1 Has financial liberalization improved economic efficiency in

1 Has financial liberalization improved economic efficiency in Korea? : Evidence from firm-level and industry-level data August 23, 2012 Jungsoo Park (Sogang University) Yung Chul Park (Korea University)

2 This Study • Financial market deregulation and opening in Korea without adequate and efficient prudential regulatory regime have been blamed as one of the major cause contributing to the 1997 financial crisis. • They may have had an efficiency improvement effect on the economy through better resource allocation and better investment screening, as noted in the literature on financial development and growth. • This study attempts to gauge this positive link between financial liberalization and growth based on firm-level and industry-level panel data in Korea since 1991. • More specifically, we investigate whether the financial liberalization had influence on the allocation behavior of the bank and non-bank financial intermediaries’(NBFI) loans and whether they have led to the improvement of the total factor productivity.

3 Literature: background papers • Financial liberalization would bring about the development of the financial sector and promotion of the growth in the real economy. ▫ Schumpeter (1911): financial intermediaries promote growth by selecting innovative and productive projects. ▫ Mc. Kinnon (1973) and Shaw (1973): The government regulations on operation of the financial services – financial repression – would stagnate the financial development and ultimately the economic growth • Financial intermediation may also promote growth and efficiency of the economy ▫ through better information processing and investment screening (Greenwood and Jovanovic, 1990) ▫ or through better resource allocation (Bencivenga and Smith, 1991).

4 Literature : cross-country evidence • Financial development has positive effect on economic growth. ▫ King and Levine (QJE 1993) �cross-country regressions �Differences in long-run economic growth across countries can be explained by differences in financial development ▫ Levine, Loayza, and Beck (JME 2000) �country-level panel regression analysis �Better-developed banks and markets are associated with faster growth ▫ Benhabib and Spiegel (2000) ▫ Aghion, Howitt and Mayer-Foulkes (QJE 2005): increases the rate of convergence

5 Literature : cross-country evidence • Importance of financial intermediation on promoting sources of growth. ▫ Beck, Levine, and Loayza (JFE 2000) � More-efficient resource allocation and productivity growth rather than through scale of invetment or savings mobilization ▫ Bekaert, Harvey, and Lundblad (JFE 2005) � Financial liberalization improves allocation of resources and the investment rate ▫ Levine and Zervos (AER 1998) • State ownership of banks and credit interventions lead to resource misallocation (negative impact on future productivity growth) ▫ La Porta, Lopez-de-Silanes, and Shleifer (JF 2002): political “public choice” view opposed to “development view • Financial development does not necessarily promote economic growth. ▫ Favara (2003) uses cross-country panel data of King and Levine (QJE 1993). • Identification issues ▫ Measurement errors, omitted variables problem, endogeneity problem ▫ IV, dynamic panel regressions

6 Literature : cross-country, industrylevel/firm-level evidence • A wider access to external finance tends to encourage long-run growth performance of firms. ▫ Demirguc-Kunt and Maksimovic (JF 1998): Firm-level data: 8500 large firms from 30 countries, use financial planning model ▫ Firms grew faster with country’s financial development and stronger legal enforcement • Industries differ on the degree of financial dependency on external financing ▫ Rajan and Zingales (AER 1998): cross-country cross-industry panel regressions, dynamic panel (36 sectors of 41 countries). ▫ Naturally heavy user of external finance (financial intensity) benefit disproportionately more from greater financial development • Growth opportunities rather than technological external finance dependency explains the growth of industries better ▫ Fisman and Love (2003, 2004)

7 Literature : cross-country, industrylevel/firm-level evidence • Firm size matters ▫ Beck, Laeven, and Levine (JME 2006): �Financial development promotes growth of smaller firms. �Industries naturally composed of small firms grow faster in financially developed countries ▫ Beck, Demirguc-Kunt, and Maksimovic (JF 2005); �Firm-survey data, firm-level study �Financial development eases obstacles that firms face to growing faster, especially for smaller firms.

8 Literature : individual country evidence • Italy ▫ Guiso, Sapienza, and Zingales (NBER 2002): �Local financial development enhances the chance of individual starting a business, increase industrial competition, and promotes growth of firms (stronger for small firms, since they have little access outside) • US ▫ Jayaratne and Stahan (QJE 1996) �Impact of bank branch reform (relaxing intrastate branching) in individual states on economic growth �bank lending quality and real per capita growth increased. �DID

9 Literature : Korean experience • Aggregate level ▫ Kim (2003) considers five facets of financial liberalization – the changes in regulations and government policy on interest rate liberalization, exchange rate liberalization, legal reserve requirement, capital account liberalization, and bank privatization. ▫ Financial liberalization in Korea has had a significantly positive impact on economic growth • Industry level ▫ Shin and Oh (2005) uses 30 to 34 Korean industry-level panel data from 1981 to 2001 to investigate how the external finance dependency and the growth opportunities have contributed to the growth in Korean industries. ▫ Their results imply that the industrial development in Korea was influenced by both external finance dependency and the growth opportunities in the 1980 s, while the growth opportunities was the main factor contributing to industrial growth in the 1990 s.

10 Literature : Korean experience • Firm level : Ahn et. al (2008) ▫ Uses Korean firm-level data from 1991 to 2003 to see if there was a differential effect of external financing on capital accumulation, R&D, and TFP growth before and after the financial crisis of 1997. ▫ Separate regressions on subsamples of 1991 – 1996 and of 1999 – 2003 were performed ▫ The external finance is associated with a faster capital accumulation but the effect softens after the crisis. ▫ The external finance effect on total factor productivity growth was found to be relatively weak both before and after the crisis.

11 This study • Construct financial liberalization index ▫ Use principal component analysis • Use the indices to gauge ▫ the extent to which financial liberalization influenced the lending behavior of the banking sector ▫ and the extent to which it helped productivity growth in the real sector

12 This study • Approach ▫ Develops financial liberalization index �based on 6 different measures ▫ Studies impact of loan financing on TFP growth at firm & industry levels • Data and empirical methods ▫ Two independent data set of firms and industries: 33000 firms and 23 industries ▫ Subsamples: KRX-listed firms vs. non-KRX listed firms ▫ Firm-fixed, industry-fixed effects model

13 Financial Liberalization Measures • A 1~ A 4 reflect diverse aspects of financial reforms. ▫ Four indices from IMF financial reform database (entrybarriers, bankingsuperv, intlcapital, and securitymarkets). Refer to Abiad et al (2008). • A 5: four phases of interest rate liberalization process • A 6: measures the volatility of the rate of change in the exchange rate.

14 Financial Reform Indices: Abiad et al (2008) • Entry barrier (A 1) • International capital flow (A 3) Banking supervision (A 2) Security markets (A 4)

15 Other indices • Interest reform index (A 5) (Stages of interest rate liberalization) Exchange rate volatility index (A 6) (s. d. of rate of change of nominal effective exchange rate)

16 Financial Liberalization Index: PCA • Financial liberalization index (derived from principal component analysis) • Note) Entry barrier, banking supervision, international capital flow, security markets, interest reform index are all measured on the scale of 0 to 3, 3 being the highest degree of liberalization. Exchange rate volatility index is normalized using the sample mean and sample standard deviation as described in the Section 3

17 Structural Change in the Financing Method • Throughout the period of financial liberalization from 1990 to 2007, financing methods of firms went through a dramatic change. ▫ Business firms become more and more dependent on direct financing (bond and equity) while gradually relying less and less on bank financing

18 Figure 2 - 5. Structural change in the financing method: Ratio of Direct Financing to Total Financing in Korea (1990 – 2007) Note: The index is the ratio of direct financing (bond and equity) to total financing Source: Flow of Funds Tables , Bank of Korea

19 3. Main Empirical Questions • Q 1: Due to the financial liberalization, has the bank rationalized its financial operation, especially in lending practices? ▫ Have banks allocated credits on the basis of firm’s (industry’s) fundamental characteristics, such as ROA (value-added growth) history, more than before? • Q 2: Due to financial liberalization, has the bank financing become more effective in choosing potential winners and in enhancing the borrowing firm’s (industry’s) productivity? • Q 3: Has the structural change in financing methods (from indirect to direct financing) in the financial liberalization process helped improving firm’s (industry’s) productivity? • => Firm-level and industry-level analysis

20 Empirical models and econometric methods: Firm-level analysis • Empirical models • Econometric method ▫ Firm, industry fixed-effects panel estimation method

21 Data description: Firm-level • KIS-VALUE database ▫ provided by NICE Information Service provides comprehensive financial data of listed and audited firms in Korea. ▫ This work uses 33162 annual observations of 6233 non -financial firms in the KIS-VALUE DB (listed and audited firms), spanning the period of 1990 to 2005. • Exclude extreme value observations ▫ TFP growth rate over 0. 5 or less than -0. 5 ▫ Percentage change in loans in excess of 100% or less than -100%, ▫ External financing to sales ratio greater than 1, ▫ R&D ratio greater than 1

22 TFP growth estimates (Baek et al. 2009) • Good, Nadiri, and Sickles (1999) ▫ Firm-level total factor productivity (TFP) was estimated by the chained-multilateral index number approach. ▫ ▫ This approach uses a separate reference point for each cross -section of observations and then chain-links the reference points together over time, as in the Tornqvist-Theil index. ▫ The output, inputs, and productivity level of each firm in each year is measured relative to the hypothetical representative firm at the base-time period. ▫ This approach allows us to make transitive comparisons of productivity levels among observations in a panel dataset.

23 TFP estimates (Baek et al. 2009) • Good, Nadiri, and Sickles (1999)

24 Data description: Firm-level Table A 1. Summary statistics and definition of variables : firm-level data Variable dln(tfp) Description Growth rate of TFP Growth rate of dlnloans external financing ROA Return over asset Financial finlib liberalization index rnd_sales Ratio of R&D to sales lnassets log of total assets ratio of liability to liab_eq equity share of direct shdirect financing Obs 32881 Mean 0. 004 Std. 0. 104 Min -0. 497 Max 0. 497 32881 0. 053 0. 358 -1. 000 32873 0. 065 0. 077 -0. 653 0. 971 32881 0. 792 0. 268 0. 323 0. 991 32881 0. 01 24. 10 0. 06 1. 36 -0. 04 19. 54 4. 24 31. 80 32771 6. 53 262. 02 -1547. 40 39200. 84 32881 0. 29 0. 31 0. 00 1. 00 Note) All variables except for finlib are firm-level annual frequency data. finlib is year-specific variable.

Figure A 2. Distribution of firms in terms of sales (1991 – 2005) 25 Figure A 2. Distribution of firms in terms of sales (1991 – 2005) KRX-listed firm sub-sample Non-KRX firm sub-sample (SME)

26 Data description: Industry-level Table A 1. Summary statistics and definition of variables : industry-level data Variable dln(tfpi) dlnloansi dlnvai finlib rnd_vai Description Growth rate of TFP Growth rate of external financing Growth rate of valueadded Financial liberalization index Ratio of R&D to valueadded Obs Mean Std. Min Max 218 0. 007 0. 034 -0. 126 0. 198 218 0. 055 0. 138 -0. 393 0. 456 218 0. 067 0. 101 -0. 409 0. 421 218 0. 889 0. 184 0. 349 1. 000 218 0. 035 0. 039 0. 000 0. 182 Note) All variables except for finlib are industry-level annual frequency data. finlib is year-specific variable

27 Firm-level analysis • Q 1: Due to the financial liberalization, has the bank rationalized its financial operation, especially in lending practices?

Table 5 -1. Determinants of bank and NBFI financing: firm-level regressions for full sample (dependent variable = dln(loans)) VARIABLES roa (1) (2) (3) (4) 0. 371*** (10. 297) 0. 378*** (10. 489) 0. 168*** (6. 236) 0. 372*** (10. 264) 0. 167*** (6. 210) 0. 225* (1. 798) -0. 066 (-0. 991) -0. 093*** (-16. 395) 0. 000 (0. 743) -0. 145*** (-10. 031) 0. 365*** (10. 092) finlib roa*finlib rnd_sales lnassets liab_eq dum_after 97 -0. 076 (-1. 138) -0. 080*** (-15. 066) 0. 000 (0. 788) -0. 066*** (-10. 168) -0. 071 (-1. 054) -0. 092*** (-16. 296) 0. 000 (0. 718) -0. 147*** (-10. 143) Firm fixed effects Yes Year fixed effects No No Observations 33162 R-squared 0. 039 0. 040 Number of firms 6233 Firm fixed effects Yes t-statistics in parentheses, *** p<0. 01, ** p<0. 05, * p<0. 1 Yes No 33162 0. 040 6233 Yes 0. 272** (2. 171) -0. 070 (-1. 048) -0. 089*** (-14. 665) 0. 000 (0. 774) Yes 33162 0. 045 6233 Yes 28

29 Table 5 -2. Determinants of bank and NBFI financing: firm-level regressions for KRX-listed firm sample (dependent variable = dln(loans)) VARIABLES roa (1) (2) (3) (4) 0. 211** (2. 032) 0. 220** (2. 114) 0. 097* (1. 746) 0. 185* (1. 744) 0. 000 (0. 000) -0. 048*** (-3. 778) 0. 000 (0. 589) -0. 120*** (-8. 108) 0. 039 (0. 084) -0. 058*** (-4. 163) 0. 000 (0. 610) -0. 165*** (-5. 552) 0. 209** (1. 961) 0. 097* (1. 738) 0. 149 (0. 473) 0. 036 (0. 079) -0. 059*** (-4. 182) 0. 000 (0. 606) -0. 164*** (-5. 488) Yes No 5187 0. 059 555 Yes No 5187 0. 060 555 finlib roa*finlib rnd_sales lnassets liab_eq dum_after 97 Firm fixed effects Year fixed effects Observations R-squared Number of firms t-statistics in parentheses, *** p<0. 01, ** p<0. 05, * p<0. 169 (0. 540) -0. 023 (-0. 050) -0. 037** (-2. 536) 0. 000 (0. 743) Yes 5187 0. 077 555

30 Table 5 -3. Determinants of bank and NBFI financing: firm-level regressions for firms not listed in KRX (dependent variable = dln(loans)) VARIABLES roa (1) (2) (3) (4) 0. 391*** (10. 166) 0. 398*** (10. 342) 0. 185*** (6. 004) 0. 390*** (10. 101) -0. 077 (-1. 134) -0. 086*** (-14. 734) 0. 000 (0. 680) -0. 053*** (-7. 338) -0. 072 (-1. 062) -0. 098*** (-15. 891) 0. 000 (0. 597) -0. 143*** (-8. 621) 0. 393*** (10. 173) 0. 185*** (5. 983) 0. 241* (1. 764) -0. 067 (-0. 991) -0. 099*** (-15. 985) 0. 000 (0. 625) -0. 141*** (-8. 531) Yes No 27975 0. 035 5678 Yes No 27975 0. 037 5678 finlib roa*finlib rnd_sales lnassets liab_eq dum_after 97 Firm fixed effects Year fixed effects Observations R-squared Number of firms t-statistics in parentheses, *** p<0. 01, ** p<0. 05, * p<0. 1 0. 296** (2. 154) -0. 072 (-1. 066) -0. 101*** (-14. 940) 0. 000 (0. 629) Yes 27975 0. 041 5678

31 Firm-level analysis • Q 2: Due to financial liberalization, has the bank financing become more effective in choosing potential winners and in enhancing the borrowing firm’s productivity? • Q 3 Has the structural change in financing methods (from indirect to direct financing) in the financial liberalization process helped improving firm’s (industry’s) productivity?

Table 5 -4. The Effect of Bank and NBFI Financing on TFP Growth: firm 32 -level regressions for full sample (dependent variable = dln(TFP)) VARIABLES dlnloans (1) (2) (3) (4) (5) (6) 0. 008*** (4. 431) 0. 008*** (4. 610) 0. 034*** (4. 112) 0. 008*** (4. 461) 0. 008*** (4. 479) 0. 008*** (4. 489) 0. 012* (1. 816) 0. 157*** (7. 748) -0. 014*** (-7. 760) 0. 012* 0. 013* (1. 822) (1. 881) 0. 157*** (7. 737) (7. 725) -0. 015*** (-7. 708) (-7. 718) 0. 002 (0. 492) (0. 514) 0. 007 (0. 655) 0. 152*** (7. 474) -0. 015*** (-9. 204) 0. 153*** (7. 521) -0. 017*** (-10. 059) 0. 008*** (4. 594) 0. 033*** (4. 017) 0. 013* (1. 847) 0. 152*** (7. 507) -0. 017*** (-10. 120) 0. 013*** (6. 287) -0. 003 (-0. 786) -0. 003 (-0. 684) Yes No 33163 0. 006 6233 finlib dlnloans*finlib rnd_sales lnassets shdirect*finlib dum_after 97 Firm fixed effects Year fixed effects Observations R-squared Number of firms Yes 33163 0. 010 6233 Yes Yes 33163 0. 010 6233

33 Table 5 -5. The Effect of Bank and NBFI Financing on TFP Growth: firm-level regressions for KRX-listed firm sample (dependent variable = dln(TFP)) VARIABLES dlnloans (1) (2) (3) (4) (5) (6) 0. 005 (1. 617) 0. 005* (1. 692) 0. 016 (1. 320) 0. 008** (2. 459) 0. 008** (2. 299) 0. 008** (2. 301) -0. 011 (-0. 977) 0. 108 (1. 083) -0. 007** (-2. 239) -0. 011 (-0. 982) 0. 109 (1. 094) -0. 007** (-2. 099) -0. 002 (-0. 298) -0. 009 (-0. 762) 0. 104 (1. 036) -0. 007** (-2. 079) -0. 002 (-0. 318) 0. 021 (1. 065) Yes Yes 5187 0. 028 555 Yes 5187 0. 029 555 0. 060 (0. 590) -0. 004 (-1. 414) 0. 065 (0. 646) -0. 006* (-1. 832) 0. 006* (1. 749) 0. 017 (1. 369) -0. 008 (-0. 711) 0. 065 (0. 645) -0. 006* (-1. 802) 0. 005 (1. 566) -0. 002 (-0. 345) -0. 003 (-0. 414) Yes No 5187 0. 001 555 Yes No 5187 0. 002 555 finlib dlnloans*finlib rnd_sales lnassets shdirect*finlib dum_after 97 Firm fixed effects Year fixed effects Observations R-squared Number of firms

34 Table 5 -6. The Effect of Bank and NBFI Financing on TFP Growth: firm-level regressions for firms not listed in KRX (dependent variable = dln(TFP)) VARIABLES dlnloans (1) (2) (3) (4) (5) (6) 0. 009*** (4. 192) 0. 009*** (4. 335) 0. 037*** (3. 718) 0. 009*** (4. 147) 0. 009*** (4. 199) 0. 009*** (4. 200) 0. 018** (2. 257) 0. 157*** (7. 318) -0. 017*** (-7. 818) 0. 018** 0. 019** (2. 268) (2. 277) 0. 157*** (7. 305) (7. 302) -0. 017*** (-7. 804) (-7. 805) 0. 003 (0. 655) (0. 661) 0. 003 (0. 198) 0. 153*** (7. 136) -0. 017*** (-9. 222) 0. 154*** (7. 174) -0. 020*** (-9. 932) 0. 009*** (4. 339) 0. 036*** (3. 624) 0. 017** (2. 151) 0. 154*** (7. 157) -0. 020*** (-10. 00) 0. 014*** (5. 925) -0. 004 (-0. 683) -0. 003 (-0. 587) Yes No 27976 0. 006 5678 Yes No 27976 0. 007 5678 finlib dlnloans*finlib rnd_sales lnassets shdirect*finlib dum_after 97 Firm fixed effects Year fixed effects Observations R-squared Number of firms Yes 27976 0. 010 5678 Yes Yes 27976 0. 010 5678

35 Industry-level analysis

36 Table 5 -7. Determinants of Bank and NBFI Financing: industry-level regressions (dependent variable = dln(loansi)) dlnvai (1) (2) (3) (4) -0. 018 (-0. 212) -0. 020 (-0. 234) 0. 139 (0. 794) 0. 117 (1. 593) 0. 122 (0. 217) -0. 177** (-2. 265) -0. 015 (-0. 166) 0. 138 (0. 785) 0. 203 (0. 469) 0. 133 (0. 236) -0. 180** (-2. 290) Yes No 218 0. 140 22 Yes No 218 0. 141 22 finlib dlnvai*finlib rnd_vai dum_after 97 0. 115 (0. 205) -0. 118*** (-5. 214) Industry fixed effects Year fixed effects No Observations 218 R-squared 0. 137 Number of industries 22 t-statistics in parentheses *** p<0. 01, ** p<0. 05, * p<0. 1 0. 459 (1. 296) -0. 158 (-0. 342) Yes No 218 0. 467 22

37 Table 5 -8. The effect of bank and NBFI financing on TFP growth: industrylevel regressions (dependent variable = dln(tfpi)) dlnloansi (1) (2) (3) (4) 0. 008 (0. 394) 0. 007 (0. 329) 0. 028 (0. 643) -0. 004 (-0. 176) 0. 070 (0. 496) -0. 020 (-0. 985) 0. 005 (0. 252) 0. 024 (0. 537) 0. 042 (0. 338) 0. 067 (0. 475) -0. 020 (-0. 984) Yes No 218 0. 018 22 Yes No 218 0. 019 22 Yes 218 0. 111 22 finlib dlnloansi*finlib rnd_vai dum_after 97 0. 068 (0. 482) -0. 007 (-1. 234) Industry fixed effects Year fixed effects No Observations 218 R-squared 0. 016 Number of industries 22 t-statistics in parentheses *** p<0. 01, ** p<0. 05, * p<0. 155 (1. 211) 0. 039 (0. 279)

38 Conclusion and Implications • This study uses panel regression on firm-level and industry-level data in Korea from 1991 – 2007 to see the impact of financial liberalization on bank and non-bank financial institution(NBFI)’s lending, before and after the 1997 crisis. • Financial liberalization index is developed incorporating multi-faceted nature of the liberalization process.

39 Conclusion and Implications • The main findings are as follow. • First, firm-level analyses reveal that the financial liberalization had influenced the allocation of the bank and NBFI’s loans for relatively smaller firms but not for the large listed firms. As for the smaller firms, the loans are allocated to firms with better ROA history. • Secondly, the financial liberalization had influenced the allocation of loans eventually leading to the improvement of the TFP growth of the smaller firms but not for the large firms. • Thirdly, the heavier reliance on the direct financing during the financial liberalization process does not seem to have influenced the firm’s efficiency.

40 Conclusion and Implications • Fourth, industry-level analyses reveal that the financial liberalization has not influenced the loan behavior of banks and NBFIs to consider more of the past performance of industries when making loans. • Finally, the financial liberalization had not influenced the allocation of loans leading to the improvement of the TFP growth of the industries • The last two findings on industry-level data may be due to the fact that the presence of financial liberalization effect on the smaller firms are dominated by the insignificance of the impact on the larger firms within each industry. •

41 Thank you !