Financial Markets and the Allocation of Capital

Abstract

Economists have long argued that financial markets can improve the allocation of capital across an economy's investment opportunities, but empirical evidence to support this belief has been lacking. This paper presents evidence from 65 countries which suggests that financial markets do indeed play a crucial role in the capital allocation process. In particular, countries with developed financial markets increase investment more in growing industries, and decrease investment more in declining industries, than financially undeveloped countries.

Three additional results shed light on some of the mechanisms behind this result. Across countries, the efficiency of capital allocation is: (1) negatively correlated with the extent of state ownership in the economy; (2) positively correlated with the degree of firm-specific movement in domestic stock returns; (3) positively correlated with the legal protections of investors (which appear to be particularly useful for limiting overinvestment in declining industries).

Note: This is a description of the paper and not the actual abstract.

JEL Classification: E22, G20, N20