How national and international financial development affect industrial R&D☆
Highlights
► We examine the impacts of both domestic and international financial market development on R&D intensities in OECD manufacturing industries. ► We take account of such industry characteristics as the need for external financing and the amount of tangible assets. ► Many forms of domestic financial development are important determinants of R&D intensity, with a particularly strong effect of bond-market capitalization. ► Only foreign direct investment is significant among alternative measures of international financial development. ► We relate these results to theories of investment monitoring with uncertain outcomes.
Introduction
One of the most fundamental issues in economic development is how important the maturation and deepening of financial markets are for growth. This issue has been much debated since its reintroduction into the literature by King and Levine (1993). According to Levine (2005), a consensus has been reached that more developed domestic financial markets stimulate economic growth. Presumably this linkage stems from firms gaining better access to credit, which allows easier financing of investment projects, in turn leading to productivity growth. At a deeper level, however, it is important to study the specific channels through which access to finance enhances economic growth. In this paper we consider one particular type of investment, namely research and development (R&D), and its association with national and international financial market development. It is prominently argued in the literature that more investment in R&D stimulates technological progress, which provides the foundation for the bulk of economic growth (Griliches, 1998, Acemoglu, 2009).
Our specific focus is to study how endogenous research intensities, defined as industry-level R&D as a share of output, respond to country-wide financial development in industries that rely heavily on external finance or have limited tangible assets. This approach sheds light on whether financially dependent companies are more likely to have higher R&D intensities when national capital markets develop or when there is greater access to international financial markets. If so, financial development and financial access provide key reasons why enterprises in countries with deeper markets invest more in R&D than do their counterparts in other nations. Additionally, industries with low proportions of tangible capital tend to be those with higher proportions of intellectual capital. If the R&D intensities of those sectors also rise with capital-market sophistication then financial development supports higher innovation in knowledge-based endeavors.
Prior work on financing investments at the firm level helps motivate our study (Aghion et al., 2004, Hall and Lerner, 2010). This research has demonstrated that firms first tap internal funds in order to maintain control rights over their innovations. As they need additional capital to fund R&D expenditures; however, they turn to external funds, first accessing bank credit and then equity markets.1 This apparent hierarchy of finance specific to innovation motivates our explicit consideration of both credit and equity measures, such as liquid liabilities, private credit, stock-market and private bond-market capitalization.
We also include variables that describe international financial market development (portfolio investment, foreign direct investment (FDI) and foreign debt), which has been ignored in this line of research. This is an important consideration as recent work has documented a positive link between the integration of financial markets across countries and economic growth (Eichengreen, 2001, Kose et al., 2009). Nevertheless, very little focus has been placed on whether openness to international capital markets may affect innovation and growth through financing R&D. The standard conception is that FDI is a direct source of technology transfer and may induce greater local innovation through learning spillovers (He and Maskus, in press, Keller and Yeaple, 2010). However, there has been considerable growth in the internationalization of R&D as multinational firms establish research affiliates abroad (Gammeltoft, 2006). Further, affiliates may be financed via a mix of ownership and debt (Kesternich and Schnitzer, 2010). It is therefore of interest to study how access to international financial sources may affect innovation.
Financing constraints may be particularly restrictive for R&D relative to other forms of investment.2 According to Brown et al. (2009), innovative firms (those with high R&D expenditures) tend to have few tangible assets that can serve as collateral for credit. R&D expenditures largely go to salaries and wages for scientists and researchers. These human-capital investments cannot be collateralized. Further, firms may wish to protect their proprietary information over innovation, and thus may be unable or unwilling to offer sufficient signals about the effectiveness of their intended R&D programs to credit providers. These issues motivate the inclusion of a measure of asset tangibility into our analysis.
The relationships between innovation and economic growth, and between financial development and economic growth, have been explored in a wide swath of literature. However, there are far fewer studies of the effects of financial development on innovation as a specific channel by which the former may stimulate growth. Aghion et al. (2010) provide one such link with a theoretical model that explores the impact of financing constraints on the composition of investment. Financial frictions may limit economic growth by reducing long-term investment in R&D during economic downturns. Aghion et al. (2008) provide related firm-level evidence. They show that R&D investment is pro-cyclical, rising with firms’ sales in the presence of firm-specific credit constraints. This link is particularly pronounced for enterprises with greater external financial dependence and fewer tangible assets.
Using aggregate data, Carlin and Mayer (2003) study the relationship between R&D intensity at the industry level and national institutional variables describing the structure of countries’ financial systems. In particular, these authors interact accounting standards, bank concentration and control of voting rights with equity finance dependence, bank finance dependence and skill dependence to look at the effects on growth, fixed investment and R&D investment. They provide initial evidence on the relationship between domestic financial institutions and R&D expenditures, showing broadly that better accounting standards and more developed credit markets positively impact investment in R&D for those industries that rely more on external equity. They find little impact on R&D from the development of equity markets.
Our paper contributes to this literature in several ways. First, we deploy alternative measures of financial development to describe more fully the impacts on R&D intensities of such different dimensions as private credit, stock markets, private bond markets, portfolio investments and foreign direct investment. Second, we derive novel findings based on two classifications of the data: a differentiation between national and international sources of finance and a categorization of financial systems as bank-based or market-based. Third, we calculate the implied impacts of financial development on R&D propensities.
To preview, our findings point to a strong association between domestic financial market development and R&D intensity. However, among sources from the international capital markets only FDI seems to be a major factor in financing research and development. We find significant effects for varieties of both bank-based and market-based financial systems. However, we obtain the strongest effect for market-based (direct) forms of finance. Quantitatively, the R&D intensity of an industry that is heavily dependent on external sources of finance in a country with well-developed domestic financial markets is more than 0.4 percentage points higher than that of an industry that relies less on external sources of funding in a country with poorly developed financial markets. This difference is about 20% of the average R&D intensity in our industry sample. The largest difference arises as the private bond market becomes larger, with our estimates suggesting as much as a 45% expansion of R&D intensity in industries located in a country with extensive bond-market capitalization versus those located in one with little capitalization.
A fourth contribution is that, to our knowledge, this is the first paper to include a measure of asset tangibility in the context of financial market development and R&D investments. We find that industries with fewer tangible assets generally benefit more from financial market development than industries that are endowed with more tangible assets.
In the next section we formally introduce the hypotheses we test and lay out the econometric methodology to do so. We then describe the data we use in Section 3 before we discuss our results in Section 4. In Section 5 we report the results of several robustness checks of our benchmark specification. We offer concluding remarks in Section 6.
Section snippets
Hypotheses and econometric approach
We study the different impacts of financial market development on R&D intensity in industries that (i) depend on external finance to different extents and (ii) are characterized by varying degrees of tangible assets in their overall balance sheets. Our hypotheses are that more developed financial markets should be associated with greater R&D in industries that (i) rely more on external finance and (ii) have less tangible assets to use as collateral.
The first industry characteristic – external
Data
We use R&D expenditure data for 22 manufacturing industries in 18 OECD countries for the years 1990–2003.5 R&D intensity is calculated from OECD data as industry-level R&D expenditures as a
Results
We discuss the role of domestic and international financial markets sequentially in the following two subsections, focusing attention on our two main hypotheses: (i) R&D intensity should be higher in industries that depend more on external finance in countries with more developed financial markets, and (ii) R&D intensity should be lower in industries that have more tangible assets in countries with more developed financial markets. Hence, estimates of β1 should be positive while estimates of β2
Sensitivity analysis
An important issue is whether there is an omitted variable bias from only considering one financial development variable at a time. Due to high correlations of financial development measures, we are unable to include all of these covariates at once. Nevertheless, we consider specific combinations that measure different aspects of financial market development and hence are less correlated. Thereby, we clarify whether the development of different types of financial variables may substitute for
Conclusions
In this paper we examine the impacts of financial market development on R&D intensity in 22 manufacturing industries in 18 OECD countries for the period 1990–2003. As financing constraints for R&D may be particularly tight due to the intangible nature of R&D assets, access to external funds can be expected to play an important role in stimulating innovation and eventually output growth.
We find statistically and economically strong effects for most domestic indicators of financial market
References (36)
- et al.
Volatility and growth: credit constraints and the composition of investment
Journal of Monetary Economics
(2010) - et al.
Finance, investment, and growth
Journal of Financial Economics
(2003) - et al.
The choice among bank debt, non-bank private debt, and public debt: evidence from new corporate borrowings
Journal of Financial Economics
(2003) - et al.
The financing of R&D and innovation
- et al.
Who is afraid of political risk? Multinational firms and their choice of capital structure
Journal of International Economics
(2010) - et al.
Entry regulation as a barrier to entrepreneurship
Journal of Financial Economics
(2006) Credit constraints, equity market liberalizations and international trade
Journal of International Economics
(2008)- et al.
Corporate financing and investment decisions when firms have information that investors do not have
Journal of Financial Economics
(1984) Introduction to Modern Economic Growth
(2009)- Aghion, P., Askenazy, P., Berman, N., Cette, G., Eymard, L., 2008. Credit constraints and the cyclicality of R&D...
Technology and financial structure: are innovative firms different?
Journal of the European Economic Association
Comparing Financial Systems
Cambridge, MA
Investment, R&D and financial constraints in Britain and Germany
Annales d’Economie et de Statistique
Financing innovation and growth: cash flow, external equity, and the 1990s R&D boom
The Journal of Finance
A multinational perspective on capital structure choice and internal capital markets
Journal of Finance
Capital account liberalization: what do cross-country studies tell us?
World Bank Economic Review
Cited by (94)
Insight into the nexus between intellectual property pledge financing and enterprise innovation: A systematic analysis with multidimensional perspectives
2024, International Review of Economics and FinanceDelayed tax rebates, cash flow, and corporate spending: A quasi-experiment from China
2024, China Economic ReviewDestination trade credit and exports: Evidence from cross-country panel data
2023, Journal of International Money and FinanceThe impact of extreme weather events on green innovation: Which ones bring to the most harm?
2023, Technological Forecasting and Social ChangeHow important are capital controls in shaping innovation activity?
2023, Journal of International Money and FinanceThe importance of international trade credit for industry investment
2022, Journal of Economics and BusinessCitation Excerpt :This measure is widely used as a measure for financial account openness. Maskus et al. (2012) use this measure in a similar specification to examine industry R&D intensity. Here, we replace the international trade credit variable with the international financial openness variable to examine whether it is the availability of international financing generally or the availability of international trade credit that facilitates investment.
- ☆
Much of this research was conducted while Neumann and Seidel were visiting scholars at the Department of Economics at the University of Colorado. Seidel gratefully acknowledges financial support from the Fritz-Thyssen-Foundation. We are grateful to two referees for insightful comments.