25. Finance and Development

The reasonable chain of causality is: colonial history \(\overset{\text{effect}}{\Rightarrow}\) legal structure \(\overset{\text{effect}}{\Rightarrow}\) financial development \(\overset{\text{effect}}{\Rightarrow}\) growth. La Porta et al. (1997) focus on the middle (legal structure \(\to\) financial development), using a sample of 49 countries to show countries with poorer investor protection (French civil law) have weaker capital markets than those with stronger protection (common law).

Background: English law is common law, made by judges and subsequently incorporated into legislature (England + its colonies); French, German, and Scandinavian laws are civil law, made partly by scholars and legislators, relying on statutes and comprehensive codes (the French code developed in 1807, exported to Belgium/Holland/Poland/Italy/Mexico; the German code in 1897, exported to Australia/Japan/Switzerland). Common law gives the judge more flexibility and power and emphasizes precedent → it's harder for any party to lobby for new legislation in their favor → common-law countries have better investor protection. Common law protects shareholders and creditors most, German and Scandinavian civil law are in the middle, French civil law protects investors least (the ranking from the metrics in Table I of La Porta et al. 1998).

Results: comparisons of different law-origin countries on the external-finance market and investor protection are in Figure 25.1 — countries with stronger investor protection have a better external financial market. External cap = stock market capitalization × the percentage of common shares not owned by the top three shareholders in the ten largest non-financial privately owned domestic firms in a country. Civil law (worse protection) → a smaller equity capital market (Figure 25.2, regressing External Cap/GNP on GDP growth, log GNP, rule of law, French/German/Scandinavian origin, antidirector rights, one-share-one-vote); → fewer domestic firms per population (Figure 25.3); → fewer IPOs per population (Figure 25.4); → less GNP-normalized outstanding debt (Figure 25.5). La Porta et al. (1998) was actually written before (1997); it first establishes the law-and-finance-development idea and uses 49 countries to thoroughly analyze each dimension of law on financial development, serving as the basis for the (1997) regressions; both share the idea: a legal system with better investor protection → a better-developed financial system.

Rajan-Zingales (1998) explore: firms more reliant on external financing (rather than their own retained earnings) should be more influenced by financial-market development. Data: the UN Statistical Division's Industrial Statistics Year-Book; some variables (GDP, PPI, exchange rate, industrial-production index) from the IMF's International Financial Statistics. Empirical strategy: first use US data to identify industry \(j\)'s need for external finance \(\text{Dependence}_j=\frac{\text{capex}_j-\text{cash flow}_j}{\text{capex}_j}\) (investment minus cash from operations); then assume US capital markets are relatively frictionless to apply that dependence to other countries; finally use the other 54 countries' data to test whether industries more reliant on external finance grow faster in countries with more developed financial markets. Main regression

$$\text{Growth}_{j,k}=\text{const}+\sum_k\beta_{1,k}\text{Country Indicator}_k+\sum_j\beta_{2,j}\text{Industry Indicator}_j+\sum_{j,k}\beta_{3,j,k}\text{Industry's share of manufacturing in 1980}_{j,k}+\sum_{j,k}\gamma_j\big(\text{External dependence}_j\times\text{Country's financial development}_j\big)+\varepsilon_{j,k} \tag{25.1}$$

external dependence \(=\frac{\text{capex}_j-\text{cash flow}_j}{\text{capex}_j}\); country financial development is measured three ways (accounting standards — the CIFAR index ranking disclosure in annual reports; total capitalization/GDP — the ratio of equity market cap + domestic credit to GDP; domestic credit to the private sector/GDP). (25.1) keeps only the interaction rather than the two separate terms, since those are absorbed by the industry FE (Industry Indicator\(_j\)) and country FE (Country Indicator\(_k\)). Result: for any measure of financial development, the interaction is always significantly positive → industries more reliant on external finance grow faster in countries with more developed financial markets (Figure 25.6, the dependent variable being the industry-country annual compounded growth rate in real value added 1980–1990); more financially dependent industries (Drug, Plastics, Computers) perform better in more developed (better accounting standards) countries, while less dependent ones (Tobacco, Pottery, Leather) perform better in less developed ones (Figure 25.7).