Nber Working Paper Series 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. Raymond Fisman Department of Economics 823 Uris Hall Columbia University 3022 Boradway New York, NY 10027 and NBER [email protected] Inessa Love World Bank 1818 H Street NW Washington, DC 20433 [email protected] Economists have long been interested in the role of financial development in resource allocation. The hypothesis that financial development facilitates the efficient allocation of resources dates back to at least Schumpeter (1912), who conjectured that banks identify entrepreneurs with good growth prospects, and therefore help to reallocate resources to their most productive uses. More recently, Levine (1997) describes a number of channels through which financial development may affect allocative efficiency, including information generation, risk-sharing, financing, and monitoring. Rajan and Zingales (1998) point out that allocation may be differentially affected by industry characteristics: those that require a lot of upfront outside financing (relative to generated cash flow), such as drugs and pharmaceuticals (perhaps due to R&D costs), will be less likely to grow in the presence of capital market imperfections than other industries where investment more closely coincides with cash generation. More recently, a number of other researchers have used a similar approach to look at the interaction of various ‘fixed’ industry characteristics and different aspects of financial development in predicting sectoral growth. In this paper, we suggest that there is an important theoretical distinction in considering the role of financial development on industry growth in the shortand long-run that has heretofore gone largely unrecognized. In the short-run, we emphasize the role of financial institutions in reallocating resources to any industry that has experienced a positive shock to growth opportunities. We contrast this with a long-run view of the allocative effects of financial development, suggested by Rajan and Zingales (RZ), who argued that certain industries will naturally be more reliant on financial institutions to finance growth. Intuitively, this leads to separate predictions on the allocative effects of financial development in the shortand long-run. In the short-run, sectoral growth will be more correlated with growth opportunities in countries