5  Assessment of the empirical evidence

There are several sources of empirical evidence to draw upon in assessing the extent to which countries and firms in general, and New Zealand in particular, are affected by information asymmetries and the development of financial systems to reduce them. There is a literature drawing on the connection between a country’s financial development and its rate of economic growth; a literature evaluating whether a shift to financial markets or intermediaries affects growth rates; and a body of research assessing the importance of financing constraints. Each of these areas of research is discussed in this section.

5.1  The empirical link between financial systems and economic growth

The interaction between financial systems and real activity has been investigated empirically since at least Gurley and Shaw (1955), who conjecture that financial systems play an important role in improving the efficiency of intertemporal trade and economic growth. Their conclusion is based on an observed correlation between economic development and financial systems. That is, developed countries tend to have highly organised and broad financial systems to facilitate the flow of loanable funds between borrowers and lenders, while in developing countries the financial system is much less evolved.

The empirical literature on the financial systems and economic growth nexus has expanded rapidly since Gurley and Shaw and the following conclusions seem to emerge.[18] Countries with better developed financial systems tend to grow faster than countries with smaller banking systems and less liquid financial markets. Also, industries and firms that rely on external financing tend to grow faster in countries with well developed financial systems than countries with poorly functioning financial systems (Levine 2003). These results are based on estimations using different statistical procedures and data sets (cross country, panel data, firm and industry level and time series data).

However, conclusions about the empirical link between finance and economic growth and the quantitative significance of financial development need to be drawn cautiously. This is because of two main problems with the estimations. First, financial development can not be directly measured and must be approximated. Second, the estimations are subject to a simultaneity bias, i.e. financial development and economic growth are likely to be simultaneously determined. Financial development affects economic growth and vice versa. The simultaneity bias can be overcome with the use of instrumental variables if appropriate instruments are available. Limited data on financial development unfortunately means that instruments are even more difficult to find.[19] As a result, answering this question presently requires extrapolation from more specific quantitative research.

The empirical link, at a country level, between economic growth and the degree to which countries’ financial systems are intermediary or market based is investigated in Levine (2002). Measuring financial structure is difficult and Levine uses a range of indicators for the size, activity and efficiency of various components of the financial system, including banks, securities markets and non-financial intermediaries. The cross-country comparisons do not reveal significant differences between the economic growth of countries with more market based or more intermediary based financial systems. The results show that specific laws and enforcement mechanisms that govern debt and equity transactions are more important in explaining economic growth than the indicators as to whether a system is intermediary or market based. This result is robust to different specifications.

Levine’s (2002) data set comprises data series for 48 countries for the period 1980 to 1995 and includes New Zealand. According to Levine’s measures, financial intermediaries and markets are both important in New Zealand with a slight predominance of financial markets. The finding of a slightly greater importance of financial markets is somewhat surprising and in contrast with other evidence which suggests that New Zealand is a more intermediary based system. For, example, a recent report by the International Monetary Fund (IMF) on financial system stability in New Zealand noted that the non-bank financial sector accounts for only a quarter of financial system assets.[20] Levine’s (2002) finding probably warrants further investigation.

The question of access to finance is generally assessed at the firm level. The empirical work shows that access to finance for particular types of firm is constrained in some circumstances. Financing constraints seem to exist for some firms even in countries with highly developed financial systems like the United States.

The propensity of smaller firms to cut work hours and production in response to cash flow constraints by more than larger firms, which are more likely to increase short-term borrowing, provides evidence that small firms are constrained in their ability to increase borrowing (Bernanke and Gertler 1995 and Gertler and Gilchrist 1994b). This view that firms’ access to external finance may be limited in some circumstances is supported by the existence of an economically significant non-bank lending sector providing finance for high risk firms unable to obtain bank credit (Denis and Mihov 2003). That younger firms more often resort to the use of expensive trade credit relative to more established firms has also been taken to demonstrate the existence of credit rationing by banks (Petersen and Rajan 1994). Finally, Faulkender and Peterson (2003) find that firms with access to public debt markets have significantly higher leverage ratios than firms without such access.[21] Their finding can be interpreted as evidence of a financing constraint – firms without access to public debt markets are constrained as to the amount of external finance they can obtain. Each of these conclusions suggests the existence of credit limitations, often particularly for smaller or younger firms, consistent with an information asymmetry hypothesis.

5.2  Empirical evidence in the New Zealand context

A key factor in firms’ decisions to undertake an investment project is the cost of finance relative to the rate of return for the investment project. Another factor is access to external financing when firms require additional funds to undertake an investment project. New Zealand research on the cost of capital, the rate of return to investment and access to financing has been limited, and has focused particularly on aggregate and survey data or case studies. Limited analysis has been conducted on the cost of finance below the aggregate level as virtually no information is available at the firm or industry level, or on the effect of aggregate measures on particular instruments.[22]

Lally (2000) compares the real (inflation-adjusted) cost of capital in New Zealand, Australia and the United States. He finds that the New Zealand real government bond rate over the second half of the 1990s was comparable with Australia’s, but significantly higher than in the United States. The New Zealand term premium for equity capital is similar to that for government bonds. Lally’s findings are in line with the results in Hawkesby, Smith and Tether (2000), who find that over the 1990s the term premium in New Zealand’s interest rates versus interest rates in the United States was quite large but much smaller versus Australian rates.

Using a panel of OECD countries, Plantier (2003) also finds a persistent although declining margin between real interest rates in New Zealand and the rest of the world. His results provide some support for the hypothesis that the cost of borrowing has been higher in New Zealand because of greater reliance on foreign borrowing. A study by Conway and Orr (2002) of interest rate differentials across a number of currencies suggests that the lower liquidity of the New Zealand dollar may also have been a contributing factor.

These analyses use government bond rates, and focus on the potential cost of finance for larger firms, which may not be a good proxy for the cost of capital for a number of New Zealand firms.[23] To date, no information is available on the proportion of firms that can actually borrow at this near risk free rate. Given the potential importance of bank lending in New Zealand, a useful first step may be to extend the analysis to incorporate the cost of bank borrowing, for which aggregate data are available.

Limited information is available on the rate of return to investment (capital) in New Zealand. Aggregate data suggest that the rate of return to capital, measured by the share of gross operating surplus in value added,is high in New Zealand compared to other OECD countries (Claus and Li 2003).[24] However, this measure of rate of return does not adjust for risk. The concept of economic value added (EVA) attempts to adjust for risk. It is an estimate of the amount by which earnings exceed (fall short of) the required minimum rate of return that lenders could achieve by investing in other securities of comparable risk.[25] In 2000, the ANZ Bank undertook a study on the economic value added of firms listed on the New Zealand stock exchange (Healy 2000). The results show that economic value added has been negative for several New Zealand companies over the 1990s. Economic value added may be low if rates of return adjusted for risk are low or if firms’ cost of borrowing is high. Further research is probably required on the risk adjusted rate of return and cost of capital in New Zealand. The concept of economic value added presents a promising avenue for future work.

The question of access to finance domestically has primarily been addressed through the use of business surveys. Available New Zealand evidence does not generally suggest that respondents believe there are problems with access to finance (Fabling and Grimes 2004 and Knuckey et al 2002). The literature reviewed in the previous section, which is based on quantitative studies conducted overseas, suggests that finance constraint issues are endemic and that certain types of firm are more likely to be affected. Reconciling these streams of work depends to some extent on how one interprets the meaning of survey respondents’ answers and how one views potential issues associated with the use of survey evidence in this context. Without further quantitative work along the lines conducted overseas, we would hesitate to draw the conclusion that New Zealand’s experience is different.[26] As a result, further New Zealand specific quantitative study would be valuable. A forthcoming survey of business finance conducted by Statistics New Zealand on behalf of the Ministry of Economic Development will provide valuable insights into firms’ access to finance and their use of different instruments.