherfactors may cause (potentially serially uncorrelated)changes in a country's investment opportunityset. Finance may simply enable the pursuit of these opportunities, and thereby enhance long-run growth.
The paper does, however, suggest that financial development may play a particularlybeneficial role in the rise of new firms. If these firms are disproportionately the source of ideas, financial development can enhance innovation, and thus enhance growth in indirect ways. Second, in the context of the literature on financial constraints, this paper provides fresh evidence that financial market imperfections have an impact on investment and growth.
Finally, in the context of the tradeliterature, the findings suggest a potential explanationfor the pattern of industry specialization across countries. To the extent that financial-market development (or the lack thereof) is determined by historical accident or government regulation, the existence of a well-developed marketin a certain country representsa source of comparative advantage for that country in industries that are more dependent on external finance. Similarly, the costs imposed by a lack of financial development will favor incumbent firms over new entrants. Therefore, the level of financial development can also be a factor in determining the size composition of an industry as well as its concentration. These issues are importantareas for future research.

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VOL. 88 NO. 3

RAJANAND ZINGALES:FINANCIALDEPENDENCE AND GROWTH

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