Financial Dependence and Growth

This paper examines whether nancial development facilitates economic growth by scrutinizing one rationale for such a relationship; that nancial development reduces the costs of external nance to rms. Speci cally, we ask whether industrial sectors that are relatively more in need of external nance develop disproportionately faster in countries with more developed nancial markets. We nd this to be true in a large sample of countries over the 1980s. We show this result is unlikely to be driven by omitted variables, outliers, or reverse causality. (JEL O4, F3, G1) A large literature, dating at least as far back as Joseph A. Schumpeter (1911), emphasizes the positive in uence of the development of a country's nancial sector on the level and the rate of growth of its per capita income. The argument essentially is that the services the nancial sector provides { of reallocating capital to the highest value use without substantial risk of loss through moral hazard, adverse selection, or transactions costs { are an essential catalyst of economic growth. Empirical work seems consistent with this argument. For example, on the basis of data from 35 countries between 1860 and 1963, Raymond W. Goldsmith (1969, p48) Raghuram G. Rajan and Luigi Zingales are both at the University of Chicago, Graduate School of Business, 1101 E 58th street, Chicago IL 60637. We thank George Benston, Marco Da Rin, Eugene Fama, Peter Klenow, Krishna Kumar, Ross Levine, Jonathan Macy, Colin Mayer, Canice Prendergast, Andres Rodriguez-Clare, David Scharfstein, Robert Vishny, and two anonymous referees for valuable comments. Jayanta Sen, Dmitrii Kachintsev, and Alfred Shang provided excellent research assistance. A preliminary study was supported by the World Bank. We gratefully acknowledge nancial support from NSF grant #SBR-9423645.