Financial Liberalization, Competition and Productivity

Cross-country studies associate financial liberalization with increases in aggregate productivity. This paper argues that this finding can be mainly attributed to reductions in distortions in capital markets that promote competition and encourage firms’ investments in technology. I first develop a simple small open economy model in which capital controls distort access to international borrowing. I show that this distortion can affect market competition and firms’ innovation incentives. Financial liberalization removes this distortion and fosters investments in technology through two forces. First, better credit conditions encourage firms that gain access to international funds to raise their innovation efforts. Second, their market rivals respond to the threat of competition by innovating more. In my empirical analysis, I test the implications of the model using firm-level census data around the deregulation of international financial flows in Hungary. I exploit differences in the access to international borrowing prior to the reform as a source of cross-sectional variation. The results confirm that firms that gain access to international funds increased their productivity and their probability of undertaking innovation activities. I provide direct evidence that this is due to greater use of external funds. Responding to the tighter competition, their market rivals also increased their investments in technology. Tougher competition is also observed in reductions in markups, industry concentration, and productivity and markup dispersions within sectors. At the macro level, a decomposition exercise shows that, reversing the previous pattern of growth, the increase in within-firm productivity explains the bulk of the expansion aggregate productivity growth following the liberalization. (