This dissertation provides micro-economic evidence to support the claim that underdeveloped financial and legal institutions adversely affect economic growth. Three chapters of this dissertation provide independent evidence that underdeveloped financial and legal systems result in a high cost of external finance which in turn restricts firm's investment policy and results in inefficient capital allocation.
The first chapter demonstrates that firms in countries with underdeveloped financial systems are financially constrained and therefore cannot invest optimally. It uses a structural investment model based on the Euler equation for optimal capital accumulation, which captures the investment growth opportunities and identifies the financial factors by the sensitivity of investment to availability of internal funds. A number of ancillary results such as effect of the firm's size on its financing constraints and evidence on the business cycle effect reinforce the main results.
The second chapter investigates the effect of weak investor protection on inside ownership concentration and capital allocation. Under weak investor protection, insiders choose higher levels of inside equity ownership to reduce the agency cost of external equity financing, but this increases their exposure to idiosyncratic risk, which raises the cost of capital and leads to underinvestment. The empirical results support two intuitive predictions of the formal model, namely: that (i) inside ownership depends on both firm and country-level measures of investor protection, and (ii) the marginal return on capital is positively correlated with the level of inside ownership.
The third chapter argues that some firms or industries may be able to mitigate the effects of deficient (formal) financial intermediaries by borrowing from (informal) intermediaries such as their suppliers. Utilizing the recently developed industry-level methodology, it shows that industries with higher dependence on trade credit financing (measured by the ratio of accounts payable to total assets) exhibit higher rates of growth in countries with relatively weak financial institutions.
Using three complementary approaches, this dissertation provides empirical evidence that financial development and the legal system play an important role in improving capital reallocation and firm growth.