Financial development and firms’ financing constraints a study of manufacturing firms in vietnam

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIESVIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS FINANCIAL DEVELOPMENT AND FIRMS’ FINANCING CONSTRAINTS: A STUDY OF MA

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FINANCIAL DEVELOPMENT AND FIRMS’ FINANCING CONSTRAINTS:

A STUDY OF MANUFACTURING FIRMS IN VIETNAM

BY

VU THI KHANH

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, MAY 2015

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FINANCIAL DEVELOPMENT AND FIRMS’ FINANCING CONSTRAINTS:

A STUDY OF MANUFACTURING FIRMS IN VIETNAM

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

VU THI KHANH

Academic Supervisor:

DR.LE VAN CHON

HO CHI MINH CITY, MAY 2015

“This is to certify that this thesis entitled “Financial development and firms’ financingconstraints: A study of manufacturing firms in Vietnam”, which is submitted by me infulfillment of the requirements for the degree of Master of Art in DevelopmentEconomics to the Vietnam – The Netherlands Programme (VNP)

The thesis constitutes only my original work and due supervision andacknowledgement have been made in the text to all materials used.”

Vu Thi Khanh

This thesis would not have been possible without the support and theencouragement from many people I would like to make a sincere effort in portraying

my deep sense of gratitude in the form of words

I owe a debt of gratitude to my supervisor, Dr Le Van Chon for his greatgenerosity and dedication in sharing his wisdom, stimulating my critical thinking skillsand guiding me to rethink and to deconstruct my thesis topic He was also not afraid oftime-consuming to explain econometric methods as well as data processing techniques

to me Moreover, he took time to diligently review my final thesis draft and help mecorrect errors and inappropriate words usages Furthermore, I am grateful to Ass.ProfNguyen Trong Hoai and Dr Tran Tien Khai for their valuable comments andsuggestions for my concept note and thesis research design Thank to Dr Pham KhanhNam for his enthusiasm of helping me collecting data I must show my gratitudetoward all lecturers VNP who have broadened my perspectives and encouraged me tothink harder and deeper about the complexity of the world’s realities

Next, I wish to express my thank you to all my friends here at VNP Together

we have walked and struggled through this whole treasured journey of learning andshared memorable and priceless moments Then, I want to say thanks to VNP officers

as well as VNP librarian for their support of comfort lab room and study materials

Finally, I dedicate my thesis to my parents and my brother who are alwaysbesides me and never stop supporting me

ADB : The Asian Development Bank

BTA : The U.S.-Vietnam Bilateral Trade Agreement

DM : Demirguc-Kunt and Maksimovic

GDP : Gross domestic production

GSO : General statistics office of Vietnam

HNX : Hanoi Stock Exchange

HOSE : Ho Chi Minh Stock Exchange

IMF : The International Monetary Fund

LLY : Liquid liabilities ratio

PCG : Private credit to GDP ratio

SMEs : Small and medium enterprises

SOEs : State-owned enterprises

SVG : Stock market total valued traded to GDP

UN : The United Nations

UPCoM : Unlisted public company market

US : The United States of America

VAR : Vector Autoregression

VES : The Vietnam Enterprise Survey

Using panel data from the Vietnamese Enterprise Survey (VES) from

2006-2012, this thesis aims to analyze the relationship between financial development andfinancing constraints of firms in Vietnam The Euler equation approach is applied tomodel firms' investment Investment sensitivity to cash-flow is employed as thevariable to test for the existence of financing constraints To control for endogeneityand firm heterogeneity, I utilize the first difference GMM estimation proposed byArellano and Bond (1991) There is robust evidence that Vietnamese manufacturingfirms face financing constraints and that financial development significantly relaxesfirms' dependence on internal funds for investment In addition, although smaller firmssuffer more severe financing constraints, their constraints are alleviated more thanthose of larger firms in the presence of financial development

Keywords: Financial development, Financing constraints, Corporate Investment

Table of contents

Chapter 1: Introduction 1

1.1Problem statement 1

1.2Research questions 3

1.3The scope of the study 3

1.4The structure of the study 3

Chapter 2: Literature review 4

2.1Sources of investment financing 4

2.1.1External financing 4

2.1.2Internal financing 5

2.2Financing constraints on firms 8

2.2.1Definition 8

2.2.2Measurement of financing constraints on firm 8

2.3Financial development and financing constraints on firms 9

2.4Conclusion 14

Chapter 3: Model specification 16

3.1Investment modeling 16

3.1.1Euler investment equation approach 16

3.1.2Detecting the presence of firm’s financing constraints using Euler equation 24

3.2Financial development measurement 25

3.3Empirical model to evaluate the impact of financial development on firm investment 28

Chapter 4: Financial development in Vietnam 30

Chapter 5: Empirical results 37

5.1Data 37

5.1.1Sample and variable construction 37

5.1.2 Descriptive (Initial relationship) 40

5.2 Estimation technique: GMM dynamic panel estimation 44

5.3 Regression results 46

Chapter 6: Conclusion 51

6.1 Main findings 51

6.2Policy implications 52

6.3Limitations and further research 52

References 53

Appendix 60

List of tables

Table 2.1: Share of financing sources in two industries in the United Kingdom 6

Table 2.2 The proportion of financing sources according to different firm sizes 6

Table 5.1: Firm level variable definitions 38

Table 5.2: Panel data structure 39

Table 5.3 The descriptive statistics of the key variables for the whole data sample 41

Table 5.4 Median value of the key variables by different firm types 41

Table 5.5 Correlation matrix 42

Table 5.6 Mean values of the key variables by manufacturing industries 42

Table 5.7 Mean values of the key variables by years 43

Table 5.8 Regression results using first difference GMM estimation 47

Table 5.9 Scenario analysis of firm’s size on investment –cash flow 50

List of figures

Figure 4.1 The mono-tier banking system in Vietnam before banking reforms 31

Figure 4.2 Structure of the two-tier banking system in Vietnam (after May 1990) 31

Figure 4.3 Brief on the Vietnamese banking system 32

Figure 4.4 Liquid liabilities (M3) as % of GDP of some countries 33

Figure 4.5 Credit to the economy 34

Figure 4.6 Private credit to GDP of some countries 34

Figure 4.7 Stock Market Capitalization as % of GDP 35

List of appendix Appendix 1 Banking system development progress from 1990’s 61

Appendix 2 Stock market development process from 1990’s 63

Appendix 3 Boxplot chart for each variable (IK,SK,CFK) by industries 66

Appendix 4 Scatter chart for each variable (IK, SK, CFK) by industries 66

to investigate the potentially prudent effects of financial development on firms’investment, pointing to the seriousness of firm’s financing constraints, under thecountry financial development background.

According to Modigliani and Miller (1958), external finance perfectlysubstitutes internal finance and firm’s investment decisions do not depend on itsfinancing choices under the strict assumption of perfect capital markets Unfortunately,perfect capital market apparently does not exist in reality According to Stiglitz&Weiss(1981) and Myers &Majluf (1984), firms have to tackle difficulties of suffering highercost of external fund due to credit risk and asymmetric information as providers ofexternal finance normally find it very costly to evaluate firms' investmentopportunities Therefore, firms have to resort to internal finance generated throughcash-flow and retained earnings But their investment is subject to fluctuations in cash-flow In other words, firms face financing constraints Rajan and Zingales (1996)argued that financial development induces more efficient reallocation of funds andmitigates the external financing constraints In better-functioned financial systems, notonly the transaction cost of saving and investing is lower but the problem ofasymmetric information is alleviated With the financial market development, some

empirical studies combine cross-country and firm panel data to investigate diversefeatures of the connection between financial development and the extent at whichfirms’ reliance on internal finance Love (2003), processing a panel data of 5,000 firms

in 36 developed and developing countries, proved that financial development lightensthe reliance of firms’ investment on internal fund, especially in small firms Using thesame data but the different method, Love and Zicchino (2006) pointed out that incountries with less developed financial systems, firms face financing constraints moreseriously This also holds at the regional level Sarno (2005) compared southern withnorthern regions of Italy and found that in less financially developed southern regions,small and medium enterprises (SMEs) harshly suffered credit constraints At provinciallevel, O’Toole and Newman (2012) investigated the effect of firms’ financingconstraints on investment opportunities in Vietnam by using the firm panel data takenfrom the Vietnam Enterprise Survey (VES) from 2002-2008 and observe thatprovincial financial development in Vietnam eases investment financing constraints

This study is similar in spirit to O’Toole and Newman (2012) in analyzing therelationship between financial development and firms’ investment in Vietnam Ofparticular interest is the role of financial development via financing constraints on thefirms’ financing investment However, there are some extensions from O’Toole andNewman (2012) Firstly, Euler equation approach is employed to model firms’investment Secondly, investment sensitivity to cash-flow is employed as the variable

to test for the presence of financing constraints, differing from O’Toole and Newman(2012) that used the ratio of investment fund by internal fund to total investmentfinance Thirdly, data in this study cover a more recent period of time from 2006-2012

1.2 Research questions

This study is to find out the impact of financial development on firms’investment By applying quantitative research to a panel data of firms in Vietnam,this thesis aims to address two main research questions:

1 Does financial development prompt investment or relax financingconstraints of Vietnamese manufacturing firms?

2 How does financial development affect investment of different types of firms?

1.3 The scope of the study

The study will examine relationship between financial development and firms’financing investment in the case of Vietnamese manufacturing firms The firm paneldata for this research is taken from VES from 2006 to 2012 Meanwhile, the macrodata of financial development is gathered from World Development Indicators ofWorld Bank’s database

1.4 The structure of the study

The paper contains 6 main chapters Following this first chapter of introduction,chapter 2 presents the critical literature review on sources of investment financing, firmfinancing constraints, and the impact of financial development on financingconstraints Next, model specification in chapter 3 specifies the methodology to test thepresence of firm financing constraints using Euler equation approach as well as theempirical model to examine the effect of financial development on financingconstraints on firms Chapter 4 gives a brief overview of financial sector development

in Vietnam Then, the result of the study is presented in chapter 5 which contains threemain parts The first part concentrates on estimation technique, the second variableconstruction as well as data collection and the third regression results Finally, chapter

6 concludes the main findings, limitations and further researches

Chapter 2: Literature review

2.1 Sources of investment financing.

For the purpose of this study, investment refers to capital expenditure (Capex),which is measured by spending on plant, property and equipment Basically, firm’sinvestment is financed by using two sources of finance: internal finance and externalfinance Internal finance, i.e self-financing, may consist of four main components: pastprofits which are not distributed to shareholders; additional capital from the owners;depreciation and amortization Besides taking the advantages from itself whencollecting internal sources for investment, firm might also use external source fromloans of banks and other financial institutions or the issue of new equity This section isdivided into two subsections: the former covers external financing and the later internalfinancing

2.1.1 External financing

Early in mainstream economic point of view, external financing is viewed as asource of firm financing and financial institutions, especially banks has been proved toplay a virtual role in financing investment Schumpter (1912) believed that anentrepreneur must borrow to afford his new business if his purchasing power is notstrong enough In this case, “he cannot become an entrepreneur by previouslybecoming a debtor” In addition, he considered the banker as the key agent in thisprocess Later, it is widely accepted by many authors when investigating finance-growth relationship that investment financing comes from the financial system(King&Levine, 1993; Levine & Zervos, 1998; Levine et al., 2000; Warchtel, 2003etc.) In econometric model of finance-growth, they use the share of broad moneysupply and private credits to gross domestic products (GDP) as the proxies of financialdevelopment The findings state that there is a significantly positive relationshipbetween financial development and economic growth Therefore, they jump to a

conclusion that a developed financial system could promote long-term economicgrowth by the channel that financial intermediaries provide credits to finance firms’development plans.

However, there are some economists arguing these results Arestis (2004; 2005)and Guirat and Pastoret (2009) raised a serious question that what type of loans thatfinancial intermediaries offer firms, long-term or short-term It is clear that the role ofshort-term loans is to facilitate firms’ cash-flow rather than to finance investment.Hence, when choosing proxies for financial development, authors need to take intoconsideration the type of credit or loans Nevertheless, this seems to be missing in thetwo proxies, the share of broad money supply and private credits to GDP, in theprevious studies Another argument is coming from commercial banks’ difficulty inmandating long-term credits Apparently, most recent commercial banks’ sourcescome from short-term deposits

2.1.2 Internal financing

Table 2.1 Share of financing sources in two industries in the United Kingdom (UK)

All samples Chemicals and

allied industries

Electrical Engineering

There is a vast literature discussing the importance of internal finance sources.According to Sweezy (1968), the firm’s profits growth mainly contributes to the capitalaccumulation gain for the purpose of production expansion Moreover, Mayer (1990)used firms’ data in the United States (US) from 1970-1985 to provide an empiricalevidence that in this case, firms mostly rely upon internal sources The result is similar

to the study of British firms of chemical and electrical engineering industries from1949-1984 that bank loans and bond securities do not play a significant role to fixedinvestment financing (see Table 1) Instead, bank loans which are considered as themain source of external finance mostly contribute to firms’ working capital

Using the same data of two industries in UK but with the different approach,Mayer (1990) examined the variation of capital structure according to the firm size.Table 2 points out that large firms seem to require more on internal financing incomparison with external financing

Table 2.2 The proportion of financing sources according to different firm sizes

Source: Business Monitors (M3) in Mayer (1990)

Corbett and Jenkinson (1997) provided another evidence to support the Mayer’sfindings by analyzing the source of finance of three developed countries includingGermany, the US and the UK from 1970-1994 The study shows that in the period1970-1994, the firms in these countries mostly rely on the internal source of financewith the average proportion of the internal finance and total fixed investment of 78.9

Retention Banks, Short-term loans

and trade creditors

Issues of Shares and Long-term Debt

Other sources All companies

percent in Germany, 93.3 percent in the UK and 96.1 percent in the US These are stories in developed countries.

What happens in the countries with the state control over financial systems? Inthese countries, state development banks and other state owned banks follow lowinterest rate policies to stimulate investment (Singh, 1998), especially in the early stage

of development The poof indicates that the most fundamental source of finance forfixed investment comes from internal finance; however the share of long-term bankloans are still high compare to the rate in developed countries mentioned above.Choosing Japan before becoming a developed country in 1990’s as the case of statecontrol over financial system, Tsuru (1993)figured out that the share of internalfinancing over gross manufacturing investment accounted for 60 percent in the late1950s, increasing to 75 percent in the late 1970’s and around 100 percent in the late1980’s The long-term bank loans covered the rest of investment financing, and hadcontinued declining from 1950’s China is a typical example for the country with thefinancial system regulated by the government Specially, the Chinese government plays

a central role in the financial system It is demonstrated that the proportion of the totalassets of state-owned commercial banks and development banks to total banks’ assetaccounts for roughly 60 percent Mlachila and Takebe (2011) argued that due to thegovernment regulation, these banks can lend lower interest rate to firms, especiallywith state-own enterprises investing in construction, logistic and heavy manufacturing

2.2 Financing constraints on firms

2.2.1 Definition

According to Modigliani-Miller (1958), firm’s capital structure is irrelevant toits value in perfect market In other words, external finance perfectly replaces internalfinance However, in financial friction or imperfect financial market, this is not true.External finance is more expensive than internal finance due to asymmetric

information, transaction costs and agency problems (Fazzari et al.,1988, Mayer, 1990,Schiantarelli, 1995, Blundell et al., 1996) Kaplan and Zingales (1997) suggested that afirm faces financing constraints when its costs or accessibility to external sourcesbecome barriers preventing the firm from profitable investment projects Laeven(2003) summarized a large body literature to introduce a definition of financingconstraints on firms that a firm’s investment is considered as financially constrained if

an unexpected increase in internal funds leads to a higher level of investment spending

2.2.2 Measurement of financing constraints on firm

In order to test the existence of financing constraints on firms, Euler investment

equation approach and q investment model are commonly applied in most empirical

studies Both two approaches contain their own advantages and disadvantages

The q model originates from Tobin (1969) and is developed to q-investment

model by Hayashi (1982) Fazzari et al (1998) first introduced the procedure to test the

presence of financing constraints on firm using q-investment model If all markets are

perfectly competitive, a firm’s production and installation functions exhibit constantreturns to scale, and stock markets are strongly efficient, then a firm’s investment only

depends on marginal q which is equal to average q However, when these strict assumptions are not satisfied, the q model is not a good proxy for firm investment (Hayashi, 1982).In the improvement process of q investment model with a novel

approach, Abel and Blanchard (1986) tried to predict the expected present value of thecurrent and future profits produced by an additional unit of fixed capital Theadvantage of this approach is that it does not use stock price data However, thedisadvantage of this approach is that a certain stochastic process on the variables needs

to be assumed

Another approach is Euler investment equation, which is a necessary conditionfor an optimal policy employed by a firm which seeks to maximize its value The first-

order conditions for investment remove the shadow cost of capital from the Eulerequation The Euler investment equation is first introduced by Albel (1980), andapplied by many authors with different adjustments (White, 1992; Hubbard, Krashyap

& White, 1995; Bond & Meghir, 1994; Harris, Schiantarelli & Siregar, 1994, Gilchrist

& Himmelberg, 1999; Love, 2003; Laeven, 2003; Forbes, 2007, Chan et al., 2012,etc.) The Euler investment equation does not use stock price data and not have toassume linear homogeneity of the net revenue function Moreover, it does not require

to assume a certain stochastic process on the variables as in the q investment model as

in the q investment model and the Abel and Blanchard (1986) model Nevertheless, theEuler equation needs to assume and adjustment cost function and a firm’s smoothinginvestment expenditures over time

2.3 Financial development and financing constraints on firms

Basically, financial sector development occurs if financial instruments, marketsand intermediaries are less prone to market asymmetry information, limitedenforcement and transaction costs However, Čihák et al (2013) argued that if onlycapture the ease of market imperfection, the financial development measurementshould cover the actual function of financial development to the whole economy.Therefore, many authors (Merton, 1992; Demirguc-Kunt & Levine, 1996;Demirguc-Kunt&Maksimovic, 1998; Rajan & Zingales, 1998; Levine, 2005; Čihák et al., 2013etc.) adopted a broader definition of financial development as improvements in fivekey financial functions, including: “(1) producing and processing information aboutpossible investments and allocating capital based on these assessments; (2) monitoringindividuals and exerting corporate governance after allocating capital; (3) facilitatingthe trading, diversification, and risk management; (4) mobilizing and pooling savings;and (5) easing the exchange of goods, services, and financial instruments.” As theresult, barriers to access to banking sector have been reduced and capital market hasbeen triggered The gap between external and internal source of finance has gradually

lowered, and the firm’s entry to banking sector has been stimulated In other words, it

is commonly thought that under the existence of financial development, costs of capitalfor firms are decreased, and barriers for firms to external sources are graduallyremoved After all, from theoretical point of view, with the presence of financialdevelopment firms’ financing constraints are ameliorated and their investmentincreases

The empirical examination of the relationship between financial developmentand firms’ investment is of contemporary concerns The current empirical findings offinancial development and financing constraints nexus in developing countries are stillambiguous Demirguc-Kunt and Maksimovic (1998, DM) used cross country firm-level data to investigate whether financial development affects the degree to whichfirms are constrained from investing in profitable growth opportunities Using the sameindicators to measure financing needs among firms in different countries, DM casteddoubt on Rajan and Zingales (1998) who used industry level data to investigate the tiebetween financial development and economic growth DM argued that it would beprecise if those differences are addressed at firm level data Firstly, DM computed therate for individual firm at which firm can grow in two cases (1) it is only funded byinternal sources and (2) both internal funds and short term loans are employed Then,the proportion of firms whose growth rates are in excess of the maximum rate that firmuse only internal fund is calculated It is denoted as Pr_faster Based on this, theproportion of firms in each country relying on external fund would be estimated Inorder to examine the impact of financial development on firm’s growth, DM run thecross country regression:

Pr_fasterit = β1FDi,t+ β2CVi,t + εi,t (1)

in which FD is financial development, CV a set of control variables and ε thedisturbance term To measure financial development variables, DM use a set offinancial indicators including the ratio of market capitalization to GDP, the total value

of shares traded divided by market capitalization and the rate of bank assets to GDP.For control variables, DM employed the different mix of macroeconomic variable such

as economic growth, inflation, the average market to book value of firms in the wholeeconomy, total amount of subsidies from government to firms, the average ratio of netfixed assets over total assets, the real GDP per head, the law and order tradition of theeconomy Finally, they found that the proportion of firms whose growth rates are inexcess of the maximum rate that firm use only internal fund is positively related tofinancial development and legal system variables Applying the same approach, butextending the sample data of the largest listed manufacturing firms in 26 countries,Beck et al (2001) confirm the findings

However, Love (2003) stated that the firms’ investment opportunities indifferent time and countries are not mentioned in DM’s approach She asserted that totest whether financial development enhances the allocation of capital within a country,growing firms need to be identified, given their investment opportunities She usedpooled cross country firm-level data in an investment model based on the Eulerequation approach It embodies financing constraints by parameterizing the shadowcost of external funds as a function of the firm’s cash-flow which is built on Gilchristand Himmelberg (1999) This approach is widely applied by Chan et al (2012), Forbes(2007), Harrison, Love and McMillan (2004) when they analyze the effect of financereform, financial liberalization or banking reform on firms’ investment decision Forfinancial development proxies, five standardized indices, including GDP, total valuetraded over GDP, total value traded over market capitalization, M3/GDP, financialdepth (credit to private sector to GDP) from Dermirguc-Kunt and Levine (1996) arecombined into a single measure This index is standardized to have the mean of zeroand the standard deviation of one Love used a panel data of 5,000 large, publiclytraded firms in 36 countries Her evidence indicates that financial development makes

investment of firms, especially small ones, less sensitive to internal finance This is in line with the theory and many previous studies.

Leaven (2003) conducted the study of firm-level data from 13 developingcountries to examine the difference of investment sensitivity to cash-flow The levels

of liberalization scaled from 1 to 6 are different across countries He found thatalthough investment is largely constrained by cash flow with both firms, there aredifferent effects of financial liberalization on small and large firms Small firms arefound to be more financially constrained before liberalization and less financiallyconstrained after liberalization in comparison with large firms Large firms also arefound to face more financially constrained after liberalization It might come from thefact that large firms often receive incentives from the state such as directed creditprogram of state development banks or other preferential loans which must be scaleddown after liberalization

A different approach is represented by O’Toole and Newman (2012) Despite ofthe same purpose of study the influence of financial development on firms’ investmentfinancing via financing constraints, they differed from previous studies in some points

Firstly, O’Toole and Newman (2012) proposed using fundamental q model based on

Gilchrist and Himmelberg (1995) and applied empirically by Love and Zicchino (2006)with following procedure:

xit = Axit – 1 + �� + ��+ ��� (1)

Qit = (c’[I - �A]) xit (2)

In which xit includes a proxy for the firms' marginal value product of capital In thisresearch, a sale to capital ratio has been used as a proxy for the marginal product of capital This is a valid proxy under constant return to scale of Cobb- Douglas

production structure as detailed in Galindo, Schiantarelli, & Weiss (2007) �� and

��

represent time and firm specific effects, respectively The vector autoregression is used

to estimate the coefficient matrix A which is then included in equation (2) Themarginal value product of capital ratio is identified by vector c, � represents thecombined discount and depreciation rate O’Toole and Newman (2012) argue that the

q

model might be flexible because it relates investment to the firm’s individualinvestment opportunities Secondly, firm’s financing composition mix is the first timedefined by using the differential cost of capital relating to the financing optionsavailable to firms Thirdly, financial development indicators are calculated atprovincial level based on Vietnam Enterprise Survey data before these added in thefirm’s investment model Provincial financial development indicators here areclassified into three families, including financial depth, state intervention and thedegree of market financing in the economy The idea is taken from Guariglia andPoncet (2008) in China due to the similarity between Chinese and Vietnameseeconomies To investigate the impact of financial development on firm’s investment,financial development indicators are interacted with firm’s financing composition mix.O’Toole and Newman’s results support the view that financial development reducesfirms’ financing constraints though credit expansion or through more efficient creditallocation However, the impact differs across firms Financial development hassignificant influences on domestic private firms, but negligible effects on foreigninvested firms

In consistent with the findings in previous studies, Harris, Schiantarelli &Siregar (1994) for the case of Indonesia, Gallego and Loayza (2001) for the case ofChile, Gelos and Werner (2002) for Mexico, they both jump to the conclusion thatfinancing constraints are relaxed for small firms but not for large ones after financialdevelopment However, the empirical findings of the relationship between financialdevelopment and firms financing constraints have not been conclusive Using the samemethod in Love (2003) but only examining the financial development in singlecountry, China and Chile, respectively, Chan et al (2012) and Forbes (2007) found

interesting findings Financial reforms in China do not benefit SMEs and SOEs interms of alleviating the financing constraints This also occurs similar to the case ofChile in the capital control period from 1991 to 1998 Chile small firms sufferedsignificant financing constraints which did not appear before and after the capitalcontrol (Forbes, 2007) Jaramillo et al (1996) found an insignificant relationshipbetween financial development and firm’s investment when examining the case ofEcuador.

2.4 Conclusion

To conclude, in order to investigate the effect of financial development onfirms’ investment, the recent approach widely used is via analyzing firms’ financingconstraints The problem is that how to formulate the firms’ investment and throughwhich the tie between financial development and firms’ financing constraints is

clarified Q model and adjusted Euler specification model are two main approaches of

modeling firms’ investment Formulating financial development indicators is also ofconcern Many different indicators are employed to represent financial development,and they have varied in different studies Most of them are financial depth, the ratio ofmarket capitalization to GDP, the total value of shares traded divided by marketcapitalization and the rate of bank assets to GDP, M3/GDP The impact of financialdevelopment on financing constraints on firms is still ambiguous Most empiricalstudies show that financial development has positive impact on firms’ investment,relaxing firms’ financing constraints Nonetheless, several studies in some developingcountries point out a contradictory result that firms seem to not benefit from thefinancial development process

In this paper, Euler investment equation approach is employed to detect thepresence of financing constraints on firms due to its outstanding advantages inaccordance with Vietnamese firm data and economy context The model specificationand hypotheses development will be presented in the next chapter

Chapter 3: Model specification

This chapter contains three main parts The first part displays the theoreticalframework to model investment As mentioned in the previous part, Euler investmentequation approach as well as how to use it to test for the presence of financingconstraints would be presented The second part discusses the measurement offinancial development indicators The final part specifies the model which is expected

to test the impact of financial development on firm investment

3.1 Investment modeling

3.1.1 Euler investment equation approach

Since the first introduction in Abel (1980), the investment Euler equationapproach has been widely used by many authors (White, 1992; Hubbard, Krashyap&White, 1995; Bond & Meghir, 1994; Harris, Schiantarelli & Siregar, 1994, Gilchrist &Himmelberg, 1999; Love, 2003; Laeven, 2003; Forbes, 2007, Chan et al., 2012) Theequation is acquired after reorganizing first order conditions when solving themaximizing firm’s value problem

In this paper, the investment model based on Euler equation approach closelyfollows models in previous studies, especially Laeven (2003) and Bond & Meghir(1994) The firm is assumed to maximize its present value, which is the sum of theexpected discounted value of dividends subject to the capital accumulation and externalfinancing constraints

Let ��be the firm value at time t, ��the dividend paid to shareholder at time t,

��

= 1 Then, the function of firm value at time t

is �� ∑�=0 ��+� ��+�, the expected value of present values of future dividend payments

conditional on time t information Let П� = ∏�(�� ,

��, ��)

denote the profit function

where �� is the firm’s capital stock at time t, �� the vector of variable input, and ��

the

firm investment at time t The profit function is assumed to be concave and boundedaccording to Gilchrist and Himmelberg (1999) With the depreciation rate � and theinvestment expenditure at time t, ��, the capital stock accumulation at time t+1

is ��+1 = (1 − �)�� + ��+1 Finally, let �� be the financial liabilities Financial

fictions are taken into account via the assumption that the marginal source of externalfinance is debt that risk-neutral debt holders require an external premium, �� =

non-∞

�

��� ∞ �� = �� ∑ ��+� ��+� (1){��+�,

dividends in equation (4) to recognize the effect of financial frictions It is the shadowcost of paying negatives dividends, i.e issuing new equity Therefore, in economicmeaning, it can be understood as the shadow cost of internal finance.

Substituting �� in (2) into (1) and using (3) to eliminate ��in the profit function,

�+1

�

�

�] = 0 (6)

Rearranging the equation below to obtain the Euler equation to take an optimal

procedure for investment (Laeven, 2003)as:

Secondly, the first order condition for debt Bt is:

marginal cost of debt

According to the study of Bond & Meghir (1994) on the hierarchy of financeapproach, when firm pays positive dividend, �� > 0 and not issue new equity, firms generate sufficient profit to finance its dividend payments and investment from

retained earnings It is the case that ��+1 = �� = 0, the shadow value of internal

In order to acquire the empirical investment model from equation (10),following Bond and Meghir (1994)the firm’s profit function is specified as:

П� = �� �� (��,�� ) − ����(��, �� ) − �� � � − ��� (11)

Where �� (��,�� ) is a constant return to scale production function;��(��,

�� ) is convex adjustment cost function of installing ��, which is assumed to be

Let Y = �� (��,�� ) − ��(��, �� ) be net output which is assumed to be

homogeneous in both K t and L t To allow for imperfect completion, �� is assumed todepend on Yt with a constant price elasticity of demand |�|>1

Differentiating �� �with respect to��:

=

−� ������ +

���)

���

−

��� )

(

Adjustment costs function:

The estimation requires an adjustment cost function A common specification widely employed is:

�(��, �� ) = 1

����

� (

From this adjustment cost function, differentiating �� with respect to ��:

��

2( ) −

�� 2+ ���� (

⇔ ��+1 =

−

��+1

1 + ��+1(1 −

��

� ��

+ (1 −

�)���

����

�

− (1 −