The Quality Effect: Does Financial Liberalization Improve the Allocation of Capital?

Abstract

The study documents evidence of a quality effect of financial liberalization on allocative efficiency, which is measured by the dispersion in Tobin's Q across firms. Based on a simple model, the authors predict that financial liberalization, by equalizing access to credit, reduces the variation in expected marginal returns. They test this prediction using a new financial liberalization index and firm-level data for five emerging markets: India, Jordan, Korea, Malaysia, and Thailand. They find strong evidence that financial liberalization, rather than financial deepening, improves allocative efficiency.

Keywords: Tobin's Q, financial liberalization, investment, allocative efficiency, inequality

JEL Classification: D61, E44, G14, G18, O16