Finance and the Business Cycle: International, Inter-Industry Evidence

1. Finance and the Business Cycle: International, Inter-Industry Evidence Matías Braun The Anderson School at UCLA Borja Larrain Harvard University December 12, 2003

2. Finance and the Business Cycle: Outline • Motivation and Previous Evidence • Basic Idea and Implementation • Main Results • Robustness and further Results • Conclusion

3. Motivation and Previous Evidence • Financial frictions might help propagate primitive shocks • External financiers do not want to provide funds: Williamson (1987), Bernanke and Gertler (1989), Kiyotaki and Moore (1997). • External financiers (banks) cannot provide funds: Bernanke and Blinder (1988), Stein (1998). • Do they? • Usual strategy: identify a-priori a set of more financially constrained firms (or group thereof) and compare their response to a negative shock to a control group. • A-priori constrained: small (most), more leveraged (Sharpe, 1994), no access to public bond markets (Kashyap, Lamont and Stein, 1994). • Response: employment (Sharpe, 1994), inventories (Kashyap, Lamont and Stein, 1994), pricing strategies (Chevalier and Scharfstein, 1996), investment/investment sensitivity (Oliner and Rudebush, 1996), sales and short-term debt (Gertler and Gilchrist, 1994; Bernake, Gertler and Gilchrist, 1996), comercial • Difficulties • Most evidence comes from a few developed countries and a few shocks • Identification: “constrained” group might just be differently affected by shocks (i.e. small firms are naturally more affected by recessions).

4. Basic Idea and Implementation • Data: Industry (28) x Country (>100) x Years (1963-99). • 1) Shock: every recession there has been. Response: real production growth. • If the financial mechanism is present: • Industries more dependent on external finance should be more affected by recessions • 2) Rajan and Zingales (1998)’s industry external finance dependence. Industry median of (capx - cash flow from oper) / capx based on U.S. public firms. Ranking is maintained across countries. • Especially if they are subject to more financial imperfections • 3a) Financial Development across countries (accounting standards, creditor rights, legal origin…) • 3b) Asset hardness across industries (industry tangibility) • Extends the evidence across countries and in time • Identification: Change in investment opportunities should not be related to financial development. Asset hardness evidence adds an additional restriction to alternative stories.

5. Results at a glance Differential Impact of Recessions Production growth Recession – Production growth non-Recession • The effect comes from: • deeper fall of highly dependent industries in recessions • financially underdeveloped countries and low tangibility industries • As long as the industry does not rely too much on external finance, or if it does it is located where financial imperfections are not too prevalent or has means to solve these, the effect of recessions will be limited.

6. Main Results

7. Financial Development measure does not matter • Not coming from cross-country income differences • Not coming from cross-industry durability, investment/consumption, or tradability

8. The effect is asymmetric: only in bad times

9. Finance and the Business Cycle: Further Robustness and Results • The results are also robust to: • Different definitions and kinds of recessions (recession size, monetary recessions, world recessions, recessions with credit crunch) • Relaxing the assumption of external finance dependence being invariant across countries and in time • The same basic pattern is observed on • employment • number of establishments • gross fixed capital formation

10. Finance and the Business Cycle: Conclusions • The financial mechanism: • Widespread across countries, relevant in magnitude • Critical for countries with low financial development and industries with little hard assets • Related Issues: • The future of Business Cycles • Political Economy of Policy Interventions • Efficacy of Monetary Policy

12. Industry Variables Low External Finance Dependence: Pottery, China, Earthenware; Tobacco; Footwear; Leather; Wearing Apparel High External Finance Dependence: Glass; Electric machinery; non-Electric machinery; Professional and scientific equipment; Plastic products

13. Cyclical GDP and recessions

14. Most – Least Dependent Difference