Empirical essays in finance, growth and institution

Using the data on asset tangibility in 27 industries across 42 countries we do find that countries with higher financial development have comparative advantage in products of intangible

EMPIRICAL ESSAYS IN FINANCE, GROWTH AND

INSTITUTION

MANOJ RAJ

M A., ECONOMICS

A THESIS SUBMITTED FOR THE DEGREE OF DOCTOR OF PHILOSOPHY

DEPARTMENT OF ECONOMICS NATIONAL UNIVERSITY OF SINGAPORE

2006

Acknowledgement

With heartfelt gratitude I acknowledge the contribution of the Thesis Committee and authors, Dr Y E Riyanto (Chair), Prof Takeshi Yamada, Dr Cheolbeom Park and Dr Jung Hur towards the completion of the thesis I take this opportunity to thank Prof Pami Dua and Prof Partha Sen from Delhi School of Economics for their encouragement in pursuing a doctoral programme and aiding me in the process I am also greatful to Thorsten Back, Matias Braun, Raghuram Rajan and Luigi Zingales for the use of their data I also humbly wish to thank Emily, Luckraz and Julian for their warmth and guidance Finally I express my gratitude and affection for Sadguru and Sadguruma whose blessings alone has made me reach this far

CHAPTER TWO: TRADE AND FINANCIAL DEVELOPMENT: ROLE OF

CHAPTER THREE: FINANCIAL DEPENDENCE AND GROWTH: FOR THE

CHAPTER FOUR: GOVERNMENT AND BUSINESS NEXUS: EVIDENCE

CHAPTER FIVE: MANAGEMENT QUALITY, HERD BEHAVIOR AND

UNDERPRICING OF INITIAL PUBLIC OFFERING: EVIDENCE FROM

Summary

The thesis seeks to study issues that have caught attention of the researchers in the recent years Finance and growth hypothesis over the last decade has received tremendous interests The improved empirical methodology and availability of more informative data has duly contributed The first essay studies the influence of financial development on trade composition It also investigates how institutional measures can also influence the trade composition The traditional trade theories abstracts from frictions in financial market However, credit constraints can influence the investment decisions In countries with less developed financial sector the collateral value of the invested assets becomes critical since financier insists to guard against the default Aggregation of such influence

of financial development on investment decisions could potentially influence the trade pattern Using the data on asset tangibility in 27 industries across 42 countries we do find that countries with higher financial development have comparative advantage in products

of intangible asset intensive industry On the other hand countries with less developed financial sector have comparative advantage in products of more tangible industries

The second essay is a comment on the influential paper Rajan and Zingales (1998) The paper using an innovative methodology finds that industries more dependent on external finance grows faster in countries with more developed financial sector But the countries chosen varied widely in terms of economic development, institutional measures etc In this essay we generate different samples for the developed and the underdeveloped countries and re-estimate the model followed in Rajan and Zingales (1998) We find that indeed the growth of the industries of the less developed countries depends on the development of the financial sector However, same conclusion does not apply for the

rich countries Such a finding raises questions that are important to investigate to have richer insights on the finance and growth relationship

The third essay is another step in the renewed interest in the institutional aspects of the countries The renewed interest is owed to the recent emphasis on the micro level empirical investigation to support the rich theoretical literature on corruption and other

institutional aspects In the third essay we examine the practice of Amakudari—the

practice to employ retired bureaucrats in the Japanese boards We seek to investigate whether sustenance of such practice over the last seven decades could potentially be influenced by economic incentives that encourage rent seeking activities We do find that firms directly entering into economic transaction with the government, whether as debtor

or supplier to government agencies, are more likely to recruit the retired bureaucrats The results though not conclusive does suggests the existence of rent seeking activities

The final essay tries to analyse the underpricing of the new issues in Singapore from the herd behaviour framework To examine the relation between herd behaviour of the investors and the underpricing of new issues we look at the management reputation of the firm We conjecture that informed investors base their decisions on the management reputation of the firms and that imitation of the less informed investors leads to the over pricing of the issue when initially listed Using the IPO data from the Singapore Stock Exchange for the last there and half years we find that underpricing is increasing in management quality However, the abnormal short run returns gets rationalized in the long run return Proxying one year return as the long run return we find that long run returns are negatively related to the management quality This evidence supports our hypothesis

List of Tables

Page Table 2.1: Effect of FINANCIAL Development and Asset Tangibility

Table 2.2: Effect of Financial Development and Asset Tangibility

Table 2.5: Correlation and Summary Statistics – Dependent Variables 42 Table 2.6: Correlation and Summary Statistics – Financial System Indicators 42 Table 3.1: The Effect of Financial Development on Industry Growth 51 Table 3.2: The Effect of Financial Development on Growth of Industries;

Estimation Based on Different Group of Countries Based on Their GDP Level 52 Table 3.3: Robust Regression: The Effect of Financial Development

on Growth of Industries; Estimation Based on Different Group of

Table 4.2: Probit regression estimates

Table 4.5: Probit regression estimates

(Dependent Variable: Amakudari: Construction Industry Dropped) Year: 1995 78

Table 4.4: Probit regression estimates

Table 4.5: Probit regression estimates

(Dependent Variable: Amakudari: Construction Industry Dropped) Year: 1991 80

Table 5.2: The effect of Management Quality on Underpricing 103 Table 5.3: The effect of Management Quality on Long Run Return 104 Table 5.3: Correlation and Descriptive Analysis (Management Quality) 105

List of Figures

Page Figure 1: Histogram of the growth in value added of the industries in

Figure 2: Histogram of the growth in value added of the industries in

Works by King and Levine was hugely criticized for the methodological issues including the problem of endogeneity Later, Rajan and Zingales (1998) in an innovative study using macro firm level data demonstrated that growth of industries more dependent on external finance grew faster in countries with developed financial sector Though not a smoking gun, the work did find a way to counter endogeniety problem Using the same methodology, Braun (2003) showed that indeed in countries with a low level of financial development, industries with more tangible assets are relatively larger in size and grow relatively faster than industries with more intangible assets1

The above works tried to link financial development with the economic growth in terms

of growth of industries or per capita income But Beck’s work (2003) tried to empirically

examine the relation between trade and finance He tested the model presented by Kletzer and Bardhan (1987) which argued that well developed financial sector can theoretically lead to a comparative advantage in industries that rely more on external financing Soon Svaleryd and Vlachos (2005) too established a positive relationship between financial sector development and the specialization pattern of international trade and comparative advantage However, Beck (2003) and Svaleryd and Vlachos (2005) had limitations in their study Beck’s result focused on the financial development indicators to explain trade variables He did not control for the standard trade theories which can as well account for the result Svaleryd and Vlachos (2005) did control for the trade theories but the study is based on OECD (rich) countries only Their results though important cannot be generalized to developing countries

In the first essay (i) we aim at extending the latter works on the link between financial development and international trade by analyzing the interplay between the financial sector development and the pattern of industrial asset-structure on the one hand, and the industrial composition of countries’ export shares and trade balance on the other hand and also (ii) overcome the limitations of work by Beck (2003) and Svaleryd and Vlachos (2005)

In the second essay we revisit the highly influential work by Rajan and Zingales (1998) which showed that industrial sectors which are relatively more in need of the external finance develop disproportionately faster in countries with more developed financial markets Using the data on 41 countries and 36 industries, their work indeed strongly suggests that finance matters for economic growth They show that those industries more dependent on external finance grows faster in countries with more developed financial

sector But question arises whether financial development proportionately matters to the wide spectrum of the countries irrespective of the stage of development Will financial development help prop up the growth of industries in Western European countries and South Asian countries alike?

Studies in the finance and growth hypothesis using industries level data do not factor in the influence of the stage of economic development in establishing the relation between financial development and growth Using the same data as Rajan and Zingales (1998) we

do establish that cross country and cross industry study do have its limitations The established hypothesis that financial sector helps in the growth of industries more dependent on external finance, holds only for the developing countries Such a hypothesis

is not supported by data on developed countries Such a result on the one hand gives further fillip to the importance of the finance and growth hypothesis while on the other hand provides insights that developed and developing countries faces different economic problems and therefore requires different prescription

Third essay studies the government and business relationship In the recent times there have been some notable empirical contributions that emphasize the connection between politics and business This literature argues that firms gain valuable advantage through political connections In this chapter I argue that just as politicians being the representative of the government could potentially bureaucrats who during long career gain vital inside information on auctions, contracts and governmental procedures

Japan provides us the laboratory to examine the government and business relationship Information exists for the Japanese firms that help us establish the relationship of a firm

with the government Second studying Japanese firms also provide us an opportunity to

revisit the practice Amakudari as part of which retired bureaucrats are recruited by firms

they once regulated Though a subject of research by Political Scientists and Sociologists, Economists were yet to examine the relationship in context of the incentive structure of the large firms

Finally in the fourth chapter I turn towards the capital market More specifically I study initial public offering Although there has been extensive theoretical justification behind the firm going public, they have been not well supported by evidence Infact Ritter and Welch (2002) argue that future explanations of the IPO anomaly “will need to concentrate on agency conflicts and share allocation issues on one hand and behavioral explanation on other hand”

Allen and Fallhaber (1989) argued that good quality firms try to distinguish themselves from the bad firms by intentionally underpricing the IPOs From the management quality perspective it can be argued that firms with good management reputation will like to underprice more in order to send the quality signal of the firm However if the management quality is an indicator of ‘good’ firm and therefore the firms underprice to distinguish then even the long run return is expected to be better for these firms Infact, the long run return to the shareholders should be increasing in the management quality But a result different from this will negate the existence of this hypothesis that issuers willingly underprice the issue in the wake of better quality firms as indicated by the higher management quality and reputation

Welch (1992) theoretically explained that ‘cascade’ effect might also be a reason for the underpricing of the issues He argued that the cascade or the herd behavior occurred

because of the sequential floating of the IPO firm shares as it gave opportunity for the potential investors of the later issues to imitate earlier investors decisions ignoring their own private information But in Welch’s work sequential issue of IPO shares was essential to cascade effect In this work we argue that IPO underpricing can be explained

by cascade effect even without sequential underpricing

Less informed investors in order to avoid their cost on effort and money closely imitate the informed investors In circumstances when informed investors base their decisions on better management quality and the less informed investors imitates these decisions then it results in higher underpricing at the time of opening of trading of the new issue In such conditions underpricing will be positively related to the management quality However such underpricing converges to the actual value in the long run During the rationalization period of the new issue price, long run return is negatively associated with management quality

We use data from Singapore Stock Exchange spread over 2002 to mid 2005 to test our hypothesis In Singapore the period between close of IPO application and listing of the shares is confined to three days This helps us to capture the herd behaviour effect on the underpricing for the short period does not allow other factors to greatly influence the underpricing

2 Trade and Financial Development: Role of Asset

Structure1

Abstract

This paper investigates the interplay between financial development, asset tangibility and international trade Using industry-level data on firms’ dependence on external finance and firms’ asset tangibility for 27 industries in 42 countries, we find that economies with higher levels of financial development have higher export shares and trade balance in industries with more intangible assets Using the same dataset we also show that the interplay between property-rights protection and asset tangibility influences the pattern of trade Higher levels of property-rights protection lead to greater export shares and trade balance in industries with more intangible assets

1

Abridged version of this essay has been published in World Development, 2006, Vol.34, No.10

2.1 INTRODUCTION

A thin segment of literature in international trade suggests that financial sector development can be a potential source of a country’s comparative advantage Using an augmented Heckscher-Ohlin model, Kletzer and Bardhan (1987) show that a well developed financial sector can theoretically lead to a comparative advantage in industries that rely more on external financing Later, Beck (2003) and Svaleryd and Vlachos (2005) find empirical evidence supporting Kletzer and Bardhan’s hypothesis Specifically, they show that countries with a well developed financial sector enjoy easier access to external finance than those without, and tend to specialize in industries that are more dependent on external finance

Access to external finance is not only influenced by the level of financial development but also by firms’ asset structure Bradley, Jarrell and Kim (1984) empirically show that a larger amount of intangible assets reduces the borrowing capacity of a firm Giannetti (2003) presents evidence showing that the ease with which a firm investing in intangible assets obtains loans depends on the legal system and the level of financial development of the country where the firm is located It is therefore sensible to argue that both the level

of financial development and firms’ asset structure are likely to affect the pattern of trade

The level of financial development and firms’ asset structure are themselves closely related A recent study by Braun (2003) shows that indeed, in countries with a low level

of financial development, industries with more tangible assets are relatively larger in size and grow relatively faster than industries with more intangible assets.1 In a similar spirit,

Claessens and Laeven (2003) also study the interplay between the level of financial development and firms’ asset structure In that paper, they use the strength of the property rights protection as a proxy for the level of financial development In addition they also analyze the implication of the financial development and firms’ asset structure on the growth rate of firms Their main result shows that industries with more intangible assets experience growth rates that are disproportionately higher than industries with more tangible assets when they are located in countries with well protected property rights

In this paper we investigate the issue of how the interplay between a country’s financial development and its firms’ asset structure determines the trade flow of different industries More specifically, we test the hypothesis that countries with higher (lower) level of financial development will have higher (lower) exports share and trade balance in industries with less (more) tangible assets In this sense, our paper extends further the literature on the impact of financial development on international trade to cover the interplay between financial development and firms’ asset structure

The core of this paper rests on our premise that there exists substitutability between the level of financial development and asset tangibility in the following sense Firms located

in a country with an under-developed financial market require tangible assets to gain access to external financing This is because the extent of moral hazard and adverse selection problems between lenders and borrowing firms tend to be more severe in this country than in a country with a well developed financial market Hence, the risk of default increases Tangible assets can be collateralized and thus provide protection for creditors against the risk of default The role of collateralized tangible-assets becomes

more prominent in countries with an under-developed financial market than in countries with a well developed financial market

We therefore argue that the interplay between the level of financial development and the level of asset tangibility should affect the pattern of international trade This paper aims

to formally investigate and test the validity of this hypothesis

We find robust evidence that supports our hypothesis Our results are also consistent to using different indicators of financial development In order to test for the robustness of asset tangibility in providing protection against different characteristics of poor financial system, we use property rights We find consistent estimates using different indicators of property rights In the paper, we also control for the simultaneity bias and possible reverse causality

The remainder of the chapter is organized as follows Section 2.2 presents the related literature and hypothesis Section 2.3 describes the methodology and the data Section 2.4 presents our main results and sensitivity test Section 2.5 concludes

2.2 RELATED LITERATURE AND HYPOTHESIS

Over the last decade, several studies have firmly established that financial development has a significant role in influencing countries’ economic variables For example, King and Levine (1993a and 1993b) and Levine (1997) showed that indeed there is a close link between the level of financial development on the one hand, and microeconomic and

macroeconomic growth on the other hand Later works by Rajan and Zingales (1998), Demirguç-Kunt and Maksimovic (1998) and Beck and Levine (2001) demonstrated that a well-developed financial sector helps countries securing access to external finance for investment projects Most recently, Beck (2003) and Svaleryd and Vlachos (2005) established a positive relationship between financial sector development and the specialization pattern of international trade and comparative advantage

Our paper aims at extending the latter works on the link between financial development and international trade More specifically, it seeks to analyze the interplay between, the financial sector development and the pattern of industrial asset-structure on the one hand, and the industrial composition of countries’ export shares and trade balance on the other hand A key factor that influences the interplay is the degree of tangibility of firms’ assets

The mechanism of this influence can be elaborated as follows In an incomplete contract setting, external finance dependence and the agency problem are inextricably linked and form the defining characteristics of the entrepreneur-financier relationship Factors that can be broadly categorized as the degree of financial development, i.e the level of financial system development, the extent of investor protection, productive monitoring technologies, and property rights enforcement, help to limit the seriousness of the agency problem and protect the interests of financiers

However, in the absence of the proper working of these factors, the nature of investable assets becomes vital Braun (2003) has shown that indeed the pattern of financing is crucially influenced by the nature of investable assets Harder or more tangible assets

protect financiers against possible debtors’ default because the collateral value of these assets and the ability of financiers to liquidate these assets cushion financiers against the adverse impact of the agency problem Accordingly, the more severe the agency problem

is, the more important the role of collateralized tangible assets will be.2 Hence there is a degree of substitutability between tangibility of assets and the quality of legal system and financial development.3 In this light, the investment decision of a firm located in a country with a lower degree of financial development might be biased towards allocating resources in industries with more tangible assets This leads us to the following

hypothesis Countries with low level of financial development should have a higher

exports share and trade balance in industries that use more tangible assets, and vice versa

Note that although our hypothesis, as well as the hypothesis tested by Beck (2003) and Svaleryd and Vlachos (2005), broadly argues on the importance of the financial development, they look at an entirely different mechanism through which international trade pattern could be influenced by the level of financial development The difference arises due to the different industry characteristics, i.e the degree of asset tangibility and external finance dependence that influence the mechanism through which financial development matters The tangibility of assets of a particular industry is related to the ability of these assets to act as collateral, while the external-finance dependence captures the ability of a particular industry to generate internal cash flow to finance the investment Both are assumed to be technologically determined and are independent of each other The correlation between the proxy (defined in next section) of tangibility and the external finance dependence in our sample is 013 Thus we have a highly tangible

industry like Iron and Steel with low external finance dependence, while another highly tangible industry –Textile has very high external finance dependence

2.3 METHODOLOGY AND DATA

(a) Methodology

On the basis of our hypothesis we would expect that countries with a less developed financial system have a higher trade balance and export shares in industries that are characterized with greater proportion of tangible assets

We run the following regression to empirically assess whether industries that are poorly endowed in tangible assets represent a disproportionately lower share of exports and trade balance in countries with poor financial system.4 We also evaluate whether or not the same relation holds for industries that are more dependent on external finance.5 We also control for factors that are likely to influence the international trade pattern

k i m k m

i m

m i

k

i k

l l l j

j j k

i

INTENSITY FACTOR

FINDEV FINDEP

FINDEV TANG

D D

Y

, , ,

,

)(

)(

)(

ε µ

δ

π γ

β α

+

×+

×+

×+

++

where Y i,k denotes the ratio of exports to GDP or the ratio of trade balance to GDP in

country i and industry k over the period 1980-89 D j and D l are dummy variables for

country j∈{1,,,J-1} and for industry l∈{1,,,L-1} respectively In order to avoid the multicollinearity problem, we use J-1 number of country dummy variables and L-1

industry dummy variables in the regression TANG denotes the degree of tangibility of k

industry k The development level of financial system for ith country is measured

byFINDEV i FINDEP is the external financial dependence for industry k, and acts as a k

control variable Finally, FACTOR i,m denotes the mth factor endowment- physical capital,

human capital and natural resources- in the ith country These factor endowments are likely to influence the trade composition and flows as explained commonly in the standard trade theories INTENSITY k,m is the mth factor intensity viz physical capital intensity, human capital intensity and natural resource intensity corresponding to industry

k The disturbance ε is allowed to be heteroskedastic and robust standard errors are

reported

Note that the dummy variables for the countries and industries control for country and industry specific effects that might influence the trade balance or export shares of a particular industry in a particular country This helps us to isolate the interaction effect between the degree of asset tangibility of an industry and the level financial development

of a country According to the hypothesis developed in section 2, the estimated

coefficient for the interaction between TANG and FINDEV should have a negative sign

If we indeed find that the estimated coefficient is significant and has the expected sign,

then it implies that, ceteris paribus, a higher level of financial development leads to a

higher export shares and trade balance of low tangibility industries However, if instead

we find a coefficient estimate with a different sign from the one hypothesized or the same sign with the one hypothesized but insignificant, then it might signal the irrelevance of asset tangibility and the level of financial development in explaining the pattern of trade

(b) Data

Our sample consists of 42 countries and 27 industries (see Appendix A) We use industry-specific and country-specific data from various sources For readers’ information, simple statistics for dependent variables and financial system indicators are provided in Appendix B and C respectively

(i) Asset tangibility

The underlying assumption in Braun’s work and in our work is that tangibility is a technologically determined parameter, and it is due to technological reasons that some industries rely more on tangible assets than other industries The industry level data on tangibility that we employ here is taken from Braun (2003) He uses the information on assets of all active U.S.-based companies from several industries as reported in COMPUSTAT’s annual industrial files for the period of 1986-1995 He then calculated the median of asset tangibility Tangibility is defined as net properties, plants, and equipment divided by the book value of assets Using the data spanning for ten years smoothens the measure Highly tangible industries include petroleum refineries, paper and its products, iron and steel and industrial chemicals The industries with the lowest level of asset tangibility are pottery, china and earthenware, professional, scientific and controlling equipment, and non-electrical machinery Braun (2003) shows that the degree

of asset tangibility across industries is fairly stable over time

(ii) External finance dependence

The industry level data on the external finance dependence is taken from the study done

by Rajan and Zingales (1998) Their innovative work assumes that the external finance dependence includes a technological component that differs across industries The difference persists across countries A firm’s dependence on external finance is defined

as the share of investment that cannot be financed through internal cash flows Again the data used to generate the ranking come from publicly listed U.S companies Under the assumptions that these firms face relatively minor constraints to access external finance, their investment and the amount of external finance they raise would equal the desired amount In order to prevent giving excessive weight to large firms, industry values for each of the industries in their study are calculated as medians rather than as means The data is averaged over the 1980s so as to smooth the fluctuations

(iii) The development of financial system

A proxy for the financial development should ideally capture the sustained process of efficient mobilization and allocation of resources This should entail of an evaluation and monitoring of firms as well as the legal and regulatory frameworks that ensures the proper working of financial-contract enforcements

It is hard to find a single measure that can act as such a proxy In some previous studies, for instance the one done by Beck, Demirguç-Kunt, and Levine (1999), the level of financial system development is represented by several proxies that measure the availability of finance or more aptly the activity of financial intermediaries In this paper,

we will use some of these proxies in the analysis The primary measure for the activity of

financial intermediaries is the PRIVATE CREDIT, which equals the value of credits by

financial intermediaries to the private sector divided by GDP This is a broad measure of financial development since it includes all financial institutions, not only deposit-taking banks For testing the robustness of our results, we also use other measures besides the private credit We use credit by deposit-taking banks to the private sector divided by

GDP (BANK CREDIT), which essentially captures the activity of banks in the credit

market Another traditionally-used measure is the liquid liabilities of the financial system

to GDP ratio (LLY) LLY includes currencies plus demand and interest-bearing liabilities

of financial intermediaries and non-bank financial intermediaries It captures the depth of the financial sector

Ideally an efficient mobilization and allocation of resources should also include measures that capture the size and activity of the stock market We therefore use the stock market

capitalization to GDP ratio (MCAP) as a size indicator, which equals to the value of listed shares to GDP, and the total value of the stock market trade to GDP (TVT) as an activity

indicator

As a proxy for the link between the level of financial development and the regulatory and

legal efficiency we use ACCOUNTING It is a measure of the comprehensiveness of

companies’ balance sheet and income statement provided to the investors.In other words,

it acts as an overall indicator of the quality of information available to investors We borrow the measure from La Porta et al (1998)

(iv) Property rights

We use three indices as proxies for the property rights The first index, which is labeled

as PROPERTY, is taken from the World Economic Forum (2002) It measures the general

extent of legal protection of private property for the period of 2001 On a scale from one

to seven, the index is increasing in protection One indicates that assets are not clearly delineated and not protected by law, while seven implies that assets are clearly delineated and protected by law Our second measure is the intellectual property index, which is

labeled as IPR It is also taken from the World Economic Forum (2002) It also measures

the protection of intellectual property in a country for the period of 2001 on a scale of one

to seven One would imply weak or absent of intellectual property right protection Seven would imply the strongest intellectual property right protection The third index is the

patent rights index in 1980 on a scale of zero to five, which is labeled as PATEN This

index is constructed by Ginarte and Park (1997) and is based on coverage, membership, duration, enforcement and loss of rights A higher score will indicate a better patent protection

All other dependent variables however are averaged over the period 1980-89 Ideally we would also want to have all indices to correspond to the same period as the other dependent variables However, we do not have such a complete data for these three indices that spans over the same period as the other dependent variables Nevertheless,

we would like to argue that there is not much variation in the values of these indices over the years Presumably this is because the extent of property-rights protection is

institutionally driven and would likely need a long term undertaking to change it

Moreover, the correlations between the three indices are in between 6817 to 9402,

which are reasonably high (see Appendix C) So our results would not likely be influenced by the choice of index among these indices and the choice of different time periods

(v) Trade data

The data on exports and imports of the 27 industries in 42 countries are obtained from the

UN Statistical Office COMTRADE database averaged over the period 1980-1989 The exports are reported free on board while imports are valued at cost, insurance, freight The data is in US dollars and deflated by exports price indices and import price indices respectively, obtained from the World Development Institute (WDI) of the World Bank The share of industry exports and imports are calculated by dividing the respective exports and imports by the real GDP, using the WDI data

(vi) Factor endowment and intensities

The proxy used for the physical capital endowment is the natural log of physical capital per worker for the period of 1980-1989 The unit is USD per worker The data has been sourced from the Global Development Network Growth database It is compiled and updated from the original source by William Easterly and Mirvat Swadeh of the World Bank The physical capital intensity is measured as the median of the ratio of industry gross capital formation to value added averaged over 1980-89 across a wide spectrum of countries

The human capital endowment is measured as the logarithm of the average number of years of formal education in the population The variable corresponds to 1980 This information is from Barro and Lee (2000) The index for human capital intensity is constructed as the median from 1986 to 1995 of the industry’s mean wage over that of the whole US manufacturing sector The data source is COMPUSTAT

For the method of measurement of the natural resource endowment and natural resource intensity we follow Braun (2003) The indicator for the natural resource endowment is taken from World Bank’s Expanding the Measure of Wealth publication, chapter 3, measuring the wealth of nations We use cropland (USD per capita) as the indicator of the resource required for food products, rubber and rubber products We use timber resource

as endowment used for wood products-and-paper and paper-products Subsoil assets are the indicator of the mineral energy of the country Therefore we use subsoil assets as indicator of the natural endowment for petroleum refineries, miscellaneous petroleum and coal products, other non metallic mineral products, iron and steel and non ferrous metals The endowment measures are used in logarithmic form in the estimation Natural Resource Intensity is the dummy variable that takes value 1 for the following industries (otherwise 0): wood products, paper and paper products, petroleum refineries, miscellaneous petroleum and coal products, other non metallic mineral products, iron and steel, non ferrous metals, food products and rubber and rubber products

(vii) Countries and industries

Our choice of countries was influenced by the availability of proxies for the measure of financial development, physical capital endowment, human capital endowment and

natural resource endowment as well as the data on exports and imports for the given list

of industries Our choice of industries was influenced by the availability of proxy for tangibility and the data on exports from COMTRADE database

2.4 EMPIRICAL RESULTS

(a) Main results

Our main results which are obtained using specification (1) are presented in Table 2.1 and Table 2.2 The results suggest that the interaction between the industry tangibility and the level of financial development can significantly explain the industrial structure of international trade across a wide spectrum of countries In terms of the main hypothesis, the coefficient of the interaction between the degree of asset tangibility and the level of financial development is significantly negative Thus, we have the following

Result 1: In countries that have low level of financial development, industries that are

poorly endowed in tangible assets have a lower share of exports and trade balance than industries that are richly endowed in tangible assets

In addition, we also find that,

Result 2: In countries that have low level of financial development, industries that rely

relatively more on the external finance have a lower share of exports and trade balance than industries that rely less on the external finance

Result 2 is consistent with the results found in Beck (2003) and Svaleryd and Vlachos (2005) However, our result represents a further improvement upon Beck (2003), as we also take into consideration control variables that account for the traditional sources of comparative advantage viz., capital formation, human capital and natural resources As such, we are able to isolate the influence of financial development on international trade pattern in a clearer manner With regards to Svaleryd and Vlachos (2005), our investigation includes 42 countries comprising the low income, middle income and rich countries, while theirs only consider OECD countries On the basis of our result, we can argue that Svaleryd and Vlachos’ result is also applicable to a larger group of countries

For the economic significance of the result we look at the following example In column I

of Table 2.1, the coefficient of the interaction term between asset tangibility and the level

of financial development takes the value -.0537 Consider an industry that is initially at the 75th percentile of the degree of asset tangibility and is located in a country at the 25th percentile of the degree of financial development Suppose that for an exogenous reason the industry switches to the 25th percentile of the degree of asset tangibility and to the 75th percentile of the degree of financial development On the basis of our results, such a change would lead to an increase in trade balance by 81%.6

Using specification (1), we can also derive estimation results for different measures of the level of financial development The variables included are size and depth of the financial system We use private credit by deposit money banks to GDP (BANK CREDIT), liquid liabilities over GDP (LLY), market capitalization (MCAP), ratio of value traded on the stock market to GDP (TVT) As reported in columns II-V of Table 2.1, our results are consistent with the result derived from using our primary measure of the level of financial

development The coefficients of the interaction term between various measures of the financial development and tangibility are both significant and have the expected sign

In Table 2.1 we also notice that the absolute value of the coefficients corresponding to the interaction between asset tangibility and indicators of activities of financial intermediaries (banks, non-banking financial institutions), Private Credit, Bank Credit, Liquid Liabilities are greater than the corresponding coefficients for the interaction between asset tangibility and indicators capturing the stock market activities, e.g stock market capitalization and the total trade in stock market Thus, indicators of activities of financial intermediaries have a larger size-effect than the variables capturing the size and activity of the stock market.7 This could perhaps indicate that the ability of the asset hardness to provide support to the entrepreneur-financier relationship matters more in case of indicator of financial intermediaries.8

Column VI of Table 2.1 reports the estimation result when financial development is

measured by ACCOUNTING In many previous works, such as Rajan & Zingales (1998),

Beck (2003), Becker and Greenberg (2004), Fishman and Love (2003), and also Svaleryd and Vlachos (2005), it has been used as an indicator of the aggregate quality of information available to investors According to our hypothesis tangibility of assets should also be a substitute for the lack of aggregate information available to the investors However, our coefficient of estimate is not significant although the sign still suggests the substitutability All in all, we still find that in general our hypothesis is accepted for a comprehensive list of indicators of financial development

Although it is not the focus of our current work we note the importance of human capital

in explaining the net exports (i.e trade balance) across countries We find that human capital is highly significant and also the size effect is important In fact, the magnitude of the coefficient of interaction between human capital indicator and factor intensity is higher than other significant coefficients explaining the variability of the trade balance

In Table 2.2, we use export share instead of the trade balance as an alternative dependent

variable With regards to the PRIVATE CREDIT, we find that its interaction term with

asset tangibility is negative and significant, which supports our hypothesis When we use other proxies for financial development, we find the same qualitatively results to our previous results that were derived using the trade balance as the dependent variable

(b) Further test

In this sub-section, we check for the sensitivity of our results to an alternative measure of international trade, namely the Revealed Comparative Advantage (RCA) index, which is

also commonly known as Balassa index (Balassa, 1986) In addition, we also test the

presence of simultaneity bias and reverse causality

Balassa index can be expressed as,

have used the same measure Note that our previous measures are weighted by GDP,

while Balassa index is weighted by the total trade

We re-estimate the specification (1) using Balassa index as our dependent variable As

reported in Table 2.3, we find that the coefficient of the interaction between asset

tangibility and PRIVATE CREDIT, i.e our primary measure of financial development, is

negative and significant Compared to our previous results that were derived using the trade balance as the dependent variable, we find that the magnitude of the interaction coefficient is still significant albeit smaller We also find significant coefficients of the interaction term between asset tangibility and financial development when we use other indicators of financial development (results are available upon request) Thus our results are quite robust to alternative specifications of international trade and proxies for financial development

To test for the simultaneity bias and reverse causality, we employ a 2-stage least square

(2SLS) estimation We instrument PRIVATE CREDIT, our primary measure of the

financial sector development, with the colonial origin of the country’s legal system viz English, French, German or Scandinavian.9 La Porta et al (1998) have shown that the legal origin does tend to have a long lasting effect on the development of the institutions and is correlated to the capital market functioning

LEGAL is the dummy variable used to determine whether a country’s legal system has

English, French, German or Scandinavian origin In the first stage of the 2SLS

estimation, we regress PRIVATE CREDIT on LEGAL and other regressors In the second stage, we use the estimated values of PRIVATE CREDIT obtained from the first stage in

the estimation of specification (1) As can be seen from Columns II and III in Table 2.3,

we find that the estimated coefficient of the interaction term between asset tangibility and

financial development is still negative and significant, irrespective of the dependent variable we employ in the estimation, i.e either the trade balance or the export share

Note that we also apply Sargan test to check for the possibility of over identification of

the instrument we used The test does not fail at 10 percent significance level (see Table 2.3) We also find that F statistic for the first stage regression is highly significant (for the sake of brevity we do not present the results of the first stage regression in the paper; however they are available upon request from the authors) More specifically, when we use the trade balance as the dependent variable, the F statistics (p values) of the excluded instruments in the first stage regression is 151.68 (0.00), and when we use the export share it is 151.94 (0.00)

Our results are also robust to using various proxy measures for the level of financial development and the degree of legal protection to investors Using property rights indices

(i.e PROPERTY, IPR, and PATENT) as alternative indicators for financial development,

we test the hypothesis that countries with more secured property-rights tend to specialize their trade in industries with more intangible assets, while countries with poor property-rights protection tend to specialize their trade in industries with more tangible assets We run the following regression:

k i m k m

i m

m i

k

i k

l l l j

j j k

i

INTENSITY FACTOR

FINDEV FINDEP

PRIGHTS TANG

D D

Y

, , ,

,

)

*(

)

*(

)

*(

ε µ

δ

π γ

β α

++

+

++

where PRIGHTS i represents any of the three indices measuring the extent of

property-rights protection in country ith that we use The rest of the variables are the same as before The results are presented in Column IV-VI of Table 2.3 We find that the coefficients of the interaction term between asset tangibility and all indices of property rights protection are negative and significant This suggests that asset tangibility is also important in explaining the pattern of international trade when property rights are not well protected

2.5 CONCLUSIONS

In this paper, we showed that the level of financial development and the asset tangibility are important determinants of the international-trade pattern of the manufacturing sectors across a wide selection of countries Countries with relatively well-developed financial sectors have a comparative advantage in industries characterized by intangible assets Countries with poorer financial development have comparative advantage in industries characterized by tangible assets

Our work is complementary to Becker and Greenberg (2004), who also investigate the link between financial development and exports However, in their paper the essential mechanism that works behind the link is different from ours They argue that exporting firms face significant upfront fixed cost in product design, marketing, distribution etc Their main results show that the marginal impact of financial development on exports is higher in those industries and country pairs where up-front investment are large either due to product characteristics or economic distance between exporter and importer

Rather than focusing on the role of up-front investment, our paper focuses on the role of asset tangibility

Overall, we believe that our paper added some new insights into the work broadly studying the subtle influence of the financial sector on the international trade We showed evidence of the importance of better financial systems on the international-trade pattern

of the manufacturing sectors Our results could also be seen as an extension to the results obtained by Demirguç-Kunt and Maksimovic (1999) They found that firms in developing countries (characterized by poor financial systems) have higher proportions of fixed assets to total assets and more tangible assets than firms in developed countries Finally, our work is also complementary to Braun (2003), who shows that industries with less tangible assets perform disproportionately better in terms of growth and GDP contribution in countries with more developed financial systems However, it is not obvious that their results can be carried over to our results After all, factors that determine the overall composition of the industrial sector of a country do not necessarily determine the industrial composition of its trade balance

of these countries The ability of tangible assets to act as collaterals leads to the substitutability between financial development and tangible assets

4 This set up was first introduced by Rajan and Zingales (1998) and has been used

in many studies They overcome the identification problem by using interaction between industry variables and country variables

5 The correlation between the index of external finance dependence and the index

of tangibility is low (.013) Therefore, the result is not influenced by the presence

or absence of the interaction term between the degree of external finance dependence and the level of financial development

6 This experiment is motivated by Rajan and Zingales (1998) Mathematically, it is

coefficient*(TANGIBILITY 25 - TANGIBILITY 75 )*(PRIVATE CREDIT 75 - PRIVATE CREDIT

25 )

7 However, the number of observations differs for different indicators

8 Johnson, McMillan and Woodruff (2002) find that only less than 2% of firms in their sample (they are located in Poland, Slovakia, Romania, Russia and Ukraine) obtain loans without collaterals This is in contrast to the U.S case where around 20% of banks loans obtained by firms are without collateral

9 We also carried out analysis using other proxies of financial development that we use in the paper, and we found consistent results Results are available from authors upon request

Table 2.1 Effect of financial development and asset tangibility on trade balance

TANGIBILITY x PRIVATE CREDIT -.0537 **

.1421 (0.107)

.1433 (0.128)

.1105 (0.272)

.1990 **

(0.058)

.0911 (0.189)

Human Capital x Human Capital

.0570 (0.106)

.0251 (0.196)

Natural Resource x Natural Resource

Table 2.2 Effect of financial development and asset tangibility on export share

TANGIBILITY x PRIVATE CREDIT -2.2537 ***

2.6272 (0.131)

2.3125 (0.189)

.6940 (0.711)

3.2147 **

(0.072)

1.4506 (0.416)

Human Capital x Human Capital

Natural Resource x Natural Resource

Table 2.3 Robustness and further tests

Independent Variables I Trade Balance

Balassa

II Trade Balance

IV Legal Origin

III Export Share

IV Legal Origin

IV Trade Balance

V Trade Balance

VI Trade Balance

VII Export Share

VIII Export Share

IX Export Share

TANGIBILITY x PRIVATE CREDIT -.0213 *

Human Capital x Human Capital Intensity .0522 ***