Does financial liberalization reduce financing constraints?

Financial Management (Financial Management Association), Spring, 2003 by Luc Laeven

I use panel data on a large number of firms in 13 developing countries to find out whether financial liberalization relaxes financing constraints of firms. I find that liberalization affects small and large firms differently. Smallfirms are financially constrained before the start of the liberalization process, but become less so after liberalization. Financing constraints of large firms, however, are low before financial liberalization, but become higher as financial liberalization proceeds. I hypothesize that financial liberalization has adverse effects on the financing constraints of large firms, because these firms had better access to preferential directed credit during the period before financial liberalization.

In this study, I explore the impact of financial market reforms on financing constraints of firms in developing countries. Although financial reform has been one of the most profound policy reforms of many developing countries in recent years and is thought to have a large potential impact on the performance of firms and on economic welfare more generally, there is no professional consensus on the net benefits of financial liberalization.

From a theoretical perspective, financing constraints may arise if there are financial frictions. Under the Modigliani and Miller theorem (1958) (without financial frictions) a firm's capital structure is irrelevant to its value. In this case, internal and external funds are perfect substitutes and firm investment decisions are independent from its financing decisions. With financial frictions, however, the costs of internal and external finance will diverge. Financial frictions can arise from information asymmetry and from incomplete contracting. (1) Financial frictions lead to a link between net worth, the cost of external financing, and firm investment. Within the neoclassical investment model with financial frictions, an increase in net worth independent of changes in investment opportunities leads to greater investment for firms facing high financial frictions and has no effect on investment for firms facing negligible financial frictions. Firms facing high financial frictions are, thus, expected to face financing constraints. It follows that financial liberalization will reduce financing constraints if it is accompanied by a reduction in financial frictions, such as improved contract enforcement or a reduction of information costs.

Financial reforms have consisted mainly of the removal of administrative controls on interest rates and the scaling down of directed credit programs. Barriers to entry in the banking sector have often been lowered as well and the development of securities markets has been stimulated. In this paper, I focus on the effects of liberalization of banking markets.

Although the main objectives of financial deregulation should be to increase the supply and improve the allocation of funds for investment, the consequence of financial liberalization on the supply of funds for investment is theoretically ambiguous. At the macro level, the effect of financial liberalization on the level of household savings, a major part of the total funds available for investment, is unclear. McKinnon (1973) and Shaw (1973) study the effect of interest rate liberalization, a key component of financial reform, on the supply of household savings. Starting from a repressed financial system in which governments intervene by keeping interest rates artificially low and replace market with administrative allocation of funds, they argue that interest rate liberalization is likely to lead to an increase in interest rates. As higher interest rates on deposits are likely to encourage household savings, they favor interest rate liberalization. Van Wijnbergen (1983), on the other hand, argues that the existence of informal credit markets can reverse the effect of an increase in interest rates on the total amount of savings. The effect of an increase in the deposit rate on the amount of loanable funds depends on whether households substitute out of informal market loans or cash to increase their holdings of time deposits. If time deposits are closer substitutes for informal market loans than for cash, then the supply of funds to firms could fall, given that banks are subject to reserve requirements and informal markets are not. Devereux and Smith (1994) show that financial liberalization may also negatively affect the level of precautionary savings as a result of improved international risk sharing, thereby reducing the overall level of funds available for investment.

The consequence of financial liberalization on the efficiency of the allocation of funds for investment is also theoretically ambiguous. On the one hand, it is often thought that financial reforms improve the allocative efficiency of savings. McKinnon (1973) and Shaw (1973) argue that interest rate ceilings, another common feature of repressed financial systems, distort the allocation of credit and may lead to under investment in projects that are risky but have a high expected rate of return. Similarly, directed credit programs are often associated with a misallocation of funds. The liberalization of financial markets is also thought to lead to an increase in the pool of funds allocated towards risky investment projects as a result of improved risk sharing (Obstfeld, 1994). It is also often thought that financial liberalization creates efficiency gains through increased financial inter-mediation by the formal financial sector. Under the presence of economies of scale in information gathering and monitoring, banks and capital markets are expected to have an advantage over the informal market in allocating investment funds, which should lead to a reduction in the cost of capital. However, Gertler and Rose (1994) claim that financial liberalization has failed to meet these expected efficiency gains in a number of countries, because accompanying a general rise in interest rates was a rise in the cost of capital for a substantial class of borrowers. Gertler and Rose (1994) also argue that the elimination of subsidized credit programs, another common feature of financial reform, could increase the financing constraints of those firms that previously benefited from the directed credit system.