28Law, finance, and firm growth

Law,Finance,andFirmGrowthAsliDemirgüç-Kunt;VojislavMaksimovicTheJournalofFinance,Vol.53,No.6.(Dec.,1998),pp.2107-2137.StableURL:=0022-1082%28199812%2953%3A6%3C2107%3ALFAFG%3E2.0.CO%3B2-YTheJournalofFinanceiscurrentlypublishedbyAmericanFinanceAssociation.YouruseoftheJSTORarchiveindicatesyouracceptanceofJSTOR'sTermsandConditionsofUse,availableat://@jstor.org.:352007THEJOURNALOFFINANCEVOI,.LIII,NO.6*IIECEMBER1998Law,Finance,andFirmGrowthASLIDEMIRGUS-KUNTandVOJISLAVMAKSIMOVICYABSTRACTWeinvestigatehowdifferencesinlegalandfinancialsystemsaffectfirms'useofexternalfinancingtofundgrowth.Weshowthatincountrieswhoselegalsystemsscorehighonanefficiencyindex,agreaterproportionoffirmsuselong-termex-ternalfinancing.Anactive,thoughnotnecessarilylarge,stockmarketandalargebankingsectorarealsoassociatedwithexternallyfinancedfirmgrowth.Thein-creasedrelianceonexternalfinancingoccursinpartbecauseestablishedfirmsincountrieswithwell-functioninginstitutionshavelowerprofitrates.Governmentsubsidiestoindustrydonotincreasetheproportionoffirmsrelyingonexternalfinancing.THECORPORATEFINANCELITERATUREsuggeststhatmarketimperfections,causedbyconflictsofinterestandinformationalasymmetriesbetweencorporatein-sidersandinvestors,constrainfirmsintheirabilitytofundinvestmentprojects.Themagnitudeoftheseimperfectionsdependsinpartontheeffectivenessofthelegalandfinancialsystems.Becausethesesystemsdifferacrosscoun-tries,theliteratureimpliesthatthereshouldexistsystematiccross-countrydifferencesinfirms'abilitytoobtainexternalcapitaltofinanceinvestment.Inthispaper,weexaminewhethertheunderdevelopmentoflegalandfinancialsystemsdoespreventfirmsinsomecountriesfrominvestinginpotentiallyprofitablegrowthopportunities.Inparticular,wefocusontheuseoflong-termdebtorexternalequitytofundgrowth(seeourearlierwork,Demirguq-KuntandMaksimovic(1996a),whichcomparesfirms'fi-nancialstructuresindevelopedanddevelopingcountriesandfindsthegreat-estdifferencetobeintheprovisionoflong-termcredit).Weestimateafinancialplanningmodeltoobtainthemaximumgrowthratethateachfirminourthirty-countrysamplecouldattainwithoutaccesstolong-termfinancing.Wethencomparethesepredictedgrowthratestogrowthratesrealizedbyfirmsincountrieswithdifferingdegreesofdevelopmentinthenrlegalandfinancialsystems.Ourapproachenablesustoidentifyspecificcharacteris-ticsofthelegalandfinancialsystemsthatareassociatedwithlong-termfinancingoffirmgrowth.Thus,weprovideamicro-leveltestofthehypoth-*DemirgiipKuntisattheWorldBankandMaksimovicisattheRobertH.SmithSchoolofBusinessattheUniversityofMaryland.WethankRen6Stulz,theeditor,JerryCaprio,MurrayFrank,RossLevine,MaryShirley,FabioSchiantarelli,SheridanTitman,IanTonks,andtheparticipantsoftheJune1996WorldBankConferenceonTermFinancingfortheircomments.Theviewsexpressedherearetheauthors'ownandnotnecessarilythoseoftheWorldBankoritsmembercountries.2108TheJournalofFinanceesis,advancedbyKingandLevine(1993)andLevineandZervos(1998),thatthedegreetowhichfinancialmarketsandintermediariesaredevel-opedisadeterminantofeconomicgrowth.Aneffectivelegalsystemisimportantbecauseafirmthatwishestoob-tainlong-termfinancingmustbeabletocommitcrediblytocontrollingop-portunisticbehaviorbycorporateinsiders.Long-termcreditorscommonlyusedebtcovenantstoconstraindebtors'opportunisticbehavior;likewise,outsideshareholdersrelyonexplicitfiduciaryresponsibilitiestoconstrainopportunisticbehaviorbycorporateinsiders.Forthesechecksoninsiderbehaviortowork,theremustexistaneffectivelegalsystemthatdetersvi-olationsandthatcanenforcecompensationforinfractions.1Aneffectivefinancialsystemisimportantbecausewell-developedmar-ketsandfinancialintermediariesserveasdirectsourcesofcapitalandasmechanismsforensuringthatinvestorshaveaccesstoinformationaboutfirms'activities.Thus,theexistenceofdevelopedandactivefinancialmar-ketsandalargeintermediarysectorshouldmakeiteasierforfirmstoraiselong-term~apital.~Theempiricalresultsforoursamplesuggestthatanactivestockmarket(thoughnotnecessarilyalargeone)andhighscoresonanindexofrespectforlegalnormsareassociatedwithfirmgrowthfinanc