The Invisible Hand in Emerging Markets: Discerning or Indiscriminate? Anusha Chari University of Michigan Peter Blair Henry** Stanford University and NBER March 2003 Abstract We present the first firm-level analysis of stock market liberalization on investment. In the year that an emerging economy liberalizes, the growth rate of its typical firm's capital stock exceeds the pre-liberalization mean by 4.1 percentage points. In each of the next three years the average growth rate of the capital stock for the 369 firms in our fivecountry sample exceeds its pre-liberalization mean by 6.1 percentage points. While liberalization leads to an increase in average investment, there is no evidence that the firm-specific differences in the post-liberalization investment increases are driven by firm-specific variation in changes in the cost of capital or investment opportunities. In other words, in the aftermath of stock market liberalizations, the invisible hand allocates more capital to emerging market firms, but it appears to do so in a somewhat indiscriminate manner. *University of Michigan Business School; 701 Tappan Street, Ann Arbor, MI 48109-1234. *Stanford University, Graduate School of Business; Stanford, CA 94305-5015; pbhenry@stanford.edu. Henry gratefully acknowledges the financial support of an NSF CAREER award and the Stanford Institute of Economic Policy Research (SIEPR). We thank Steve Buser, Paul Romer, and Antoinette Schoar and Rene Stulz for helpful comments. We also thank seminar participants at the AEA, Michigan and Stanford. Any remaining errors are our own.

1. Introduction Broadly speaking, there are two views about the invisible hand and the allocation of capital in emerging economies. The first view says that the invisible hand is indiscriminate. Stock prices in emerging economies generally contain little firm-specific information, and this is problematic because stock prices provide public signals of real investment opportunities (Morck, Yeung and Yu, 2000; Morck, Shleifer and Vishny, 1990; Morck, Durnev, and Yeung, 2003). If managers in emerging economies make capital budgeting decisions in accordance with changes in stock prices, but stock prices contain little firm-specific information, then investment will also be divorced from firmspecific fundamentals. Morck et al (2000) speculate, "Our results suggest that stock markets in emerging economies may be less useful as processors of economic information... If stock price movements in emerging markets are mainly due to either politically driven shifts in property rights or noise trading, numb invisible hands in their stock markets may allocate capital poorly, thereby retarding economic growth." The second view sees the invisible hand as discerning. The discerning-invisiblehand view is more optimistic about the prospects for efficiency. It says that stock prices do contain important economic information, if only researchers will care to examine natural experiments where the signal-to-noise ratio in stock prices is high. Stock market liberalizations provide just such experiments, because the liberalization-induced changes in stock prices are large, and firm-specific risk-sharing characteristics account for roughly 40 percent of the typical firm's stock price increase (Chari and Henry, 2002). Chari and Henry also speculate about the importance of their findings for investment, "Since risk sharing matters for stock prices and stock prices should matter for investment, this paper I

provides a first step towards understanding whether physical investment is efficiently reallocated when countries liberalize the capital account." This paper goes beyond speculation and confronts the two views with facts. It does so by using the International Finance Corporation's Corporate Finance Database to construct a new dataset on investment by 369 firms in India, Jordan, Korea, Malaysia, and Thailand from 1980 to 1994. We use this dataset to assess whether the adjective 'discerning' or 'indiscriminate' best characterizes the behavior of the invisible hand. Specifically, we ask the following question: Does firm-level investment in emerging economies respond to the implicit signals about firm-specific changes in fundamentals that are embedded in the stock price changes we see when countries liberalize? We answer this question by exploiting the theoretical prediction that a firm's stock price response to a liberalization contains two signals. The first signal is a common shock to all firms in the economy- the aggregate risk free rate falls because liberalization increases net capital inflows. All else equal, the common shock implies that all firms should increase their investment. The second signal is firm specific and therefore delivers implications for the cross-sectional behavior of firm-level investment following liberalization. Liberalization alters the set of systematic risks for the representative investor, because liberalization switches the relevant benchmark for pricing individual stocks from the local stock market index to a world market index (Stulz, 1999). Consequently, liberalization reduces (increases) the equity premium for firms whose returns are more (less) correlated with the local market than they are with the world market. 2

Given the first signal, the second implies that the cost of capital falls by more for firms whose systematic risk decreases than it does for those whose systematic risk increases. Since the cost of capital falls by more for firms whose systematic risk decreases, all else equal, they should also experience a larger increase in investment. In other words, while liberalization reduces the average cost of capital, and all firms should invest more on average, theory predicts that we should observe relatively larger increases in investment by firms whose systematic risk falls and relatively less by those whose systematic risk rises. We confront the cross-sectional prediction by defining systematic risk in the following manner: the historical covariance of a firm's returns with the local market minus its historical covariance with the world market (DIFCOV). If the discerning invisible hand view is correct, high DIFCOV firms should experience faster capital stock growth than low DIFCOV firms following liberalization, all else equal. If the indiscriminate invisible hand view prevails then DIFCOV should have no explanatory power for the cross-sectional variation in firm-level investment in the aftermath of liberalizations. We use panel data estimations to provide information on both the average and cross-sectional behavior of firms' investment. The estimations show that the crosssectional behavior of investment following liberalizations is more consistent with the indiscriminate-invisible-hand view in the sense that DIFCOV and other firm-specific risk-sharing fundamentals have no explanatory power for the cross-sectional variation in investment. With respect to the average behavior of investment, the invisible hand works as it should. In the four-year period following liberalization, firms that are listed on the 3

stock market experience capital stock growth that exceeds their pre-liberalization mean by an average of 6 percentage points. Put another way, our results suggest that liberalizing stock markets permits and results in cross-country efficiency in the allocation of capital. The firms in our sample do experience more investment as a result of liberalization. But capital is fungible, so liberalization alone may not guarantee within-country efficiency in the allocation of capital. Indeed, our cross-sectional results provide no evidence that a discerning invisible hand is efficiently guiding the relative distribution of investment in the post-liberalization period. We recognize that regressing firm-specific investment on firm-specific DIFCOV provides a relatively narrow test of the two views. Our test focuses on the effect of liberalization on investment through its cross-sectional implications for changes in the cost of capital, but liberalization may be associated with other large cross-sectional changes in the fundamentals besides the cost of capital. Hence, we also look to see whether post-liberalization investment is positively correlated with the on-impact change of other important fundamentals such as earnings growth, stock prices, sales growth and Tobin's q. None of these firm-specific fundamentals have any significant explanatory power for the cross-sectional variation in investment. In addition to providing the very first firm-level analysis of the cross-sectional adjustment of investment to liberalization and presenting evidence that helps to distinguish between competing views of the stock market and the allocation of capital in emerging markets, this paper makes several other contributions relative to previous work. 4

First, firm-level investment data presents a much more reliable empirical picture of the effects of liberalization on the time series behavior of real economic activity in emerging economies than existing studies, which use aggregate data. For example, previous work shows that aggregate investment rises in the aftermath of liberalizations (Henry, 2000). But it is not clear how much confidence we can have in an empirical result that attributes an economy-wide investment boom to a policy change that directly affects only those firms that are listed on the stock market. Stock-market-listed firms account for no more than a third of the economic activity and a small fraction of aggregate private investment in the liberalizing countries. Similarly, the growth rate of GDP per capita increases in the aftermath of liberalizations (Bekaert and Harvey, 2002). But since the link from liberalization to GDP growth works through investment, it too, must be treated with skepticism. This point is reinforced by the fact that the existing estimates of the effect of liberalization on growth are simply too large to be plausible (Henry, 2003). Instead of using aggregate investment data as a proxy for the capital budgeting decisions of publicly traded firms, this paper employs actual balance sheet and income statement data that allow us to measure directly the investment of those firms that are listed on the stock market. Our firm-level data also allow us to construct measures like Tobin's q, sales, earnings and other variables that help us control directly for other factors that might affect investment independently of the liberalization. With our firm-level data set we are able to provide more reliable estimates of the effect of liberalization on investment and therefore more plausible estimates of the effect of liberalization on growth. Overall, our new data set provides direct evidence on the transmission 5

mechanism from liberalization to the investment activity of those firms directly affected by the liberalization and increases the confidence we may have in the view that liberalization has real economic effects. Another contribution of the paper is that we construct what is to our knowledge the only database that is capable of addressing questions about the impact of liberalization on the investment of emerging market firms. For example, our dataset provides a distinct advantage over publicly available datasets such as Global Vantage and Worldscope. This is because the median stock market liberalization date is 1988, and Worldscope and Global Vantage contain virtually no emerging market company data before 1988. Therefore, it is impossible to use Worldscope and Global Vantage to study whether firms' investment behavior before liberalization differs from their investment behavior after liberalization. Despite its modest size, our data set should be useful to economists conducting future research in this area. Having said that, there are also several limitations to our data, which impose limits on our ability to obtain and interpret results. For example, the fundamentals with which we try to explain the cross-sectional variation in investment implicitly assume perfect domestic capital markets. If capital market imperfections are present, however, investment could be correlated with liquidity constraints and firms' dependence on equity financing (Baker, Stein, and Wurgler, 2002). To the extent that liberalization eases liquidity constraints and makes it cheaper for equity-dependent firms to raise external equity, our cross-sectional fundamentals could be missing an important part of the story. We are in the process of constructing data that will allow us to address this issue. 6

2. Data and Descriptive Findings The primary source of data is the International Finance Corporation's Corporate Finance Database. Singh et al. (1992) and Booth et al. (2001) provide complete descriptions of the International Finance Corporation (IFC, 1999) database. The data discussion here provides only those details relevant to this paper. Between 1980 and 1994, the IFC collected annual financial statements for a maximum of the 100 largest publicly traded, non-financial firms in eleven developing countries: Argentina, Brazil, India, Jordan, Korea, Malaysia, Mexico, Pakistan, Thailand, Turkey, and Zimbabwe. The IFC's collection criteria were that quality data were available for a reasonably large sample of firms and that developing countries from each continent were represented. For several countries, the early years of the sample did not contain data of sufficiently high quality. For these countries, the sample begins after 1980. For some of the smaller countries, fewer than 100 firms are traded or meet the data availability criteria, which resulted in smaller samples. In order for a country to be included in our sample, the IFC must provide balance sheet and income statement data before and after the year in which a country liberalized its stock market. This before-and-after criterion, in combination with the short length of the time series in some cases, reduces the number of feasible countries to the following set of five: India, Jordan, Korea, Malaysia, and Thailand. Despite its modest size there are a total of 369 firms the sample available from the IFC database is better suited to addressing the question of whether liberalization affects firms' investment decisions than competing databases such as Worldscope and Global Vantage. This is 7

because the median stock market liberalization date in the sample is 1988. Worldscope and Global Vantage contain virtually no company data before 1988. Table 1 summarizes the essential characteristics of the countries and firms in the sample. Column I provides the name of the country; Column 2 lists the year in which the stock market was liberalized; Column 3 gives the number of firms in each country. Column 4 lists the ratio of stock market capitalization of the firms in the IFC sample to the total stock market capitalization of all publicly traded firms in the country. The stock market capitalization of the 369 firms in our sample constitutes 40 percent of total stock market capitalization. This figure indicates that the firms in the IFC Database comprise a significant fraction of all publicly traded companies in these countries. 2A. Construction of Firm-level Capital Stocks and Tobin's q The IFC Corporate Finance Database reports the nominal value of property, plant, and equipment on an annual basis. These annual values are divided by the local consumer price index to create an index of each firm's real capital stock. For each firm in the sample, Tobin's q is the ratio of the market value of that firm's securities to the replacement cost of its tangible assets. The replacement cost of tangible assets is the book value of net fixed assets (property, plant and equipment). The market value of each firm's securities is the sum of the market value of equity its stock market capitalization and the book value of its current and long-term liabilities. We use book values of debt because the IFC database does not contain information on market values. In the absence of directly observable market values of debt, the standard approach converts book values of debt to market values in two steps (Blanchard, Rhee, and 8

Summers 1993). First, the book value of short-term debt is assumed to be the same as its market value. The second step converts the book value of long-term debt to market value by capitalizing net interest payments using the yield on Moody's corporate A bond.' This conversion method cannot be applied directly to this study, because data on corporate bond rates are not available for the relevant time period. Estimating the market value of debt would require further assumptions about unobservable corporate bond rates. Rather than adopting a cure worse than the ailment, we follow the alternative convention of using book values of debt as proxies for market values. Another potential concern is that the construction of Tobin's q measures average, not marginal q. While it is marginal q, the ratio of the increment of market valuation to the cost of the associated investment, that matters, the same factors which raise or lower marginal q will raise or lower average q. Thus one would also expect investment to vary with the level of average q. 2B. Do Tobin's q and Investment Respond to Liberalization? Allocative Efficiency predicts that liberalization will raise the market value of capital. Removing restrictions on capital inflows permits financial resources to move from capital-abundant countries, where expected returns are low, to capital-scarce countries, where expected returns are high. The flow of resources into the liberalizing country reduces the average cost of capital and drives up Tobin's q. If this view has any empirical bite, we should observe an increase in the typical firm's level of Tobin' s q relative to its pre-liberalization mean when the stock market is Equation (1) on page 357 of Von Furstenberg (1977) is used for conversion assuming a ten-year maturity. 9

liberalized. Table 2 verifies this prediction. The average level of Tobin's q across all 369 firms before liberalization is 3.84. The average level of Tobin's q in the liberalization year is 5.61, approximately 40 percent higher than the pre-liberalization mean. Turning to individual countries, the average level of Tobin's q in the year of liberalization exceeds the pre-liberalization mean in every country except Malaysia. The numbers in Table 2 suggest that q increases with liberalization, but they need to be interpreted with caution. The level of Tobin's q may not be directly comparable across countries, because of differences in accounting practices. For example, firms in India, Malaysia, and Jordan value assets using the practice of fair-market valuation in accordance with North American Generally Accepted Accounting Principles (GAAP). In contrast, Korea and Thailand rely on strict historic-cost accounting as in Germany and Japan (Booth et al., 2001). In light of these differences, growth rates of q provide more compatible crosscountry measures. Figure 1 shows that the average deviation of the growth rate of Tobin's q from its pre-liberalization mean is 18 percentage points on impact (year [0]), 11 percentage points in the first year after liberalization (year [+1]), and 8 percentage points in the second year after liberalization (year [+2]). The cumulative deviation over years [0, +2] is 37 percentage points. Under Allocative Efficiency, profit-maximizing firms should respond to the increase in Tobin's q by installing more capital. Once the asset market value of capital goods and their replacement cost are equalized agaiin investment should slow to a rate that is sufficient to maintain this equality. To examine this implication of the theory, Figure 2 plots the average deviation of the growth rate of the real capital stock from its 10

pre-liberalization mean for all 369 firms. Figure 2 suggests a lagged response of investment to stock market liberalization. On impact, the growth rate of the capital stock increases sharply and remains above its pre-liberalization mean for each of the three subsequent years. Taken together, Figures 1 and 2 suggest that, on average, liberalization drives up the relative price of capital, and firms respond to this relative price increase by installing more capital. 3. Time Series Evidence: Are the Increases in Tobin's q and Investment Robust? While roughly consistent with Allocative Efficiency, Figures 1 and 2 must be interpreted with caution. They simply describe the behavior of the raw data on Tobin's q and investment without controlling for firm, country, and world-specific factors that may drive q and investment independently of any stock market liberalization policies. This section of the paper wrestles empirically with these issues. 3A. Tobin's q We begin by estimating a benchmark regression for the pooled group of 369 firms. The regression examines whether, in each of the three years immediately following stock market liberalization, the growth rate of Tobin's q differs significantly from its pre-liberalization growth rate: A(ln q)it = a+ Lib[O]j + Lib[+l]j + Lib[+2]j + Lib[+3]j + FIRMi + ij (1) The left-hand-side variable is the growth rate of Tobin's q for firm i in country j in year t. Lib[O]j is a variable that equals one in the year that country j liberalizes its stock market. Lib[+l]j, Lib[+2]j, and Lib[+3]j take on the value 1 in the first, second and 11

third years after liberalization, respectively. FIRM is a set of firm-specific dummy variables, which means that the intercept term, a, measures the average change in the growth rate of Tobin' s q after removing firm-specific fixed effects. The error term in Equation (1) requires further discussion. All firms in a given country share the same liberalization date in addition to other country-specific factors. Therefore, the standard assumption that the error term for the growth rate of Tobin's q is random and uncorrelated across firms may no longer obtain. Three steps are taken to address this issue. First, the variance-covariance matrix used to calculate the standard errors was adjusted to account for clustering. Second, the estimation procedure also corrects for potential heteroscedasticity across firms. Third, estimates of Equation (1) that include country-specific fixed effects are also presented. Table 3, Panel A presents the results. The first row presents the benchmark specification, which controls for firm-fixed effects. Moving across columns shows the estimate for each year relative to liberalization. For example, the entry under column [0] in the row labeled "Firm-fixed Effects" shows that in the year the stock market is liberalized, the growth rate of Tobin's q exceeds its pre-liberalization mean by 18.2 percentage points. The adjacent column, [+1], shows that in the year immediately following liberalization, the growth rate of q exceeds its pre-liberalization mean by 13.2 percentage points. In year [+2], this number is 8.6 percentage points. All three estimates are statistically significant at the 1 percent level. In year [+3] the growth rate of q falls significantly below its pre-liberalization mean. The negative and significant growth rate of q following an initial rise is consistent with the theory. Liberalization drives up the relative price of capital, and firms respond 12

by increasing their capital stock with a lag. Once investment starts rising, q begins falling back toward pre-liberalization levels. Shortness of the time series prevents estimation of the response of q to liberalization beyond year [+3]. Row 2 of Panel A presents estimates that control for country-specific characteristics other than liberalization that might be driving the results. The estimates are almost identical to those that use firm-fixed effects. The growth rate of q exceeds the pre-liberalization mean by 18.3 percentage points in year [0], 13.3 percentage points in year [+1], and 8.7 percentage points in year [+2]. As in the firm-specific estimates, the growth rate of q falls significantly below its pre-liberalization mean in year [+3]. If liberalizations coincide with high points in the world business cycle, then Tobin's q might increase independently of any change in capital account policy. There are two possible approaches to this problem: indirect and direct. The indirect approach would use year-specific dummy variables to control for movements in the world business cycle. The potential for multicollinearity of the year dummies with the liberalization variable makes this indirect approach unadvisable. Therefore, we attempt to control directly for movements in the world business cycle by including the contemporaneous growth rate of OECD industrial production, the three-month real US Treasury bill rate, and the 10-year real US government bond rate as right-hand-side variables. Row 3 presents these estimates. Accounting for fluctuations in the world business cycle reduces slightly the point estimates. The growth rate of Tobin's q is now 15.4 percentage points above the pre-liberalization mean in year [0] as compared to 18.2 in Row 1 and 9.7 percentage points above the pre-liberalization mean in year [+1] as compared to 13.2 in Row 1. The point estimate in year [+2] is no longer statistically 13

significant. The negative point estimate in year [+3] is stronger than without business cycle controls. Row 4 re-estimates the country-fixed effects model, but this time includes controls for fluctuations in the world business cycle. These results are almost identical to those in Row 3. Estimates using various leads and lags of all three business cycle controls were also tried but did not yield significantly different results. Regardless of the specification, the point estimates for the growth rate of q in years [0] and [+1] are positive and statistically significant. 3B. Investment The following panel regression evaluates the response of the growth rate of the average firm's capital stock to liberalization: A(ln K)ijt = + Lib[O] + Lib[+l] + Lib[+2] + Lib[+3] + FIRM, + ~ijt (2) This specification is identical to Equation (1) except that instead of Tobin's q, the lefthand-side variable is now the growth rate of the capital stock. Table 3, Panel B presents the results. There is a strong relationship between liberalization and the growth rate of the capital stock. Row 1, which presents the firmfixed effects estimates, indicates a strong lagged response of the capital stock to liberalization. The growth rate of the capital stock is 5.5 percentage points above the preliberalization mean in year [+1], 6.9 percentage points above the mean in year [+2], and 3.9 percentage points above the mean in year [+3]. The estimates from the country-fixed effects specification in Row 2 are almost identical to the firm-fixed effects specification in Row 1. The estimates in Rows 3 and 4 contain proxies for the world business cycle. 14

The only significant change relative to the estimates in Rows I and 2 is that the year [0] estimates are now statistically significant. It is useful to think about the economic significance of the estimated effect of liberalization on investment. The average growth rate of the capital stock across all 369 firms in the pre-liberalization period is 10 percent per year. Now make the following assumptions: the production function for all firms is Cobb-Douglas, there is no technological progress, the size of the labor force is constant, and capital's share in output is one-third. With this set of assumptions the pre-liberalization growth rate of output for the average firm equals one-third times 10 percent, or 3.3 percent per year. The estimates in Row 4 of Table 3 show that the growth rate of the capital stock exceeds the pre-liberalization mean by 4.7 percentage points in year [0], 4.7 percentage points in year [+1], 8.2 percentage points in year [+2], and 6.9 percentage points in year [+3]. To get a rough sense of how much faster the average firm will grow as a result of liberalization multiply each of these coefficient estimates by a third, and add the resulting number to 3.3 percent. Doing so suggests that instead of growing at 3.3 percent per year, the average firm will grow by 4.9 percent in year [0], 4.9 percent in year [+1], 6 percent in year [+2], and 5.6 percent in year [+3]. Rough as they may be, these are large numbers with non-trivial welfare implications when one considers that the firms in this sample constitute roughly 40 percent of the total market capitalization of publicly traded firms in these countries. 15

4. Cross-Sectional Evidence: Does Risk Sharing Drive the Reallocation of Capital? Allocative Efficiency also makes predictions about the cross-sectional behavior of investment following stock market liberalizations. Liberalization alters the set of systematic risks for the representative investor, because the relevant benchmark for pricing individual stocks switches from the local stock market index to a world index. Stock prices should rise in sectors where systematic risk and therefore the cost of capital falls. The stock price data are consistent with this prediction (Chari and Henry 2001). But optimal smoothing of production risk in an open-capital-market world also requires the reallocation of physical capital in accordance with changes in systematic risk. All else equal, we should observe relatively more investment by firms whose systematic risk falls and relatively less investment by those whose systematic risk rises. To investigate these predictions, define the variable DIFCOV as follows: The covariance of a firm's stock return with the local market index minus the covariance of that firm's stock return with the world stock market index. Allocative Efficiency predicts that the capital stocks of high DIFCOV firms will grow more quickly than those of the low DIFCOV firms following liberalization. We move towards testing this prediction by constructing two measures of DIFCOV for each firm in the sample. For firm i in country j, DIFCOVI is calculated as follows. First we calculate the historical covariance of firm i's annual stock return with the annual aggregate market return for country j. Second, we calculate the covariance of firm i's annual stock return with the annual return on the Morgan Stanley World Capital Market Index (MSCI). DIFCOVI equals the first covariance minus the second. We calculate DIFCOV2 by following the same steps, but 16

instead of using stock returns to calculate covariances, we use growth rates of real earnings. We test the prediction that capital will be reallocated towards sectors that provide the greatest diversification benefits following liberalization by regressing the cumulative deviation of the percentage change in the capital stock from its pre-liberalization mean over various horizons on DIFCOVI and DIFCOV2, a proxy for the change in expected earnings growth, and country-fixed effects. KDEVjt = a+ ADIFCOVli +,2DIFCOV2i + AEarnings + Countryj + ~ij (3) The symbol KDEVij denotes the following. For country j, it is the growth rate of firm i's capital stock at time t minus the average growth rate of firm i's capital stock in the preliberalization period. The country-fixed effects remove the liberalization shock that is common to all firms: a countrywide fall in the cost of capital. The data do not support the prediction that capital is reallocated across firms in accordance with optimal risk sharing. The estimates in Rows 1 and 2 of Table 4 show that the cumulative change in the capital stock over the period [0, +3] is not significantly related to either measure of diversification. The coefficients on DIFCOVI, the measure based on returns covariances, and DIFCOV2, the measure based on firm level earnings covariances, are insignificant in all specifications. Moving across columns, equation (3) was also estimated using cumulative capital stock growth over the following horizons: [0, +2], [0, +1], [+1, +2]. The point estimates on DIFCOVI and DIFCOV2 are statistically insignificant in each of these specifications. 4A. Is the Reallocation of Capital Related to Changes in Tobin's q 17

A fall in the cost of capital stemming from risk sharing is just one of the two channels through which liberalization may affect investment. Liberalization may also change firms' expected future profitability. Movements in Tobin's q capture changes in both the cost of capital and expected future profitability. Therefore, as an additional test of Allocative Efficiency we examine whether post-liberalization changes in the capital stock are related to the liberalization-induced changes in Tobin's q. All else equal, firms that experience the largest increases in q should also experience the largest increases in investment. We examine this prediction as follows. For each firm, we regress the cumulative deviation of the growth rate of the capital stock from its pre-liberalization mean, over various horizons, on the on-impact deviation of the growth rate of q from its preliberalization mean. Row 3 of Table 4 shows that the result is the same for all event windows. The on-impact deviation of the growth rate of Tobin's q has no explanatory power for post liberalization changes in the capital stock. As a final test of the theory we replace the on-impact change in q with the on-impact change in the stock price. The results, presented in Row 4, are the same. The cross-sectional changes in the price of capital have no explanatory power for the cross-sectional changes in quantities of capital. 5. Discussion It is important to understand whether physical capital is efficiently reallocated when barriers to capital movements are removed. Previous work shows that liberalization induces stock price revaluations (Henry, 2000a). These revaluations have two components. The first is common to all firms: a fall in the risk-free rate as the 18

country moves from financial autarky to financial integration with the rest of the world. The second is specific to any given firm. Prices rise for firms whose systematic risk falls and fall for firms whose systematic risk rises (Chari and Henry, 2002). These revaluations signal to managers that they can increase shareholder welfare by investing in physical capital (Blanchard et al. 1993; Morck, Shleifer, and Vishny, 1990; Wurgler, 2000). On average, investment should increase for all firms in the economy because the risk free rate has fallen. This is the time series implication of liberalization for the reallocation of capital across countries. We should also observe relatively more investment by firms whose systematic risk falls and relatively less investment by those firms whose systematic risk rises. This is the cross-sectional implication of liberalization for the reallocation of capital within countries. The time series results are more consistent with the discerning invisible hand than with the indiscriminate. The typical firm in our sample experiences a significant increase in both Tobin's q and investment around liberalization. The cross-sectional results are more consistent with indiscriminate invisible hand than with the discerning. The reallocation of physical investment following liberalization bears no significant correlation to changes in systematic risk or investment opportunities. Taken together, these results suggest that neither view provides a complete description of the adjustment process. Liberalizing capital markets appears to facilitate an efficient transfer of capital from low to high-return countries. But capital is fungible, so there is no guarantee that the inflow of real resources will be allocated efficiently across firms. However, if the magnitude of the firm-specific component of the revaluation is small, then its impact on resource allocation may also be small. Therefore, 19

an alternative interpretation of our results is that the firm-specific fall in the cost of capital pales in comparison to the fall in the average cost of capital for all publicly traded firms. Yet another alternative interpretation is that the absence of empirical support for the cross-sectional predictions stems not from an indiscriminate invisible hand, but a lack of empirical power. Data availability restricts the empirical analysis to only three years following the liberalizations, but the reallocation of capital across firms may take several years to complete. This explanation appears at odds with the adjustments to the aggregate capital stock that take place within the three-year window. Investment responds to liberalization, but it does so in a somewhat indiscriminate manner. This paper provides a first step towards understanding whether physical investment is efficiently reallocated when barriers to capital movements are removed. Future work should try to determine the factors that drive the cross-sectional distribution of new capital across firms within a given country. There are models of investment in the corporate finance literature that generate predictions about the cross-sectional determinants of firm-level investment, which could be applied to capital account liberalization. For example, it could be the case that firms in industries that are more dependent on external finance show the largest increase in investment (Rajan and Zingales, 1998). Yet other explanations could be related to the political economy of liberalization. Firms that receive preferential government treatment may be better positioned to raise stock market financing than other firms (Johnson and Mitton, 2001). Preferential treatment may in turn determine which firms are made investible. The available data cannot resolve these issues. Nevertheless, they do bring us a step closer to 20

understanding whether removing barriers to international capital flows promotes efficient resource allocation. Future research may bring us yet nearer. 21

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Table 1 Summary Statistics, 369 Firms, 5 Countries. Country Liberalization Number of Firms Market Capitalization of Year in Sample Firms as a Fraction of Total Market Capitalization Full Sample NA 369 0.40 India 1992 99 0.25 Jordan 1987 35 0.14 Korea 1987 89 0.38 Malaysia 1987 85 0.45 Thailand 1988 61 0.66 Notes: Column 2 contains the liberalization date for each country in our sample. Column 3 gives the number of firms in each country. Column 4 presents the fraction of total market capitalization that the firms in our sample represent as a fraction of Total Market Capitalization in the respective countries. The total market capitalization represents the value of all publicly traded companies on the domestic exchange in the liberalization year.

Table 2: Tobin's q Rises When Liberalizations Occur. Country Average q before Average q in Liberalization Liberalization Year Full Sample 3.84 5.61 India 4.33 7.86 Jordan 1.14 1.25 Korea 3.33 5.25 Malaysia 8.53 6.1 Thailand 3.88 7.60 Notes: Column 2 represents the values of average q in the pre-liberalization window. Column 3 gives the value of average q in the liberalization year. Average q is the average, across all firms in each country, of the ratio of the market value of assets relative to their replacement cost. 25

Table 3, Panel A: The Post-Liberalization Increases in Tobin's Q are Robust. Year [0] Year [+1] Year [+2] Year [+3] Sum Years [0, +3] Firm-Fixed 0.182*** 0.132*** 0.086*** -0.074*** 0.097*** Effects (0.024) (0.028) (0.028) (0.028) (0.018) Country-Fixed 0.183*** 0.133*** 0.087*** -0.074*** 0.098*** Effects (0.023) (0.027) (0.027) (0.027) (0.018) Firm and 0.154*** 0.097*** 0.028 -0.173*** 0.131*** Business Cycle (0.030) (0.034) (0.035) (0.045) (0.024) Country and 0.151*** 0.099*** 0.029 -0.174*** 0.130** Business Cycle (0.029) (0.032) (0.034) (0.043) (0.024) Notes: Table 3, panel A presents results for alternative specifications of the benchmark regression specification, which is given by the following equation: A(ln q),ij =a+ Lib[ + Lib[+O]] + Lib[+l ] + Lib[+2]3] + Firmi + ij,. Columns 1, 2, 3, 4, and 5 present the coefficient estimates for the liberalization year and years 1,2 and 3 post-liberalization, respectively. Column 5 presents the cumulative coefficient estimate for the four years taken together. The lefthand side variable is the first difference of the log of q. Row 1 presents the coefficient estimates for the regression specification that controls for firm fixed effects. Row 2 presents the coefficient estimates for the regression specification that controls for country-fixed effects. Row 3 incorporates controls for both firm-fixed effects and world business cycle effects: the contemporaneous growth rate of OECD industrial production, the three-month real US Treasury bill rate, and the 10-year real US government bond rate. All specifications control for clustering in the error structure. The symbols (***), (**) and (*) represent significance at the 1%, 5% and 10% levels, respectively. Standard errors are in parentheses. 26

Table 3, Panel B: The Post-Liberalization Increases in Investment are Robust. Year [0] Year [+1] Year [+2] Year [+3] Sum Years [0, +3] Firm-Fixed 0.018 0.055*** 0.069*** 0.039** 0.041*** Effects (0.017) (0.020) (0.020) (0.020) (0.013) Country- 0.023 0.062*** 0.077*** 0.047** 0.048 Fixed Effects (0.018) (0.021) (0.021) (0.021) (0.013) Firm and 0.041* 0.044* 0.077*** 0.063** 0.049*** Bcycle (0.021) (0.024) (0.025) (0.032) (0.017) Country and 0.047** 0.047* 0.082*** 0.069** 0.054*** Bcycle (0.022) (0.025) (0.026) (0.033) (0.018) Notes: Table 3, panel B presents results for alternative specifications of the benchmark regression, which is given by the following equation: A(ln K)i, = a + Lib[O] + Lib[+l] + Lib[+2] + Lib[+3] + Firm + ij. Columns 1, 2, 3, 4, and 5 present the coefficient estimates for the liberalization year and years 1,2 and 3 post-liberalization, respectively. Column 6 presents the cumulative coefficient estimate for the four years taken together. The left-hand-side variable is the first difference of the log of the capital stock (investment). Row 1 presents the coefficient estimates for the regression specification that controls for firmfixed effects. Row 2 presents the coefficient estimates for the regression specification that controls for country-fixed effects. Row 3 incorporates controls for both firm-fixed effects and world business cycle effects: the contemporaneous growth rate of OECD industrial production, the three-month real US Treasury bill rate, and the 10-year real US government bond rate. All specifications control for clustering in the error structure. The symbols (***), (**) and (*) represent significance at the 1%, 5% and 10% levels, respectively. Standard errors are in parentheses. 27

Table 4: Allocative Efficiency Variables Do Not Explain the Cross Sectional Variation in the Post-Liberalization Increases in Investment. KDEV [0, +3] KDEV[O, +1] KDEV [0, +2] KDEV [+1, +2] DIFCOV1 0.001 0.08 0.17 0.42 (0.99) (0.61) (0.8) (0.56) DIFCOV2 -0.02 0.001 -0.007 -0.016 (0.03) (0.02) (0.02) (0.016) QDEV[0] -0.09 -0.07 -0.06 -0.002 (0.09) (0.05) (0.07) (0.050) PDEV[0] 0.02 0.02 0.04 0.05 (0.09) (0.06) (0.08) (0.05) Notes: The second column presents regression results for the deviation of cumulative investment from its pre-liberalization mean in the (0,1) window post liberalization. Column 3 presents regression results for the (0,1,2) window post liberalization. Column 4 presents regression results for the (0,1,2,3) window postliberalization. Column 5 presents regression results for the (1,2) window post liberalization. QDEV is the deviation of the change in Tobin' s q on impact in the liberalization year relative to the average change in q pre-liberalization. dlnp (lib) is the change stock price upon impact in the liberalization year. Difcovl and Difcov2 are the two measures of the difference in covariance based on returns and earnings. Standard errors in parentheses. All specifications control for country fixed effects. 28

Figure 1: Tobin's q and Stock Market Liberalization 0.2 0.15 0.1 0.05 0 -0.05 -0.1 — qhatdev -5 -4 -3 -2 -1 0 1 2 Year Relative to Liberalization 3

Figure 2: Capital Stock Growth and Stock Market Liberalization 0.06 0.05 0.04 0.03 0.02 0.01 0 -0.01 -0.02 -0.03 -0.04 khatdev -5 -4 -3 -2 -1 0 1 2 Year Relative to Liberalization 3