International aspects of capital allocation efficiency

Abstract

A fundamental job of the economy is to allocate capital efficiently. This thesis is about capital allocation efficiency: its causes, internal dynamics and contributions to output growth. The conventional explanation for output growth relies on banking development and stock market liquidity (Levine & Zervos, 1998). However, financial liberalization and “big push” strategies for investment smother economic development amid the recovery from the 2008 global financial crisis, thus suggesting that economists may have badly overstressed the role of banking development; the past crises caused by an over-developed credit market have led economies to grow disproportionately. Whereas most previous empirical studies focused on banking and stock market development, little was known about capital allocation efficiency prior to the study by Wurgler (2000), who focused on whether and how financial markets improve the allocation of capital. Capital allocation efficiency has an overarching effect on sustained output growth: if financial markets and institutions do not perform this fundamental allocative function, sustained economic growth will not happen, and without sustained economic growth, development will not happen. Following the inspiration regarding growth dynamics provided by The Growth Report (Commission on Growth and Development, 2008), ten developing countries were identified as having sustained output growth (seven per cent or higher) over the past 25 years. Nine out of these ten countries (90 per cent) registered the highest growth rate in the broad financial intermediation sector, followed by the manufacturing sector. This finding motivates this thesis, a study of how financial capital allocation efficiency is correlated with sustained output growth in developing countries and whether the high output growth of developing countries can be explained and, importantly, repeated. This thesis aims at providing a better understanding on the aforementioned issues. In particular, it presents three empirical articles, which investigate the following important themes: 1. What is the role of financial capital allocation efficiency in explaining output growth in developing countries? 2. How do external monitoring mechanisms shape a firm’s payout policy and improve the firm’s capital allocation efficiency through the actions of short sellers? 3. Are developing countries still able to achieve sustained output growth by directing investment into the manufacturing sector? Has the importance of manufacturing in economic development changed? Predicated on the above research questions, the empirical findings indicate: 1. The role of capital allocation efficiency positively contributes to output growth of developing countries, it also plays a predictive role in short- and long-term output growth. 2. Rigid external monitoring mechanisms can curb managerial misbehaviour and encourage managers to pursue value-maximizing and growth-enhancing investment policies, thus, improving the firm’s output growth. 3. The development quality and quantity of the manufacturing sector in developing countries relative to other sectors have not changed over the last 40 years. The findings indicate that it is not the contribution of manufacturing to economic development that has changed and made the path of industrialization more difficult, but that it is country-specific conditions and policies that have made differences in the outcome.