Empirical essays in finance, growth and institution

EMPIRICAL ESSAYS IN FINANCE, GROWTH AND INSTITUTION MANOJ RAJ M. A., ECONOMICS A THESIS SUBMITTED FOR THE DEGREE OF DOCTOR OF PHILOSOPHY DEPARTMENT OF ECONOMICS NATIONAL UNIVERSITY OF SINGAPORE 2006 Acknowledgement With heartfelt gratitude I acknowledge the contribution of the Thesis Committee and coauthors, Dr Y E Riyanto (Chair), Prof Takeshi Yamada, Dr Cheolbeom Park and Dr Jung Hur towards the completion of the thesis. I take this opportunity to thank Prof Pami Dua and Prof Partha Sen from Delhi School of Economics for their encouragement in pursuing a doctoral programme and aiding me in the process. I am also greatful to Thorsten Back, Matias Braun, Raghuram Rajan and Luigi Zingales for the use of their data. I also humbly wish to thank Emily, Luckraz and Julian for their warmth and guidance. Finally I express my gratitude and affection for Sadguru and Sadguruma whose blessings alone has made me reach this far. Table of Content Page Acknowledgements Table of Contents Summary 5-6 List of Tables List of Figures CHAPTER ONE: INTRODUCTION 9-13 CHAPTER TWO: TRADE AND FINANCIAL DEVELOPMENT: ROLE OF STRUCTURE 14-42 2.1 Introduction 15 2.2 Related Literature and Hypothesis 17 2.3 Methodology and Data 20 2.4 Empirical Results 28 2.5 Conclusions 34 CHAPTER THREE: FINANCIAL DEPENDENCE AND GROWTH: FOR THE RICH OR THE POOR? 43-53 3.1 Introduction 44 3.1 Background Literature 45 3.2 Results 47 3.3 Conclusion 50 CHAPTER FOUR: GOVERNMENT AND BUSINESS NEXUS: EVIDENCE FROM JAPAN 54-80 4.1 Introduction 55 4.2 Background literature 58 4.2 Hypotheses 62 4.3 Methodology and Data Description 66 4.4 Empirical Results 69 4.5 Conclusion 74 CHAPTER FIVE: MANAGEMENT QUALITY, HERD BEHAVIOR AND UNDERPRICING OF INITIAL PUBLIC OFFERING: EVIDENCE FROM SINGAPORE STOCK EXCHANGE 81-105 5.1 INTRODUCTION 82 5.2 Data 87 5.3 Hypothesis 92 5.4 Empirical Tests and Results 96 5.5 Conclusions 101 CHAPTER SIX: CONCLUSION 106-108 BIBLIOGRAPHY 109-121 APPENDIX A: NEW LISTING PROCEDURES IN SINGAPORE 122-123 Summary The thesis seeks to study issues that have caught attention of the researchers in the recent years. Finance and growth hypothesis over the last decade has received tremendous interests. The improved empirical methodology and availability of more informative data has duly contributed. The first essay studies the influence of financial development on trade composition. It also investigates how institutional measures can also influence the trade composition. The traditional trade theories abstracts from frictions in financial market. However, credit constraints can influence the investment decisions. In countries with less developed financial sector the collateral value of the invested assets becomes critical since financier insists to guard against the default. Aggregation of such influence of financial development on investment decisions could potentially influence the trade pattern. Using the data on asset tangibility in 27 industries across 42 countries we find that countries with higher financial development have comparative advantage in products of intangible asset intensive industry. On the other hand countries with less developed financial sector have comparative advantage in products of more tangible industries. The second essay is a comment on the influential paper --Rajan and Zingales (1998). The paper using an innovative methodology finds that industries more dependent on external finance grows faster in countries with more developed financial sector. But the countries chosen varied widely in terms of economic development, institutional measures etc. In this essay we generate different samples for the developed and the underdeveloped countries and re-estimate the model followed in Rajan and Zingales (1998). We find that indeed the growth of the industries of the less developed countries depends on the development of the financial sector. However, same conclusion does not apply for the rich countries. Such a finding raises questions that are important to investigate to have richer insights on the finance and growth relationship. The third essay is another step in the renewed interest in the institutional aspects of the countries. The renewed interest is owed to the recent emphasis on the micro level empirical investigation to support the rich theoretical literature on corruption and other institutional aspects. In the third essay we examine the practice of Amakudari—the practice to employ retired bureaucrats in the Japanese boards. We seek to investigate whether sustenance of such practice over the last seven decades could potentially be influenced by economic incentives that encourage rent seeking activities. We find that. firms directly entering into economic transaction with the government, whether as debtor or supplier to government agencies, are more likely to recruit the retired bureaucrats. The results though not conclusive does suggests the existence of rent seeking activities. The final essay tries to analyse the underpricing of the new issues in Singapore from the herd behaviour framework. To examine the relation between herd behaviour of the investors and the underpricing of new issues we look at the management reputation of the firm. We conjecture that informed investors base their decisions on the management reputation of the firms and that imitation of the less informed investors leads to the over pricing of the issue when initially listed. Using the IPO data from the Singapore Stock Exchange for the last there and half years we find that underpricing is increasing in management quality. However, the abnormal short run returns gets rationalized in the long run return. Proxying one year return as the long run return we find that long run returns are negatively related to the management quality. This evidence supports our hypothesis. List of Tables Page Table 2.1: Effect of FINANCIAL Development and Asset Tangibility on Trade Balance 38 Table 2.2: Effect of Financial Development and Asset Tangibility on Export Share 39 Table 2.3: Robustness and Further Tests 40 Table 2.4: Countries and Industries 41 Table 2.5: Correlation and Summary Statistics – Dependent Variables 42 Table 2.6: Correlation and Summary Statistics – Financial System Indicators 42 Table 3.1: The Effect of Financial Development on Industry Growth 51 Table 3.2: The Effect of Financial Development on Growth of Industries; Estimation Based on Different Group of Countries Based on Their GDP Level 52 Table 3.3: Robust Regression: The Effect of Financial Development on Growth of Industries; Estimation Based on Different Group of Countries Based on Their GDP Level 52 Table 4.1: Summary Statistics 76 Table 4.2: Probit regression estimates (Dependent Variable: Amakudari) Year: 1995 77 Table 4.5: Probit regression estimates (Dependent Variable: Amakudari: Construction Industry Dropped) Year: 1995 78 Table 4.4: Probit regression estimates (Dependent Variable: Amakudai) Year: 1991 79 Table 4.5: Probit regression estimates (Dependent Variable: Amakudari: Construction Industry Dropped) Year: 1991 80 Table 5.1: Descriptive Analysis of sample 102 Table 5.2: The effect of Management Quality on Underpricing 103 Table 5.3: The effect of Management Quality on Long Run Return 104 Table 5.3: Correlation and Descriptive Analysis (Management Quality) 105 List of Figures Page Figure 1: Histogram of the growth in value added of the industries in Developing Countries 53 Figure 2: Histogram of the growth in value added of the industries in Developed Countries 53 1. Introduction The present thesis consists of four empirical essays those studies current economic issues drawn from different streams of literature. The first and the second essays draw from the ‘Finance and Growth’ debate. It is widely documented that two schools of thought argue the relevance of finance. Nobel Prize winner Merton Miller (1998) once remarked that “financial markets contributes to the economic growth is a proposition almost too obvious for serious discussion”. On the other hand Nobel Prize winner Robert Lucas (1988) believes that role of finance in economic growth has been over stressed. But dating back to Schumpeter (1911), it is emphasized that developed financial sector has positive influence on the level and per capita growth of a country. In recent times, this school of thought got impetus and wider acceptability following significant number of empirical contributions starting from the works of King and Levine (1993a; 1993b). Works by King and Levine was hugely criticized for the methodological issues including the problem of endogeneity. Later, Rajan and Zingales (1998) in an innovative study using macro firm level data demonstrated that growth of industries more dependent on external finance grew faster in countries with developed financial sector. Though not a smoking gun, the work did find a way to counter endogeniety problem. Using the same methodology, Braun (2003) showed that indeed in countries with a low level of financial development, industries with more tangible assets are relatively larger in size and grow relatively faster than industries with more intangible assets1. The above works tried to link financial development with the economic growth in terms of growth of industries or per capita income. But Beck’s work (2003) tried to empirically examine the relation between trade and finance. He tested the model presented by Kletzer and Bardhan (1987) which argued that well developed financial sector can theoretically lead to a comparative advantage in industries that rely more on external financing. Soon Svaleryd and Vlachos (2005) too established a positive relationship between financial sector development and the specialization pattern of international trade and comparative advantage. However, Beck (2003) and Svaleryd and Vlachos (2005) had limitations in their study. Beck’s result focused on the financial development indicators to explain trade variables. He did not control for the standard trade theories which can as well account for the result. Svaleryd and Vlachos (2005) did control for the trade theories but the study is based on OECD (rich) countries only. Their results though important cannot be generalized to developing countries. In the first essay (i) we aim at extending the latter works on the link between financial development and international trade by analyzing the interplay between the financial sector development and the pattern of industrial asset-structure on the one hand, and the industrial composition of countries’ export shares and trade balance on the other hand and also (ii) overcome the limitations of work by Beck (2003) and Svaleryd and Vlachos (2005). In the second essay we revisit the highly influential work by Rajan and Zingales (1998) which showed that industrial sectors which are relatively more in need of the external finance develop disproportionately faster in countries with more developed financial markets. Using the data on 41 countries and 36 industries, their work indeed strongly suggests that finance matters for economic growth. They show that those industries more dependent on external finance grows faster in countries with more developed financial 10 towards the collusive behaviour between the government and the corporate firms. The findings will further strengthen the viewpoint that such a practice of reemploying the retired regulators to the regulated firms does contribute to the loss of resources of the society. This area of research is still new and there is lot of issues that required investigation. Hitherto micro level studies have confined to government and firm nexus via the political connection. Investigations are also required that captures other dimensions of the corruption and sent seeking activities present in society. Kick backs between sellers and buyers, collusion among competitors in pricing, intra industry corrupt practices are some of the avenues still largely unexplored. The final essay looks at capital market phenomena that have been studied over the three decades. Underpricing of the new issues still draws lot of interest in the literature. This essay tries to examine the new issue underpricing within the herd behaviour framework. It is found that informed investors base their decisions on the management quality of the firms which triggers the herd behaviour among the less informed investors. As a result listing of the new issue starts at a much higher level than the true value. But in the long run the stock price of the new issue is rationalized and converges to its true value. Our findings are in contrast to the findings of Chemmanur and Paeglis (2005). However, the hypothesis tested is quite different. The future works might study the underpricing in a country with different institutional setting and be able to provide newer insights on the ongoing investigation in underpricing of new issues. 108 BIBLIOGRAPHY Aghion, P., Howitt, P. and Mayer-Foulkes, D. (2005). The effect of financial development on convergence: theory and evidence. 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Global competitiveness report, CD-Rom. Switzerland: World Economic Forum. Yamamoto, N. (1975). Ministry of Construction, Personnel and Amakudari: A ‘dowried bridegroom’?, Shukan Yomiuri (in Japanese) Websites Singapore Stock Exchange Website: http://www.sgx.com.sg Yahoo finance website: http://finance.yahoo.com 121 Appendix A: New listing procedure in Singapore Companies that whished to go public can engage the services of an underwriter approved by the SGX although it is not mandatory. Those who want to list independently of the underwriters have to consult the exchange. Underwriters perform two main functions. First is the data and information collection like companies past accounts and draft a prospectus. Second, is the issuing the new security on own or in collaboration with other underwriters. Generally underwriters will earn a fee of about 2.5 per cent of the issue size. Thereafter they perform the “insurance/commitment” function in which the underwriter commits to buy the whole issue from the firm and in turn sell it to the market at a slightly higher price. Therefore, the expected pay off to the underwriter is the underwriter spread and the fees earned from the management function of the new issue. After the issuer has chosen an underwriter the latter will prepare draft prospectus and all the necessary information required in the SGX listing. This will take upto weeks. Once this is done, a formal application is made to the SGX for processing of the application. After the application is approved, the underwriter will gather the company’s directors, lawyers and accountants to determine the accuracy of the prospectus. Thereafter, the underwriter will fix the offer price which must be .20 S$ each as per the listing requirements. This price appears in the prospectus. Generally 9-14 days are provided to the investors to send their application for the purchase of new securities through ATMs and internet. If the issue is oversubscribed balloting takes place. Therefore, as per the regulation of SGX there cannot be any tinkering with the allocation of the shares by the issuers or the underwriters. Unsuccessful application will be notified and the application money will be returned within 24 hours of the balloting. 122 This is important feature since this does not allow the underwriter or the issuer to earn interest on the application of the new issues. Another important feature is that from the closing day of the application to the listing day, the duration is extremely short. This is mostly to days. 123 [...]... This paper investigates the interplay between financial development, asset tangibility and international trade Using industry-level data on firms’ dependence on external finance and firms’ asset tangibility for 27 industries in 42 countries, we find that economies with higher levels of financial development have higher export shares and trade balance in industries with more intangible assets Using the... (1997) showed that indeed there is a close link between the level of financial development on the one hand, and microeconomic and 17 macroeconomic growth on the other hand Later works by Rajan and Zingales (1998), Demirguç-Kunt and Maksimovic (1998) and Beck and Levine (2001) demonstrated that a well-developed financial sector helps countries securing access to external finance for investment projects... of industrial asset-structure on the one hand, and the industrial composition of countries’ export shares and trade balance on the other hand A key factor that influences the interplay is the degree of tangibility of firms’ assets The mechanism of this influence can be elaborated as follows In an incomplete contract setting, external finance dependence and the agency problem are inextricably linked and. .. and equipment divided by the book value of assets Using the data spanning for ten years smoothens the measure Highly tangible industries include petroleum refineries, paper and its products, iron and steel and industrial chemicals The industries with the lowest level of asset tangibility are pottery, china and earthenware, professional, scientific and controlling equipment, and non-electrical machinery... economic development in establishing the relation between financial development and growth Using the same data as Rajan and Zingales (1998) we do establish that cross country and cross industry study do have its limitations The established hypothesis that financial sector helps in the growth of industries more dependent on external finance, holds only for the developing countries Such a hypothesis is... decisions ignoring their own private information But in Welch’s work sequential issue of IPO shares was essential to cascade effect In this work we argue that IPO underpricing can be explained by cascade effect even without sequential underpricing Less informed investors in order to avoid their cost on effort and money closely imitate the informed investors In circumstances when informed investors base... to the interaction between asset tangibility and indicators of activities of financial intermediaries (banks, non-banking financial institutions), Private Credit, Bank Credit, Liquid Liabilities are greater than the corresponding coefficients for the interaction between asset tangibility and indicators capturing the stock market activities, e.g stock market capitalization and the total trade in stock... financial sector development can be a potential source of a country’s comparative advantage Using an augmented Heckscher-Ohlin model, Kletzer and Bardhan (1987) show that a well developed financial sector can theoretically lead to a comparative advantage in industries that rely more on external financing Later, Beck (2003) and Svaleryd and Vlachos (2005) find empirical evidence supporting Kletzer and. .. Finally, FACTORi ,m denotes the mth factor endowment- physical capital, human capital and natural resources- in the ith country These factor endowments are likely to influence the trade composition and flows as explained commonly in the standard trade theories INTENSITYk ,m is the mth factor intensity viz physical capital intensity, human capital intensity and natural resource intensity corresponding... literature and hypothesis Section 2.3 describes the methodology and the data Section 2.4 presents our main results and sensitivity test Section 2.5 concludes 2.2 RELATED LITERATURE AND HYPOTHESIS Over the last decade, several studies have firmly established that financial development has a significant role in influencing countries’ economic variables For example, King and Levine (1993a and 1993b) and Levine . Will financial development help prop up the growth of industries in Western European countries and South Asian countries alike? Studies in the finance and growth hypothesis using industries. established that financial development has a significant role in influencing countries’ economic variables. For example, King and Levine (1993a and 1993b) and Levine (1997) showed that indeed there. mechanism of this influence can be elaborated as follows. In an incomplete contract setting, external finance dependence and the agency problem are inextricably linked and form the defining characteristics