The Role of Financial Markets and Innovation in Productivity and Growth in Europe

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1 The Role of Financial Markets and Innovation in Productivity and Growth in Europe Philipp Hartmann, Florian Heider, Elias Papaioannou, Marco Lo Duca European Central Bank Disclaimer: This paper is based on internal and external research. Any views expressed are only the authors own and should not be regarded as views of the ECB or the Eurosystem or bind them in any form United Nations Economic Commission for Europe Conference Investing in Innovation: Promoting New Opportunities in the UN Economic Commission for Europe Region, Geneva, Palais des Nations, 10 April

2 Introduction Large academic literature on finance and growth King & Levine (1993), Rajan & Zingales (1998), Wurgler (2000) Complications, esp. from European policy point of view No distinction between industrialised and developing countries Often using historical data Often analysing a very narrow issue This paper Adopts a comprehensive view of financial systems Chooses from a large number of indicators and most recent data Updates existing ones Introduces new ones Focuses on industrial countries and Europe/euro area Presents new econometric estimations Ambition to inform European policy 2

3 Elements of the analysis 1) Conceptual framework based on an extensive review of the theoretical and empirical literature on finance and growth With a particular eye on what works for industrialised countries 2) Compilation of a comprehensive set of indicators of financial development Embedded in the conceptual framework Firmly grounded in the literature Comprehensively checked for data quality and comparability 3) Econometric analysis of how financial development affects economic efficiency Does a more developed financial system help Schumpeterian process of creative destruction, i.e. speed up the reallocation of capital from declining to rising industry sectors? What indicators are particularly relevant for this process? 3

4 Main results Total capital market size is a useful summary statistic Captures overall financial development of an economic region Financial market framework conditions could be improved 1) Certain aspects of corporate governance General shareholder rights have improved in Europe But it is still difficult to curb self-dealing of corporate insiders 2) Efficiency of legal system in resolving financial disputes Having many formal steps that regulate legal disputes limits the supply of capital 3) Structural features of European bank sectors A small number of countries still have significant levels of ownership of banks by the public sector Do these banks perform better than the average recorded in the literature (e.g. such banks distort competition)? 4

5 Less strong results Information processing capacity of stock markets Less pricing of idiosyncratic risk and greater uncertainty about firm prospects in a few specific European countries Creditor rights Bondholders say in reorganisations and secured creditors priority increases depth and breadth of capital markets But the overall strength is still unclear Ownership structures More dispersed ownership of large publicly traded firms and more institutional shareholders could improve corporate governance Financial regulation and supervision Some aspects could be improved w.r.t. incentives for risk taking and management Moral-hazard of deposit insurance and forbearance discretion 5

6 Financial system concepts and their interrelation Fundamentals of the financial system Legal System, Financial Regulation and Corporate Governance Monetary Institutions Financial Structure Market Infrastructures Other Structural Features Performance of the financial system Financial Integration Financial Development /Modernisation Financial Stability Financial Efficiency Performance of the economy Economic Stability Price stability Economic Efficiency Economic Growth 6

7 Size of capital markets % 450% 400% 350% 300% 250% 200% 150% 100% 50% 0% AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK JP US (% of GDP; sum of loans, equity and bonds, BIS, ECB, IMF, Eurostat, WFE) 7

8 Enforcement of shareholder rights against selfdealing by corporate insiders AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK JP US (high score = strong rights, anti-self dealing index, Djankov et al. 2006) 8

9 Duration of enforcement AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK JP US (calender days, Worldbank, data refer to 2005) 9

10 State ownership of banks % 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK JP US (% of total assets, World Bank) 10

11 Hypothesis Argument (Bagehot, 1873; Schumpeter, 1911): In financially developed countries capital flows to industries (as well as firms and entrepreneurs) with positive prospects Financial Markets Productivity-Innovation (relevance for advanced economies) Only one broad channel addressed, there are others 11

12 Two-step procedure 1. Estimate country-specific speeds of inter-sectoral capital reallocation Using industry-level data (in manufacturing), investment growth is regressed on value-added growth (industry prospects). Control in the estimation for all possible sources of unobserved heterogeneity to precisely isolate the inter-industry response of industry investment to the emergence of growth opportunities (i.e. controlling for specialisation patterns; industry-specific global trends; common sector trends). 2. Examine the effect of capital markets size (financial development) on the estimated speed of capital reallocation and identify the sources of financial development. Two-stage least squares estimation. Significant refinement of Wurgler (JFE, 2000) 12

13 Data 65 countries Industrial and developing We separate three groups, distinguishing high and low income countries 28 manufacturing industries 1963 to 2003 Source: UNIDO, Industrial Statistics Database 13

14 Speed of inter-sectoral capital reallocation and capital markets size: Plots All Countries High Income Investment-Value Added Growth Elasticity (b4) AUS KOR MAR AUT GTM ZWE GRC ITA DNK NZL PER PAK ECU EGY IRL URY CAN CMR COL ESP NOR LBY IRN VEN ISR LKA PHL CYPFRA JOR TUR MLT BEL KWT DEUW BGD MEX TTO TUN MWI NGA FINCHL TZA SLVIDN FJI PRT ZMB ETH IND KEN PAN BRB SWZ BOL GBR SWE NLD USA MYS SGP JPN HKG Investment-Value Added Growth Elasticity (b4) AUS KOR GRC ITA DNK AUT NZL IRL ESP NOR CAN ISR CYP FRA BEL KWT MLT DEUW PRT FIN BRB GBR SWE NLD USA SGP JPN HKG Financial Development (FD) Investment-Growth elasticity estimated: controlling for country, industry, year, country-industry, industry-year and country-year fixed-effects Financial Development (FD) Investment-Growth elasticity estimated: controlling for country, industry, year, country-industry, industry-year and country-year fixed-effects 14

15 Legal efficiency and capital market size Financial Development (FD) HKG JPN SGP MYSUSA NLD GBR SWE AUS CAN FRA DEUW JOR NOR KOR NZL AUT CYP IRL FIN ISR PRT TTO BRB MLT DNK BEL ITA TUN KWT GRC SWZ LKA EGYURY COL TUR CHL ESP PHL MEX MARECU SLV PAN VEN BOL PER GTM Legal Formalism Index (LEXFORM) Estimation: Excluding Low Income Countries 15

16 Anti-self dealing and capital market size Financial Development (FD) VEN ECU BOL NLD SWE JOR DEUW FRA AUT ESP TUN PAN ITA GRC PHL JPN USA CAN NOR KOR CHL FIN PRT DNK BEL URY MEX LKA EGY MAR COL SLV TUR PER ISR AUS IRL HKG SGP MYS GBR NZL Anti Self Dealing Index (ANTISELF) Estimation: Excluding Low Income Countries 16

17 State ownership of banks and capital market size Financial Development (FD) HKG USA GBR CYP IRL TTO JPN NLD CAN DNK SGP MYS PAN SWE AUS JOR FIN ESP NZL GTM BEL KWT URY DEUW NOR KOR PHL COL MAR SLV BOL AUT ISR FRA ITA MEX IRN TUR PER Government Ownership of Banks (BGOV) Estimation: Excluding Low Income Countries TUN VEN CHL GRC PRT EGY ECU LKA LBY 17

18 Venture capital financing (early investment stage) % 0.09% 0.08% 0.07% 0.06% 0.05% 0.04% 0.03% 0.02% 0.01% 0.00% AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK JP US (% of GDP, by country of management, EVCA, PWC, Eurostat) 18

19 Venture capital and innovation Generally significant economic effect of VC on innovation Lerner and Kortum (RAND, 2000) find that in the US over , VC has accounted for 8% of industrial innovation while being only 3% of R&D investment. Da Rin and Penas (NBER, 2007) find that unlike public funding, VC pushes portfolio companies towards more in-house R&D effort. However, little effect has been found of VC on Europe s most innovative firms ability to raise equity capital, grow and create jobs (Da Rin and Botazzi [CEPR, 2002]), and several case studies show that VC has little impact on the innovation output of European firms (e.g., Peneder [SSRN, 2007] for Austria). Interpretation: VC promotes innovation, but only when coupled with available innovative technologies, highly trained workforce, infrastructure, and management expertise, and under the right public policies. 19

20 Public policies promoting VC: Literature Taxes Low capital gains tax is a crucial stimulus to VC investment; Tax advantaged stock options most noteworthy change of later years. Regulations Integrated financial services market and a harmonized regulatory network reduce the cost of capital and widen access to investors; Common accounting standards ensure transparency and promote confidence in prospective investors; At the same time, too strict anti-trust regulation may create hurdles where no competition issues are raised; Labour regulations Hiring and firing restrictions hamper high-tech VC investments. Stock markets targeted at entrepreneurial companies positively affect the share of early stage and high-tech VC investments 20

21 Panel analysis of VC determinants New market (0.049)* Capital gains tax (0.003)*** Per capita public R&D Share of high-tech investment Share of early-stage investment (i) (ii) (iii) (i) (ii) (iii) (0.006) Per capita VC funds (0.039) Last-year s per capita VC funds Aggregate barriers to entry Hiring and firing indicator Immigration law indicator (0.048) (0.038) (0.045)* (0.003)*** (0.006) (0.038) (0.048) (0.019)** (0.046)* (0.003)*** (0.006) (0.038) (0.048) (0.023)** (0.033)*** (0.002)*** (0.005) (0.028) (0.035) (0.027) (0.033)*** (0.002)*** (0.005) (0.028) (0.035) (0.014) (0.033)*** (0.002)*** (0.005) (0.028) (0.035) (0.017) Observations Source: Da Rin et al. (2005), Public policy and the creation of active venture capital 21 markets, ECB WP, no. 430, January.

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23 Securitisation % 25% 20% 15% 10% 5% 0% AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK JP US (% of GDP, by country of collateral, ESF, Eurostat, SIFMA) 23

24 Pricing of firm-specific information AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK JP US (R2, high score = less pricing of idiosyncratic risk, own estimations/datastream) 24

25 Dispersion of analysts EPS forecasts AT BE DE ES FI FR GR IE IT NL PT EA CH SE UK JP US (standard deviation of EPS forecast/level of forecast, Thomson Financial) 25

26 Bank concentration AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK JP US (Herfindahl index for total assets, Bankscope) 26

27 Supervisory forbearance discretion AT BE DE ES FI FR GR IE IT LU NL PT EA CH SE UK JP US (high score = strong discretion, World Bank and ECB) 27

28 Empirical approaches 1. Pure Cross-Country Cross-Industry Fisman and Love (2004a,b); Ciccone and Papaioannou (2006a) Is industries that experience global investment-growth opportunities growing faster in financially developed countries? 2. Cross-Country (1) Bekaert, Harvey, Lundbald, and Siegel (forthcoming) Do financially developed countries respond faster to shocks in the industries they specialize in? 3. Cross-Country (II) Wurgler (2000) Is industry investment more responsive to output growth (as a proxy for future growth opportunities) in financially developed countries? 28