Impact of financial development on outsourcing and aggregate productivity

Abstract

This study examines how costly financial contracting and weak contract enforcement influence firms’ outsourcing decisions. A multisector neoclassical model in which external investors can play a role in monitoring suppliers is developed. Financial development improves investors’ monitoring efficiency and encourages firms to outsource more production, particularly to suppliers that are more dependent on external finance. The global financial crisis is used along with firm-level data from the United Kingdom to provide causal evidence of this channel. The model is then calibrated to match the borrowing costs of 88 countries and is used to quantify the effects of financial development on total factor productivity. Setting borrowing costs to the level in the United States leads to an average 7 percent increase in aggregate productivity for these countries.