Capital Account Liberalization and Aggregate Productivity: The Role of Firm Capital Allocation

• Published date: 01 August 2017
• Date: 01 August 2017
• DOI: http://doi.org/10.1111/jofi.12497
• Author: MAURICIO LARRAIN,SEBASTIAN STUMPNER

THE JOURNAL OF FINANCE •VOL. LXXII, NO. 4 •AUGUST 2017

Capital Account Liberalization and Aggregate

Productivity: The Role of Firm Capital Allocation

MAURICIO LARRAIN and SEBASTIAN STUMPNER∗

ABSTRACT

We study the effects of capital account liberalization on firm capital allocation and ag-

gregate productivity in 10 Eastern European countries. Using a large firm-level data

set, we show that capital account liberalization decreases the dispersion in the return

to capital across firms, particularly in sectors more dependent on external finance.

We provide evidence that capital account liberalization improves capital allocation

by allowing financially constrained firms to demand more capital and produce at a

more efficient level. Finally, using a model of misallocation we document that capital

account liberalization increases aggregate productivity through more efficient capital

allocation by 10% to 16%.

IN THE LAST THREE DECADES,MANY developing countries have opened their cap-

ital accounts, lifting legal restrictions imposed on international capital trans-

actions. There is a growing consensus that capital account liberalization leads

to higher economic growth (Quinn and Toyoda (2008)). Higher growth can be

the result of factor accumulation or higher productivity. Recent cross-country

studies show that financial openness affects growth primarily through higher

productivity (Bonfiglioli (2008), Bekaert, Harvey,and Lundblad (2011)). In this

paper, we use a large cross-country firm-level data set to show that capital ac-

count liberalization increases aggregate productivity through a more efficient

allocation of capital across firms.

∗Mauricio Larrain is at the Graduate School of Business, Columbia University,and the School of

Management, Pontificia Universidad Cat´

olica de Chile. Sebastian Stumpner is with Department

of Economics, Universit´

edeMontr

´

eal. We thank Julien Bengui; Patrick Bolton; Murillo Campello;

Yuriy Gorodnichenko; Matteo Maggiori; Atif Mian; Ted Miguel; Benjamin Moll; Emi Nakamura;

Gabriel Natividad; Tomasz Piskorski; Francisco Rodriguez; Andres Rodriguez-Clare; Shang-Jin

Wei; Daniel Wolfenzon; Pierre Yared; Luigi Zingales; and seminar participants at UC Berkeley,

Midwest Macro Meeting (Notre Dame), Columbia Business School, Chicago Booth Junior Finance

Symposium, Midwest Finance Meeting (Chicago), and Cornell University (Johnson School of Man-

agement) for very useful comments. We also thank Kenneth Singleton (the Editor), an Associate

Editor, and two anonymous referees for their valuable feedback. Weare grateful for financial sup-

port from the Institute of Business and Economic Research at Berkeley. Larrain is grateful for

financial support from the Ewing Marion Kauffman Foundation. Stumpner is grateful for support

from Actors, Markets, and Institutions in Developing Countries: A Microempirical Approach. This

paper was previously circulated under the title “Financial Reforms and Aggregate Productivity:

The Microeconomic Channels.” The authors declare that they have no relevant or material financial

interests related to the research in this paper.

DOI: 10.1111/jofi.12497

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1826 The Journal of Finance R

Specifically, we study the episode of capital account liberalization in 10 East-

ern European countries between 1996 and 2013. The timing of these events was

driven primarily by the process of accession to the European Union (EU).1We

start our analysis by showing that capital account liberalization spurs financial

development. Using aggregate data, we exploit variation in the timing of the

capital account opening events across countries. We show that capital account

liberalization is associated with an increase in the ratio of capital inflows to

GDP, an increase in the ratio of private bank credit to GDP, and a decrease in

the spread between deposit and lending interest rates.2

Next, we find that capital account liberalization is associated with an increase

in country-level total factor productivity (TFP). Aggregate TFP can be higher

because firms become individually more productive or because factors are al-

located more efficiently across firms. Our analysis shows that a more efficient

allocation of capital is a key driver of this effect. We argue that, by spurring

financial development, capital account liberalization allows financially con-

strained firms to demand more capital and produce at a more efficient level.

This leads to a more efficient allocation of capital across firms, which increases

aggregate TFP.

To guide our analysis, we develop a multisector heterogeneous-firm model of

misallocation. Firms in the same sector face different costs of capital because

some firms (young, small, opaque) have to borrow funds from an intermediary

banking sector, while others can borrow directly from households. This results

in a misallocation of capital across firms, which can be measured using the dis-

persion in the return to capital. Capital misallocation is more severe in sectors

where firms depend more on external finance, which we model as higher fixed

costs. We model capital account liberalization as a policy that allows banks to

obtain funding from abroad at lower cost. We then consider the effects of liber-

alization on various aggregate, sectoral, and firm-level outcomes. Importantly,

the model implies that opening the capital account reduces capital misalloca-

tion. As banks raise capital from abroad, bank-dependent firms can borrow

more and expand toward their efficient scale. This effect is more pronounced

in sectors with higher fixed costs.

Guided by our model, we use a large firm-level data set to estimate the ef-

fect of capital account liberalization on within-sector dispersion in the return

to capital across firms, as measured by the log marginal revenue product of

capital. We first show that the dispersion in the return to capital is systemat-

ically higher in manufacturing sectors more dependent on external finance.3

Taking advantage of the within-country variation in external financial depen-

dence across sectors, we next show that capital account liberalization reduces

the dispersion in the return to capital, particularly in sectors more reliant on

1Most of the countries in the sample were seeking EU membership and EU candidate countries

had to fully liberalize their capital accounts by the time of EU accession.

2We define a capital account liberalization event as a one-standard-deviation increase in the

capital account openness index developed by Chinn and Ito (2006).

3Following Rajan and Zingales (1998), we define external financial dependence as the fraction

of capital expenditures not financed with internal cash flows.

Capital Account Liberalization and Aggregate Productivity 1827

external finance. Opening the capital account closes 15% of the gap in the dis-

persion of the return to capital between sectors at the top and bottom quartiles

of the external financial dependence distribution. We find that this effect ma-

terializes rather quickly and levels off after six years, indicating a permanent

reduction in capital misallocation.

Next, we conduct two sets of tests to determine whether, consistent with

our argument, our results are driven by a reduction in financial constraints.

First, we show that our results are robust to controlling for changes in several

institutional factors that could have been triggered by capital account liberal-

ization and could have also improved capital allocation. Second, based on the

predictions of our model, we conduct three tests that provide direct evidence

regarding the financial constraints channel. First, we show that, after opening

the capital account, firms in financially dependent sectors increase their capi-

tal and observe a decrease in the return to capital, indicating that those firms

become less financially constrained and produce at a more efficient level. Sec-

ond, in line with young firms typically being bank-dependent, and thus having

fewer sources of external finance than older firms, we find that, within finan-

cially dependent sectors, the firms that expand the most are the young firms.

Third, we project our measure of return to capital onto age and find that the

decline in the dispersion in the return to capital is due to a reduction in the

dispersion explained by differences in firm age, which captures differences in

financial constraints across firms.

Firms in our sample might be constrained not only because they are young,

but also because capital might be allocated to politically connected firms. Con-

sistent with this idea, we find suggestive evidence that the effect of capital

account liberalization on capital misallocation is stronger in countries with

lower levels of initial corruption, where political connections should be less im-

portant. In addition, we show that our main sectoral results are robust to using

alternative de jure and de facto capital openness measures. Finally, we use our

model of misallocation to map the reduced-form estimates into aggregate TFP

gains. According to our calculations, capital account liberalization increases

aggregate TFP through more efficient firm capital allocation by 10% to 16%.

Overall, our paper makes three contributions. First, we contribute to the

literature on financial openness and economic growth. Bekaert, Harvey, and

Lundblad (2005) were the first to show that financial liberalization spurs

growth. Bonfiglioli (2008) and Bekaert, Harvey, and Lundblad (2011) find that

the effect of financial openness on growth works primarily through higher ag-

gregate productivity. Our paper is the first to connect financial openness to

aggregate TFP through the efficiency of firm capital allocation.4

Second, we contribute to the literature on financial markets and factor alloca-

tion. Wurgler (2000) documents that financially developed countries increase

investment more in their growing sectors and decrease investment more in

their declining sectors. Gupta and Yuan (2009) and Levchenko, Ranciere, and

4Harrison, Love, and McMillan (2004)andForbes(2007) use firm-level data to show that capital

controls increase firms’ financial constraints.