VoxEU Column Development Productivity and Innovation

Financial constraints and innovation: Why poor countries don't catch up

How can poor countries stop playing catch up? The question continues to puzzle economists. This column argues that the innovative and productive activities of domestic firms in emerging markets are inhibited by financial frictions. Financial reforms will be most effective if they target the vulnerable small and young domestic firms and those in the service sector.

Does international assistance spur development? Dambisa Moyo’s critical evaluation of aid in Africa has once more caused us to question what we really know about growth and development (see for example Easterly 2009, Moyo 2009, Sachs 2009).

  • Why do large disparities in income and development between countries persist despite increasing globalisation?
  • How can poor countries catch up?

Much of the empirical and theoretical research has been developed to identify factors that prevent less developed countries from “catching up” with developed countries. But after decades of research, the question continues to puzzle the profession.

Most of the difference in income across countries is attributed to differences in productivity. But “productivity”, in the words of Zvi Griliches, is a measure of our ignorance.

A prominent theory advocates that cross-country differences in credit market development considerably contribute to cross-country differences in incomes and productivity (see for example Banerjee and Duflo 2008 and Levine 2005 for surveys). Indeed, there is ample macroeconomic evidence that the development of financial markets is strongly correlated with the development of a country. But while the microeconomic channels for this relationship are an area of active research, many aspects of micro-level determinants remain unclear. The lack of micro-level evidence is particularly striking for non-OECD countries and for dynamic aspects of productivity gains such as innovation flows.

In recent research (Gorodnichenko and Schnitzer 2010), we aim to shed more light on what determines variation in the level of productivity and hence income across countries. To do this, we focus on better understanding the frictions that prevent firms from innovation and other productivity enhancing activities such as exporting goods. In other words, the frictions that prevent them from catching up.

Foreign ownership

One stylised fact that appears from emerging markets and transition economies is that foreign-owned firms tend to be more productive than domestically owned firms and these productivity differences between domestic- and foreign-owned firms do not seem to diminish over time (Estrin et al. 2009). To the extent that foreign-owned firms embody the technological frontier, one can interpret this fact as suggesting that some forces prevent domestically owned firms from emulating the best practices and techniques. Stylised facts from OECD countries point to what these forces might be. Financial frictions affect investment as well as research and development spending made by firms at the microeconomic level (Hall and Lerner 2009). Furthermore, financial frictions tend to adversely affect a firm’s ability to export (Greenaway et al. 2007). Since exporting firms are more productive than non-exporting firms – which in part could be attributed to export stimulating productivity enhancements – financial constraints can prevent firms from realising gains from trade liberalisation which in turn should foster productivity growth.

We have tested the predictions of our theory using Business Environment and Enterprise Performance Surveys from 2002 and 2005. These cover a broad array of sectors and countries in Eastern Europe and Commonwealth of Independent States. Most importantly, our survey data collects direct measures of innovation and financial constraints so that we do not have to rely on indirect proxies for the key variables in our analysis. In addition, the survey provides information on shocks to firms' cash flow and internal funds, which we can use as firm-level instrumental variables for our measures of financial constraints.

New insight: The influence of financial frictions

Our preferred econometric results based on instrumental variable estimates unambiguously suggest that innovative activities of firms are strongly influenced by financial frictions.

Moreover, we show that domestically owned firms are more likely to be affected by financial constraints than foreign firms, which helps explain why domestically owned firms do not catch up.

We also find that financial frictions affect export status and, consistent with our theoretical predictions, the joint incidence of export and innovation activities decreases in the severity of financial constraints. This may explain why the integration of product markets does not necessarily help domestically owned firms to catch up.

Finally, Figures 1 and 2 show that financial frictions measured at the firm level are strongly negatively correlated with macroeconomic measures for productivity and trade intensity. Thus, our analysis suggests financial frictions adversely affecting innovation as one potential microeconomic channel restraining macroeconomic productivity and growth.

Figure 1. Financial constraints and macroeconomic outcomes

Source: BEEPS, Penn World Tables, IMF IFS.

Figure 2. Innovation, export and economic growth

Source: BEEPS, Penn World Tables.

Policy insights

As underdevelopment of financial and banking sectors is particularly acute in developing and transition economics, design and evaluation of reforms to reduce the adverse effects of financial frictions and to spur productivity acceleration is an area of active debates. Our results provide several implications for these discussions.

  • First, our evidence presented in Gorodnichenko and Schnitzer (2010) may help to understand why the productivity of domestically owned firms in emerging economies catches up slowly to the technological frontier. Specifically, we argue that domestically owned firms may find it difficult to finance their productivity enhancing activities.
  • Second, we offer a more detailed perspective for policymakers. We document that financial frictions are particularly detrimental for small or young firms. Policies aimed to help these types of firms are likely to have the biggest effect.
  • Third, we find that firms in the service sector are more sensitive to financial constraints probably because it is harder to collateralise investment and innovation in this sector. Since the service sector has been underdeveloped in emerging market economies and, consequently, there is a grave need to expand the size and quality of the service sector, public policy should provide support to firms in the service sector so that they can overcome financial frictions and catch up faster to world standards. For instance, transition and emerging market economies can benefit from emulating policies that support innovations of firms most sensitive to financial frictions (e.g., Small Business Innovation Research grants in the US).
A call for financial market reforms

More broadly, our analysis strongly indicates that the severity of financial frictions faced by firms is decreasing in the level of development of financial markets. Since financial frictions slow down improvements in technology and the welfare costs of delayed productivity catch up are probably enormous, policy should also be directed towards establishing a framework for deep credit markets and a strong banking sector willing to provide access to external financing for a broad range of firms. To be clear, we do not advocate “sprinkling” money (i.e. blind injection of liquidity into firms), which neglects the disciplinary effects of external finance that comes from careful screening and monitoring. Instead, a sensible strategy may include enhanced screening process, improved information systems, and well maintained clear property records. As suggested by Figure 3, deeper reforms in banking and financial sectors are likely to alleviate the adverse effects of financial frictions and, consequently, to stimulate the growth of the economies in our sample.

Figure 3. Financial constraints and reforms in financial and banking sectors

Source: BEEPS, European Bank for Reconstruction and Development.

Our findings also suggest that financial constraints may force firms to choose between innovation and internationalisation strategies, thus losing out on the complementary effects of both strategies. This could explain why domestically owned firms in emerging economies benefit less from trade liberalisation than we might have expected. This may be because they lack the finance to take advantage of new export opportunities, while at the same time are confronted with increased import competition. Thus, the integration of international product markets does not have the desired effects of pushing domestically owned firms towards the technology frontier if it is not accompanied by complementary financial market reforms.


Banerjee, Abhijit V and Esther Duflo (2008), “Do firms want to borrow more? Testing credit constraints using a directed lending program,” mimeo.

Easterly, William (2009), “Lost in the tropics: Sachs’ misguided African geography”, VoxEU.org, 1 June.

Estrin, Saul, Jan Hanousek, Evzen Kocenda and Jan Svejnar (2009), “The effects of privatization and ownership in transition economies”, Journal of Economic Literature, Vol. 47(3):699-728.

Gorodnichenko, Yuriy, and Monika Schnitzer (2010), “Financial constraints and innovation: Why poor countries don't catch up”, NBER Working Paper 15792.

Greenaway, David, Alessandra Guariglia, and Richard Kneller (2007), “Financial factors and exporting decisions”, Journal of International Economics, Vol. 73(2):377-395.

Hall, Bronwyn H and Josh Lerner (2009), “The financing of R&D and innovation”, NBER Working Paper 15325.

Levine, Ross (2005), “Finance and growth: Theory and evidence”, in Philippe Aghion and Steven Durlauf (eds), Handbook of Economic Growth, Elsevier, Vol. 1: 865-934.

Moyos, Dambisa (2009), Dead Aid, Allen Lane, January.

Sachs, Jeffrey (2009), “Moyo's confused attack on aid for Africa”, VoxEU.org, 29 May.

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