We study whether financial development leads to a more efficient allocation of capital. Research indicates that countries are not poor because they invest too little but because they do not invest well. One reason could be that financial institutions and markets are underdeveloped. As a result, they are not able to identify good investment opportunities, provide financing and ensure a correct implementation of investments. This means that investment does not go where it is most productive. In turn, this reduces productivity and welfare.
A large body of work supports the idea that financial development is good for growth. But we are not aware of any work on the link between such development and capital allocation efficiency. We fill this gap by calculating measures of capital allocation efficiency for six economies (China, India, Japan, Korea, Mexico and the United States), going back for the most part to the early 1980s. We relate those measures to an index that captures various aspects of financial development. Unlike most of the relevant literature, we look at the allocation of capital and labour across economic sectors rather than across firms within one sector. This means, for example, that we want to know whether physical capital is concentrated in the less productive construction industry or the more productive IT industry, and not whether less productive construction firm A invests more than the more productive construction firm B. Our analysis uses data on output and labour and capital inputs for 26 sectors of our target economies.
Our results support the idea that financial development is associated with a more efficient allocation of capital. In more developed financial systems, higher investment tends to go hand in hand with a better allocation of capital. In less developed financial systems, the opposite is true: higher investment goes to less productive sectors and capital allocation is worse. Not surprisingly, industries that undertake more research and development or rely more on external funding to finance investment benefit most from financial development.
This study investigates how financial development affects capital allocation across industries in a panel of countries at different stages of development (China, India, Mexico, Korea, Japan and the US) over the period 1980-2014. Following the approach proposed by Chari et al (2007) and Aoki (2012), we compute wedges for capital and labour inputs for 26 industrial sectors in the six countries and add them up to economy-wide measures of capital and labour misallocation. We find that more developed financial systems allocate capital investment more efficiently than less developed ones. If financial development is low, faster capital accumulation is associated with a worsening of allocative efficiency. This effect reverses for higher levels of financial development. Sectors with high R&D expenditures or high capital investment benefit most from financial development. These effects are not only statistically significant, they are also large in economic terms.
JEL classification: E22, E23, O16, O47
Keywords: factor allocation, total factor productivity, financial development
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