Does Financial Development Promote Innovation in Developing Economies? An Empirical Analysis

• DOI: http://doi.org/10.1111/rode.12314
• Author: Maria Aristizabal‐Ramirez,Maria Camila Botero‐Franco,Gustavo Canavire‐Bacarreza
• Published date: 01 August 2017
• Date: 01 August 2017

Does Financial Development Promote Innovation in

Developing Economies? An Empirical Analysis

Maria Aristizabal-Ramirez, Maria Camila Botero-Franco, and

Gustavo Canavire-Bacarreza*

Abstract

Using firm-level data from 2006 to 2013 fora set of developing countries, we examine the effects of financial

development on innovation. Financial development boosts innovation by improving resource allocation and

investment in strategic sectors as well as facilitating technology to promote growth. Using binary response

models and instrumental variable techniques to correct for endogeneity, we find robust but puzzling results.

Contrary to most of the existing literature, financial development has a negative effect on the probability of

a firm to innovate in developing countries. This effect is conditional on firm size, and only larger firms

benefit from financial development. These results are robust to different measures of financial development

and econometric specifications. We argue that this is a result of the design of the financial system in regard

to the lack of capital and institutional system. Consequently, developing countries should first generate

appropriate institutional conditionsif they want financial development to spurgrowth through innovation.

1. Introduction

Financial development boosts economic growth by lowering information and

transaction costs when mobilizing resources (Levine, 2005). However, the existing

literature shows ambiguous results with regard to this relationship. On the one hand,

based on theoretical and empirical work, Levine (2005) argues that financial

development has a positive effect on growth by improving resource allocation. On the

other hand, Rousseau and Wachtel (2011) suggest that the benefits of financial

deepening could lead many countries to liberalize before developing legal and

regulatory institutions, which could attenuate the positive effect of financial

development on economic growth. Moreover, Blanco (2013), using a sample from

Latin American countries, finds that financial development has no significant effect on

economic growth in the short term, but that there are long-term differentiated effects.

Two related issues may explain why understanding the relationship between

financial development and economic growth is difficult. First, the channels through

which financial development operate are not well understood. Second, current

studies do not differentiate the effect of financial development on growth at

different stages of economic development (Levine, 1997, 2005; Blanco, 2013). This

paper tackles these two issues by providing significant evidence on the effects of

financial development on innovation in developing countries.

From a classical perspective, following Schumpeter’s (1982) thinking, financial

intermediaries facilitate technological innovation and then affect growth and

development. Moreover, as suggested by Levine (2005), financial development

*Aristizabal-Ramirez: Department of Economics, University of Michigan Ann Arbor, MI, USA; Botero-

Franco: Bancolombia, Medellin, Colombia; Canavire-Bacarreza (Corresponding author): School of

Economics and Finance, Universidad EAFIT, Medellin, Colombia. E-mail: gcanavir@eafit.edu.co. The

authors are grateful for comments from two anonymous referees on previous versions of the paper.

Review of Development Economics, 21(3), 475–496, 2017

DOI:10.1111/rode.12314

©2017 John Wiley & Sons Ltd

improves resource allocation by creating innovative processes that promote

investment and simultaneously lead to greater productivity and economic growth.

Highly developed countries with innovative processes achieve economic growth

and capital accumulation through global innovation networks that include

institutions such as universities and think tanks, the production sector, global

trade networks consisting of domestic and foreign markets, public policy-makers,

and financial channels (Moguillansky, 2006). Therefore, the effects of financial

development on innovation are expected to be positive. Yet, developing

countries have limited access to global innovation networks as well as limited

resources directed toward innovation due to different factors, such as limited

number of research universities, restricted amount of public research and

development (R&D) investment, and limited investment in innovation from

private companies.

These factors, along with a small financial sector, may explain why the effects of

financial development on innovation are not equal in magnitude or direction in

developing economies compared with developed economies.

To examine the relationship between financial development and innovation in

developing economies, we use binary response models, particularly probit models.

Following Benfratello et al. (2008), the dependent variable is the probability of a

firm to innovate; however we do not differentiate the effects of financial

development on product and process innovation because those are out of the scope

of this paper. More specifically, in order to measure the effects on innovation as a

whole, we use the probability of a firm to introduce new products, processes, or

patents to the market as our dependent variable.

Given that there is a potential endogenous relationship between financial

development and innovation due to reverse causality and omitted variable bias, we

apply instrumental variable techniques. We include legal origins as an instrument

for financial development. La Porta et al. (1997, 1998) show that a country’s legal

origin (e.g., English, French, German, or Scandinavian system) defines the current

legal rules regarding the protection of corporate shareholders and creditors, as well

as influencing the size of the debt and equity markets. Thus, it satisfies the

condition of relevance of legal origins as an instrument. Furthermore, as suggested

by Rajan and Zingales (1998) and Beck and Levine (2002), most countries acquired

their legal systems through occupation and colonialism; therefore, the legal origin

of a country can be regarded as exogenous, and is likely to satisfy the exclusion

restriction of instrumental variables. In addition, Acemoglu et al. (2001) find that

property rights have a great impact on financial development, and the type of

institutions depend on historical variables, such as the settlers’ mortality rate and

population density in 1500. Since these are historical variables, similar to legal

origin, they are not correlated with innovation and therefore we also use them as

instruments (Acemoglu et al., 2010; Acemoglu and Johnson, 2003). In sum, this

paper contributes to the existing literature because it considers micro-data from

developing economies, uses a broad definition of innovation improving on Hsu

et al.’s (2014) results, and corrects for endogeneity.

The structure of the paper is as follows. In Section 2 we present a literature

review. In Section 3 we briefly define financial development and innovation

concepts, and sho w the descriptive statistics. In Section 4 we specify the empirical

model, and in Section 5 we interpret the results. In Section 6 we provide our

conclusions.

476 Aristizabal-Ramirez, Botero-Franco, and Canavire-Bacarreza

©2017 John Wiley & Sons Ltd