Legal Institutions, Sectoral Heterogeneity, and Economic Development

Abstract

A large body of evidence suggests that poor countries tend to invest less (have lower PPP-adjusted investment rates) and to face higher relative prices of investment goods. It has been suggested that this happens either because these countries have lower TFP in the investment-good producing sectors, or because they are subject to greater investment distortions. What is still to be understood, however, is what are the causes of these shortcomings. In this paper we address this question by providing a micro-foundation for the cross-country dispersion in investment distortions. Our analysis rests on two premises: 1) countries differ with respect to the rights enjoyed by outside investors (such as bondholders and minority shareholders) and 2) firms producing capital goods face a higher level of idiosyncratic risk than their counterparts producing consumption goods. In a model of capital accumulation where the protection of investors' rights is incomplete, this difference in risk induces a wedge between the returns on investment in the two sectors. The wedge is bigger, the lower the investor protection. In turn, this implies that countries endowed with weaker institutions are poorer, face higher relative prices of investment goods, and invest a lower fraction of their income. Our analysis also suggests that the mechanism we study may be quantitatively important.

Aggregate Consequences of Dynamic Credit Relationships

“…Since input financing frictions are captured by standard measure of firm productivity, it is possible that the noted sectorial and cross-country differences in firm access to credit attributed to heterogeneous productivity (Castro, Clementi, and Macdonald [2009], Buera et al [2011]) could also reflect differences in monitoring efficiency arising from, for example, different management practices (Bloom, Eifert, Mahajan, McKenzie, and Roberts [2013]), as well as differences in legal institutions (La Porta, de Silanes, Shleifer, and Vishny [1997], La Porta, de Silanes, Shleifer,…”

From Institutions to Financial Development and Growth: What are the Links?

“…As the papers surveyed before in this subsection, Himelberg et al (2002) In the extension of Castro et al (2004) to the two-sector model by Castro et al (2009), the key driver of low investment is the fact that, because of its inherent higher risk, production of investment goods disproportionately su¤ers from imperfect risk-sharing driven by weak institutions (i.e., low investor protection). A calibrated version of this model shows that between 38 and 81 percent 35 of the cross-country variation in (log) investment can be accounted for by di¤erences in investor protection.…”

“…It is against this background that we see the recent breed of quantitative general equilibrium models (Antunes et al (2008), Amaral and Quintin (2010), Castro et al (2009), Buera et al (2011), Buera and Shin (2013), Midrigan and Xu (2014)) as a promising area to understand the mechanisms by which institutional, …nancial and economic development may a¤ect one…”

“…In subsequent work, Castro, Clementi, and MacDonald (2009) provide an extension to their earlier paper by studying a two-sector model in which a capital producing sector faces larger shocks (is "riskier") than a consumption goods sector. Financial frictions, again stemming from agency problems, generate incomplete risk-sharing and a wedge between the returns to investment in the capital and in the consumption goods sector that is only partially compensated by an increase in the price of capital.…”

Financial Infrastructure, Technological Shift, and Inequality in Economic Development

“…To mention a few, Saint-Paul (1992) shows that without a well-functioning financial market, risk-averse agents may choose less specialized and less productive technologies. Castro et al (2005) demonstrate that stronger investor protection facilitates economic development, given that the technology for producing investment goods involves a higher idiosyncratic risk than does the technology for producing consumption goods. In contrast, Bencivenga et al (1995) show that a technological shift resulting from a better financial infrastructure may reduce the growth rate if the new technology requires a longer duration for which investments must be committed.…”