Empirical Evidence-Financial Systems and Economic Activity - Essay Example

?Table of Contents Table of Contents 1.Introduction 2 2.Review of Economic Performance and Financial Systems 3 3.Empirical Evidence-Financial Systems and Economic Activity 6 4.Conclusion 12 References 14 1. Introduction The role of financial activities in national economic performance is highly important. A consent needs still to be developed to determine if the differences in the framework of corporate, financial and legal systems across the country have any unexpected impact over the cross-country economic performance. However, this question has instigated the efforts to formulate data banks for corporate and financial systems enabling us to compare the global economic performance. This study is aimed towards reviewing such issues and providing empirical evidence along with presenting some new analyses of this evidence. The next chapter presents the discussion about the comparative features of the financial and corporate systems for the economic performance. Lately, this debate has led to the bilateral country comparisons on the roles played by various elements as for instance, the contribution of banks towards the relative German and British industrial performance after the late 19th century. The contribution of the German banking system towards the development of the German industrialization by granting external finance commonly attained the position of a ‘stylized fact’ in the debate of relative economic performance. The assessment of the discussions over relative corporate, financial and legal systems in the further chapter reflects that despite there exists obvious distinctions in the frameworks, it is much harder to establish the influence of these differences over the economic performance. Specifically, the systems that are commonly presumed as to provide the connection between the structural differences and the performance seldom exist in the data sets of the organizations. In chapter three, empirical evidence is provided for this study, which is obtained from an empirical study that includes 14 OECD countries. A robust inter-relation amongst the type of the financial and corporate system, the attributes of various sectors and their rates of development in various countries was recorded through the empirical research. Moreover, it was found that the expenditures over research and development, and not fixed capital formation, serve are the medium through which this impact takes place. It was also observed that the interaction amongst the structures and the industrial activity of the country greatly depends upon the levels of its economic growth. The concluding chapter of this paper explains the implications for the economic policy of the consideration that the institutional structure might be inter-related with the type of activity. 2. Review of Economic Performance and Financial Systems Joseph Schumpeter explained in 1912 that how the provision of loan was essential for the development and for the entrepreneurship. According to him, despite giving loan is not central to the normal circular flow, it is true that there exists a gap to overcome in the execution of new combinations. He further affirmed that the obligation of the lender is to bridge this gap, which he very well does by placing the power-to-purchase developed ad hoc at the disposal of the businessman. Thorstein Veblen observed that the mechanism of assessing firms subject to “standardized bureaucratic routine” adopted by the entrepreneurs whom he referred to as the “lieutenants of finance” where as he dubbed the “syndicated bankers” as the “captain of finance” (Veblen, 1919). Nevertheless, Robert Lucas, among various others, debates that the economists poorly exaggerated the importance of financial attributes in economic performance (Lucas, 1988). While the significance of financial systems is doubtful, the efficacy of various sorts of financial systems has been found to be even more controversial. Clapham (1936) in his work agreed with the views of a principal officer of one of the Great Banks of Germany that the development of the German Empire is to a larger part due to the banks in Germany since they fostered and established its industries (Clapham, 1936). During the 2nd half of the 19th century, a series of bank failures stimulated the withdrawal of British banks. By the 1980s, the banks were reluctant to serve as partners in the industrial development. They were found to be emphasizing over the efficient national short term credit system and thus, extensively deviated from the long term credit system (Jefferys, 1938). However, various other scholars argued this analysis of German banking. Edwards and Fischer (1994) found that the common perception about the benefits of the financial investment system of Germany, on the basis of the provision of external finance to businesses, is not at all supported by the analysis of the evidence available. Edwards and Ogilvie (1996) argued that the present contribution of the German universal banking has been exaggerated and even at its peak, it was probably not as important as commended at the turn of the century. The view that evolves does not comply with the assertion that the universal banks in Germany applied significant control on the German industries and offered abundant finance. Albeit some of such cases have been observed, they were still exceptions to the general rule that required the companies to self-finance themselves to a larger part (Edwards and Ogilvie,1996). Similar debates have been observed about Japanese banks. Hoshi, Kashyap and Scharfstein (1990) stated that if the financial structures of an organization have small information and free rider problems then the performance of that organization is better than that of those where such problems are at large. Specifically, the organizations in the industrial groups, which have close financial ties with their banks, customers and suppliers have been observed to invest and sell more after the distress as opposed to non-group organizations. However, this analysis has been questioned. Weinstein and Yafeh (1998) observed that even before the independence of Japan’s financial markets, core bank customers did not show higher performance in comparison to their competitors. In addition to this, the banks were able to use their monopoly authority so as to lower the profits of their customers and thereby, prevent their progress with the conservative investment policies (Caves and Uekusa, 1976; Nakatani, 1984). The event of financial distress in the Fat East during the 1990s reinforced the negative perspective about the banking systems. Rather than carrying out the active monitoring and governance functions that are being assigned to them through the financial intermediation theory, banks have been observed to be at the centre of the vicious systems. Common views have shifted significantly from promoting the systems causing sustained high growth rates and levels of investment towards the extreme quibble for their deficiency of transparency and openness. During the 1980s, the discussion about the comparative systems and finance literature has expanded to comprehend other cross-country differences as well. Franks and Mayer (1998a) observed significant differences in the concentration of ownership across countries. The UK and the US include large quoted sectors in which shared-proprietorship is scattered across numerous investors. In the case of UK, the dominant shareholding group represents the group of the institutional investors where as in the case of US the dominant shareholding group is actually the group of individual investors. On the contrary, Germany and France include small quoted sectors. In general, even the largest quoted company includes at minimum one shareholder possessing above 25 % of the equity and usually most part of the shareholding. In particular, such large shareholdings are linked to corporate and family investors (Franks and Mayer, 1998). Two sets of studies analyzing the concentration of voting power and share-ownership have also found such differences. This chapter has discussed the literature related to the subject of comparative governance and finance. Significant and persistent differences have been found, through various studies, in the levels of: involvement of the bank in the corporate sector, ownership concentration, and legal protection of investors. However, the efforts to combine the processes that associate differences in the financial structure with the economic performance have not been markedly successful. 3. Empirical Evidence-Financial Systems and Economic Activity Carlin and Mayer (1999) carry out the first empirical investigation of the association between the composition of economic activity and the financial systems that in turn include legal and corporate systems. The presumption to follow is that different financial systems may support the industries having different types of characteristics. The relationships amongst various kinds of systems, different nature of industries and different levels of financial activity in those industries across various countries have been analyzed by Carlin and Mayer (1999). On the basis of various theories of economic performance and of financial, corporate and legal systems, Carlin and Mayer (1999) assessed that if there exists some relationship amongst the growth rates of industries in various countries, the interaction across the financial structures of those countries, such as the level of bank and market arrangement of their financial frameworks, and the characteristics of the industry that refer to the reliance of industries upon the sources of bank debt or external equity and upon the skilled labor inputs. For instance, various researched have found that the organizations depending upon high levels of skilled labor would gain from the concentrated ownership as it provides deep level of commitment. Therefore, Carlin and Mayer questioned in a cross-country context that if the industries that are recognized as skill or labor intensive proper in countries that possess concentrated ownership structures in comparison to the similar industries in those countries where the ownership structure is dispersed and also in comparison to those industries that do not rely upon high degree of skilled labor. In particular, the two researchers define: sxk as X matrix of s structural features in k countries. kxi as Y matrix of i growth rates of industries in k countries. cxi as Z matrix of c industrial characteristics in i industries. The authors evaluated the sxc as B matrix that associates the structural characteristics of the country and the variables of industry’s finance with the growth rates of the industries specifically in the countries that are included in the following equation: Y = X’BZ + ? In the above equation, ? refers to the error term in the regression. The data sample of the empirical study consists of 27 three digit industries with in 14 OECD countries. The financial activity and economic performance of these industries is evaluated during the period of 1970 till 1995. The financial systems’ structure (X) of various countries is estimated with their standards of accounting, stock markets’ size, level of the ownership of the bank for the corporate equity and the ratio of bank credit/loan to GDP. The corporate systems’ structure is determined through the level of ownership concentration and the degree of ownership pyramid. The legal systems’ characteristics are determined through two ways, which are (1) by investor’s or creditor’s legal protection indicators and (2) by the legal system’s civil or public law origin as referred through its source in English, Scandinavian, German or French law. The market capitalization to GDP ratio is positively related to the measure of accounting standards (0.29). The bank-firm ties, as determined through the non financial firms’ ownership of the bank, are positively related to the bank-credit to GDP ratio (0.68). The ownership concentration is positively related to the measure of the existence of the ownership pyramid (0.52). On the other hand, accounting standards are negatively related to the bank-credit to GDP ratio (-0.46) and also, they are negatively related to the ownership concentration (-0.2). However, very small negative correlation exists between the concentration of the ownership and the banking sector’s size (-0.04). These relationships are to a great extent persistent with the perspective that some groups of institutional characteristics are found in some countries where as the other groups are found in other countries. The industrial characteristics (matrix Z) are determined through the bank finance, external equity and investment in labor skills in various countries. Industries might differ from each on the basis of their fundamental characteristics such like their dependence over human capital, the uncertainty linked to research and development, and the short-live or long-live tendency for investment projects. Carlin and Mayer use the contribution of equity finance as proxies for the various industrial characteristics where as they use the bank-credits as the investment source and they use the skills (estimated through the number of employees in accordance to on and off-the-job training) where such industrial characteristics are evaluated in countries and where institutional structures are considered to be most effective to their extensive supply. As a rule, one would like to determine the degree to which industries experiencing no institutional restrictions employ external financial sources and thereby, invest in skills. In reality, none of these are observed. In lieu, Carlin and Mayer evaluated these variables in such countries where institutional restrictions are probably to be least confining: organization are considered to have coziest reach to the external finance’s market sources in the United States , to the skilled labor in Germany and to the bank-credits in Japan. The level of external finance and skills in various industries is thus, estimated in above mentioned three countries. The empirical results for the 27 industries show that the 0.07 interdependence is between bank financed industries and equity dependent industries, 0.17 interdependence is between skill intensive industries and equity dependent industries and -0.46 interdependence is between skill intensive industries and bank financed industries. The paper investigates that if there is any correlation between these variables and economic performance, through creating interactive variables between the industrial characteristics and country structures, as determined via the industrial growth rates in various countries during the period from 1970 till 1995. In 27 industries with the 14 OECD countries, the rates of financial growth are reverted on the interactive variables’ product between industrial characteristics and country financial structures. The regression to the mean effects and the growth regressions to account for recovery constituted the initial shares of industries in various countries. Other variables are provided controls through getting the difference of all the variables from their corresponding means through out the complete sample population. The study provides significant evidence for the presence of a relationship between the growth rates of industries in various countries and the correspondence of the country financials structures with the industrial characteristics. Specifically, there is robust interactive influence of the country variables accounting standards as well as ownership concentration with the 2 industrial characteristics that are labor skills and equity finance. This refers to the interpretation that the industries that rely upon these two industrial characteristics - equity finance and skills – grow specifically swiftly in countries with numerous accounting standards and high extent of ownership concentration. Concentrations of ownership and information disclosure are linked to high growth rates of industries that rely upon skill intensive labor forces and market finance. These findings are in line with the study that financial systems depending on the market are appropriated for activities that require such types of finance that include diverse evaluations by numerous participants. The result is also in line with the concentrations of ownership that benefit such financial activities that involve investments to be contributed by other stakeholders such as the employees in this case. Then the study executes similar investigations about the determinants of research and development shares (as a measure of value added) and fixed investment share in 27 countries out which 14 were OECD countries and 15were for R & D. The correspondence between industrial characteristic variables and country financial structure are attributed to higher proportion of the alteration in R & D in comparison to proportion of changes in fixed investment through out the various industries in different countries. The impact of country financial structures over the industrial growth rates thus seems to occur through R & D instead of FCF expenditures. This is also indicated in a similar association of accounting standards with the R & D as was observed previously for growth. Industries having high degrees of external equity finance and employing skilled labor intensively possess, as shown in the growth equation, high shares of R & D in countries that have numerous accounting standards. Specifically, the interaction with skills is pronounced when the measure of skills is constrained to the ratio of the labor workforce to the highest qualifications’ levels. This infers that the disclosure of information is helpful in the financing of the high level of skill training that is needed in R & D. In contrary to growth, the concentration of ownership is not related to R & D that leads to the interpretation that ownership concentrations offer the obligation that needed to support investment by the labor force and firms however this investment should be limited to mobiles advanced skills training. In line with the studies of Huang and Xu (1998a) and Dewatripont and Maskin (1995) market systems enforcing strict budget constraints are linked to higher growth in industries that rely upon financial market sources and investments in the training of skills. As suggested by Huang and Xu (1998a), one analysis of the finding that the levels of R & D are highly related to the means of country and industry in countries that have accounting standards in skill intensive and equity dependent industries, is the prevalence of hard budget constraints so as to support R & D even in the presence high technological uncertainty. It is logical that in high skill intensive and equity dependent industries high uncertainty characterizes the technological growth. Ownership concentrations are linked to industries that need investments in less advanced training of skills. The study repeats the assessment of the connection of growth with interactive industry and country variables on a group consisting of 4 countries at an initial stage of the development as estimated through the per capita GDP in the year 1970 in contrast to the use of 14 countries that were used above in this analysis. The study also found that the impact of banking structures and ownership of concentration is to significantly different in comparison to that of developed countries. High levels of ownership concentrations are related to lower growth rates of industries relying upon labor skills and external equity finance in countries with low GDP. In line with the study of Huang and Xu (1998a), during the early stages of industrial development, the possible soft budget constraints related to the high ownership concentrations thus serve to the disadvantage of industries in these countries. Moreover, in accordance to the studies related to the role of banks during the initial developmental stages of industries by Huang and Xu’s (1998b) and Gerschenkron’s (1962), there is evidence of higher growth rates of industries relying on banks in developing countries that are bank oriented however such high growth rates are not observed in developed countries. In the end, the study analyzes the impact of legal structures over the industrial growth rates and investment. In the growth regressions as well as in the R & D regression, a positive impact of investor protections has been observed. For the growth regression, the investor protection is linked to the skill intensive industries where as for the case of R & D regression, the investor protection is associated with the equity financed industries. The promotes the perception that the protection of investor by the legal structure augments the impacts of financial and corporate structure through the promotion of growth in skill intensive and external financed industries with the help of R & D expenditures. Some evidence has also been found for that the creditor protection encourages capital expenditures in industries that are skill intensive. In line with all the theories of financial systems, corporate systems, legal systems and types of economic activities, support has thus been found for the impact of the financial, corporate and legal structures on the structure of economic activity. Financial systems that are market oriented are linked to the high growth of skill intensive and external equity financed industries. The impact is directed from the investment in R & D as opposed to fixed capital expenditures. High ownership concentrations are also related to low growth of these industries in developing countries and at the same time, to the high growth of these industries in the developed countries. In addition to this, their impact is not directed through R & D even in the developed countries which infers that the concentrations of ownership are linked to the growth of comparatively low risk activities, as per the anticipations of Huang and Xu (1998a). 4. Conclusion This paper has presented a brief account of the available literature related to the impact of the financial, corporate and legal systems, supporting the financial activity with in a country, over the economic performance of various countries. The impact of financial systems over the country’s economic performance over a long period of time had been significantly discussed in this paper. However, as mentioned previously in this paper, the international comparisons of corporate and financial infrastructure in the developed world were unable to disclose evident relationship between the financial or corporate structures and the economic performance of a country. Due to this finding, it can be concluded that no financial or governance mechanism functions specifically well in regulating agency issues and for that matter solutions should be hunted from some where else, for instance, from product market competition. However, empirical analyses indicated persistently towards the significant role for financial development in economic performance. A clear correlation has been identified between the economic growth across countries and the establishment of both securities markets and banking systems. The paper includes the theoretical literature on the interaction among the financial and corporate mechanisms and the types of economic activities. Link of high risk R & D type activities has been established with the dispersed ownership financial systems and the market based financial systems, in case of the significant imposition of strict budget constraints. On the other hand, the financial systems with concentrated ownership and the bank oriented financial systems should be linked to long term investment with stimulated nature, in case of financial structures that require commitments to other stakeholders. These theoretical propositions are supported by the first empirical evidence provided in chapter 3 of this paper. Clear evidence has presented for the presence of the relationship between types of economic activities and various financial and corporate systems. Market based financial systems are related to high growth of industries that are skill intensive or that are dependent over external equity and this influence is linked to the R & D effort. These industries in developed countries and not in developing countries are also linked to the high ownership concentrations however this influence is related to R & D. Although the empirical analyses of the relationship between the types of economic activity and financial and corporate systems are currently at its initial stage, they have significant policy implications if they are promoted through the provision of further evidence in this regard. Specifically, they indicate that there is not essentially a commanding financial system that is suitable for all economies or for all industries inside an economy. The financial systems or considerations that are deemed appropriate for a developed economy might turn inappropriate for a developing economy. Similarly what is appropriate for a highly innovative R & D economy might be inappropriate for a more imitative economy. 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