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The Quarterly Review of Economics and Finance
46 (2006) 190–210
Financial development and dynamic investment
behavior: Evidence from panel VAR
Inessa Love a , Lea Zicchinob,∗
a World Bank, Rearch Department—Finance Group, 1818 Hst, NW, MC3-300,
Washington, DC 20433, United States
b Bank of England, Monetary Instruments and Markets Division, HO-2,
Threadneedle Street, London EC2R 8AH, UK
Received 14 April 2004; received in revid form 31 October 2005; accepted 4 November 2005
Abstract
We apply vector autoregression (VAR) to firm-level panel data from 36 countries to study the dynamic
relationship between firms’ financial conditions and investment. By using orthogonalized impul-respon
functions we are able to parate the ‘fundamental factors’ (such as marginal profitability of investment)
北京交通大学爆炸from the ‘financial factors’ (such as availability of internal finance) that influence the level of investment. We
find that the impact of financial factors on investment, which indicates the verity of financing constraints,
is significantly larger in countries with less developed financial systems. Our finding emphasizes the role of
financial development in improving capital allocation and growth.
© 2006 Board of Trustees of the University of Illinois. All rights rerved.
my love歌词Keywords: Financial development; Vector autoregression; Dynamic investment behavior
1. Introduction
Unlike the neoclassical theory of investment, the literature bad on asymmetric information
emphasizes the role played by moral hazard and adver lection problems in a firm’s decision
to invest in physical and human capital. The prence of asymmetric information means that the
classical dichotomy between real and financial variables may no longer hold. Financial variables
can have an impact on real variables, such as the level of investment and the real interest rate, as well
as propagate and amplify the effects of exogenous shocks to the economy. For example, Bernanke
∗ Corresponding author. Tel.: +44 20 7601 5212; fax: +44 20 7601 3217.
E-mail address: lea.uk (L. Zicchino).
1062-9769/$ – e front matter © 2006 Board of Trustees of the University of Illinois. All rights rerved.
doi: 10.1016/j.qref.2005.11.007
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I. Love, L. Zicchino / The Quarterly Review of Economics and Finance 46 (2006) 190–210 191
and Gertler (1989) show that a firm’s
net worth (a financial variable) can be ud as collateral in
order to reduce the agency cost associated with the prence of asymmetric information between
典故的意思
lenders and borrowers. In this model, firms’ investment decisions are not only dependent on the
prent value of future marginal productivity of capital, as the q-theory predicts, but also on the
level of collateral available to the firms when they enter a loan contract.
Since economists started to look at real phenomena abstracting from the Arrow-Debreu
framework with its frictionless capital markets, a vast literature has been developed on the rela-
tionship between investment decisions and firms’ financing constraints (e Hubbard, 1998, for
a review). Even though asymmetric information between borrowers and lenders may be not
the only source of imperfection in the credit markets, firms em to prefer internal to external
finance to fund their investments. This obrvation leads to the prediction of a positive relation-
ship between investment and internal finance. The first study on panel data by Fazzari, Hubbard,
and Peterson (1988) finds that, after controlling for investment opportunities with Tobin’s q,
changes in net worth have a greater impact on investment by firms with higher costs of external
financing.
The link between the cost of external financing and investment decisions not only sheds light
on the dynamics of business cycles but also reprents an important element in understanding
economic development and growth. For instance, in the prence of moral hazard in the credit
market, firms that need a bank loan may be induced to undertake risky investment projects with
英语词典大全low expected marginal productivity. This corporate decision affects the growth path of the econ-
omy, which may even fall into a poverty trap (e Zicchino, 2001). Rajan and Zingales (1998),
Demirguc-Kunt and Maksimovic (1998) and Wurgler (2000), among others, have investigated the
link between finance and growth by asking whether underdeveloped legal and financial systems
hippcould prevent firms from investing in potentially profitable growth opportunities. Their empirical
results show that an active stock market, developed financial intermediaries and the respect of
legal norms are determinants of economic growth.
Estimation of the relationship between investment and financial variables is challenging
becau it is difficult for an econometrician to obrve firms’ net worth and investment oppor-
tunities. In theory, the measure of investment opportunities is the prent value of expected
future profits from additional capital investment, or what is commonly called marginal q. This
is the shadow value of an additional unit of capital and, under certain conditions, it can be
shown to be a sufficient stati
stic for investment (Hayashi, 1982). In other words, it is the
‘fundamental’ factor that determines investment policy of profit-maximizing firms in efficient
markets. The difficulty in measuring marginal q, which is not obrvable, results in low explana-
tory power of the q-models and, typically, entails implausible estimates of the adjustment cost
1
parameters.
Another challenge is finding an appropriate measure for the ‘financial’ factors that enter the
investment equation in models with capital markets imperfections. A widely ud measure for
the availability of internal funds is cash flow (current revenues less expens and taxes, gen-
erally scaled by capital). However, cash flow is likely to be correlated with future investment
profitability.2 This makes it difficult to distinguish the respon of investment to the ‘fundamen-
1 See Whited (1998) and Erickson and Whited (2000) for a discussion of the measurement errors in investment models.
Also e Schiantarelli (1996) and Hubbard (1998) for a review on methodological issues related to investment models
考研专业课考试时间
with financial constraints.
2 For example, the current realization of cash flow would proxy for future investment opportunities if the productivity
shocks were positively rially correlated.
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192 I. Love, L. Zicchino / The Quarterly Review of Economics and Finance 46 (2006) 190–210
tal’ factors, such as marginal profitability of capital, and ‘financial’ factors, such as net worth (e
Gilchrist and Himmelberg, 1995, 1998, for further discussion of this terminology).
In this paper we u the vector autoregression (VAR) approach to overcome this problem and
isolate the respon of investment to financial and fundamental factors. Specifically, we focus
on the orthogonalized impul-respon functions, which show the respon of one variable of
interest (i.e. investment) to an orthogonal shock in another variable of interest (i.e. marginal
productivity or a financial variable). By orthogonalizing the respon we are able to identify the
effect of one shock at a time, while holding other shocks constant.
We u firm-level panel data from 36 countries to study the dynamic relationship between firms’
akashicfinancial conditions and investment levels. Our main interest is to study whether the dynamics of
investment are different across countries with different levels of development of financial markets.
We argue that the level of financial development in a country can be ud as an indication of the
different degrees of financing constraints faced by firms. After controlling for the shocks to
‘fundamental’ factors, we interpret the respon of investment to ‘financial’ factors as evidence
of financing constraints an
d we expect this respon to be larger in countries with lower levels of
financial development. To test this hypothesis we divide our data in two groups according to the
degree of financial development of the country in which they operate. We document significant
differences in the respon of investment to ‘financial’ factors for the two groups of countries.
Furthermore, splitting the sample bad on different indicators of economic development does
bus metro walknot produce significant differences, supporting our claim that the level of financial development
is the main determinant of financing constraints.
We believe our paper contributes to a number of strands in the recent financial economics liter-
ature. We contribute to the literature on financial constraints and investment in veral ways. First,
by using vector autoregressions on panel data we are able to consider the complex relationship
between investment opportunities and the financial situation of the firms, while allowing for a
firm-specific unobrved heterogeneity in the levels of the variables (i.e. fixed effects). Second,
thanks to a reduced-form VAR approach, our results do not rely on strong assumptions that are
necessary in models that u the q-theory of investment or Euler equations. Third, by analyzing
orthogonalized impul-respon functions we are able to parate the respon of investment to
shocks coming from fundamental or financial factors.
We also contribute to the finance and growth literature by prenting new evidence that
investment in firms operating in financially underdeveloped countries exhibits dynamic patterns
consistent with the prence of financing constraints. Our paper also adds to the recent work that
ud dynamic panel-data techniques to argue that there is a casual link between financial develop-
ment and growth (e, for example, Beck and Levine, 2004). While most of the previous studies
relied on country-level data, our paper us firm-level data to demonstrate how the link between
finance and growth operates on the level of the firm and to provide additional evidence on the
channels behind this link. Specifically, we find that financial development has an immediate effect
on efficient allocation of capital via investment that follows the most productive us of capital.
Our finding is also consistent with the evidence prented by Beck, Demirguc-Kunt, Levine, and
Maksimovic (2001) who found that it is easier for firms’ to access external financing in countries
with a higher level of overall financial ctor development.
Our paper also adds to the recent debate on bank-bad versus market-bad financial systems
(e, for example, Demirguc-Kunt and Levine, 2001a, b, and Beck and Levine (2002), among
others). This literature demonstrated that despite conflicting theoretical predictions, there is no
empi
rical evidence of the relationship between financial structures and economic growth. How-
ever, the literature has found that it is the overall financial development that helps in explaining
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I. Love, L. Zicchino / The Quarterly Review of Economics and Finance 46 (2006) 190–210 193
cross-countries differences in economic performance. Our findings are consistent with this liter-
ature and expand the range of real effect previously studied to include the micro-level evidence
of the effect of financial development on investment behavior and capital allocation.
Our paper is also related to Gilchrist and Himmelberg (1995, 1998), who were the first to
analyze the relationship between investment, future capital productivity and firms’ cash flow with
a panel-data VAR approach. They u a two-stage estimation procedure to obtain measures of
what they call ‘fundamental’ q and ‘financial’ q. The factors are then substituted in a structural
model of investment, which is a transformation of the Euler-equation model. Unlike Gilchrist
and Himmelberg, we do not estimate a structural model of investment, but instead study the
unrestricted reduced-form dynamics afforded by the VAR (which is in effect the first-stage in
their estimation). Gallegati and Stanca (1999) also investigate the relationship between firms’
balance sheets and investment by estimating reduced-form VARs on company panel data for UK
firms. Despite some differences in the specification of the empirical model and the estimation
methodology, the approach and the results of their paper are similar to ours. However, they do
not prent an analysis of the impul-respon functions, which we consider to be the main tool
in parating the role of financial variables in companies’ investment decisions. In addition, the
distinguishing feature of our paper is the focus on the differences in the dynamic behavior of firms
in countries with different levels of financial development.
Finally, our paper is related to Love (2003) who us the Euler-equation approach and shows
that financing constraints are more vere in countries with lower levels of financial development,
the same as we find in this paper. However, the interpretation of the results in the previous paper
is heavily dependent on the assumptions and parameterization of the model, while the approach
we u here impos the bare minimum of restrictions on parameters and temporal correlations
economy是什么意思among variables.
The rest of the paper is as follows: Section 2 prents the empirical specification and the data
description; Section 3 provides the results of our work; and Section 4 prents our conclusions.
2. Empirical methodology
We u a panel-data vector autoregression methodology. This technique combines
the tra-
ditional VAR approach, which treats all the variables in the system as endogenous, with the
panel-data approach, which allows for unobrved individual heterogeneity. We specify a first-
order VAR model as follows:
z = Γ + Γ z + f + d + e (1)
it 0 1 it −1 i c,t t
where zt is either a three-variable vector {SKB, CFKB, IKB} or a four-variable vector {SKB,
CFKB, IKB, TOBINQ}; SKB, sales to capital ratio, is our proxy for the marginal productivity of
capital,3 IKB is the investment to capital ratio, which is our main variable of interest, CFKB is
cash flow scaled by capital, and TOBINQ is ‘Tobin’s q’, measured as market value of asts over
book value of asts.
In this model sales to capital ratio and Tobin’s q reprent ‘fundamental’ factors, i.e. factors that
capture the marginal productivity of capital. In the abnce of market frictions, positive shocks to
3 See Gilchrist and Himmelberg (1998) for a derivation of the ratio of sales to capital as a measure of marginal
wto什么意思productivity of capital.
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194 I. Love, L. Zicchino / The Quarterly Review of Economics and Finance 46 (2006) 190–210
the fundamental factors should lead to an increa in investment as firms will take advantage
of better investment opportunities.
Cash flow is commonly ud in investment models as an indicator for internally available
funds (e Hubbard, 1998, for a review). In our model, we consider cash flow also as a proxy
for ‘financial factors’.4 Our analysis is implicitly bad on an investment model in which, after
controlling for the marginal profitability, the effect of the financial variables on investment is
interpreted as evidence of financing constraints.5 We do this by relying on the orthogonalization
of impul respons. Becau the shocks are orthogonalized, i.e. ‘fundamentals’ are kept constant,
the impul respon of investment to cash flow isolates the effect of the ‘financial’ factors. We u
this orthogonalized respon of investment to ‘financial factors’ as a measure of market frictions
and financing constraints.
The impul-respon functions describe the reaction of one variable to the innovations in
another variable in the system, while holding all other shocks equal to zero. However, since
the actual variance–covariance matrix of the errors is unlikely to be diagonal, to isolate shocks
to one of the variables in the system it is necessary to decompo the residuals in a such a
way that they become orthogonal. The usual convention is to adopt a particular ordering and
allocate any correlation between the residua
