Financial Development and Growth in the Short- and Long-Run

We analyze the relationship between financial development and inter-industry resource allocation in the shortand long-run. We suggest that in the long-run, economies with high rates of financial development will devote relatively more resources to industries with a ‘natural’ reliance on outside finance due to a comparative advantage in these industries. By contrast, in the short-run we argue that financial development facilitates the reallocation of resources to industries with good growth opportunities, regardless of their reliance on outside finance. To test these predictions, we use a measure of industry-level ‘technological’ financial dependence based on the earlier work of Rajan and Zingales (1998), and develop new proxies for shocks to (short run) industry growth opportunities. We find differential effects of these measures on industry growth and composition in countries with different levels of financial development. We obtain results that are consistent with financially developed economies specializing in ‘financially dependent’ industries in the long-run, and allocating resources to industries with high growth opportunities in the short-run. World Bank Policy Research Working Paper 3319, May 2004 The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org. * Fisman: Meyer Feldberg Associate Professor, Economics and Finance, 823 Uris Hall, Columbia University, 3022 Broadway, New York, NY, 10027. Telephone: (212) 854-9157. Fax: (212) 854-9895. Email: [email protected]. Love: Economist, World Bank, 1818 H Street NW, Washington, D.C., 20433. Telephone: (202) 458-0590. Fax: (202) 522-1155. Email: [email protected]. We thank Raghuram Rajan and Luigi Zingales for kindly allowing us the use of their data. Finally, we thank Thorsten Beck, Asli Demirgüç-Kunt, Ann Harrison, Charles Himmelberg, Andrei Kirilenko, Luc Laeven, Sendhil Mullainathan, Jan Rivkin, Tarun Khanna, and Luigi Zingales for extremely helpful conversations and advice.