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Economic growth will occur if property rights make it worthwhile to undertak socially productive activity Douglass C North and Robert Paul Thomas- 1. Introduction Recently, a large number of papers have established that financial development fosters growth and that financial development is related to a countrys institutional characteristics, including a strong legal framework. This law and finance literature has found that firms in countries with well-developed financial markets and a strong legal ramework find it easier to attract (long-term) financing for their investment needs (la Porta et al. 1998, Demirguc-Kunt and Maksimovic 1998, Rajan and Zingales, 1998) Related work has established that debt structures of firms differ across institutional frameworks(Rajan and Zingales 1995, Demirguc-Kunt and Maksimovic, 1999, Booth et al. 2000). In particular, it has been established that firms in developing countries have a smaller fraction of total debt in the form of long-term debt Thus far, however, the literature has not paid much attention to differences in firms' asset structure across countries. But these differences are large as well. Demirguc- Kunt and Maksimovic (1999) find, for example, that firms in developing countries have higher proportions of fixed assets to total assets and less intangible assets. This surprising as the literature on optimal capital structures(Harris and Raviv, 1991)would suggest that a lack of long-term financing would make it more difficult to finance fixed assets. So far, to our knowledge, no explanation of these findings has been provided How come that firms in developing countries have more fixed assets while they find it more difficult to get long-term external financing? Is it that they need more nominal collateral to attract the same amount of financing? Or are the returns to fixed assets more secure from the firm's point of view than the returns on intangible assets? In this paper, we explore the role on property rights in influencing the availability of external financing and the allocation of investable resources. Using a simple framework, we investigate the effects of legal framework on the amount of financing, The Rise of the Western World: A New Economic History( Cambridge, MA: Cambridge University Press, 1973),8

2 “Economic growth will occur if property rights make it worthwhile to undertake socially productive activity” Douglass C. North and Robert Paul Thomas2 1. Introduction Recently, a large number of papers have established that financial development fosters growth and that financial development is related to a country’s institutional characteristics, including a strong legal framework. This law and finance literature has found that firms in countries with well-developed financial markets and a strong legal framework find it easier to attract (long-term) financing for their investment needs (La Porta et al. 1998, Demirgüç-Kunt and Maksimovic 1998, Rajan and Zingales, 1998). Related work has established that debt structures of firms differ across institutional frameworks (Rajan and Zingales 1995, Demirgüç-Kunt and Maksimovic, 1999, Booth et al. 2000). In particular, it has been established that firms in developing countries have a smaller fraction of total debt in the form of long-term debt. Thus far, however, the literature has not paid much attention to differences in firms’ asset structure across countries. But these differences are large as well. Demirgüç- Kunt and Maksimovic (1999) find, for example, that firms in developing countries have higher proportions of fixed assets to total assets and less intangible assets. This is surprising as the literature on optimal capital structures (Harris and Raviv, 1991) would suggest that a lack of long-term financing would make it more difficult to finance fixed assets. So far, to our knowledge, no explanation of these findings has been provided. How come that firms in developing countries have more fixed assets while they find it more difficult to get long-term external financing? Is it that they need more nominal collateral to attract the same amount of financing? Or are the returns to fixed assets more secure from the firm’s point of view than the returns on intangible assets? In this paper, we explore the role on property rights in influencing the availability of external financing and the allocation of investable resources. Using a simple framework, we investigate the effects of legal framework on the amount of financing, 2 The Rise of the Western World: A New Economic History (Cambridge, MA: Cambridge University Press, 1973), 8

confirming the well-established proposition in the law and finance literature that weaker legal frameworks diminish the availability of external resources. The model also shows that the allocation of investable resources between fixed and intangible assets is related to the protection of property rights. In particular, we show that it may be efficient for a firm, which operates in markets with weaker property rights, to choose more investment in fixed assets relative to intangible assets. The strength of this substitution effect will depend on the general protection of property rights, and maybe particularly on the strength of a country's intellectual property rights. The model thus shows that two effects affect the choice of a firm's asset structure in countries with imperfect financial markets and weaker property rights a lack of finance and an asset substitution effect The paper investigates empirically for a large number of countries the finance and asset substitution effects. We find that weaker property rights are associated with lower firm growth on account of both effects: firms get less financing, and thus underinvest overall; and they underinvest in intangible assets relative to fixed assets. empirically, the two effects appear to be equally important drivers of growth in sectoral value added for a large number of countries. USing firm specific data, we furthermore show that firms in developing countries invest relatively more in fixed assets despite a legal framework that little collateral value to fixed assets. We confirm that this occurs because these countries' property rights to protect intangible assets are even worse than those protecting fixed assets are. As a result. firms in these countries favor investments in fixed assets over investments in intangible assets. At the same time, firms in developing countries have less long-term financing for a given amount of fixed assets, as weaker creditor rights diminish the collateral value of their fixed assets The paper is structured as follows. Section 2 reviews the related literature. Section 3 describes the finance and asset substitution effect using a simple framework and ance and asset substitution effect empirically. Section 4 presents the data used in the empirical work. Section 5 presents the empirical results. Section 6 concludes Intellectual property rights are monopoly rights and broadly include patents(property rights to inventions trademarks(property rights for distinctive commercial marks or symbols/S, artists, and composers ),and and other technical improvements), copyrights(property rights to author

3 confirming the well-established proposition in the law and finance literature that weaker legal frameworks diminish the availability of external resources. The model also shows that the allocation of investable resources between fixed and intangible assets is related to the protection of property rights. In particular, we show that it may be efficient for a firm, which operates in markets with weaker property rights, to choose more investment in fixed assets relative to intangible assets. The strength of this substitution effect will depend on the general protection of property rights, and maybe particularly on the strength of a country’s intellectual property rights.3 The model thus shows that two effects affect the choice of a firm’s asset structure in countries with imperfect financial markets and weaker property rights: a lack of finance and an asset substitution effect. The paper investigates empirically for a large number of countries the finance and asset substitution effects. We find that weaker property rights are associated with lower firm growth on account of both effects: firms get less financing, and thus underinvest overall; and they underinvest in intangible assets relative to fixed assets. Empirically, the two effects appear to be equally important drivers of growth in sectoral value added for a large number of countries. Using firm specific data, we furthermore show that firms in developing countries invest relatively more in fixed assets despite a legal framework that gives little collateral value to fixed assets. We confirm that this occurs because these countries’ property rights to protect intangible assets are even worse than those protecting fixed assets are. As a result, firms in these countries favor investments in fixed assets over investments in intangible assets. At the same time, firms in developing countries have less long-term financing for a given amount of fixed assets, as weaker creditor rights diminish the collateral value of their fixed assets. The paper is structured as follows. Section 2 reviews the related literature. Section 3 describes the finance and asset substitution effect using a simple framework and presents our methodology to disentangle the finance and asset substitution effect empirically. Section 4 presents the data used in the empirical work. Section 5 presents the empirical results. Section 6 concludes. 3 Intellectual property rights are monopoly rights and broadly include patents (property rights to inventions and other technical improvements), copyrights (property rights to authors, artists, and composers), and trademarks (property rights for distinctive commercial marks or symbols)

2. Related Literature Our work is related to several strands of literature. The starting point is the so-called law and finance literature initiated by La Porta et al. (1998 )and Rajan and Zingales(1998) This literature focuses on the relationship between the institutional framework of a country and its financial development(see also La Porta et al. 1997, Demirguc-Kunt and Maksimovic 1998, and Carlin and Mayer, 2000 ). This literature has established that financial sector development is higher in countries with better legal systems and creditor rights because such environments increase the ability of lenders to finance firms. Related is the work by King and Levine(1993), Levine and Zervos(1998), and Beck et al. (2000) that has established an empirical link between financial development and economic growth, with a focus on the role of legal systems The second stram we draw on is the capital structure literature(Myers 1977 Titman and Wessels 1988, and Harris and Raviv 1991). This literature has established that real, tangible assets, such as plant and equipment, support more debt than intangib assets. In particular, fixed assets can support more long-term debt as they have more liquidation and collateralizable value. As intangibles have value only as part of a going concern, it follows that the debt-to-firm value ratio will be lower the larger the proportion of firm value represented by investment options(Myers 1977). Bradley et al. (1984)and Long and Malitz(1985) provide empirical support for the argument that a larger amount of intangible assets reduces the borrowing capacity of a firm. Rajan and Zingales(1995) and Demirguc-Kunt and Maksimovic (1999)show for firms in a cross-sectio countries that debt maturity and asset structures are related, with firms with more fixed assets being able to support more long-term debt Demirguc-Kunt and Maksimovic (1999)also show that firms in developing countries have a large share of fixed assets out of total assets, although they do not provide an explanation for it. This difference in asset composition for firms developing countries can have large implications for firm growth, in light of recent studies on the importance of different types of inputs in firm production. The growth literature has broadened the set of productive inputs from capital and labor( Solow 1956) to human capital and technology (Romer 1990, and Barro 1991, among others). In particular, Romer(1986, 1987)shows that technology exhibits increasing returns to scale

4 2. Related Literature Our work is related to several strands of literature. The starting point is the so-called law and finance literature initiated by La Porta et al. (1998) and Rajan and Zingales (1998). This literature focuses on the relationship between the institutional framework of a country and its financial development (see also La Porta et al. 1997, Demirgüç-Kunt and Maksimovic 1998, and Carlin and Mayer, 2000). This literature has established that financial sector development is higher in countries with better legal systems and creditor rights because such environments increase the ability of lenders to finance firms. Related is the work by King and Levine (1993), Levine and Zervos (1998), and Beck et al. (2000) that has established an empirical link between financial development and economic growth, with a focus on the role of legal systems. The second strand we draw on is the capital structure literature (Myers 1977, Titman and Wessels 1988, and Harris and Raviv 1991). This literature has established that real, tangible assets, such as plant and equipment, support more debt than intangible assets. In particular, fixed assets can support more long-term debt as they have more liquidation and collateralizable value. As intangibles have value only as part of a going concern, it follows that the debt-to-firm value ratio will be lower the larger the proportion of firm value represented by investment options (Myers 1977). Bradley et al. (1984) and Long and Malitz (1985) provide empirical support for the argument that a larger amount of intangible assets reduces the borrowing capacity of a firm. Rajan and Zingales (1995) and Demirgüç-Kunt and Maksimovic (1999) show for firms in a cross-section of countries that debt maturity and asset structures are related, with firms with more fixed assets being able to support more long-term debt. Demirgüç-Kunt and Maksimovic (1999) also show that firms in developing countries have a large share of fixed assets out of total assets, although they do not provide an explanation for it. This difference in asset composition for firms in developing countries can have large implications for firm growth, in light of recent studies on the importance of different types of inputs in firm production. The growth literature has broadened the set of productive inputs from capital and labor (Solow 1956) to human capital and technology (Romer 1990, and Barro 1991, among others). In particular, Romer (1986, 1987) shows that technology exhibits increasing returns to scale

and therefore the current endowment of technology is important for future growth Empirically, a link has been established between equipment investment, which incorporates technology, and economic growth, especially for developing countries(De Long and Summers, 1991, 1993). Investment in intangibles also appears to foster growth. Nickell and Nicolitsas (1996)find a link between increased R&D expenditure and subsequent increase in fixed capital investment. The relatively higher degree of investment in fixed assets by firms in developing countries could thus mean that growth is below optimal levels The lower degree of investment in intangible assets in developing countries may relate to the weaker protection of property rights in these countries. Mansfield(1995) already hints that there may be a relationship between protection of property rights and he allocation of investable resources between fixed and intangible assets. Using a survey of firm managers he states that "Most of the firms we contacted seemed to regard intellectual property rights protection to be an important factor.."[influencing] investment decisions". More generally, the institutional economics literature(North, 1990, and De Soto, 2000)can be interpreted to suggest that investment in different type of assets will tend to be higher the more protected is the property right of the particular asset Framework and Empirical Methodology This section develops the link between on one hand the protection of property rights and he other hand the amount of investable resources and its allocation between fixed and intangible assets. Using a simple framework, we show that it may be efficient for a firm in a country with weaker property rights to choose more investment in fixed assets elative to intangible assets compared to a firm functioning environment with strong property rights. The law and finance literature already established that firm with stronger property rights would find it easier to attract external financing and more generally have the benefit of more developed financial markets. A firm's asset size and tructure will thus be affected by the strength of property rights in the country in two ways: an availability of external finance and an asset substitution effect

5 and therefore the current endowment of technology is important for future growth. Empirically, a link has been established between equipment investment, which incorporates technology, and economic growth, especially for developing countries (De Long and Summers, 1991, 1993). Investment in intangibles also appears to foster growth. Nickell and Nicolitsas (1996) find a link between increased R&D expenditure and subsequent increase in fixed capital investment. The relatively higher degree of investment in fixed assets by firms in developing countries could thus mean that growth is below optimal levels. The lower degree of investment in intangible assets in developing countries may relate to the weaker protection of property rights in these countries. Mansfield (1995) already hints that there may be a relationship between protection of property rights and the allocation of investable resources between fixed and intangible assets. Using a survey of firm managers, he states that “Most of the firms we contacted seemed to regard intellectual property rights protection to be an important factor” … “[influencing] investment decisions”. More generally, the institutional economics literature (North, 1990, and De Soto, 2000) can be interpreted to suggest that investment in different type of assets will tend to be higher the more protected is the property right of the particular asset. 3. Framework and Empirical Methodology This section develops the link between on one hand the protection of property rights and the other hand the amount of investable resources and its allocation between fixed and intangible assets. Using a simple framework, we show that it may be efficient for a firm in a country with weaker property rights to choose more investment in fixed assets relative to intangible assets compared to a firm functioning in an environment with strong property rights. The law and finance literature already established that firms in a country with stronger property rights would find it easier to attract external financing and more generally have the benefit of more developed financial markets. A firm’s asset size and structure will thus be affected by the strength of property rights in the country in two ways: an availability of external finance and an asset substitution effect

Figure 1 develops the difference between the finance effect and the asset substitution effect. Take labor and human capital as fixed. Assume the optimal production point given world factor prices for fixed and intangible assets entails combinations of amounts of fixed and intangible assets that lay along the line from the origin through point A. Assume the firm wants to expand from initial point A as demand increases. If the firm has access to highly developed financial markets and is able to collateralize all types of assets, it would be able to raise enough external financing to invest in an optimal proportion of fixed assets and intangible assets to arrive at say point D. The investment of firms in countries with well-developed financial markets should exhibit such patterns If the supply of external financing is limited, the firm may only be able to reach point C. The difference between point D and point C could then be ascribed to a more limited supply of external financing. The firm, however, could also deviate from the optimal production line, points A, C and D. It may, for example, find it more efficient to hoose point B rather than point C. This would be if the firm finds it more difficult to secure for itself returns from intangible assets compared to returns from fixed assets. This could be the case in developing countries, where due to poor (intellectual) property rights it may hard for a firm to collect revenues from assets such as patents and other intangible assets. More generally, a preference for investments in fixed assets rather than intangible assets may arise in countries with poor protection of property rights when there are fixed costs to producing intangible assets. With poor protection of property rights, it will be less attractive for a firm to incur any fixed costs to produce intangible assets, like investing in research and development, marketing, networks, human resources, etc. This could make it more attractive for a firm to invest largely in fixed assets The law and finance literature focuses on the difference between point D and C, as the supply of external financing is not assumed to be affected by the asset choice. If firms in countries with low financial development and poor property rights systematically were to choose point B rather than point C, then the law and finance approach would ascribe the whole difference between point D and B, and any impact on firm growth, to limited financial development only. In other words, the law and finance literature ignores any differences on the asset side of the firm's balance sheet when studying the effects of legal frameworks on firm financing and growth patterns. But the difference between

6 Figure 1 develops the difference between the finance effect and the asset substitution effect. Take labor and human capital as fixed. Assume the optimal production point given world factor prices for fixed and intangible assets entails combinations of amounts of fixed and intangible assets that lay along the line from the origin through point A. Assume the firm wants to expand from initial point A as demand increases. If the firm has access to highly developed financial markets and is able to collateralize all types of assets, it would be able to raise enough external financing to invest in an optimal proportion of fixed assets and intangible assets to arrive at say point D. The investment of firms in countries with well-developed financial markets should exhibit such patterns. If the supply of external financing is limited, the firm may only be able to reach point C. The difference between point D and point C could then be ascribed to a more limited supply of external financing. The firm, however, could also deviate from the optimal production line, points A, C and D. It may, for example, find it more efficient to choose point B rather than point C. This would be if the firm finds it more difficult to secure for itself returns from intangible assets compared to returns from fixed assets. This could be the case in developing countries, where due to poor (intellectual) property rights it may hard for a firm to collect revenues from assets such as patents and other intangible assets. More generally, a preference for investments in fixed assets rather than intangible assets may arise in countries with poor protection of property rights when there are fixed costs to producing intangible assets. With poor protection of property rights, it will be less attractive for a firm to incur any fixed costs to produce intangible assets, like investing in research and development, marketing, networks, human resources, etc. This could make it more attractive for a firm to invest largely in fixed assets. The law and finance literature focuses on the difference between point D and C, as the supply of external financing is not assumed to be affected by the asset choice. If firms in countries with low financial development and poor property rights systematically were to choose point B rather than point C, then the law and finance approach would ascribe the whole difference between point D and B, and any impact on firm growth, to limited financial development only. In other words, the law and finance literature ignores any differences on the asset side of the firm’s balance sheet when studying the effects of legal frameworks on firm financing and growth patterns. But the difference between

Overall, the above discussion suggests that firms in countries with stronger legal frameworks will have more overall investment and better asset structures. which in turn will be reflected in higher growth rates. To empirically test whether firms in countries with better legal frameworks indeed experience higher growth rates, we use a setup to assess the relationship between financial development and growth similar to the one used by rajan and zingales(1998, RZ). In particular, we test whether industrial sectors that typically use a lot of intangible assets grow faster in countries with stronger property rights. In addition to testing the effects of property rights on firm growth, we directly test the asset substitution effect by investigating whether firms in countries with weaker property rights invest less in intangible assets. We also directly explore the supply of external financing effect by investigating the relationship between the strength of legal rights and the amount of long-term debt extended by lenders per unit of fixed assets. In what follows, we develop testable regression specification for these three hypotheses Let there be m countries, each indicated by index k, and n industries, each indicated by index j. The first set of equations relate the growth in real value added of a firm in a particular country to a number of country and firm-specific variables. The law and finance effect is measured by the interaction term between the typical external dependence variable for the particular sector and the country's level of financial development. The argument of RZ is that financially dependent firms grow more in countries with a higher level of financial development. This equation also allows us to disentangle the law and finance effect from the asset substitution effect. We do this by testing directly whether growth is higher for firms that typically use a lot of intangible assets in countries with good protection of property rights. Specifically, aquation (1a) extends the basic model in rz by adding a variable that is the interaction of the typical ratio of intangible to fixed assets and the property rights inde In line with RZ, we use US firm data to construct proxies for the typical external dependence for a particular industry and the typical ratio of intangible-to-fixed assets for a particular industry. The presumption here is that the Us financial markets are well developed and that property rights are protected well in the US such that firms are at the optimal external financing and asset structure point for their respective industrial sector Followin RZ, we add in the regression the industry's market share in total

9 Overall, the above discussion suggests that firms in countries with stronger legal frameworks will have more overall investment and better asset structures, which in turn will be reflected in higher growth rates. To empirically test whether firms in countries with better legal frameworks indeed experience higher growth rates, we use a setup to assess the relationship between financial development and growth similar to the one used by Rajan and Zingales (1998, RZ). In particular, we test whether industrial sectors that typically use a lot of intangible assets grow faster in countries with stronger property rights. In addition to testing the effects of property rights on firm growth, we directly test the asset substitution effect by investigating whether firms in countries with weaker property rights invest less in intangible assets. We also directly explore the supply of external financing effect by investigating the relationship between the strength of legal rights and the amount of long-term debt extended by lenders per unit of fixed assets. In what follows, we develop testable regression specification for these three hypotheses. Let there be m countries, each indicated by index k, and n industries, each indicated by index j. The first set of equations relate the growth in real value added of a firm in a particular country to a number of country and firm-specific variables. The law and finance effect is measured by the interaction term between the typical external dependence variable for the particular sector and the country’s level of financial development. The argument of RZ is that financially dependent firms grow more in countries with a higher level of financial development. This equation also allows us to disentangle the law and finance effect from the asset substitution effect. We do this by testing directly whether growth is higher for firms that typically use a lot of intangible assets in countries with good protection of property rights. Specifically, equation (1a) extends the basic model in RZ by adding a variable that is the interaction of the typical ratio of intangible to fixed assets and the property rights index. In line with RZ, we use US firm data to construct proxies for the typical external dependence for a particular industry and the typical ratio of intangible-to-fixed assets for a particular industry. The presumption here is that the US financial markets are well developed and that property rights are protected well in the US such that firms are at the optimal external financing and asset structure point for their respective industrial sector. Following RZ, we add in the regression the industry’s market share in total

10 manufacturing to control for differences in growth potential across industries. Industries with large market shares initially may have less growth potential than industries with small market shares initially. . (Intangible assets/Fix ed assets US industry Property rights country ) (External dependence US industry Financial developmen t country ) (Industry share of manufactur ing in country in 1980) Growth Constant Country indicators Industry indicators , 3 2 1 , 1... 1... j k m n m n m n j k m m m n j k j k j k e b b b b b + + × × + × × + × = + × + × + + + + + + + + (1a) The law and finance literature asserts that financial markets are more developed in environments with better law and order (and creditor rights). In this view, financial development is the result of a good legal framework and the supply of external financing is not independent of the quality of the legal framework. We therefore also estimate a variation on the previous specification that uses the law and order index of a country rather than its financial development to measure the link between a sector’s financial dependence and growth (equation 1b).4 . (Intangible assets/Fix ed assets US industry Property rights country ) (External dependence US industry Law and order country ) (Industry 'sshare of manufactur ing in country in 1980) Growth Constant Country indicators Industry indicators , 3 2 1 , 1... 1... j k m n m n m n j k m m m n j k j k j k e b b b b b + + × × + × × + × = + × + × + + + + + + + + (1b) The next two sets of tests focus on firm’s actual choices of investment and financing patterns, providing the supporting evidence that investment and financing structures can both be affected by the quality of the legal framework in a country. The first set of tests relate the investment structure of firm j in county k to the quality of property rights in country k. Equation (2) specifically tests whether firms in countries with better protection of property have relatively less amounts of fixed assets and larger