Does Financial Liberalization Improve the Allocation of Investment? Micro Evidence from Developing Countries

Has financial liberalization improved the efficiency with which investment funds are allocated to competing uses? In this paper, we address this question using firm level panel data from twelve developing countries. We develop a summary index of the efficiency of investment allocation that measures whether, and to which extent, investment funds are going to firms with a higher marginal return to capital. We then examine the relationship between this index and various measures of financial liberalization. The results suggest that financial reform tends to lead to an increase in the efficiency with which investment funds are allocated. This conclusion holds after a series of robustness checks and is consistent with firm level evidence we present suggesting that the association between investment and fundamentals has become stronger with financial liberalization