Does Financial Development Promotes Innovation in Developing Economies? An Empirical Analysis

Using firm-level data from 2006 to 2013 for a set of developing countries, we examine the effects of financial development on innovation. Financial development boosts innovation by improving resource allocation and investment toward strategic sectors as well as facilitating technology to promote growth. Using binary response models as well as instrumental variable techniques to correct for endogeneity, we find robust but puzzling results. Contrary to most existing literature, financial development has a negative effect on the probability of a firm to innovate. The effect is conditional on firm size, and only larger firms are the ones that benefit from financial development. These results are robust to different measures of financial development. We argue that this is a result of the design of the financial system in regards to the lack of capital and the institutional system. Consequently, developing countries should first generate appropriate institutional conditions if they want financial development to spur growth through innovation