93Financial markets and the allocation of capital

JournalofFinancialEconomics58(2000)187}214FinancialmarketsandtheallocationofcapitalqJe!reyWurgler*YaleSchoolofManagement,Box208200,NewHaven,CT06520-8200,USAReceived11June1999;receivedinrevisedform30September1999AbstractFinancialmarketsappeartoimprovetheallocationofcapital.Across65countries,thosewithdevelopednancialsectorsincreaseinvestmentmoreintheirgrowingindus-tries,anddecreaseinvestmentmoreintheirdecliningindustries,thanthosewithundevel-opednancialsectors.Thee$ciencyofcapitalallocationisnegativelycorrelatedwiththeextentofstateownershipintheeconomy,positivelycorrelatedwiththeamountofrm-specicinformationindomesticstockreturns,andpositivelycorrelatedwiththelegalprotectionofminorityinvestors.Inparticular,strongminorityinvestorrightsappeartocurboverinvestmentindecliningindustries.(2000ElsevierScienceS.A.Allrightsreserved.JELclassixcation:G15;G31;D92Keywords:Capitalallocation;Investment;Economicgrowth;StateownershipqIwouldliketothankAlexandreAganine,AndrewBernard,MarianneBertrand,RichardCaves,ChristopherFoote,PeterHenry,DirkJenter,G.AndrewKarolyi,VassilKonstantinov,RafaelLaPorta,RossLevine,EllenMeara,MiguelMessmacher,MichaelMilken,SerkanSavasoglu,DavidScharfstein,ReneHStulz,JakeVigdor,KatiaZhuravskaya,ananonymousreferee,seminarpartici-pantsatBostonUniversity,HarvardUniversity,LondonBusinessSchool,theNationalBureauofEconomicResearch,StanfordUniversity,TheOhioStateUniversity,theUniversityofChicago,theUniversityofNorthCarolinaatChapelHill,andYaleUniversity,andespeciallyMalcolmBaker,JohnCampbell,PaulGompers,andAndreiShleiferforhelpfulcomments.ThisstudyhasbeensupportedbytheDivisionofResearchoftheHarvardGraduateSchoolofBusinessAdministrationandbyaprizefromtheMilkenInstitute.*Tel.:#[phone];fax:#[phone].E-mailaddress:je.0304-405X/00/$-seefrontmatter(2000ElsevierScienceS.A.Allrightsreserved.PII:S0304-405X(00)00070-2Politicaleconomistssaythatcapitalsetstowardsthemostprotabletrades,andthatitrapidlyleavesthelessprotablenon-payingtrades.Butinordinarycountriesthisisaslowprocess.2InEngland,however,2capitalrunsassurelyandinstantlywhereitismostwanted,andwherethereismosttobemadeofit,aswaterrunstonditslevel.Bagehot(1873),asquotedbyLevine(1997,p.695)1.IntroductionAfundamentaljoboftheeconomyistoallocatecapitale$ciently.Toachievethis,capitalissupposedtobeinvestedinthesectorsthatareexpectedtohavehighreturnsandbewithdrawnfromsectorswithpoorprospects.Foralongtimeandformanyreasons,economistshavesuspectedthatformalnancialmarketsandassociatedinstitutionsimprovethecapitalallocationprocessandthuscontributetoeconomicgrowth.Onepopulartheoryisthate$cientsecondarymarketpriceshelpinvestorsdistinguishgoodinvestmentsfrombadonesthroughamechanismlikeTobin'sQ.Anotheristhatlendersandintermediariesscreenoutbadprojects(Bagehot,1873;Schumpeter,1912;Dia-mond,1984;BoydandPrescott,1986).Agencytheoriesarguethatpressuresfromexternalinvestors,aswellasmanagerialownership,encouragemanagerstopursuevalue-maximizinginvestmentpolicies(Jensen,1986);inturn,e!ectivelawsagainstmisuseofminorityinvestors'fundsdeterminethesupplyofnancetogoodprojects(LaPortaetal.,1997).Despitethisbodyoftheory,thereislittledirectevidenceonwhetherandhownancialmarketsimprovetheallocationofcapital.Thispapertakesasteptowardllingthegap.Thebasicdatasetisa65-country,28-industry,33-yearpanelofgrosscapitalformation(investment)andvalueadded(salesminuscostofintermediategoods).Themainndingisthatdevelopednancialmarkets,asmeasuredbythesizeofthedomesticstockandcreditmarketsrelativetoGDP,areassociatedwithabetterallocationofcapital.Financiallydevelopedcoun-triesincreaseinvestmentmoreintheirgrowingindustriesanddecreaseinvest-mentmoreintheirdecliningindustries.Thus,althoughnanciallydevelopedcountriesmightnotinvestatahigherlevel(CarlinandMayer,1998;Becketal.,2000),theydoseemtoallocatetheirinvestmentbetter.Forexample,theelasticityofindustryinvestmenttovalueaddedisseveraltimeshigherinGermany,Japan,theUnitedKingdom,andtheU.S.thaninnanciallyundevelopedcountriessuchasBangladesh,India,Panama,andTurkey.Relativetocountrieswithlargenancialmarkets,othercountriesbothoverinvestintheirdecliningindustriesandunderinvestintheirgrowingindustries.SincevalueaddedgrowthisreliablypositivelycorrelatedwithTobin'sQ(which,unfortunately,cannotbeconstructedforawiderangeof188J.Wurgler/JournalofFinancialEconomics58(2000)187}214countriesandindustries),thisresultsuggeststhatnancialdevelopmenthelpsacountrytakebetteradvantageofitsinvestmentopportunities.Thus,nancialmarketsandinstitutionsdomorethanjustprovideasideshowtotherealeconomy;theyperformafundamentalallocativefunction.Andalthoughnan-cialmarketvariablesarenotabletoexplainallofthecross-countryvariationinthequalityofcapitalallocation,theyareabletoexplainasubstantialpropor-tion.Indevidencethatcapitalallocationisimprovedthroughatleastthreemechanisms.First,countrieswithstockmarketsthatimpoundmorerm-specicinformationintoindividualstockprices}thosethathavelessstockprice`synchronicityaasmeasuredbyMorcketal.(2000)}exhibitabetterallocationofcapital.Thi