What Explains the Link between Finance and Development?

Large income differences exist between the richest and poorest countries. While access to financial markets seems to be associated with economic development, the reasons why are not clearly understood, as noted in a recent Regional Economist article.

To that end, Economist Fernando Leibovici and Research Associate Matthew Famiglietti analyzed cross-country data to shed light on the link between economic development and access to financial markets. In particular, they examined the extent to which differences in financial market development might account for differences in income per capita across countries.For their analysis, the authors used firm-level data from the World Bank Enterprise Surveys. The data were based on surveys conducted over the period 2006-14 and spanned 141 countries. The authors focused on manufacturing firms. For their measure of a country’s economic development, they used GDP per capita.

Access to Finance

The authors first looked at the relationship between economic development and firms’ access to financial markets. They found that countries with higher real gross domestic product (GDP) per capita had higher shares of firms that relied on external finance through a financial institution.

“These findings suggest that firms in poorer economies are likely to find the lack of access to finance as a hindrance for their operations and growth,” they wrote.

Long-Term Investments

One way that financial markets might play an important role is the financing of long-term investments, such as buildings, machinery, and research and development, the authors noted.

To investigate this channel, they examined the relationship between real GDP per capita and the share of internally financed fixed assets. Sources of internal finance include firms’ retained earnings and accumulated cash holdings.

Leibovici and Famiglietti found that countries with higher shares of internally financed fixed assets tended to have lower real GDP per capita. This suggests that differences in access to finance are likely to affect economic development by distorting firms’ long-term investments, they noted.

“This is intuitive, as fixed assets generally consist of large-scale investment projects that have very high fixed costs, such as structures,” they explained. “In countries with better access to financial markets, one would expect firms to take advantage of credit for these types of investments.”

Differences in Firm Size

The authors went on to look at the relationship between average firm size (in terms of the number of employees) and access to credit. They posited that countries with better financial markets should have relatively larger firms.

They found that the share of firms that reported difficulty accessing finance was statistically significant in explaining differences in firm size across countries. A 10 percentage point increase in the share of firms reporting access to finance to be a problem was associated with almost a five-worker decline in the average firm size across countries, they noted.

Conclusion

“The findings documented in this article suggest that differences in financial market development are systematically associated with disparities in economic development,” Leibovici and Famiglietti wrote.

Regarding the underlying nature of this relationship, they noted, “we documented that distortions to long-term investments are a more likely channel through which financial underdevelopment may feed into economic underdevelopment.”

They added, “Moreover, we found evidence consistent with this possibility, as differences in the degree to which firms report difficulties accessing finance are strongly correlated to differences in firm size.”

Notes and References

¹ For their analysis, the authors used firm-level data from the World Bank Enterprise Surveys. The data were based on surveys conducted over the period 2006-14 and spanned 141 countries. The authors focused on manufacturing firms. For their measure of a country’s economic development, they used GDP per capita.

Additional Resources

• Regional Economist: Finance and Development: Evidence from Firm-Level Data
• On the Economy: Why Intellectual Property Rights Protection Matters for Economic Growth
• Timely Topics podcast: The Role of Trade in Cross-Country Income Differences