Financial Restraints and Private Investment: Evidence from a Nonstationary Panel

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I. INTRODUCTION

In the early 1970s, McKinnon (1973) and Shaw (1973) put forward the idea that financial repression--that is, government-imposed controls on lending and deposit rates, capital controls, and directed credit--had a negative impact on investment and growth by suppressing domestic saving and distorting the allocation of credit. Although their views were vigorously challenged by a range of critics, (1) their main policy recommendation for financial liberalization gained momentum among policy makers in both developing and developed countries. As a result, the last 40 years have witnessed a gradual removal of financial restraints worldwide with increased movement of capital around the globe. (2)

Both these developments are likely to influence the behavior of private investment. Increased international capital flows are likely to result in a relaxation of borrowing constraints for many firms, leading to credit expansion. (3) Under fully liberalized conditions the price of credit for many, if not all, firms will rise, making their investment plans more sensitive to the price of credit and no longer sensitive to the availability of credit. Under partial liberalization or continued financial repression, however, some firms may continue to have access to subsidized credit while others may have access to more expensive international loans. Does the retention of financial restraints under these circumstances deter or promote investment? In other words, once a country moves away from complete financial repression--where the only source of credit for private investment is the domestic banking system--can the provision of cheaper, albeit rationed, domestic credit help stimulate private investment? This is the question we address in this article. To do so, we employ a theoretical model of investment which assumes that firms have access to quantity-constrained domestic loans that are cheaper than those they can obtain from international capital markets. (4) This accommodates the idea that increased international capital flows might have relaxed borrowing constraints for many firms while, at the same time, some firms may have continued to benefit from access to cheaper policy loans. We operationalize the model in a multicountry setting and derive five variants of a private investment equation including a baseline neoclassical model without financial restraints. To estimate the investment equations, we employ recently developed nonstationary panel methodologies that allow for cross-sectional dependence across countries. The presence of dependence across countries is a plausible hypothesis in a world characterized by growing real and financial interlinkages, which we test by appropriate econometric procedures.

Our sample includes 20 developing countries over the period 1972-2000. The econometric analysis consists of three steps. First, unit root tests for cross-sectionally dependent panels are applied. Second, the existence of a cointegrating relationship among the variables is investigated, fully allowing for cross-section dependence. Third, the fully modified ordinary least squares (FMOLS) estimator developed by Bai and Kao (2006) is used to estimate the investment equations. We contrast our results with those obtained using the pooled FMOLS estimator of Pedroni (2000), which assumes cross-sectional independence.

Our findings confirm the importance of taking into account cross-country dependence. We find that when we allow for cross-sectional dependence, investment displays more sensitivity to world capital market conditions and exchange rate uncertainty. Perhaps more surprisingly, we find that "repressing" domestic real interest rates resulted in higher levels of private investment than those that would have been obtained under more "liberalized" conditions. This finding, which contrasts sharply with the McKinnon-Shaw prediction, complements a growing literature on the possible negative effects of financial liberalization on the channels of economic growth. …