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Financial Market Imperfections
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Financial systems across the world have become deeper, more efficient, and more stable over recent decades. However, the development of domestic financial systems has been uneven across the world’s countries and regions as well as among users within a country. Countries with sound macroeconomic policy frameworks and robust growth have deepened their financial systems considerably (Beck, Demirgüç-Kunt, and Levine 2009). However, low- and lower-middle-income countries still exhibit low levels of financial depth, lower access to formal financial services (such as savings accounts and bank loans), and restricted access to external finance (Banerjee and Duflo 2005; DemirgüçKunt, Feyen, and Levine 2013; Lane and Milesi-Ferretti 2007, 2017).
Financial development, in turn, enhances growth at both the country and firm levels. It fosters economic growth through improvements in the allocation of resources and higher TFP growth (Beck, Levine, and Loayza 2000). Financial deepening stimulates the growth of those industries that are more dependent on external finance (Rajan and Zingales 1998) and helps reduce the financing constraints on firms—in particular, small enterprises (Beck, Demirgüç-Kunt, and Maksimovic 2005). It has a transformative impact on economic activity: it shapes the structure of industries, the size distribution of firms, and organizational structures (Demirgüç-Kunt, Love, and Maksimovic 2006). Countries with deeper financial systems also tend to experience faster poverty reduction as the income shares of their poorest quintiles tend to grow at the fastest pace (Beck, Demirgüç-Kunt, and Levine 2007).
Allocative efficiency and productivity growth are enhanced if the financial system (a) enhances the quality of information about firms; (b) exerts sound corporate governance over the resource-borrowing firms; (c) provides effective mechanisms to manage, pool, and diversify risks; (d) mobilizes savings from surplus units toward the most promising projects in the economy; and (e) facilitates trade (Levine 2005).
Financial Frictions and Aggregate Productivity: The Channels of Transmission
Financial frictions play an important role in influencing entrepreneurs’ ability to enter the industry or expand their scale of operations. Firms are heterogeneous in their level of productivity (and hence their optimal scale of operation) or in the sector in which they operate. Financial frictions can affect firm-level and aggregate growth dynamics, and their impact on aggregate productivity will depend on the number and type of entrepreneurs as well as their distribution across the different types (Buera, Kaboski, and Shin 2015).
Financial frictions can affect TFP through several different channels. At the intensive margin, financial frictions introduce distortions in the allocation of capital (capital misallocation) among heterogeneous operating production units. The inefficient allocation of capital among active entrepreneurs (as captured by the dispersion in their marginal product of capital) would lower TFP. At the extensive margin, financial frictions affect aggregate TFP through two different channels: the number and the composition of entrepreneurs. In other words, financial frictions introduce distortions in (a) the selection into entrepreneurship, as productive but poor individuals delay their entry while rich and low-productivity entrepreneurs remain in business (misallocation of talent); and (b) the number of production units for a given distribution of entrepreneurial talent in an economy (Buera, Kaboski, and Shin 2015).
The Intensive Margin
Financial frictions can influence productivity through their impact on the level and dispersion of the marginal product of capital (MPK). Firms’ MPK tends to be higher than it would be otherwise amid binding credit constraints (and holding constant wages and rental rates of capital). There is evidence of large returns to capital among small-scale retailers in Mexico—about 20–30 percent per month or three to five times the market interest rates (McKenzie and Woodruff 2008). Similarly, randomized grants to
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microentrepreneurs in Ghana render very large returns to capital: 7–10 percent and approximately 25 percent per month for cash and in-kind grants, respectively (Fafchamps et al. 2011).
In equilibrium, the MPK is higher if the entrepreneur’s productivity is greater (given any amount of capital). In this context, the MPK of constrained entrepreneurs is higher if their levels of productivity increase (for any given amount of wealth), even in cases of pure collateral constraints. The empirical evidence shows a great degree of concentration in the returns of Mexican entrepreneurs who report themselves as financially constrained (McKenzie and Woodruff 2008). In addition, the larger returns of women entrepreneurs in Ghana correspond to those firms that were already more profitable (Fafchamps et al. 2011). These findings suggest that productivity leads to higher returns to capital.
The MPK across firms also varies greatly. Empirical evidence suggests that manufacturing firms in Sub-Saharan Africa with less access to finance have higher MPK and that, conditional on access to finance, small firms have lower MPK. These findings imply that higher efficiency could be attained by allocating more capital to larger firms (Kalemli-Ozcan and Sørensen 2016). Restricted access to finance has important real effects: for instance, moving firms from environments with easy access to finance to those with poor access will increase their MPK by 45 percent. Therefore, financial constraints may help explain resource misallocation within countries, and this misallocation is significantly associated with the strength of property rights. In other words, firms may be reluctant to reinvest their profits in the absence of secure property rights.
The Extensive Margin
Financial frictions can also affect productivity through their impact on individuals’ occupational choices. They tend to operate through the occupational choices of low-wealth, marginal-ability entrepreneurs. In partial equilibrium, financial frictions increase the activity of entrepreneurs but lower their number; hence the impact of tighter credit constraints on firm size is ambiguous.
The shift in the composition of entrepreneurs leads to higher average productivity and, therefore, greater labor demand. However, financial frictions reduce the amount of capital used by entrepreneurs with binding credit constraints. Poor, marginal-ability entrepreneurs will switch their occupations from entrepreneur to worker in the presence of financial constraints. The demand for labor declines while the supply increases, and lower wages will clear the market. The constrained demand for capital declines, thus lowering the interest rate and the cost of capital. Lower labor and capital costs lead to an increase in the firm’s profitability as well as in the threshold for entry or survival. Relative to a frictionless environment, some high-wealth, low-productivity individuals will enter and replace poor, marginal-productivity entrepreneurs.
Although financial frictions have an ambiguous net impact on entrepreneurship in partial equilibrium, they unequivocally lead to higher entrepreneurship rates in general equilibrium (Moll 2014). Amid financial constraints, wealthier individuals are more likely to become entrepreneurs while lower wages and capital rental rates translate into higher firm profits. The lower input prices, in turn, lead to a larger unconstrained scale of production for all entrepreneurs. The region of high-productivity, low-wealth entrepreneurs who are capital-constrained expands with lower input prices in general equilibrium. Those high-productivity, low-wealth individuals who remain as entrepreneurs are more constrained than they would be in partial equilibrium, whereas the high-wealth, low-productivity entrepreneurs who enter because of the lower input prices tend to be unconstrained.
Financial frictions tend to have sizable effects on labor productivity, aggregate and sector-level TFP, and capital-output ratios.
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Financial frictions may lead to an estimated decline of 20–30 percent in aggregate TFP at equilibrium in one-sector, closed economy models (Buera, Kaboski, and Shin 2011; Buera and Shin 2013). The intensive margin (capital misallocation) explains nearly 40 percent of the TFP reduction, and financial frictions tend to reduce entrepreneurship rates (Midrigan and Xu 2014).
Financial frictions have more deleterious effects on manufacturing activities than on services. They tend to reduce the TFP of manufacturing sectors by more than 50 percent, while the TFP of services sectors fall by less than 30 percent. The differential impact across sectors might reflect the higher relative price of manufacturing goods to services in financially underdeveloped economies. At the same time, the capital-output ratio declines by 15 percent in the presence of financial frictions—an effect driven primarily by the higher relative price of manufactured investment goods in financially underdeveloped economies (Buera, Kaboski, and Shin 2011).
Alleviation of financial constraints has dynamic effects on entrepreneurship rates and aggregate TFP. For instance, quadrupling access to financial services will increase entrepreneurship rates in Thailand by 4 percentage points (Giné and Townsend 2004). Financial deepening explains 70 percent of the overall TFP growth in Thailand from 1976 to 1996 (Jeong and Townsend 2007). Financial frictions also have an impact on the transition dynamics after growth-enhancing reforms: output growth converges slowly to a new equilibrium after reforms that trigger an efficient reallocation of resources (at half the speed of a neoclassical Solow model). Additionally, investment rates and TFP tend to be initially low and increase over time, consistent with the experience of miracle economies (Buera and Shin 2013).
Finally, financial market development could ensure that capital is channeled to those firms that are more productive and whose survival is highly dependent on the availability of finance. Technological improvements in financial intermediation may increase understanding of this channel. Costly verification models enable financial intermediaries to select the amount of labor devoted to monitoring loan activity. In these models, the likelihood of detecting malfeasance depends on this decision and the technology used in the financial sector (Greenwood, Sanchez, and Wang 2010).
Model simulations suggest that technological improvements in financial intermediation account for about 29 percent of US growth (Greenwood, Sanchez, and Wang 2010). Further analysis shows that 45 percent of per capita growth in Taiwan, China, from 1974 to 2004 (6.3 percent per year) is attributed to financial development (and about 16 percent to TFP growth). Finally, the evidence suggests that the output per capita of Uganda could more than double if the country were to adopt global best practices in financial intermediation. However, this impact amounts to only 29 percent of the gap between Uganda’s potential and actual output (Greenwood, Sanchez, and Wang 2013).
Wealth, Self-Financing, and Financial Frictions
Wealth is an important driver of occupational choice in the presence of financial frictions. Savings are incentivized by the higher rates of entrepreneurship stemming from financially constrained environments and the role played by wealth in relaxing these constraints. In turn, self-financing motives will depend on the persistence of the firm’s productivity. There is ample evidence of highly persistent capital (and other asset) returns in Thailand (Pawasutipaisit and Townsend 2011); among manufacturing firms in the Republic of Korea (Midrigan and Xu 2014); and among industrial plants in Chile and Colombia (Moll 2014).
Financial frictions also play an important role in business entry decisions in low- and middle-income countries. Wealth and access to finance greatly influenced the business entry decisions of individuals in rural and semiurban regions of Thailand before the 1997 Asian financial crisis (Paulson and Townsend 2005). However, wealth did not
