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

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UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS FINANCIAL DE

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UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY THE HAGUE

VIETNAM THE NETHERLANDS

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

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UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM THE NETHERLANDS

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

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Declaration

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

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

Vu Thi Khanh

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Acknowledgments

This thesis would not have been possible without the support and the encouragement 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 great generosity and dedication in sharing his wisdom, stimulating my critical thinking skills and guiding me to rethink and to deconstruct my thesis topic He was also not afraid of time-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 me correct errors and inappropriate words usages Furthermore, I am grateful to Ass.Prof Nguyen Trong Hoai and Dr Tran Tien Khai for their valuable comments and suggestions for my concept note and thesis research design Thank to Dr Pham Khanh Nam for his enthusiasm of helping me collecting data I must show my gratitude toward all lecturers VNP who have broadened my perspectives and encouraged me to think 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 and shared 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 always besides me and never stop supporting me

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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

UK : The United Kingdom

UN : The United Nations UPCoM : Unlisted public company market

US : The United States of America VAR : Vector Autoregression

VES : The Vietnam Enterprise Survey

WB : The World Bank

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Abstract

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

2006-2012, this thesis aims to analyze the relationship between financial development and

financing constraints of firms in Vietnam The Euler equation approach is applied to

model firms' investment Investment sensitivity to cash-flow is employed as the

variable to test for the existence of financing constraints To control for endogeneity

and firm heterogeneity, I utilize the first difference GMM estimation proposed by

Arellano and Bond (1991) There is robust evidence that Vietnamese manufacturing

firms face financing constraints and that financial development significantly relaxes

firms' dependence on internal funds for investment In addition, although smaller firms

suffer more severe financing constraints, their constraints are alleviated more than

those of larger firms in the presence of financial development

Keywords: Financial development, Financing constraints, Corporate Investment

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Table of contents

Chapter 1: Introduction 1

1.1 Problem statement 1

1.2 Research questions 3

1.3 The scope of the study 3

1.4 The structure of the study 3

Chapter 2: Literature review 4

2.1 Sources of investment financing 4

2.1.1 External financing 4

2.1.2 Internal financing 5

2.2 Financing constraints on firms 8

2.2.1 Definition 8

2.2.2 Measurement of financing constraints on firm 8

2.3 Financial development and financing constraints on firms 9

2.4 Conclusion 14

Chapter 3: Model specification 16

3.1 Investment modeling 16

3.1.1 Euler investment equation approach 16

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

3.2 Financial development measurement 25

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

Chapter 4: Financial development in Vietnam 30

Chapter 5: Empirical results 37

5.1 Data 37

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5.1.1 Sample 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

6.2 Policy implications 52

6.3 Limitations and further research 52

References 53

Appendix 60

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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

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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

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Chapter 1: Introduction 1.1 Problem statement

The study of financial development-economic growth nexus, which is originated from Schumpeter (1912), has attracted many scholars’ concerns The significant positive correlation has been proved in a number of empirical studies such as Cameron (1967), Goldsmith(1969), McKinnon (1973), Levine (1997), Levine and Zervos (1998), Beck et al (2003), Huang (2010, 2011) etc In an indispensable research, Levine and King (1993) asserted that economic growth is influenced by the financial development in the last 10 to 30 years However, the question is in what mechanism financial development stimulates economic growth A prevailing research direction is

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

According to Modigliani and Miller (1958), external finance perfectly substitutes internal finance and firm’s investment decisions do not depend on its financing 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 higher cost of external fund due to credit risk and asymmetric information as providers of external finance normally find it very costly to evaluate firms' investment opportunities Therefore, firms have to resort to internal finance generated through cash-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 and mitigates the external financing constraints In better-functioned financial systems, not only the transaction cost of saving and investing is lower but the problem of asymmetric information is alleviated With the financial market development, some

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

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

This study is similar in spirit to O’Toole and Newman (2012) in analyzing the relationship between financial development and firms’ investment in Vietnam Of particular interest is the role of financial development via financing constraints on the firms’ financing investment However, there are some extensions from O’Toole and Newman (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 investment finance Thirdly, data in this study cover a more recent period of time from 2006-2012

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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 financing constraints 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 panel data for this research is taken from VES from 2006 to 2012 Meanwhile, the macro data of financial development is gathered from World Development Indicators of World 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, firm financing constraints, and the impact of financial development on financing constraints Next, model specification in chapter 3 specifies the methodology to test the presence of firm financing constraints using Euler equation approach as well as the empirical model to examine the effect of financial development on financing constraints 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 three main parts The first part concentrates on estimation technique, the second variable construction as well as data collection and the third regression results Finally, chapter

6 concludes the main findings, limitations and further researches

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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’s investment is financed by using two sources of finance: internal finance and external finance Internal finance, i.e self-financing, may consist of four main components: past profits which are not distributed to shareholders; additional capital from the owners; depreciation and amortization Besides taking the advantages from itself when collecting internal sources for investment, firm might also use external source from loans of banks and other financial institutions or the issue of new equity This section is divided into two subsections: the former covers external financing and the later internal financing

2.1.1 External financing

Early in mainstream economic point of view, external financing is viewed as a source of firm financing and financial institutions, especially banks has been proved to play a virtual role in financing investment Schumpter (1912) believed that an entrepreneur must borrow to afford his new business if his purchasing power is not strong enough In this case, “he cannot become an entrepreneur by previously becoming a debtor” In addition, he considered the banker as the key agent in this process 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, 2003 etc.) In econometric model of finance-growth, they use the share of broad money supply and private credits to gross domestic products (GDP) as the proxies of financial development The findings state that there is a significantly positive relationship between financial development and economic growth Therefore, they jump to a

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conclusion that a developed financial system could promote long-term economic growth 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 that financial intermediaries offer firms, long-term or short-term It is clear that the role of short-term loans is to facilitate firms’ cash-flow rather than to finance investment Hence, when choosing proxies for financial development, authors need to take into consideration the type of credit or loans Nevertheless, this seems to be missing in the two proxies, the share of broad money supply and private credits to GDP, in the previous studies Another argument is coming from commercial banks’ difficulty in mandating long-term credits Apparently, most recent commercial banks’ sources come 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

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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 capital accumulation gain for the purpose of production expansion Moreover, Mayer (1990) used firms’ data in the United States (US) from 1970-1985 to provide an empirical evidence 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 from 1949-1984 that bank loans and bond securities do not play a significant role to fixed investment financing (see Table 1) Instead, bank loans which are considered as the main 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 in comparison with external financing

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

Retention Banks, Short-term loans

and trade creditors

Issues of Shares and Long-term Debt

Other sources All companies

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

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

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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? In these countries, state development banks and other state owned banks follow low interest rate policies to stimulate investment (Singh, 1998), especially in the early stage

of development The poof indicates that the most fundamental source of finance for fixed investment comes from internal finance; however the share of long-term bank loans 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 state control over financial system, Tsuru (1993)figured out that the share of internal financing over gross manufacturing investment accounted for 60 percent in the late 1950s, increasing to 75 percent in the late 1970’s and around 100 percent in the late 1980’s The long-term bank loans covered the rest of investment financing, and had continued declining from 1950’s China is a typical example for the country with the financial 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 total assets of state-owned commercial banks and development banks to total banks’ asset accounts for roughly 60 percent Mlachila and Takebe (2011) argued that due to the government regulation, these banks can lend lower interest rate to firms, especially with 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 to its value in perfect market In other words, external finance perfectly replaces internal finance However, in financial friction or imperfect financial market, this is not true External finance is more expensive than internal finance due to asymmetric

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information, transaction costs and agency problems (Fazzari et al.,1988, Mayer, 1990, Schiantarelli, 1995, Blundell et al., 1996) Kaplan and Zingales (1997) suggested that a firm faces financing constraints when its costs or accessibility to external sources become barriers preventing the firm from profitable investment projects Laeven (2003) summarized a large body literature to introduce a definition of financing constraints 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 constant returns 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 the current and future profits produced by an additional unit of fixed capital The advantage of this approach is that it does not use stock price data However, the disadvantage 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 condition for an optimal policy employed by a firm which seeks to maximize its value The first-

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order conditions for investment remove the shadow cost of capital from the Euler equation The Euler investment equation is first introduced by Albel (1980), and applied 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 to assume 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, the Euler equation needs to assume and adjustment cost function and a firm’s smoothing investment expenditures over time

2.3 Financial development and financing constraints on firms

Basically, financial sector development occurs if financial instruments, markets and intermediaries are less prone to market asymmetry information, limited enforcement and transaction costs However, Čihák et al (2013) argued that if only capture the ease of market imperfection, the financial development measurement should 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., 2013 etc.) adopted a broader definition of financial development as improvements in five key financial functions, including: “(1) producing and processing information about possible investments and allocating capital based on these assessments; (2) monitoring individuals and exerting corporate governance after allocating capital; (3) facilitating the trading, diversification, and risk management; (4) mobilizing and pooling savings; and (5) easing the exchange of goods, services, and financial instruments.” As the result, barriers to access to banking sector have been reduced and capital market has been triggered The gap between external and internal source of finance has gradually

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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 capital for firms are decreased, and barriers for firms to external sources are gradually removed After all, from theoretical point of view, with the presence of financial development firms’ financing constraints are ameliorated and their investment

increases

The empirical examination of the relationship between financial development and firms’ investment is of contemporary concerns The current empirical findings of financial development and financing constraints nexus in developing countries are still ambiguous Demirguc-Kunt and Maksimovic (1998, DM) used cross country firm-level data to investigate whether financial development affects the degree to which firms are constrained from investing in profitable growth opportunities Using the same indicators to measure financing needs among firms in different countries, DM casted doubt on Rajan and Zingales (1998) who used industry level data to investigate the tie between financial development and economic growth DM argued that it would be precise if those differences are addressed at firm level data Firstly, DM computed the rate for individual firm at which firm can grow in two cases (1) it is only funded by internal 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 firm use only internal fund is calculated It is denoted as Pr_faster Based on this, the proportion of firms in each country relying on external fund would be estimated In order to examine the impact of financial development on firm’s growth, DM run the cross 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 the disturbance term To measure financial development variables, DM use a set of financial indicators including the ratio of market capitalization to GDP, the total value

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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 whole economy, total amount of subsidies from government to firms, the average ratio of net fixed assets over total assets, the real GDP per head, the law and order tradition of the economy Finally, they found that the proportion of firms whose growth rates are in excess of the maximum rate that firm use only internal fund is positively related to financial development and legal system variables Applying the same approach, but extending 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 in different time and countries are not mentioned in DM’s approach She asserted that to test whether financial development enhances the allocation of capital within a country, growing firms need to be identified, given their investment opportunities She used pooled cross country firm-level data in an investment model based on the Euler equation approach It embodies financing constraints by parameterizing the shadow cost of external funds as a function of the firm’s cash-flow which is built on Gilchrist and 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 finance reform, financial liberalization or banking reform on firms’ investment decision For financial development proxies, five standardized indices, including GDP, total value traded over GDP, total value traded over market capitalization, M3/GDP, financial depth (credit to private sector to GDP) from Dermirguc-Kunt and Levine (1996) are combined into a single measure This index is standardized to have the mean of zero and the standard deviation of one Love used a panel data of 5,000 large, publicly traded firms in 36 countries Her evidence indicates that financial development makes

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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 developing countries 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 that although investment is largely constrained by cash flow with both firms, there are different effects of financial liberalization on small and large firms Small firms are found to be more financially constrained before liberalization and less financially constrained after liberalization in comparison with large firms Large firms also are found to face more financially constrained after liberalization It might come from the fact that large firms often receive incentives from the state such as directed credit program of state development banks or other preferential loans which must be scaled down after liberalization

A different approach is represented by O’Toole and Newman (2012) Despite of the same purpose of study the influence of financial development on firms’ investment financing 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 + 𝜗𝑖 + 𝜃𝑡+ 𝜀𝑖𝑡 (1)

Qit = (c’[I - 𝜑A]) xit (2)

In which xit includes a proxy for the firms' marginal value product of capital In this research, 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) 𝜃𝑡 and 𝜗𝑖represent time and firm specific effects, respectively The vector autoregression is used

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to estimate the coefficient matrix A which is then included in equation (2) The marginal value product of capital ratio is identified by vector c, 𝜑 represents the

combined 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 individual investment opportunities Secondly, firm’s financing composition mix is the first time defined by using the differential cost of capital relating to the financing options available to firms Thirdly, financial development indicators are calculated at provincial level based on Vietnam Enterprise Survey data before these added in the firm’s investment model Provincial financial development indicators here are classified into three families, including financial depth, state intervention and the degree of market financing in the economy The idea is taken from Guariglia and Poncet (2008) in China due to the similarity between Chinese and Vietnamese economies 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 reduces firms’ financing constraints though credit expansion or through more efficient credit allocation However, the impact differs across firms Financial development has significant influences on domestic private firms, but negligible effects on foreign invested 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 of Chile, Gelos and Werner (2002) for Mexico, they both jump to the conclusion that financing constraints are relaxed for small firms but not for large ones after financial development However, the empirical findings of the relationship between financial development and firms financing constraints have not been conclusive Using the same method in Love (2003) but only examining the financial development in single country, China and Chile, respectively, Chan et al (2012) and Forbes (2007) found

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interesting findings Financial reforms in China do not benefit SMEs and SOEs in

terms of alleviating the financing constraints This also occurs similar to the case of

Chile in the capital control period from 1991 to 1998 Chile small firms suffered

significant financing constraints which did not appear before and after the capital

control (Forbes, 2007) Jaramillo et al (1996) found an insignificant relationship

between financial development and firm’s investment when examining the case of

Ecuador

2.4 Conclusion

To conclude, in order to investigate the effect of financial development on

firms’ investment, the recent approach widely used is via analyzing firms’ financing

constraints The problem is that how to formulate the firms’ investment and through

which 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 of

concern Many different indicators are employed to represent financial development,

and they have varied in different studies Most of them are financial depth, 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, M3/GDP The impact of financial

development on financing constraints on firms is still ambiguous Most empirical

studies show that financial development has positive impact on firms’ investment,

relaxing firms’ financing constraints Nonetheless, several studies in some developing

countries point out a contradictory result that firms seem to not benefit from the

financial development process

In this paper, Euler investment equation approach is employed to detect the

presence of financing constraints on firms due to its outstanding advantages in

accordance with Vietnamese firm data and economy context The model specification

and hypotheses development will be presented in the next chapter

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Chapter 3: Model specification

This chapter contains three main parts The first part displays the theoretical framework to model investment As mentioned in the previous part, Euler investment equation approach as well as how to use it to test for the presence of financing constraints would be presented The second part discusses the measurement of financial 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 equation approach 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) The equation is acquired after reorganizing first order conditions when solving the maximizing firm’s value problem

In this paper, the investment model based on Euler equation approach closely follows 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 the expected discounted value of dividends subject to the capital accumulation and external financing constraints

Let 𝑉𝑡be the firm value at time t, 𝐷𝑡the dividend paid to shareholder at time t, and 𝛽𝑡+𝑗𝑡 = ∏𝑗 (1 + 𝑟𝑡+𝑖−1 )−1

𝑖=1 the j–period discount factor for j≥ 1 where 𝑟𝑡 is the risk-free expected rate of return and 𝛽𝑡𝑡 = 1 Then, the function of firm value at time t

is 𝐸𝑡∑∞ 𝛽𝑡+𝑗𝑡

𝑗=0 𝐷𝑡+𝑗, the expected value of present values of future dividend payments

conditional on time t information Let П𝑡 = ∏ (𝐾𝑡 𝑡, 𝐿𝑡, 𝐼𝑡) denote the profit function

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where 𝐾𝑡 is the firm’s capital stock at time t, 𝐿𝑡 the vector of variable input, and 𝐼𝑡 the firm investment at time t The profit function is assumed to be concave and bounded according to Gilchrist and Himmelberg (1999) With the depreciation rate 𝛿 and the investment expenditure at time t, 𝐼𝑡, the capital stock accumulation at time t+1

is 𝐾𝑡+1 = (1 − 𝛿)𝐾𝑡 + 𝐼𝑡+1 Finally, let 𝐵𝑡 be the financial liabilities Financial fictions are taken into account via the assumption that the marginal source of external finance is debt that risk-neutral debt holders require an external premium, 𝜂𝑡 = 𝜂(𝐵𝑡) This premium is expected to be increasing in the amount of debt due to agency costs Following Gilchrist (1999) and Laeven (2003), the gross required rate of return on debt

is assumed to be equal (1 + 𝑟𝑡)(1 + 𝜂(𝐵𝑡))𝐵𝑡

To ensure that the only debt is the firm’s marginal source of finance, a negativity constraint on dividends is introduced It also means that shareholders favor dividends paid out instead of retention For all of the above, the manager’s problem of maximizing firm’s value is as follows:

non-𝑀𝑎𝑥{𝐾𝑡+𝑗, 𝐿𝑡+𝑠,,𝐵𝑡+𝑗} 𝑗=0∞ 𝑉𝑡 = 𝐸𝑡∑ 𝛽𝑡+𝑗𝑡

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Substituting 𝐷𝑡 in (2) into (1) and using (3) to eliminate 𝐼𝑡in the profit function, the Lagrangian function is constructed as:

{𝐾 𝑡+𝑗, 𝐿 𝑡+𝑗, ,𝐵 𝑡+𝑗 }𝐸𝑡{∑∞ 𝛽𝑡+𝑗𝑡

𝑗=0 (1 + 𝜆𝑡+𝑗)[П𝑡+𝑗(𝐾𝑡+𝑗, 𝐿𝑡+𝑗, 𝐼𝑡+𝑗) + 𝐵𝑡+𝑗−(1 + 𝑟𝑡+𝑗−1)(1 + 𝜂(𝐵𝑡+𝑗−1))𝐵𝑡+𝑗−1]} (5)

Firstly, the first order condition for Kt is taken as:

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

procedure for investment (Laeven, 2003)as:

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Secondly, the first order condition for debt Bt is:

According to the study of Bond & Meghir (1994) on the hierarchy of finance approach, when firm pays positive dividend, 𝐷𝑡 > 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 𝜆𝑡+1 = 𝜆𝑡 = 0, the shadow value of internal fund

is zero, or the firm is not financially constrained Then, the Euler equation (8) transforms to the standard investment model without financial friction:

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Let Y = 𝐹𝑡(𝐾𝑡,𝐿𝑡) − 𝐶𝑡(𝐼𝑡, 𝐾𝑡) be net output which is assumed to be homogeneous in

both K t and L t To allow for imperfect completion, 𝑝𝑡 is assumed to depend on Yt with

a constant price elasticity of demand |𝜀|>1

Differentiating П𝑡with respect to𝐼𝑡:

Adjustment costs function:

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

which is strictly convex in I t and homogeneous of degree one in I t and K t

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From this adjustment cost function, differentiating 𝐶𝑡 with respect to 𝐼𝑡:

𝐾𝑡 (16) Regarding to the above assumption of production function𝐹𝑡(𝐾𝑡,𝐿𝑡)that it is homogeneous with 𝐾𝑡,𝐿𝑡, 𝐹𝑡(𝐾𝑡,𝐿𝑡) could be expressed as:

𝐹𝑡(𝐾𝑡,𝐿𝑡) = 𝜕𝐹𝑡

𝜕𝐾𝑡𝐾𝑡 +

𝜕𝐹𝑡

𝜕𝐿𝑡𝐿𝑡Rearranging the equation to obtain 𝜕𝐹𝑡

𝐾𝑡]}

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𝐾𝑡+ 𝛼𝑐𝑏𝑝𝑡 − 𝑝𝑡𝐼) −

(1 − 𝛿)

1 + 𝑟𝑡+1 (𝛼𝑐𝑏𝑝𝑡+1 − 𝑝𝑡+1𝐼 )} + 𝜀𝑡+1

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⇔ 𝐼𝑡+1

𝐾𝑡+1 = −

1 + 𝑟𝑡+1 (1 − 𝛿)𝛼𝑏𝑝𝑡+1𝛼𝑝𝑡

𝑌𝑡

𝐾𝑡−

1 + 𝑟𝑡+1 (1 − 𝛿)𝛼𝑏𝑝𝑡+1𝛼𝑏𝑝𝑡(

𝐼𝑡

𝐾𝑡)2

+ 1 + 𝑟𝑡+1 (1 − 𝛿)𝛼𝑏𝑝𝑡+1𝛼𝑏𝑐𝑝𝑡

𝐼𝑡

𝐾𝑡 +

1 + 𝑟𝑡+1 (1 − 𝛿)𝛼𝑏𝑝𝑡+1𝑤𝑡.𝐿𝑡

𝐾𝑡+ 1 + 𝑟𝑡+1

(1 − 𝛿)𝛼𝑏𝑝𝑡+1𝛼𝑏𝑝𝑡

𝐼𝑡

𝐾𝑡 −

1 + 𝑟𝑡+1 (1 − 𝛿)𝛼𝑏𝑝𝑡+1𝛼𝑐𝑏𝑝𝑡 + 1 + 𝑟𝑡+1

(1 − 𝛿)𝛼𝑏𝑝𝑡+1𝑝𝑡𝐼 + (𝛼𝑐𝑏𝑝𝑡+1 − 𝑝𝑡+1𝐼 )

1𝛼𝑏𝑝𝑡+1+ 𝜀𝑡+1

⇔ 𝐼𝑡+1

𝐾𝑡+1 = (1 −

1 + 𝑟𝑡+1 (1 − 𝛿) .

𝑝𝑡

𝑝𝑡+1) 𝑐 +

1 + 𝑟𝑡+1 (1 − 𝛿) .

1 − 𝜀.

𝑌𝑡

𝐾𝑡 +

1𝛼

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𝐾𝑡 −

𝜃𝑡+1𝑏𝛼

𝐶𝐹𝑡

𝐾𝑡+𝜃𝑡+1

𝛼𝑏 𝐽𝑡+1+ 𝑣𝑡+1 (20)

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

In order to test the presence of the firm’s financing constraints on investment, the empirical specification is constructed from equation (20) with the exclusion of the cost of capital J due to its measurement difficulty

And the subscript i refers to the firm, f i and d t denote firm- and time-specific effects

Under the null of no financial friction, Bond and Meghir (1994) demonstrated that 𝛽1 > 1; 𝛽2 < −1;𝛽3 > 0 and 𝛽4<0 If any of these restrictions is not satisfied, investment diverges from its optimal path Especially, if 𝛽4>0 or investment responds positively to an increase in cash-flow, the firm faces financing constraints The intuition behind is that an expected increase in cash-flow lead to a higher level of investment which is funded before internal finance is up Moreover, a firm could be considered more financially constrained if the coefficient 𝛽4 is more positive

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3.2 Financial development measurement

Based on the definition quoted in 2.3, Čihák et al (2013) constructed measures

of four main characteristics consisting depth, access, efficiency and stability of financial institutions and financial markets A 4x2 framework for benchmarking financial systems (see below) in their study has been used by most mainstream economists and adopted into policy guidelines of World Bank, IMF and UN

Table 3: A 4x2 framework for benchmarking financial systems

FINANCIAL INSTITUTIONS FINANCIAL MARKETS

 Private debt securities to GDP

 Public debt securities to GDP

 International debt securities to GDP

 Stock market capitalization to GDP

 % of firms with line of credit (all firms)

 % of firms with line of credit (small

 Ratio of domestic to total debt securities

 Ratio of private to total debt securities (domestic)

 Ratio of new corporate bond issues to GDP

 Non-interest income to total income

 Overhead costs (% of total assets)

 Profitability (return on assets, return on

 Price synchronicity (co-movement)

 Private information trading

 Price impact

 Liquidity/transaction costs

 Quoted bid-ask spread for government bonds

 Turnover of bonds (private, public) on securities exchange

 Settlement efficiency

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 Z-score (or distance to default)

 Capital adequacy ratios

Source: Čihák et al (2013)

In empirical studies, authors used wide range of proxies of financial development Among them, Dermirguc-Kunt and Levine (1996) employed five standardized indices, including GDP, total value traded over GDP, total value traded over market capitalization, M3/GDP, financial depth (credit to private sector to GDP) Love (2003) inherited these proxies for his research Demirguc-Kunt and Maksimovic (1998) used a set of financial 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 Notably, they are country level proxies of financial development Another approach of financial development proxies could be found in Guariglia and Poncet (2008) when studying the case of China In this study, financial development is decomposed into three features, including financial depth and intermediary development; state involvement and the degree of market financing All the features are calculated for provincial level These proxies seem to be more appropriate for the context of transition economies from the central planned to the market-oriented O’Toole and Newman (2012) employed these proxies for their study of Vietnam the close similarity in the economy context between Vietnam and China However, problems might come from calculating process in using VES data The VES sample selection mainly focuses on provinces with high number of enterprises Using VES data for computing provincial level data might cause bias results

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Due to no existence of a single aggregate index in the literature and the availability of data, in this paper I employ three principal indicators that are widely used as proxies for financial development Those are liquid liabilities ratio, private credit to GDP ratio, and stock market total value traded to GDP (Dermirguc-Kunt & Levine, 1996; Levine et al., 2000; Love, 2003; Huang, 2011b; Čihák et al.,2013)

Liquid liabilities ratio (LLG)

Liquid liabilities ratio is one of the primary indicator to measure the size of financial intermediaries compare to the whole economy (Huang, 2011b; Love, 2003; Beck et al., 2001; Levine et al., 2000); Demirguc-Kunt& Levine, 1996; and King & Levine, 1993) It is measured by the ratio of the liquid liabilities of banks and non-bank financial intermediaries (i.e M3, the currency plus demand and interest-bearing liabilities) to GDP According to Levine et al (2000), LLG might not an efficient indicator to measure the effectiveness of financial system in relaxing asymmetry information problem as well as the transaction costs However, due to the positive relationship between the size of financial intermediaries and the feature and quality of financial services, LLG is accepted by authors as a measure of financial depth

Private credit to GDP ratio (PCG)

Private credit to GDP ratio is calculated by the credit from banks and other financial intermediaries to private sector over GDP This not only excludes the credit to government, government agencies and state-owned companies but also the credit from policy and development banks De Gregorio and Guidotti (1995) argued that this indicator measures the allocation of fund to private sector, which triggers investment and investment efficiency Levine et al (2000) argue that although PCG indicator poorly explains the improvement of financial development on dealing with information asymmetry and transaction costs problem, higher level of PCG indicates better financial services and thus the greater financial development

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Stock market capitalization to GDP (SCG)

Together with financial institutions, stock market also plays a crucial role in the development of financial sector as well as economic growth (Levine & Zervos, 1998)

By taking part in the stock market, investors can diversify their investment portfolio and reduce transaction costs and their risk Čihák et al (2013) argued that stock market capitalization to GDP, which is measured by the ratio of total value of all listed in the stock market to GDP, is a common choice for financial market depth due to the its approximating of the stock market

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

This thesis aims to examine whether financial development relaxes firm’s financing constraints or stimulates the firm’s investment For this purpose, Love (2003), Laeven (2003), Forbes (2007), Chan et al (2012) proposed that the interaction term of the cash stock variable and commonly used financial development indicators should be added in the model (21) above Moreover, to investigate whether the impact

of financial development varies with the firm’s size, the interaction terms among𝐶𝐹𝑡

𝐾𝑡, firm’s size (SIZE =Size of the firm measured by Log of total assets_lnTA), and financial development indicators (FD) is included in the model (20) The final empirical function is as follows:

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