Corporate Transparency, Financial Development and the Allocation of Capital: Empirical Evidence

Abstract

There is controversy regarding the role of financial development in promoting economic growth. Lucas (1988) suggests that the role of financial intermediation in economic growth has been very badly over‐stressed in the popular and professional discussion. Levine et al. (2000), on the other hand, show that in a cross‐country setting the exogenous component of financial intermediary development is positively and robustly linked to economic growth. Although empirical methodologies to investigate the finance‐growth nexus have been refined, there is a lack of understanding about the exact mechanisms through which the financial system could affect economic performance in the real sector. Wurgler (2000) investigates one such mechanism of economic growth: whether capital is allocated efficiently. He then empirically shows that countries with well‐developed financial architecture improve capital allocation. This article extends Wurgler (2000) by investigating the role of an important economic institution, the financial reporting system, on the efficiency of capital allocation. Financial reporting provides the primary source of independently verified information to the capital providers about the performance of managers and facilitates efficient resource allocation decisions. Results show that financial transparency is positively and significantly related to capital allocation efficiency. Further, this result holds after controlling for the impact of stock price synchronicity, state‐owned enterprises and investor protection rights.