THE WILLIAM DAVIDSON INSTITUTE AT THE UNIVERSITY OF MICHIGAN BUSINESS SCHOOL Financial Dependence, Stock Market Liberalizations, and Growth

Stock market liberalizations provide a natural experiment to test for the causal relation between financial development and economic growth. We test this relation by investigating whether liberalizations facilitate growth through the particular mechanism of reducing capital market imperfections that drive a wedge between the external and internal cost of capital to firms. Using panel data on a large sample of emerging markets, we find no evidence of a uniform shift across all sectors in average industry growth following liberalization. Instead, consistent with the hypothesis that liberalizations lower the incremental cost of external capital, it appears that industries that depend more on external finance experience significantly higher growth following liberalization. We also find that growth occurs through the creation of new establishments, which is more likely to require external funds, rather than through an expansion in the average size of existing establishments, which firms are more likely to finance with internal cash. These results are robust to alternative hypotheses, country and industry specific controls, other economic reforms, world business cycle effects, and contemporaneous macroeconomic shocks. ∗Nandini Gupta is at the William Davidson Institute at the University of Michigan Business School, [email protected]. Kathy Yuan is at the University of Michigan Business School, [email protected]. We thank Raghuram Rajan and Luigi Zingales for use of