Figure 1 develops the difference between the finance effect and the asset substitution effect. Take labor and human capital as fixed. Assume the optimal production point given world factor prices for fixed and intangible assets entails combinations of amounts of fixed and intangible assets that lay along the line from the origin through point A. Assume the firm wants to expand from initial point A as demand increases. If the firm has access to highly developed financial markets and is able to collateralize all types of assets, it would be able to raise enough external financing to invest in an optimal proportion of fixed assets and intangible assets to arrive at say point D. The investment of firms in countries with well-developed financial markets should exhibit such patterns If the supply of external financing is limited, the firm may only be able to reach point C. The difference between point D and point C could then be ascribed to a more limited supply of external financing. The firm, however, could also deviate from the optimal production line, points A, C and D. It may, for example, find it more efficient to hoose point B rather than point C. This would be if the firm finds it more difficult to secure for itself returns from intangible assets compared to returns from fixed assets. This could be the case in developing countries, where due to poor (intellectual) property rights it may hard for a firm to collect revenues from assets such as patents and other intangible assets. More generally, a preference for investments in fixed assets rather than intangible assets may arise in countries with poor protection of property rights when there are fixed costs to producing intangible assets. With poor protection of property rights, it will be less attractive for a firm to incur any fixed costs to produce intangible assets, like investing in research and development, marketing, networks, human resources, etc. This could make it more attractive for a firm to invest largely in fixed assets The law and finance literature focuses on the difference between point D and C, as the supply of external financing is not assumed to be affected by the asset choice. If firms in countries with low financial development and poor property rights systematically were to choose point B rather than point C, then the law and finance approach would ascribe the whole difference between point D and B, and any impact on firm growth, to limited financial development only. In other words, the law and finance literature ignores any differences on the asset side of the firm's balance sheet when studying the effects of legal frameworks on firm financing and growth patterns. But the difference between
6 Figure 1 develops the difference between the finance effect and the asset substitution effect. Take labor and human capital as fixed. Assume the optimal production point given world factor prices for fixed and intangible assets entails combinations of amounts of fixed and intangible assets that lay along the line from the origin through point A. Assume the firm wants to expand from initial point A as demand increases. If the firm has access to highly developed financial markets and is able to collateralize all types of assets, it would be able to raise enough external financing to invest in an optimal proportion of fixed assets and intangible assets to arrive at say point D. The investment of firms in countries with well-developed financial markets should exhibit such patterns. If the supply of external financing is limited, the firm may only be able to reach point C. The difference between point D and point C could then be ascribed to a more limited supply of external financing. The firm, however, could also deviate from the optimal production line, points A, C and D. It may, for example, find it more efficient to choose point B rather than point C. This would be if the firm finds it more difficult to secure for itself returns from intangible assets compared to returns from fixed assets. This could be the case in developing countries, where due to poor (intellectual) property rights it may hard for a firm to collect revenues from assets such as patents and other intangible assets. More generally, a preference for investments in fixed assets rather than intangible assets may arise in countries with poor protection of property rights when there are fixed costs to producing intangible assets. With poor protection of property rights, it will be less attractive for a firm to incur any fixed costs to produce intangible assets, like investing in research and development, marketing, networks, human resources, etc. This could make it more attractive for a firm to invest largely in fixed assets. The law and finance literature focuses on the difference between point D and C, as the supply of external financing is not assumed to be affected by the asset choice. If firms in countries with low financial development and poor property rights systematically were to choose point B rather than point C, then the law and finance approach would ascribe the whole difference between point D and B, and any impact on firm growth, to limited financial development only. In other words, the law and finance literature ignores any differences on the asset side of the firm’s balance sheet when studying the effects of legal frameworks on firm financing and growth patterns. But the difference between
point D and B is not only due to a lack of finance effect, but also due to an asset substitution effect. The two effects may not only be different, they may also have different and complementary effects on final firm growth. The empirical question is whether the asset substitution effect is present, how it can be differentiated from the law and finance effect, and what its quantitative importance might be Note that in our example firms in countries with a well-developed financial sector but poor protection of property rights would choose point E in Figure 1. Thus, point illustrates the case where the finance effect is absent and the deviation from the optimal llocation(point D)can be contributed fully to the asset substitution effect that arises from poor property rights
7 point D and B is not only due to a lack of finance effect, but also due to an asset substitution effect. The two effects may not only be different, they may also have different and complementary effects on final firm growth. The empirical question is whether the asset substitution effect is present, how it can be differentiated from the law and finance effect, and what its quantitative importance might be. Note that in our example firms in countries with a well-developed financial sector but poor protection of property rights would choose point E in Figure 1. Thus, point E illustrates the case where the finance effect is absent and the deviation from the optimal allocation (point D) can be contributed fully to the asset substitution effect that arises from poor property rights
Figure 1: Investment in intangible assets versus fixed assets financial development and asset substitution effects Intangible Assets (A) lA 1, High lA L Low Asset substitution E B Allow Fixed Assets(FA)
8 Figure 1: Investment in intangible assets versus fixed assets: financial development and asset substitution effects Fixed Assets (FA) FA0 FA1,Low FA1,High IA1,High IA 1, Low IA0 Intangible Assets (IA) Asset substitution Finance A D B C E
Overall, the above discussion suggests that firms in countries with stronger legal frameworks will have more overall investment and better asset structures. which in turn will be reflected in higher growth rates. To empirically test whether firms in countries with better legal frameworks indeed experience higher growth rates, we use a setup to assess the relationship between financial development and growth similar to the one used by rajan and zingales(1998, RZ). In particular, we test whether industrial sectors that typically use a lot of intangible assets grow faster in countries with stronger property rights. In addition to testing the effects of property rights on firm growth, we directly test the asset substitution effect by investigating whether firms in countries with weaker property rights invest less in intangible assets. We also directly explore the supply of external financing effect by investigating the relationship between the strength of legal rights and the amount of long-term debt extended by lenders per unit of fixed assets. In what follows, we develop testable regression specification for these three hypotheses Let there be m countries, each indicated by index k, and n industries, each indicated by index j. The first set of equations relate the growth in real value added of a firm in a particular country to a number of country and firm-specific variables. The law and finance effect is measured by the interaction term between the typical external dependence variable for the particular sector and the country's level of financial development. The argument of RZ is that financially dependent firms grow more in countries with a higher level of financial development. This equation also allows us to disentangle the law and finance effect from the asset substitution effect. We do this by testing directly whether growth is higher for firms that typically use a lot of intangible assets in countries with good protection of property rights. Specifically, aquation (1a) extends the basic model in rz by adding a variable that is the interaction of the typical ratio of intangible to fixed assets and the property rights inde In line with RZ, we use US firm data to construct proxies for the typical external dependence for a particular industry and the typical ratio of intangible-to-fixed assets for a particular industry. The presumption here is that the Us financial markets are well developed and that property rights are protected well in the US such that firms are at the optimal external financing and asset structure point for their respective industrial sector Followin RZ, we add in the regression the industry's market share in total
9 Overall, the above discussion suggests that firms in countries with stronger legal frameworks will have more overall investment and better asset structures, which in turn will be reflected in higher growth rates. To empirically test whether firms in countries with better legal frameworks indeed experience higher growth rates, we use a setup to assess the relationship between financial development and growth similar to the one used by Rajan and Zingales (1998, RZ). In particular, we test whether industrial sectors that typically use a lot of intangible assets grow faster in countries with stronger property rights. In addition to testing the effects of property rights on firm growth, we directly test the asset substitution effect by investigating whether firms in countries with weaker property rights invest less in intangible assets. We also directly explore the supply of external financing effect by investigating the relationship between the strength of legal rights and the amount of long-term debt extended by lenders per unit of fixed assets. In what follows, we develop testable regression specification for these three hypotheses. Let there be m countries, each indicated by index k, and n industries, each indicated by index j. The first set of equations relate the growth in real value added of a firm in a particular country to a number of country and firm-specific variables. The law and finance effect is measured by the interaction term between the typical external dependence variable for the particular sector and the country’s level of financial development. The argument of RZ is that financially dependent firms grow more in countries with a higher level of financial development. This equation also allows us to disentangle the law and finance effect from the asset substitution effect. We do this by testing directly whether growth is higher for firms that typically use a lot of intangible assets in countries with good protection of property rights. Specifically, equation (1a) extends the basic model in RZ by adding a variable that is the interaction of the typical ratio of intangible to fixed assets and the property rights index. In line with RZ, we use US firm data to construct proxies for the typical external dependence for a particular industry and the typical ratio of intangible-to-fixed assets for a particular industry. The presumption here is that the US financial markets are well developed and that property rights are protected well in the US such that firms are at the optimal external financing and asset structure point for their respective industrial sector. Following RZ, we add in the regression the industry’s market share in total
manufacturing to control for differences in growth potential across industries. Industries with large market shares initially may have less growth potential than industries with small market shares initially Growth k=Constant +P,m Country indicators +P, m+l.m+n indicators +Bmn+. (Industry j share of manufactur ing in country k in 1980) +Bn+n+2. (External dependence US industry j. Financial developmen t country k)(la) +Bm+n+3. (Intangible assets/Fix ed assets US industry j Property rights country k) The law and finance literature asserts that financial markets are more developed in environments with better law and order (and creditor rights). In this view, financial development is the result of a good legal framework and the supply of external financing is not independent of the quality of the legal framework. We therefore also estimate a variation on the previous specification that uses the law and order index of a countr rather than its financial development to measure the link between a sectors financial d ependence and gre owth(equation 1b) Growth /.=Constant +BI.m Country indicators +Bm+l.+m. Industry indicators + Bnanl (Industry j's share of manufactur ing in country k in 1980) Bran+2( Extermal dependence US industry j. Law and order country k) +Bmns (Intangible assets/Fix ed assets US industry j. Property rights country k) The next two sets of tests focus on firm's actual choices of investment and financing patterns, providing the supporting evidence that investment and financing structures can both be affected by the quality of the legal framework in a country. The first set of tests relate the investment structure of firm j in county k to the quality of k. Eq (2) specifically tests whether firms in countries with better protection of property have relatively less amounts of fixed assets and larger
10 manufacturing to control for differences in growth potential across industries. Industries with large market shares initially may have less growth potential than industries with small market shares initially. . (Intangible assets/Fix ed assets US industry Property rights country ) (External dependence US industry Financial developmen t country ) (Industry share of manufactur ing in country in 1980) Growth Constant Country indicators Industry indicators , 3 2 1 , 1... 1... j k m n m n m n j k m m m n j k j k j k e b b b b b + + × × + × × + × = + × + × + + + + + + + + (1a) The law and finance literature asserts that financial markets are more developed in environments with better law and order (and creditor rights). In this view, financial development is the result of a good legal framework and the supply of external financing is not independent of the quality of the legal framework. We therefore also estimate a variation on the previous specification that uses the law and order index of a country rather than its financial development to measure the link between a sector’s financial dependence and growth (equation 1b).4 . (Intangible assets/Fix ed assets US industry Property rights country ) (External dependence US industry Law and order country ) (Industry 'sshare of manufactur ing in country in 1980) Growth Constant Country indicators Industry indicators , 3 2 1 , 1... 1... j k m n m n m n j k m m m n j k j k j k e b b b b b + + × × + × × + × = + × + × + + + + + + + + (1b) The next two sets of tests focus on firm’s actual choices of investment and financing patterns, providing the supporting evidence that investment and financing structures can both be affected by the quality of the legal framework in a country. The first set of tests relate the investment structure of firm j in county k to the quality of property rights in country k. Equation (2) specifically tests whether firms in countries with better protection of property have relatively less amounts of fixed assets and larger