Sunday, March 8, 2015

Financial market growth and resource mis-allocation

Gretchen Morgenson points to a recent paper by Stephan Cecchetti and Enisse Kharroubi which finds that overall productivity gains were dragged down in economies with rapidly growing financial markets. They studied 33 manufacturing industries in 15 countries and came to two interesting conclusions,
First, the growth of a country's financial system is a drag on productivity growth. That is, higher growth in the financial sector reduces real growth. In other words, financial booms are not, in general, growth-enhancing, likely because the financial sector competes with the rest of the economy for resources... This is a consequence of the fact that financial sector growth benefits disproportionately high collateral/low productivity projects. This mechanism reflects the fact that periods of high financial sector growth often coincide with the strong development in sectors like construction, where returns on projects are relatively easy to pledge as collateral but productivity (growth) is relatively low... 
Second, using sectoral data, we examine the distributional nature of this effect and find that credit booms harm what we normally think of as the engines for growth – those that are more R&D intensive... We report estimates that imply that a highly R&D-intensive industry located in a country with a rapidly growing financial system will experience productivity growth of something like 2 percentage points per year less than an industry that is not very R&D-intensive located in a country with a slow-growing financial system... By draining resources from the real economy, the financial sector becomes a drag on real growth.
In simple terms, when capital is available in plenty and cheap, it is more likely to get mis-allocated to less-productive sectors prone to asset-bubbles like construction and real-estate and away from more productive but riskier activities like start-ups and entrepreneurial ventures or research and development intensive sectors. They also find that "when finance is ascendant in an economy, it attracts an inordinate number of highly skilled workers who might otherwise take their productivity and brains to non-financial industries." A corollary to this is that real estate and construction asset bubbles generate financial resource mis-allocation effects that adversely affects the real economy.

This mechanism partially explains India's brief high-growth episode of 2003-08. It was associated with cheap and plentiful credit which fuelled a real-estate bubble and construction boom. This was amplified by sharply increased public and private spending on infrastructure sectors - roads, ports, airports, power projects, urban utilities, mining etc. The share of construction sector in the gross value added and total employment rose disproportionately. In contrast manufacturing's share of employment contracted and output remained stagnant. Instead of trying their luck in knowledge-based sectors and manufacturing, entrepreneurial talent flocked to high-return but less productive real estate and infrastructure sectors.

The net result was a growth episode whose foundations were laid on low productivity non-tradeable construction sector. This was unlikely to be sustainable and collapsed when faced with adverse shocks leaving behind distressed balance sheets in both the construction-intensive infrastructure sectors as well as among their creditors. An infrastructure and construction focussed revival of economic growth, without adequate contribution from productivity enhancing tradeable sectors like manufacturing, is only likely to repeat the story. 

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