DP5969 Adjustment to Target Capital, Finance and Growth

Author(s): Antonio Ciccone, Elias Papaioannou
Publication Date: December 2006
Keyword(s): financial development, growth, investment opportunities, measurement error, sector analysis
JEL(s): E230, E440, F300, G100, O400
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5969

Does financial development result in capital being reallocated more rapidly to industries where it is most productive? We argue that if this was the case, financially developed countries should see faster growth in industries with investment opportunities due to global demand and productivity shifts. Testing this cross-industry cross-country growth implication requires proxies for (latent) global industry investment opportunities. We show that tests relying only on data from specific (benchmark) countries may yield spurious evidence for or against the hypothesis. We therefore develop an alternative approach that combines benchmark-country proxies with a proxy that does not reflect opportunities specific to a country or level of financial development. Our empirical results yield clear support for the capital reallocation hypothesis.