Firms, Financial Markets and the Law: Institutions ... - Banco de Portugal

“Firms, Financial Markets and the Law: Institutions and Economic Growth in Portugal”*

José Albuquerque Tavares Faculdade de Economia Universidade Nova de Lisboa

This version: February 2002

Preliminary. Comments appreciated.

* This paper was prepared for the conference “Desenvolvimento Económico Português no Espaço Europeu: Determinantes e Políticas”, organized by the Banco de Portugal. Comments from an anonymous referee are sincerely appreciated. Contact address: Faculdade de Economia, Universidade Nova de Lisboa, Campus de Campolide, 1099-032 Lisboa, Portugal. E-mail: [email protected] 1

Abstract: In this paper we present a broad diagnostic of the current level of development of Portuguese institutions. Our focus is on three closely related institutional areas: the legal system, corporate governance and the financial system. For each of these areas, we review the determinants of effective institutions as well as their impact on economic growth. We compare the characteristics of Poprtuguese institutions with those in Spain, Greece, the European Union and a group of East Asian high growth economies. By comparing institutional development across countries we are able to assess the progress required in each area of Portuguese institutional development. Our first conclusion is that Portuguese institutional development generally lags behind the European Union average and well beyond the average for East Asia. Portugal tends to be above Greek levels but the comparison with Spain delivers mixed results. We use the experience of a broad cross-section of countries since 1960 to estimate the empirical relationship between institutional indicators and long-term economic growth, thus identifying areas where institutional reform has a statistically and economically significant effect on growth. Based on these empirical results and the assessment of relative institutional development we construct three new indices to assess the benefit of institutional reform, the impact on growth, the required reform effort and the efficiency of reform index. These three indices measure, respectively, which reforms have the most payoff in terms of growth, which are “less costly” to undertake and which deliver the most growth per required effort. Our empirical results strongly support the view that, in Portugal, comprehensive reform of institutions will translate into higher rates of economic growth. Irrespective of which of the three reform related indices is used, out of the ten most promising reforms, six are in the legal area. Moreover, legal reform is promising at both the aggregate and the microeconomic level. On the other hand, while in the finance area it is aggregate indicators that offer the widest scope for productive reform, in the corporate governance area it is indices at the firm level that hold the most promise. Portugal has recently experienced a slowdown in economic growth resulting in slower convergence vis-à-vis richer countries in the European Union. The slow and infrequent change in institutions suggests that low institutional development is partly responsible for the disappointing growth performance in Portugal. Our results support the view that a comprehensive and sustained reform effort is necessary for Portuguese growth to attain higher rates, allowing faster real convergence with the richest countries in the European Union.

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Table of Contents

Introduction What Are Institutions and What Do They Do? Institutions and Economic Growth The Legal System and the Law Firms and Corporate Governance The Financial System, Banks and Stock Markets Institutions and Growth: An Empirical Exercise Strategies for Institutional Reform in Portugal Conclusions

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1. Introduction “We cannot see, feel, touch, or even measure institutions; they are constructs of the human mind.” Douglass North (1990) In the last couple of decades the importance of institutions for economic growth has received increasing attention by academics and policy-makers. Today, the cliché “institutions matter” is more likely to be among the set of priors held by economists. Agreeing what institutions are, why and how they matter, and what they matter for raises considerably more disagreement. In this paper we provide a characterization of institutions based in the economic roles they perform. Our focus is on three different areas of institutional development: the legal system, the governance of the firm and financial markets. The internal organization of firms, the access to financial resources and the legal framework within which firms and individuals operate all affect the growth rate of an economy. After reviewing the arguments and the evidence linking each of these policy areas to economic growth, we conduct econometric tests to assess the importance of each institutional characteristic for growth. Our analysis uses a broad cross section of countries and wide data array to derive policy implications for the Portuguese case. We characterize Portuguese institutional development in the legal, financial and firm governance areas and compare Portugal to Spain, Greece, the European Union partners and East Asian competitors. The assessment of relative institutional development in Portugal is then crossed with estimates of the impact of each institution in economic growth. We can thus compute the benefits of bringing Portuguese institutions up to par with European Union institutions. Three new indices of the benefits of reform are calculated, which compute the impact of reform on growth, the effort required to raise the quality of Portuguese institutions and the efficiency of reform, that is, the impact on growth per effort required. We are able to recommend specific institutional reforms, which are likely to have a substantial impact on Portuguese growth at relatively low effort.

2. What Are Institutions and What Do They Do? In analyzing institutions, it is natural to start from the work of Douglass North, who defines institutions as “the humanly devised constraints that (…) structure incentives in human exchange, whether political, social or economic” (North (1990, p. 3)). The idea of institutions as constraints that nevertheless facilitate exchange is key. Coase (1960) had shown that in a zero transaction cost world where bargaining and contracting are costless, competitive markets arrive at the solution that maximizes aggregate income. In such a world institutions are redundant. But when interactions are one shot (not repeated), information is incomplete or asymmetric, or when transactions occur over an extended time period between a large number of players, exchange and cooperation become difficult.1 In other words, transaction costs arise from problems of search and information, bargaining and contracting, or policing and enforcing of contracts. In this context, institutions do matter. 1

See, for instance, North (1990, p. 12).

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What do institutions do? What roles do they perform that affect exchange and economic growth? In spite of the multiple, often concurring, roles ascribed to institutions, a short list of their functions should include the following: A. Creating and Enforcing Rules – Institutions restrict the set of choices available to individuals and change social outcomes when indivdualistic behavior does not result in the most efficient joint outcomes. Examples include situations characterized by multiple equilibria, public goods, externalities or prisoner’s dilemma type of incentives. A rule is only as relevant as it is enforceable and institutions are also mechanisms to enforce rules, even when private individuals have no incentive to do so. Creating rules, determining if and when they are violated and what to do in that case is an important part in the life of institutions. B. Aggregating Information and Preferences – The differences in preferences between individuals cannot be overcome by simple market mechanisms when the goods and services involved have certain complex characteristics. An example is the case of public goods and externalities, where private and social benefits are not aligned and individuals may even lack incentives to reveal their true preferences. In these cases institutions may be set up with one main objective: to aggregate information on preferences and deliver a choice. A national parliament or the general assembly of a firm are institutions with such a role. C. Sharing Risks and Reducing Uncertainty – Institutions, as collective endeavors, can be valuable as risk-sharing mechanisms. Overall, institutions provide a structure to everyday transactions that reduces uncertainty and allows groups and individuals to engage in an expanded set of fruitful exchanges. When performing this role, institutions often involve a trade-off between more stability and better performance. D. Optimizing Resource Utilization – By pooling individual capabilities and resources institutions may be able to increase social output in ways that individuals acting alone cannot. E. Redistributing Resources – Institutions may be created to alter the distribution of resources away from what results from untethered market interactions. This redistribution may occur because society believes that certain groups – e.g. retired people – or certain conditions – e.g. unemployed – merit special consideration and the response of the market is unsatisfying. If institutions are defined by the functions above, we naturally realize that they combine formal and informal features. In their formal incarnation, institutions are a set of explicit, detailed, coded rules that are applied within defined limits. On the other extreme, informal institutions are no more than an evolving set of social conventions and behavior that is widely followed in a given society. It is important to distinguish organizations from institutions. Organizations have a clearly defined purpose that forwards the interests of their limited set of members. Institutions have broader objectives, they are intermediate bodies that facilitate the attainment of diverse individual and group objectives. As an example,

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while a specific corporation is an organization, corporate law is an institution whose existence furthers the interests of corporations, governments and individuals. As institutions evolve through time they tend to do so slowly and incrementally rather than through discrete change. The substantial amount of inertia in institutional change is expressed in terms like “history matters” or path dependence. This inertia may in some cases be an integral part of the role institutions are expected to perform: were institutions to change constantly in response to economic and social circumstances, they would perform their role more poorly.

3. Institutions and Economic Growth Institutions matter for economic growth. One first possibility is to depart from neoclassical growth accounting, which sees production as resulting from the combination of different inputs – say land, labor and capital – to produce an output. To the direct costs of inputs one could add the transaction costs involved in combining thse inputs in the most efficient way. Institutions matter because they affect this transaction costs.2 A second possibility is to see institutions as encouraging specialization. As North (1990) has put it “non-specialization is a form of insurance when the costs and uncertainties of transactions are high. The greater the specialization and the number and variability of attributes, the more weight has to be put on reliable institutions (…)”. The importance of institutions becomes evident as one recalls how Adam Smith understood specialization of production as the key mechanism in economic development. By broadening the set of possible exchanges, institutions increase the effective size of the market and allow further specialization.

3.1. The Legal System and The Law The relationship between the law, the judiciary and economic growth has been the subject of political economy from early on. Adam Smith (1755, p. 322) highlighted that “a tolerable administration of justice,” in conjunction with peace and low taxes, could bring a state “to the highest degree of opulence.”3 In his studies on society and economics, Max Weber also examined the relation between the law, the judiciary and economic development. There are two broad reasons why the judicial system may affect economic performance. First, it enforces property rights, in particular keeps the government in check by avoiding abuses of governmental power. Second, the judiciary facilitates exchanges between private parties.4 2

See North (1990, p.28). Wallis and North measure the importance of transaction costs by summing the value of banking, insurance and commerce activities as well as the income of lawyers, accountants, managers, etc. They found that about 45 percent of total U.S. output was devoted to these activities, up from 25 percent a century earlier. In a certain sense, the rise in the importance of services reflects the efforts to reduce transaction costs. 3 In the tradition of Adam Smith, North (1981) highlights the emergence of a system of enforceable property rights as the important institutional prerequisite for economic growth. 4 A 17th century political philosopher presented this argument by stating that in general contracts “he that performeth first has no assurance the other will perform after because the bonds of words are too weak to bridle men’s ambitions, avarice, anger, and other passions without the fear of some coercive power” As quoted in Messick (1999).

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The protection of property rights is generally accepted as the minimum necessary level of government intervention. In a seminal paper, Coase (1960) discusses the importance of the law for economic transactions. Income maximization can be independent of the legal system if the price system works without transaction costs. Individuals can then buy and sell rights as needed.5 Notice that a legal system (any legal system) needs to be in place and rights duly enforced so that they can be exchanged just as other goods in the market. In reality there are important transaction costs and the specific legal system in place affects the economy. Coase (1988, p. 28) restates the primacy of the law: “economic policy involves choice among alternative social institutions, and these are created by the law or are dependent on it.” In the absence of clear property and contract laws, contracts tend to be simple, involve fewer parties and be closed in “spot” markets as a way to reduce the scope for breach of contract.6 The type and benefits of economic transactions are decrease concomitantly. Williamson (1995) noted the prevalence of long-term contracts in developed economies. It is true that the extra gains from repeated interactions may be a sufficient inducement for keeping a contract when the discounted present value of earnings to be realized in the future exceeds the one-time gain from breaching the agreement. In other cases the benefits of acquiring and maintaining a good reputation provide the necessary incentives.7 However, as Posner (1998) ably puts, the key to prosperity is the legal infrastructure, centered on the protection of property and contract rights: “In its ideal form (an important qualification), the machinery consists of competent, ethical, and well-paid professional judges who administer rules that are well designed for the promotion of commercial activity. The judges are insulated from interference by the legislative and executive branches of government. (…They are advised by competent, ethical, and wellpaid lawyers. …) Their decrees are dependably enforced by (…) police or other functionaries (again, competent, ethical, and well paid). The judges are numerous enough to decide cases without interminable delay, and they operate against a background of rules and practices, such as accounting standards, bureaus of vital statistics, and public registries of land titles and security interests, that enable them to resolve factual issues relating to legal disputes with reasonable accuracy and at reasonable cost to the disputants.” (Posner (1998, p. 2-3))

The enforcement of property rights is an important element of a legal system. With diffuse and non-enforceable property rights production relies on as little physical capital as possible and transactions tend to be limited both in time and over the number of actors. Common Law versus Civil Law Most of the actual legal systems in place in the world originated in the British or the French system, also designated as the common law and the civil (or Roman)

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The University of Chicago approach to law and economics, of which Coase is a major exponent, emphasizes market and non-market behavior reacting to implicit prices established through laws. 6 Williamson (1995) suggests that the quality of a judicial system is indirectly assessed by the complexity of the economic transactions it is able to support. 7 Similar principles are behind mechanisms that have gained force in developed societies, such as consumer testing laboratories and better business bureaus, which “sell” their reputation through seals of approval or quality guarantees.

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law traditions.8 While the French system relies heavily on legal codes, written rules and professional judges, the British system relies on broader principles, oral arguments, rule of precedent and lay judges. Why these systems evolved in different directions is beyond the scope of this paper. But it is clear that the different characteristics of the systems are coherent. For instance, codification is a natural mechanism of control in the presence of judges appointed by a central state. Often, as is the case in former European colonies, legal systems are involuntarily acquired. But legal systems may have been the object of conscious choice in England and France. Mahoney (2000) suggests that the English common law developed as landed interests and merchants wanted protection for property and contract rights strong enough to limit the crown’s ability to interfere in markets. On the other hand, French civil law may have originated in the desire of the generation of the French revolution and of Napoleon afterwards to keep judges from changing the thrust of government policies.9 The ideologies underlying common law and civil law systems differ and the latter is more comfortable with centralized and activist governments.10 There are many reasons why the origin and characteristics of the law may matter. The quality of the legal rules themselves may vary systematically across legal traditions.11 The process of litigation, prevalent in the common law system is an example of a procedure that may lead to the survival of the more efficient rules, as argued in Posner (1972). In other words, judge-made law may be more efficient than statutory (coded) law.12 A second possibility is that, even if the average quality of the rules is similar, their application differs in such a way that common law provides greater predictability, thus reducing uncertainty.13 According to Mahoney (2000) there are two features that raise the predictability of outcomes in common law 8

Two other important legal systems are the German and Scandinavian, also derived from Roman law. Germany and countries in Scandinavia have civil law traditions distinct from the French system: while the content of the legal rules is similar the political association are not. The independence of judges is upheld by Germany’s constitution, which does not allow their involuntary reassignment. Still, German judges, as the French, lack the prestige of their common law equivalent. 9 Glaeser and Shleifer (2001) review the historical origins of the two legal systems and model their functioning and consequences. One key problem of legal systems is the enforcement of the law and the protection of law enforcers vis-à-vis powerful local interests. Coercion and corruption by local interests must be kept in check in order for private property to be protected. In this case it is more efficient to leave dispute resolution to well-informed local decision makers, such as juries; if local interests are very strong it may make sense to use less informed but more insulated judges nominated by a central authority. The authors above suggest that France adopted professional judges controlled by the King instead of the independent juries in England because local interests (landlords) were much more powerful in France and thus benefited from a central (and relatively weak) authority as the legal arbiter. 10 See Merryman (1985). 11 For example, La Porta et al. (1997, 1998) provide evidence that common law countries have superior systems of corporate law on average. At a more general level, common law countries seem to have more efficient governments, as shown by LaPorta et al. (1999) after controlling for other determinants such as income per capita, religion and ethnolinguistic fractionalization. 12 Tullock (1997) has put forth a strong refutation of this notion, arguing instead for the benefits of codinfication. 13 The 1997 World Bank Development Report reports from a survey covering 3,600 firms in 69 countries whereby around 70 percent of the interviewed mentioned an unpredictable judiciary as a major problem for their business operations. Public confidence in government institutions, including the judicial system, was very highly correlated with measures of the level of private investment and economic performance in general.

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systems: the respect for the precedent and the important powers of appellate courts.14 It is extremely difficult to make an argument for or against a particular legal system, given their complexities and inter-relatedness with cultural and political traditions. In general, both legal traditions perform well on the question of protecting fundamental property and contract rights and there are prosperous countries in each legal tradition. In Table I and Figure I below we present summary statistics for legal performance indicators in common and civil law countries. These general indicators measure the extent of the rule of law, the efficiency of the judicial system and the level of corruption, as well as the risks of contract repudiation and of expropriation. We report the average for countries with similar legal systems. A higher value for an indicator suggests better performance. It is clear that countries with legal systems of English origin perform better than countries with French legal origin in all indicators. While Scandinavian and German legal origins are associated with the best performances, since these legal systems were not as disseminated through colonization there is a bias toward the inclusion of developed countries that would tend to perform better anyway.

Table I Performance of the Legal System in Different Traditions Rule of Law Efficiency of Corruption Risk of Risk of Judicial Contract Expropriation System Repudiation English French German Scandinavian

6.46 6.05 8.68 10

8.15 6.56 8.54 10

7.06 5.84 8.03 10

7.41 6.84 9.47 9.44

7.91 7.46 9.45 9.66

Whole Sample

6.85

7.67

6.9

7.58

8.05

Note: From LaPorta, Lopez-de-Silanes, Shleifer and Vishny, (1998). European Union excludes Luxembourg. East Asian Tigers refers to Hong Kong, Singapore, Taiwan and South Korea. A higher value corresponds to better performance.

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Nominally, these features are not present in civil law, where the code itself takes precedence as binding law, but courts in civil law countries do in practice take into account precedence and the decisions of higher courts. As noted in Merryman (1985).

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Figure I Measures of Performance in Different Legal Systems

Risk of Expropriation Risk of Contract Repudiation Corruption Efficiency of Judicial System Rule of Law 0

2

4 English

6 French

German

8

10

12

Scandinavian

Djankov et al. (2001) assesses how dispute resolution is handled in practice in 109 different countries. The authors concentrate on the procedure to evict a tenant for nonpayment of rent and the procedure to collect a bounced check. Both are common economic transactions in which substantial fractions of the population are potentially involved so they are very informative as to the workings of the legal system.15 The authors find that in civil law countries dispute resolution is associated with heavier regulation, longer duration of legal proceedings, poorer access to justice and lower judicial efficiency.16 This represents a greater deviation from an informal neighbor resolution ideal, involving voluntary and lower cost resolution of conflicts through a friendly third part. Restraining the State The state is an economic player that enjoys a special power. The ability to restrain that power so that it does not harm economic well-being is one of the main tasks of a legal system. Weingast (1993) has posed this dilemma in the clearest terms: ”a government strong enough to protect property rights is also strong enough to confiscate the wealth of its citizens.” The legal and political systems need to force credible commitments on the state so it won’t arbitrarily alter property and contract rights. One such mechanism of commitment is the separation of powers among the

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Moreover, they involve lower level courts, whose functioning is extremely relevant to the mass of a country’s citizens and thus to economic development. 16 There are two possible views of heavy regulation: it may reduce error and further benevolent political goals, protecting the judicial process from possible subversion by powerful interests (the idea is that even if heavily regulated adjudication appears inefficient, adjudication would be even less efficient without the regulation); on the other hand, the reality of heavy regulation is extreme costs and delays, unwillingness to use the court system, and ultimately injustice. These last burdens of heavy regulation of adjudication may be therefore unnecessary, and could be relieved through reform.

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legislative, executive and judiciary branches of government, such as the “checks and balances” of the US political system.17 The formal separation between the judiciary and other branches of government is greater in common law countries. Actually, the vision of the judiciary as a branch of government in itself is associated with the Anglo-Saxon political tradition. Typically, judges are appointed to a post following successful careers as lawyers, positions are prestigious and well-compensated. The role of the judiciary in common law countries is also highlighted by the mobility between this branch and the executive as judges tend to pursue political careers.18 In civil law countries, becoming a judge is a separate career, embarked on immediately after leaving law school and passing general examinations. Prestige is associated with promotions and transfer to more desirable locations, which often depend on the favors of the executive. Mahoney (2000) presents evidence that the executive in civil law countries takes advantage of this dependence relationship. Actual administration and enforcement of rules falls not on the courts and the judicial system but on the state’s administrative agencies. The independence of these state agencies has to be weighed against their potentially negative role in for rent extraction.19 The independence of the administrative bodies is often enhanced by the law, as the statutes of the civil service may explicitly protect administrative personnel against termination by the executive on the basis of policy disagreements alone. Shaping the Corporation As will be pointed out below, legal origin correlates strongly with creditor and minority shareholder rights that are associated with financial market development. Nevertheless, corporate law is an unlikely place to find systematic differences between legal systems. This is because, relative to other areas of commercial law such as contracts, corporate law has been based on codes from early on, even in common law countries. 20 Levine has recently presented evidence that countries with legal systems that enforce contracts effectively display more developed financial intermediaries. Instrumenting for financial intermediation with legal system characteristics shows that the component of financial intermediary development defined by the legal and regulatory environment is positively associated with economic growth. The evidence also suggests that a better legal environment leads to capital markets that are broader

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Persson et al. (1999) model how different regimes affect public finance outcomes. They show that judicial independence can reinforce the separation of powers and make fiscal redistribution costlier so that separation of powers becomes associated with lower taxation and redistribution. 18 Messick (1999) points out the United States may differ from other countries in this respect. In the United States judges play a significant role in policymaking, and lawyers are often able to engineer significant policy changes through litigation. 19 Motivated by private gain, including future employment in the private sector. The theory of “capture” of regulatory agencies by private interests was proposed by Stigler (1971). Olson (1982) elaborates on the possibility of governments respond to the demands of rent-seeking groups by modifying property or contract rights. 20 As pointed by Mahoney (2000).

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and higher valued and that French civil law countries have the least developed capital markets.21 Formal Laws and Informal Rules An explicit legal framework may not be essential for growth either because it is too expensive for developing countries (though inexpensive in relative terms); because the effects of formal law are only as good as the law itself;22 or because there are good informal substitutes for protection and enforcement of contractual rights.23 Contracts signed under the guidance of formal rules typically have multiple dimensions but cannot foresee all possibilities. They are typically incomplete and delegate to a third party such as a court the resolution of disputes arising during the life of the contract. Informal customs, rules and mores can complement formal rules. However, economic development is almost always accompanied by a move from informal unwritten rules to formal written rules.24 Among the informal substitutes for formal legislation and enforcement are arbitration - with or without the legal enforcement – reputation, merger - which internalizes disputes between independent firms-, bilateral monopoly - a substitute for legally enforceable employment contracts-, strong-arm tactics - used in illegal markets, or altruism - enabling family-owned firms to operate effectively outside a legal framework.25 These informal substitutes may be extremely important, even in developed countries. One needs to recall that property rights and contract enforcement were present before a formal state and an effective government came into existence. These substitutes for formal law may be expensive. Enforcement of rights may depend on the threat and the occurrence of violence, with high costs. Family alliances become dysfunctional in a complex economy. When reputation constitutes the basis of exchange, new firms without family or ethnic connections find it difficult to enter the contracting network.26 These costs are important even when not apparent: new innovative firms remain outside of established alliances, simple, one-time transactions, common in modern economies, become less favored relative to complex transactions that ensure informal enforceability. Containing Crime 21

See La Porta et al (1998). As Posner (1998) puts it, the “legal system does more than enforce contract and property rights; it may also enforce bad laws that reduce economic efficiency”. 23 A common example is that of commercial law. Historically it originated in the customs of merchants that were enforced privately by arbitration and only later it was adopted by the courts and codified. 24 The division of labor between formal and informal mechanisms is affected by the technical complexity involved as more traders move in and it becomes harder to check their reputation. However, economic development may lower some of the costs involved in operating an informal enforcement mechanism. The use of faxes, computers, and other technologies, for example, reduces the costs of compiling and disseminating information. 25 See Posner (1998). 26 Greif (1996) compares "collectivist" and “individualist” societies, where the former rely on personal reputation and trust in contracting and the latter on formal legal mechanisms and reputation. As this author mentions "most collectivist societies are low-income economies and most individualist societies are high-income economies…". 22

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Several reasons suggest why crime may harm economic growth.27 Crime and specially generalized violence deplete the physical capital stock and discourage the accumulation of any kind of capital, including human capital. Crime diverts public resources from other, potentially more productive uses. Papers which compute the direct and indirect costs of crime generally find it to be high as a share of GDP. Bourguignon (1999) estimates that the aggregate cost of crime in Latin America is 7.5 per cent of GDP. In addition to direct measurable economic costs, crime and the fear of crime impact the quality of life for given income per capita. What is the role for legal institutions in reducing crime? In virtually all countries all deliberate acts of violence or harm to property are subject to penal sanctions so that the functioning of the criminal justice system is key to reduce crime. A recent study by the Fanjzylber et al. (1998) analyzes the relation between the amount of policing and the rates of homicide and robbery for the period 1970–1994 based on information from the United Nations World Crime Survey. Among their findings is that, while economic downturns and income inequality raise violent crime rates, the strength of the police and of the judicial system are significant deterrents of violent crime. The Characteristics of Legal Systems: Portugal in Context Tables II through IV present indicators of legal performance for Portugal and other economies. We have chosen to compare Portugal with Spain and Greece, southern European countries that also joined the European Union in the mid-1980´s and have sustained parallel experiences of political authoritarianism and delayed institutional development. We report average values for institutional indices in the European Union average and the four East Asian fast-growing economies - Hong Kong, South Korea, Singapore and Taiwan. These are relevant benchmarks as they characterize the institutional development of European partners and the strongest competitors in world markets. As far as general indicators of legal performance are concerned, Table II shows that Portugal compares well with Spain and Greece, performing as well or better than both countries in Rule of Law, Corruption, Risk of Contract Repudiation and Citizen´s Access to Justice and better than Greece in Risk of Expropriation. However, Portugal is well below the average European Union levels of performance in all these indicators. The difference is most acute in the indices of Efficiency of the Judicial System, Corruption and Contract Enforcement. Portugal also compares poorly with East Asian countries.

Table II Performance of the Legal System Rule of Law Portugal Spain Greece 27

8.68 7.8 6.18

Efficiency Corruption Risk of Risk of Citizen's Contract of Judicial Expropriation Contract Access to Enforcement System Repudiation Justice 5.5 6.25 7

7.38 7.38 7.27

8.9 9.52 7.12

8.57 8.4 6.62

7.5 5 5

4.54 6.23 5.81

See Davis and Trebilcock (1999).

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European Union East Asian Tigers

8.97 7.67

8.63 8.19

8.74 7.22

9.44 8.76

9.07 8.86

7.86 4.38

7.25 6.49

Note: Variables Efficiency of Judicial System to Risk of Contract Repudiation are from LaPorta, Lopez-de-Silanes, Shleifer and Vishny, (1998). European Union excludes Luxembourg. East Asian Tigers refers to Hong Kong, Singapore, Taiwan and South Korea. Data on Citizen´s Access to Justice and Enforcement is from Djankov et al. (2001) and measure the degree to which there is “equal access to non-discriminatory judiciary” and the “enforceability of contracts”. A higher value corresponds to better performance.

The duration of legal procedures, a more specific measure of legal performance, is reported in Table III.28 The data is quite revealing: Portugal has the highest duration for legal procedures by far, well above Spanish, Greek, European and East Asian levels. The time for completion of a legal procedure is 1.5 times that of the EU for the eviction of a tenant and almost twice the EU level for collection of a bounced check. The data allow us to pinpoint the origin of the problem more finely. Iit is the time spent in court that is well above international levels, standing in Portugal at about five times Spanish levels. The time spent on other phases of the legal process - service of the process and enforcement – is actually at or below international duration levels.

Table III Duration of Legal Procedures for Tenant Eviction and Bounced Checks TENANT EVICTION

Portugal Spain Greece European Union East Asian Tigers

Service of Process

Trial

Enforcement

Total Duration

20 60 32 18.0 19.0

280 55 35 143.4 94.8

30 68 180 91.1 108.4

330 183 247 252.5 221.1

BOUNCED CHECK

Portugal Spain Greece European Union East Asian Tigers 28

Service of Process

Trial

Enforcement

Total Duration

20 49 180 28.1 16.9

280 69 45 118.0 39.4

120 29 90 81.3 41.9

420 147 315 227.3 98.1

Data is from Djankov et al. (2001).

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Note: Data is from Djankov et al. (2001). The table presents estimates of the expected duration of each type of dispute, from the original filing of a complaint to the ultimate enforcement of judgment for two common disputes, the eviction of a non-paying tenant and the resolution of a bounced check case. Duration of enforcement refers to the time between notification and actual enforcement. Table IV below presents additional indices related to different aspects of the legal procedures. A higher index value represents a move towards more formalism and legalism, except in the case of Defendant Protection, Time Limits and Administrative Procedure.29 Notice the high index levels for Portugal, generally higher than the European Union and East Asian levels. In particular, note how the Dispute Resolution Index - measuring the number of independent procedures necessary to resolve an issue - is higher in Portugal than in the EU, both for tenant eviction and bounced check procedures. The difference is even higher as Portugal is compared with the highly competitive East Asian economies. The relatively high levels of Defendant Protection, Mandatory Time Limits and the presence of Administrative Procedures in the Portuguese case do not seem to reflect positively on the efficiency of legal procedures. These characteristics of the system may instead be substitutes and responses to the lack of legal efficiency.

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All variables are described in the data appendix.

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0.75 0.88 1 0.8 0.7

Written vs. Oral

0.75 1 1 0.8 0.6

1 0.67 1 0.6 0.6

Professionals vs. laymen

0.67 1 0.67 0.6 0.3

1 1 1 0.7 0.3

Legal Justification

1 1 1 0.7 0.6

Legal Justification

0.5 0.63 0.5 0.3 0.3

Statutory Regulation of Evidence

0.38 0.63 0.5 0.3 0.3

Statutory Regulation of Evidence 0 0.67 0.67 0.2 0.1

0.67 0.67 0 0.6 0.4

0 0.67 0.67 0.2 0.2

BOUNCED CHECK Other Control of Statutory Superior Interventions Review

1 0.67 0 0.7 0.7

TENANT EVICTION Control of Other Superior Statutory Review Interventions

Note: Source is Djankov et al. (2001). Defendant protections represent a broad concept of efficiency.

Portugal Spain Greece European Union East Asian Tigers

Portugal Spain Greece European Union East Asian Tigers

Written vs. Oral

Professionals vs. laymen

4.58 5.96 3.83 3.7 2.5

Dispute Resolution Index

5.13 5.5 4.17 3.9 3.4

Dispute Resolution Index

0.5 0.67 0.5 0.6 0.5

Defendant Protection

1 1 . 0.5 0.2

Defendant Protection

Table IV Legal Procedures for Tenant Eviction and Bounced Checks

1 1 0 0.1 0

0.8 0.4 0 0.3 0.3

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0 0 0 0.1 0

Mandatory Administrative Time Limits Collection Procedure

1 1 1 0.3 0.3

Mandatory Administrative Time Limits Eviction Procedure

3.2. Firms and Corporate Governance In the neoclassical view of the firm managers choose quantities of inputs and technologies so that the value of outut is maximized. With freely available information, management lacks any meaningful role. Coase (1937) was first to point that, in a setting without transaction costs, there would be no reason for the existence of firms. All transactions would be undertaken in the market. However, even if “(…) production could be carried out in a completely decentralized way by means of contracts between individuals, the fact that it costs something to enter into these transactions means that firms will emerge (…) whenever their costs [a]re less than the costs of carrying out the transactions through the market.” (Coase (1988, p. 7).30 These relative costs determine what the firms buy and sell in the market and what they produce in-house. It also sets a limit to the size of the firm, as the organization of additional internal transactions increases costs. In sum, firms arise when it is less costly to take transactions out of the market place and bring them into a controlled environment, for reasons of monitoring, enforcing, etc. A series of different and complex contracts can be substituted for one simple contract stipulating that the employee works for a certain remuneration, under the directions of a manager and within certain limits.31 There are other views of the firm. One sees it as a unit that transforms uncertainty: the employee trades his autonomy for a fixed or stable income while the employer directs all resources, obtains an income which is uncertain and becomes the residual claimant.32 A third view is that firms are the result of the need to organize an ever-increasing specialization and division of labor. But the main issue, as Coase (1988) has pointed out, is one of relative costs: when is firm organization more efficient than the price system. There are different stakeholders in a firm, from managers and employees to owners and creditors. While shares giver firm owners the fundamental right to vote for firm managers, debt gives creditors the power to repossess collateral when the company fails. These rights are the instruments through which owners and creditors control the actions of managers, however indirect and diffuse that control might be. As put in LaPorta et al. (1998) “shareholders receive dividends because they can vote out the directors who do not pay them, and creditors are paid because they have the power to repossess collateral.” Shareholder Rights In securities markets investors pay large amounts of money for intangible and diffuse rights, which depend on information that is imperfect, including the behavior of managers about which investors know little about. In unregulated markets this is a difficult act to pull. Black (2000) addresses the issue of how to create strong securities 30

The firm is, in such a view, an environment within which the price mechanism takes the back seat, even if its internal transactions need to remain reasonably linked to market prices through what the firm buys and sells. The entrepreneur becomes the the substitute of the price system in the management of firm resources. 31 More generally, a firm may imply control over another person’s property/capital as well as labor. 32 This is the view of Knight (1933). The system under which “the confident and venturesome assume the risk and insure the doubtful and timid by guaranteeing to the latter a specified income (…)”.

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markets and argues for two essential prerequisites: quality information about the firm and confidence that company’s insiders (managers and controlling shareholders) won’t cheat minority shareholders out of the value of their investment.33 Institutions have an important role in prodding managers to maximize firm value, instead of just firm size or prestige. Proper disclosure and control are tools to attain that objective. Bankruptcy codes, company laws and commercial codes, affect the relation between the firm managers and the holders of claims on the firm, namely shareholders and creditors.34 Ownership concentration may alleviate the agency problem – the difficulty of controlling the actions of the managers so they reflect the interests of the owners -, through the internalization of monitoring costs.35 However, when certain shareholders have a prevailing and controlling influence, conflicts of interest can arise between minority shareholders and the controlling bloc, as the latter may be tempted to extract private benefits. The result may be a reduction in the incentives to invest by non-controlling shareholders and debtors, decreasing the stock market importance as a way to mobilize savings. In other words, the protection of minority owners enhances the liquidity of equity markets and allows diversification but dampens the private incentives to monitor managers. The shareholders main instrument to exercise their rights of control is the vote for company directors or on specific company issues. This power to influence companies decisions through the vote is not equally distributed: there are non-voting shares, shares that have diluted as well as increased voting powers. In some cases legislation enforces the one-share/one vote rule for ordinary shares but this does not preclude ownership blocs and ownership concentration since the interests of dominant shareholders and managers can also be protected by raising the cost of voting. The prohibition on mailing proxy votes, mandatory share deposit prior to the general shareholder meeting, non-voting shares, founders’ shares with extremely high voting rights, shares whose weight increases with holding period, or even the option to first purchase new stock issues are different mechanisms to change the even distribution of voting rights. Other mechanisms work in the opposite direction. The possibility of cumulative voting (casting all votes for one candidate), of proportional representation in the board, right to call a shareholder meeting, to challenge management decisions in court, or the right to force the repurchase of stocks if shareholders disagree with a fundamental decision all protect minority shareholders. Creditor Rights Stronger creditor rights are another way to elicit efficient decision-making by managers. Creditors are an interested part since managers may be tempted to undertake projects that are excessively risky. However high the expected return on the project, the incentives of managers and creditors as residual claimants are not aligned. 33

Minority shareholders are defined as those holding less than 10 percent of the stock. Company law regulates the relations between company shareholders, directors and other insiders, on the one hand, and the corporation itself on the other. It also regulates the relations between the corporation and specific outsiders such as creditors. Bankruptcy laws are more general and discriminate the procedures to be unravelled in the case of default and firm failure. See LaPorta et al. (1998) and Leahy et al. (2001) for discussions. 35 The controlling shareholders face strong incentives to monitor managers and maximize profits when they retain substantial cash flow rights in addition to control. These incentives restrain the diversion of corporate resources and enhance the value also of minority shares. 34

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One possibility to overcome this is the attribution of stronger creditor rights for secured lenders, which can lower the cost of collateralized borrowing. The cost is the possible crowding-out of the remaining - non-secured - borrowing and equity as their lower priority in paybacks discourages lenders. The rights of creditors and bankruptcy provisions in general can change managers´ and lenders´ incentives. The automatic stay on assets in reorganization procedures prevents secured creditors from obtaining property rights over collateral. The immediate liquidation of the firm is thus avoided and the interests of managers, shareholders and other creditors are protected.36 Managers get a clear sign of the possible impact of default on their job and reputation if the law mandates their replacement in reorganization. More generally, stakeholder rights are of little consequence if they do not dwell in an environment of disclosure and enforcement. Financial systems rely on the enforcement of regular and timely disclosure of firm performance information. Ownership Structures The view of the corporation as an organization where ownership is fractured and diffuse and management has substantial discretion - such as was presented in Berle and Means (1932) - may not correspond to reality. In a paper on the structure of ownership for large corporations in 27 developed countries, LaPorta et al. (1998b) made a special effort to identify the ultimate firm owners.37 Only in economies with very high levels of shareholder protection, particularly in the richest common law countries such as the United States, do widely held firms arise.38 Families or the State control most of the firms Financial institutions – the German model - or other corporations are other typical controlling owners. The power of the controlling shareholders is, by definition, much in excess of what is justified by the capital invested and derives from direct participation in management decisions, special voting rights, and pyramid ownership of different corporations. Even large firms are rarely run by professional managers without equity ownership. Controlling shareholders are well placed to control the managers but, as the latter tend to be of the same family, both managers and controlling shareholders retain the interest and ability to expropriate minority owners. This temptation to expropriate is diminished by the fact that controlling shareholders also own rights to the cash flow. In countries where the protection of minority investors is poor, the involuntary loss of control by controlling shareholders is very costly. Controlling shareholders can thus be expected to bias voting rights towards themselves and sell smaller fractions of the total shares in order to guarantee control. The result is that in counntries that neglect minority shareholder rights the voting premium - the relative price of shares with extra voting rights versus those with low voting rights – is higher. So, the existing ownership structures are a natural response to the domestic legal 36

Whereas in certain countries secured creditors are still paid first when creditors get paid, in others they take second seat to other stakeholders, such as the government and employees. 37 So that when the shares in a company are held by another firm, the authors go back and investigate who owns that firm, and so on. 38 Notice that the study of large firms in mostly rich countries biases the results towards finding widelyheld ownership.

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environments and Italy and Israel have a higher premium than the United States.39 The strengthening of minority investor protections is a transfer from the controlling to the minority shareholders. The fact that control rights are more valuable than other income for controlling shareholders is made clear by the fact that controlling shareholders tend not to support minority investor protection. How can the power of controlling shareholders specifically be put in check? One possibility is to improve the legal environment, mandate one-share one-vote rules and to stress public disclosure of information. The recent trend to list non-US companies in United States stock exchanges is part of such a move. Companies can partially escape home country institutions and enhance reputation by listing their shares on another country’s stock exchange. However, investors realize that reputation alone is not enough and local institutions and enforcement are important. Black (2000). The need to attract capital may force firms opt for regimes that are more protective of minorities.40 In this context, entrepreneurs may be interested in a minority shareholder protection that increases access to equity and new firm creation but their voice is typically less vocal than that of corporate families. Firm Creation and Destruction The ease with which firms are created and liquidated – and the issue of bankruptcy in general – relates directly to the allocative and adaptive efficiency in an economy. The first has to do with efficiency in a static context, a moment in time, the latter with the context of rules that affect how an economy evolves through time.41 Societies that allow more trial and error can over time, find better solutions to diverse problems. Adaptive efficiency harks back to the “creative destruction” which Schumpeter (1934) viewed as the basis for economic growth. A recent paper by Djankov et al. (2001) analyzed entry regulations in several countries and found official costs of entry to be very high in many countries. The official creation of a firm tends to be a cumbersome, time-consuming, and expensive operation and these authors focus on the number of procedures required and the time and dollar costs involved in entry procedures.42 The cost of entry into a business is associated with higher levels of corruption, larger underground economies, larger governments and less democratic countries. As to the possible benefits, larger costs to entry are not associated with a higher quality of public or private goods - such as pollution control, health outcomes or market competition -, dispelling the “benevolent ruler” or public interest explanations. The association between better governmental and political institutions and lower entry costs suggests that what is at the root of entry costs is increasing the benefits of regulators through bribes, nepotism, etc.43 39

The results are reported in LaPorta et al. (1998). In Italy, a country where investor protection is specially low, firms go public much less often than in the United States, according to LaPorta et al. (1998). 41 See North (1990, p. 80). 42 Requirements to initiate operation of a business vary substantially from 16 procedures, US$3,946 in fees and use of 62 business days in Italy as compared with 2 business days, 2 procedures and US$280 in fees in Canada, according to Djankov et al. (2001). The lowest relative official cost is less than 0.5 percent of per capita GDP in the United States, while the average is about 50 percent of per capita GDP. 43 This is what Djankov et al. (2000) designate as the tollboth theory of regulation, suggesting the creation of barriers to entry in order to collect material benefits. 40

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The Financial System, Privatization and Corporate Governance The nature of the finance system affects how firms raise funds and how firms are managed, what Stulz (2000) has dubbed the financing and the governance problems. The financial and corporate governance systems are thus intimately associated. Academic economists tend to take it as given that savings are naturally directed to the best uses and ignore the role of firms. In the traditional neoclassical view of perfect capital markets and risk-neutral agents, the interest rate is a sufficient instrument to channel savings to the most valuable investments. But, more important than differences in the cost of capital – which is small across developed countries – the differences in management incentives and monitoring leads to different investment projects being pursued in different countries. The “elimination of politically motivated resource allocation [in favor of market allocation] has unquestionably been the principal benefit of privatization around the world”, as argued in Shleifer (1998). Johnson and Shleifer (2001) pursue the issue further and argue that, for privatization to be successful, a proper legal framework that includes protection of minority investors needs to be in place. The context of privatization is also important. According to LaPorta et al. (1998), shares in Russian firms were basically worthless after privatization - 100 times cheaper relative to American firms backed by similar assets)- due to the almost absolute lack of protection of the rights of minority investors. Corporate Governance: Portugal in the International Context Let us now compare indicators of institutional development in corporate governance for Portugal and other countries. Table VII displays aggregate firm level indicators concerning the rights of shareholders in the governance process of the firm. These rights are naturally defined vis-à-vis the power of managers and the rights of minority shareholders, revealing the balance between the different stakeholders. In broad terms and for the issues where data is available, Portuguese corporate law does not seem to differ dramatically from the European Union norm. Portuguese corporate law does not follow a strict “one share - one vote” rule, does not allow proxy voting by mail and does not require that a dividend be paid. As to minority shareholders – those holding 10 percent or less of the company – the law in Portugal is not specially protective since it does not allow cumulative voting for a director, proportional representation of minority interests, nor a clear judicial venue to settle grievances or a sell option if company policy diverges fundamentally from shareholders desires. The summary indicator of Anti-Director rights shows that the situation in Portugal is more favorable towards minority shareholders than in Greece or even in the European Union but worse than in Spain or East Asia. The panorama above reflects the formal content of Corporate Law but legal status is not the end of the story. Life in the firms is affected by the actual distribution of ownership. Table IX shows that the average ownership share of the three biggest shareholders - for the ten largest private, non-financial firms – is similar in Portugal, Spain and East Asia, at around 50 percent. For Greece this average share ownership is larger, while for the European Union it is much smaller. The difference between the

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51 percent average share ownership in Portugal and the 44 percent in the EU is more real than one may first think: while 51 percent generally implies majoritarian control, 44 percent often does not. In addition to shareholders, creditors are also an important stakeholder in the firm. The role of creditors is specially important in the Portuguese economy, where a large part of the financial funds of the firms comes from the banking system, not the stock market.44 In the item Creditor Rights, Table X shows that the situation in Portugal is similar to the Greek but worse than the Spanish, the EU and the East Asian cases. The selected summary indicator takes the value 1 for Portugal and 3.25 for East Asia, where a higher index corresponds to better protection of creditor rights. This is the result of several concurring facts: in Portugal there is no automatic stay on assets, there are few restrictions on reorganizations when companies are failing and management may stay during reorganizations. The rule that creditors are those first paid when a company fails is the sole sign of strong creditor rights in Portugal. The ease with which firms are created and closed can be gleamed from the data in Table IX, which presents a summary of the procedural mechanisms needed to open a business in several economies. The costs of following those procedures and actually opening a firm, in terms of both dollars – the share of average yearly income - and of time costs. As to the firm destruction side, we present information on the frequency of bankruptcies. The emerging picture is clear: in Portugal the law demands a greater number of procedures to open a firm than in the EU or the East Asia. Only Greece imposes heavier bureaucratic steps before opening a firm but the time cost is still higher in Portugal. It takes twice as much time to open a business in Portugal than in a European Union country. In terms of total cost, it is two and a half times more costly to open a business in Portugal than in an East Asian economy and about fifty percent more costly than in a European Union economy. The number of bankruptcies as a share of total businesses in existence reveals that in Portugal a firm is almost 30 times less likely to go bankrupt than a firm in the European Union and about 20 times less than in an East Asian country. The likelihood of bankruptcy is lower for Portugal and Spain than for any other EU country, and significantly so. There is a strong suggestion of a link between the cost of opening and of closing a firm, with both rise and fall together: in countries where it is hard to open a firm it is also hard to close one.45 Innovation suffers as existing firms outlive their competitive advantage live off their one unfair advantage, the fact that they are already in existence. In sum, the situation of corporate governance development in Portugal does not differ much from the European Union’s as far as the letter of the law. However, the comparison of the costs of opening and closing a business show that Portugal, 44

As analysed further below. We have computed the sample correlation between the time required to open a business and the likelihood of bankruptcy and found it to be –0.51, suggesting a strong link between barriers to creating and closing a business firm. 45

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Spain and Greece are characterized by less dynamism than the European Union or East Asia.

23

0 0 0 0.14

0.25

0.39 0.05 0 0.25

0.18

0 0 1 0.07

0.50

0.17 0.29 0.33 0

0.22

English French German Scandinavian

Whole Sample

0.71

1 0.57 0.17 1

0.50

Shares not Blocked Before Meeting 1 0 0 0.43

0.27

0.28 0.29 0.33 0

0.25

Cumulative Voting Proportional Representation 0 1 0 0.07

0.53

0.94 0.29 0.5 0

1.00

0 1 0 0.21

Oppressed Minority

0.53

0.44 0.62 0.33 0.75

0.50

1 1 1 0.79

0.11

0.09 0.15 0.05 0.1

0.07

0.05 0.05 0.05 0.10

3

4 2.33 2.33 3

3.50

3 4 2 2.50

Preemptive Share of Anti Director Right to New Capital to Call Rights Issues ESM

0.05

0 0.11 0 0

0.00

0 0 0.35 0.03

Mandatory Dividend

24

Note: From LaPorta, Lopez-de-Silanes, Shleifer and Vishny, (1998). European Union excludes Luxembourg. East Asian Tigers includes Hong Kong, Singapore, Taiwan and South Korea.

Portugal Spain Greece European Union East Asian Tigers

Proxy by Mail Allowed

One Share One Vote

Table VIII Shareholder Rights

Table IX Ownership by Large Shareholders Average 3 Largest Shareholders

Median 3 Largest Shareholders

Capitalization 10 Largest Firms

Portugal Spain Greece European Union East Asian Tigers

0.52 0.51 0.67 0.44 0.53

0.59 0.5 0.68 0.41 0.55

259 1,256 163 4216.21 1473.55

English French German Scandinavian

0.43 0.54 0.34 0.37

0.42 0.55 0.33 0.33

6,586 1,844 8,057 2,644

Whole Sample

0.46

0.45

4,521

Note: The first two columns are the average and median percentage of common shares owned by the three largest shareholders in the ten largest non-financial, privately owned domestic firms (state is not a known shareholder). The third column provides average market capitalization of the largest 10 firms. From LaPorta, Lopez-de-Silanes, Shleifer and Vishny, (1998). The sample has a total of 49 countries. European Union excludes Luxembourg and East Asian Tigers refers to Hong Kong, Singapore, Taiwan and South Korea.

25

0 1 0 0.36 1 0.72 0.26 0.67 0.25 0.49

0 0 0 0.57 0.5

0.72 0.42 0.33 0.75

0.55

Portugal Spain Greece European Union East Asian Tigers

English French German Scandinavian

Whole Sample

0.81

0.89 0.65 1 1

1 1 0 0.86 1

Secured Creditors First Paid

0.45

0.78 0.26 0.33 0

0 0 1 0.14 0.75

Management Does not Stay in Reorganizati on

2.3

3.11 1.58 2.33 2

1 2 1 1.93 3.25

Creditor Rights

0.15

0.01 0.21 0.41 0.16

0.2 0.2 0.33 0.13 0.375

Legal Reserve Required as % of Capital

Note: From LaPorta, Lopez-de-Silanes, Shleifer and Vishny, (1998). European Union excludes Luxembourg. East Asian Tigers includes Hong Kong, Singapore, Taiwan and South Korea.

No Automatic Stay on Assets

Restrictions Reorganizati on

Table X Creditor Rights

26

27

Number of Safety & Environment Taxes Labor Screening Time Cost Dollar Dollar plus Percentage Procedures Health Cost Time Cost Bankruptcies 12 0 0 2 2 8 76 0.1844 0.4884 0.08 Portugal 11 0 0 4 2 5 82 0.173 0.501 0.02 Spain 15 0 0 4 2 9 36 0.586 0.73 na Greece 9.00 0.00 0.07 2.07 1.43 5.43 36.57 0.16 0.31 1.96 European Union 8.25 0.00 0.00 1.00 2.25 5.00 25.25 0.10 0.20 1.64 East Asian Tigers Note: From Djankov, LaPorta, Lopez de Silanes and Shleifer (2001). European Union excludes Luxembourg. East Asian Tigers refers to Hong Kong, Singapore, Taiwan and South Korea.

Table XI Opening and Closing a Business

3.3. The Financial System, Banks and Stock Markets Capital is a key factor of production. Its ready availability to firms and enterprising individuals depends on the functioning of a country’s financial system. Gerschenkron (1962) has highlighted the relationship between finance and development in contrasting the experiences of Britain and other European countries.46 The Schumpeterian view of the process of development as one of “creative destruction” implies economies where the amassing of resources for new ventures as well as the prompt liquidation of unsustainable firms go hand in hand.47 In the case of OECD countries, Leahy et al. (2001) have used assessed the relation betwee growth, innovation and indicators of financial development: stock market capitalization and private credit issued by deposit banks are both important factors. Jayaratne and Strahan (1996) has shown that when individual states in the US relaxed intrastate banking restrictions, the quality of bank lending improved and economic growth accelerated. Thus, the size of the financial market and the level of competition within it can have a significant impact on growth. The study of financial markets within the larger role of institutions in development is fairly recent. One of the preeminent economic institutions, secure property and contract rights, is seen as key for banks and financial institutions to work properly. Weak contract enforcement creates incentives for default by debtors and decreases willingness to lend.48 Less investor protection substantially affects opportunities for external finance and leads to smaller capital markets.49 What functions do financial markets and intermediaries perform? An efficient financial system increases financial savings and improves their allocation. First, the financial sector may increase saving rates and increase liquidity, the process of financial deepening. Financial intermediaries such as banks and securities markets are able to pool resources that would not otherwise be available for firms that want to reach a larger and more efficient scale of operation. Intermediaries also channel funds to projects with a longer horizon by providing liquidity services. The economies of scale and expertise available to financial intermediaries provide stimulate savings by giving savers a higher yield. Asecond role is that of acquiring information and evaluating projects, a process too costly to be undertaken at the individual level. A third role is to overcome idiosyncratic risk involved in single-project investment, even when the amount of financial resources available to the investor is small. Risk is priced, diversified and transacted so that projects with high-return and high-risk can be financed. Fourth, financial intermediaries monitor firm managers, overcoming the another problem of high cost of information acquisition. Trust and Financial Development

46

Wheareas Great Britain relied on a market-based system, Germany, as a latecomer, relied on bankbased system. 47 See Schumpeter (1934). 48 As argued in Shleifer and Vishny (1997). Using a dataset on legal and institutional country characteristics and the level of legal protection and enforcement of investor’s rights, La Porta et al. (1997) find wide cross-country differences: common law countries protect investors better and French civil law countries fare the worst in investor protection. 49 As shown by La Porta et al (1998).

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The relationship between trust and development is highlighted in recent work on social capital and institutions. Knack and Keefer (1997) argues that institutions may be a substitute for trust: when the latter is low, institutions that provide formal mechanisms for contract enforcement become more valuable. A financial contract is trust intensive by nature: resources are transferred today in expectation of future paybacks. Financial contracts are also intrinsically incomplete and monitoring costs high so that opportunism can easily arise and collateral requirements become the standard response. The effectiveness of institutions, particularly as they enforce contracts and the repossession of collateral in disputes, affects aggregate outcomes directly. The size and nature of financial markets, how much is borrowed and lent ultimately depends on the levels of trust or the institutions that substitute for it. Guiso, Sapienza and Zingales (2000) study the relationship between trust and financial development by contrasting trust attitudes between northern and southern Italians. Even after taking full account of regional differences in education and law enforcement, their evidence supports the hypothesis that trust and financial development go hand in hand as in regions with higher levels of trust households hold less cash, have higher stock investments, use more checks, have more access to credit, and use informal markets less frequently. Even southern migrants in the north display financial behavior that is closer to their region of origin. Caldéron et al. (2001) examines aggregate data and - after controls for the size of the economy, level of human capital, inflation and law enforcement - finds higher levels of trust associated with deeper financial markets, lower interest rate margins and overhead costs and more dynamic stock markets. Countries with lower trust or poorer institutions tend to have smaller and less efficient financial markets. Bank-Based versus Market Based Financial Systems An important issue is the comparative advantage of banks versus stock markets. At low levels of financial development, the type of financial system affects the type of external finance. In countries where the legal system predicts a developed securities market, there are more firms growing at rates that require longterm sustained external finance. Securities markets may be better suited for long-term financing, whereas the banking sector is closely related to the availability of shortterm financing. The type of system has implications for which firms and which projects obtain financing.50 The authors that argue banks can better finance the expansion of existing firms as well as the establishment of new firms emphasize the low cost for banks of screening and monitoring and the longer-term relationships with firms. Stiglitz (1985) has argued that there is a public good problem in acquiring information from developed financial markets. As markets reveal new information – aggregated in stock prices –quickly to all investors there are little incentives for individual spend resources researching firms. Bank-based systems mitigate this problem through the longer-term relationships and the fact that acquired information is not publicly revealed. Since shareholders can easily sell their stake in a corporation and increase it in another, there is little incentive to exert influence over management. Such is not the 50

As argued in Demirgüç-Kunt and Maksimovic (1996).

29

case with banks. Stock markets also have the extra cost of management colluding with boards of directors against the interests of the shareholders. Moreover, since banks enter a long-term relationship with firms, they can credibly commit to make new resources available as the firm’s expansion and its performance justifies.51 An opposing view stresses the benefits of financial systems based on the stock market. The stock market is large in terms of resources mobilized and very liquid so it has some advantages in financing firm creation and growth. Efficient prices in secondary markets help investors identify good and bad investments through a mechanism similar to Tobin’s q. New technologies have a better chance of being objectively appraised in such large and liquid markets. Contrary to the views expressed above, the fact that individuals can reap substantial profits from acquiring information, information acquisition in stock markets may be at reasonable levels. The relationship between managers compensation and firm performance in the stock market and the possibility of takeovers are mechanisms of corporate control. By acquiring inside information, banks can extract informational rents from firms so that the price of finance increases. The insider status of banks is also evident in the fact that bankers often hold equity so that collusion with managers and the board of directors against the interests of minority shareholders is possible. Moreover, banks are debt issuers with a conservative bias against risky projects, thus stifling innovation and growth. The benefits of solid collateral can lead banks to continued financing of established firms with low-return projects versus new and innovative firms.52 In sum, there are also good reasons to believe developed stock markets further innovationa and growth in ways that banks cannot. The Financial Services View Research on the relative merits of the two types of financial systems uses long-term analyses and comparisons of Germany and Japan - as bank-based systems – versus the United States and Great Britain - as market-based. There does not seem to be a difference between bank-based or market-based financial systems in terms of firm growth, whether new or existing.53 A third view of financial systems, - the financial services view – suggests that different firms participate in both markets and that each type can gain the most in different markets. Smaller firms and newer firms with banks, larger and more innovative firms with stock markets. Banks and markets act as complements and both can promote the flow of external funds to solid and entrepreneurial firms.54 Beck and Levine (2001) decomposes sectoral growth into growth in establishment size and firm entry and finds that overall financial development explains cross-country variation in the number of establishments. The Legal Determinants of Financial Systems Financial systems and their institutional characteristics have deep roots in the history and political culture of a country.55 The legal system conditions the type of 51

See Beck and Levine (2000). As argued in Rajan and Zingales (1999). 53 See evidence in Beck and Levine (2001). 54 Garcia and Liu (1999) find that the development of financial intermediaries such as banks actually supports the increase in stock market capitalization, further validating the complementary view. 55 The legal and political influences on development are very closely related. In England, William the Conqueror ordered in 1086 the systematic record of property rights to ownership of land, livestock, 52

30

financial system that evolves over time. Legal traditions put different emphasis on the comparative rights of individual investors vis-à-vis the state, with consequences for financial development.56 Beck et al. (2001) show that the level of overall financial development is indeed affected by the legal tradition. Moreover, the level to which firms are financially constrained is higher when the risk of expropriation is high, legal systems are inefficient and the associated corruption high.57 Whenever a strong legal system that can protect external investors is absent, financial intermediaries who have sufficient bargaining power to enforce their rights privately come forward and extract rents, as argued in Modigliani and Perotti (1999). Another prediction is that overall financial development as determined by the legal system increases opportunities for the entry of new firms and the expansion of existing ones. Rajan and Zingales (1998) and Beck and Levine (2001) decompose industrial growth into two components: existing firm growth and the emergence of new firms. Rajan and Zingales (1998) shows that firms dependednt on external funds grow faster in economies where the legal system duly enforces the rights of outside investors.58 The legal environment also explains variation in the growth in the number of establishments across countries. In accordance with this view, Demirgüç-Kunt and Maksimovic (2000) use firm-level data for 40 countries to analyze how external finance impacts economic growth by asking the questions: does the financial system have an effect on growth independent of the legal system?; is the use of external financing different in market-based and bank-based systems?; do market-based and bank-based systems differ in the provision of long-term and short-term funds? They do not find evidence that differences across financial systems unrelated to the legal system (such as bank versus market based) affect access to external finance. Use of external finance is positively related to both developed banking and market-based systems. A variation on the law and finance view above highlights the ability of legal traditions to adapt and evolve with development.59 Differences in the realm of adaptability may affect financial development as legal traditions that adapt quickly to close the gap between the needs of the economy and the capabilities of the legal system will foster financial development. The common law is seen as particularly dynamic as individual judges respond on a case-by-case basis and contribute to setting new precedent in an expeditious way. The civil law tradition tends to see the codified written law as immutable and unchangeable. Practice does not entirely accord with this dichotomy and all countries adapte to a greater or lesser extent to new economic and contractual realities.60 ploughs, mills, fishponds. The objective was certainly selfish in that a property registry allowed efficient taxation and a load of information on the assets of friends and enemies. The Doomsday Book was meant to outlive all until the day of the Last Judgment and thus had the result of limiting the discretion of monearchs to expropriate property. As to the civil law tradition, one of its major sources was Roman Law as compiled by Byzantine Emperor Justinian about 534 A.D. 56 This legal-based view thus rejects the dichotomy between bank and market-based systems. 57 The effect of these factors works indirectly through financial development, as reported in Love (2001). 58 In previous studies, Levine (1999) and Levine, Loayza and Beck (1999) find an association between countries that offer better investor protections and more developed financial markets. 59 As in Beck et al. (2001). 60 According to Beck et al. (2001), the German legal tradition has explicitly rejected the French approach and sought to create a dynamic legal code. An emphasis on the evolutionary capabilities of legal systems approaches the German and the common law systems.

31

Bank Regulation and Supervision An important issue is how banks are regulated and the consequences of the regulatory framework. The impact of banking crises on economic growth, of which the recent East Asian crisis is the most preeminent example, have put banking regulation reform high on the agenda. International financial institutions, including the Bank for International Settlement’s through the Basel Committee on Bank Supervision have devised list of “best practices” for regulation and supervision of banks with the hope of promoting bank “safety and soundness”.61 But there is no evidence that the current set of best practices is best or that more checks are better than less. Instead, views on supervision reflect broader views on government and its role in the economy. Two broadly contrasting views of regulation and supervision frame our discussion, the “helping-hand” and the “grabbing-hand” views.62 The helping-hand view sees governments as regulators that correct market failures whereas the grabbing-hand view sees the support of political constituencies as the motivation of regulation. Pigou’s (1938) treatment of regulation has put forth the view of government as correcting monopoly power, externalities and informational asymmetries and thus increasing general welfare. Applied to the banking system, this helping hand view of government would tend to favor close and stringent regulation of banking activities on issues such as capital standards, range of bank activities, firm entry and deposit insurance. Gerschenkron (1962), for instance, focused on the financial prerequisites to start economic growth. He argued that, in spite of privately owned commercial banks being the main vehicle to channel savings into industry in countries such as Germany, in other countries such privately-owned intermediaries are just not available and the government needs to step in.63 The helping-hand view takes as given that there are market failures and that the government can help overcome these failures. If instead it is the grabbing-hand view that is correct, one expects countries with strong supervisory frameworks, entry restrictions and limitations on bank activities and government ownership of banks to present lower levels of political accountability and economic performance without any improvement in bank 61

See Barth et al. (2001a) for a discussion. As in Shleifer and Vishny (1998). These views translate into alternative views as to the effect of private versus government supervision. An example is the possibility that the high cost of overcoming informational barriers limits the monitoring of complex financial conglomerates by the private sector so that banks incur risk levels which are higher than optimal. Industrial conglomerates may also impede competition in financial products as a way to protect their market position. In this case it is beneficial for governments to monitor banks more closely. 63 In the developmental view, ownership of banks enables the government to collect savings and direct them toward strategic long term projects. The government overcomes institutional failures which pervade private capital markets, and generates aggregate demand and other externalities that foster growth. “The scarcity of capital in Russia was such that no banking system could conceivably succeed in attracting sufficient funds to finance a large scale industrialization; the standards of honesty in business were so disastrously low, the general distrust of the public so great, that no bank could have hoped to attract even such small capital funds as were available, and no bank could have successfully engaged in long term credit policies in an economy where fraudulent bankruptcy had been almost elevated to the rank of a general business practice” (Gerschenkron (1962), p. 19). 62

32

performance. Encouraging private sector control of banks along with high levels of competition would have be the needed remedy.64 Barth et al. (2001a) have developed a database on bank regulation and supervision for 107 countries.65 The best mechanisms to promote bank performance and stability seem to be private ownership and control together with information disclosure. Over reliance on direct government oversight of banks needs to be put in check. Authors such as Shleifer and Vishny (1998) advance the hypothesis that government intervention serves only to support private constituencies through employment, subsidies and other benefits. In the end, government failure is at least as important as market failures and powerful regulation and supervision do not seem beneficial. Deposit Insurance and Financial System Risk Many countries have adopted programs of deposit insurance with the goal of . reducing the risk of bank failure through bank runs and generally stabilizing the financial sector. Insurance may increase the size of the financing pool and lead to a more developed financial system through an increse in public confidence, benefitting economic growth in the process. On the other hand, if the government absorbs too much of the system’s risk, a moral hazard problem emerges where monitoring decreases and excessive risk is taken by financial intermediaries. The fact that, when a crisis emerges, depositors tend to be bailed independently of whether explicit deposit insurance is available or not, leads to systemic problems.66 These negative effects of deposit insurance may be compounded under lax regulatory frameworks. Demirgüç-Kunt and Detragiache (2000) have analyzed banking crises data for 61 countries between 1980 and 1997. Variations in coverage, funding and management of deposit insurance schemes significantly affect the likelihood of banking crisis, especially when the broad institutional framework is weak. But the same explicit deposit insurance program will have different effects depending on the institutional environment. Cull et al. (2001) examined the effect of deposit insurance on the size and volatility of the financial sector for long horizons. They find that insurance leads to financial instability in lax regulatory environments - proxied by indices of the rule of law-, even if it leads to financial development and growth in sound regulatory environments. Furthermore, the longer a deposit insurance scheme is in place - regardless of its specifics - the less concentrated the banking sector is. Financial Development, Financial Constraints and Capital Allocation 64

La Porta et al. (2002) show that government ownership of banks is ubiquous and quantitatively important, though higher in low-income countries with less deveoped financial systems and interventionist political cultures. For the average country, 59 and 42 percent of the equity of the 10 largest banks is owned by the government in 1970 and 1995, respectively. Higher government ownership of banks in 1970 leads to slower financial development and slower growth in income per capita income and productivity. Corroborating this view, Sapienza (2002) finds that Italian state-owned banks pursue political objectives in their lending policies. 65 These authors assess how the development and fragility of the banking system is affected by the mixing of banking and commerce, regulations on bank entry and capital adequacy, deposit insurance, independence and power of the supervisory agencies, information disclosure and government ownership of banks, among others. 66 Authors such as Gropp and Vesala (2000) argue that implicit insurance as has been the case in Europe may imply more potential for moral hazard than explicit systems. The trade-off is between a higher uncertainty of being bailed out versus a more encompassing implicit coverage.

33

Capital is scarce and its good allocation is an important economic function. Bringing capital to sectors where its return is highest is one of the ways financial intermediaries promote economic growth. Wurgler (1999) uses data on investment for 65 countries and 28 manufacturing industries for over 30 years and uncovers that the size of the domestic stock and credit markets relative to GDP is associated with a better allocation of capital. Financially developed countries finance growing industries better, at the expense of investment in declining industries. This may be due to better flow of information on specific firms, lower incidence of state ownership and better investor rights which limit investment in declining industries.67 Love (2001) measures financial constraints by the sensitivity of investment to the availability of internal funds and finds stricter constraints to be associated with lower financial development, after controling for such determinants of financial constraints as firm size and the business cycle. Laeven (2001) confirms the results by Love (2001) that financial development and financial constraints change together but adds that the effect is different for small and large firms: small firms become less constrained financially after financial liberalization whereas there is no significant difference for large firms. The result is that the relative ease of access to finance decreases with financial development. This is probably due to large firms’ better (and unfair) access to capital even in systems that are not fully developed or due to larger firms ability to overcome informational asymmetries. To an extent, size is information. The allocation of capital also impacts growth through the creation of new firms. Rajan and Zingales (1998) and Beck and Levine (2001) find that industries which depend on external funds grow faster wherever the financial system has a high level of development, in addition to better legal protection of outside investors.68 These authors also corroborate the view that new firms are more easily established in countries with developed financial markets. Financial Systems: Portugal in the International Context We now provide a brief description of the development of financial systems in Portugal as compared to other countries. We move from broad general characteristics to firm-specific financial indicators. Figures II through IV present the evolution of indicators of financial sophistication in Portugal, Spain, Greece, the European Union and the East Asian high growth economies. Figure II shows that, since the 1960’s, liquid liabilities as a share of GDP have been traditionally high in Portugal. While Greece still displays lower levels, Spain has caught up and surpassed Portugal in the 1990’s. The East Asian economies not only caught up but now clearly surpass Portuguese level of liquid liabilities in GDP, while average levels in the European Union are similar to Portugal’s. The depth of stock market finance is given in Figure III as Stock Market Capitalization to GDP. Portugal experienced a steady increase in this ratio since the 1960’s with a spurt in the late 1980’s that corresponds to the 67

This latter channel suggests that, in the absence of efficient monitoring by investors, firm executives freely allocate cash flow and tend to overinvest in declining industries. 68 Rajan and Zingales (1998) use industry-level data and focus on firms which are highly dependent on external funds. In countries where financial markets are highly developed these financially dependent firms grow faster than firms which rely more on internal capital. Demirgüç-Kunt and Maksimovic (1996) draw their attention to firms within better developed financial markets and show that they grow faster than they would have grown without access to external finance. Both papers can be seen as supporting the view that external finance matters.

34

revival of the role of the stock market in financing private equity. However, in international terms, the level of stock market capitalization in Portugal is only above that of Greece, below Spain’s and well below the European Union and East Asian levels. The value of firm stock quoted is below 20 percent of GDP in Portugal, compared with levels above 40 percent for the European Union. Figure IV presents private bond market capitalization to GDP, where Portugal displays levels above those of Spain and Greece but again clearly below the EU levels. The value of private bonds as a share of Portuguese GDP was around 20 percent in 1996, compared with 30 percent for the EU. In terms of financial sophistication, Portugal is above that of Greece, compares well with Spain but poorly with the European Union as a whole, while the contrast with the East Asian high growth economies is starker. Over time, Portugal saw a deterioration of its relative level of financial development, at least as far as stock market capitalization and liquid liabilities as a whole are concerned. In Table V we present several indicators characterizing the financial system as a whole. The first four indicators measure the intensity of financial activity, the next four the structure of financial activity, namely the relative reliance on banks or the stock market as the source of finance. The very last three indicators in Table V measure aggregate financial market efficiency through the net interest margin, the share of private credit and the total value traded in the stock market as a share of GDP. The intensity of financial transactions is lower in Portugal than in Spain, the European Union and East Asia. Only Greece displays lower levels of financial deepening than Portugal. As to the balance between banks and the stock market, indicators suggest that Portugal relies relatively more on financing by banks. This bias is more pronounced than that of Greece, with a low level of financial development. The high level of private credit to GDP in Portugal, 0.63 as compared to 0.72 for Spain and 0.40 for Greece, goes hand in hand with a value of total stock traded that is only 2 percent of GDP in Portugal and Greece but 6 percent in Spain. The European Union and East Asia have substantially higher shares of stock value trade.69 The net interest rate margin, with a value in Portugal about twice as high as that for the East Asian economies, also points towards low efficiency levels of the Portuguese financial system.70 Table VI presents indicators on the bank sector and bank supervision in general. Portugal has the highest level of bank sector concentration: the five largest banks control almost 82 percent of Portuguese total bank assets while even in financially unsophisticated Greece the corresponding figure is below 70 percent.71 In Spain, and in spite of the movement towards the merger of the largest banks, the five largest banks control only about 50 percent of total sector assets. Compared with the EU as a whole, Portugal has more government ownership presence in the banking sector and weaker international bank presence. Spain has lower levels of government ownership of banks and levels of foreign ownership similar to Portugal’s. As far as bank supervision, frequency, quality and independence indicators do make Portugal 69

One should note that the levels of stock market capitalization are much higher in the United States and even in the United Kingdom than in the EU in general. 70 It is unclear whether a lower net interest margin is always for the better. The experience of the East Asian economies leading to the financial crisis of 1997 suggests that the net interest margin in these countries was lower than efficient and resulted in excessive lending to the private sector. 71 There may be an argument for higher bank concentration ratios in small countries as a minimum efficient level has to be attained. It is specially useful, in this regard, to compare Portugal with a similar-sized economy such as Greece.

35

stand out from the general practice in the European Union. The number of supervisors and the number of onsite examinations in Portugal is on a par with Europe and the likelihood of supervisors being employed by the bank industry after abandoning their role as public regulators is not higher. As in all other EU economies for which information is available, there is an explicit deposit insurance scheme in Portugal. We now turn to the financial life of firms, as captured by indicators of financial health at the firm level. Table VII presents several measures of firm’s operating income variability, the share of debt in equity and of net working capital in total assets. The picture for Portuguese firms is revealing: operating income is more volatile than in other economies and the levels of indebtedness – short or long term – are much higher, while the share of net working capital in total assets is lower. In sum, Portuguese firms face more volatile income streams, have less capital to work with and more of that capital is externally lent so that Portuguese firms are very vulnerable to economic fluctuations. In spite of their higher indebtedness to the bank sector, as compared with similar firms in other countries, Portuguese firms are relatively capital starved: the 0.05 share of net working capital to assets compares with 0.12 for Spain and 0.18 for Greece. The high short-term indebtedness is only surpassed by the East Asian economies, which were to experience the financial crisis of 1997, arguably due to their vulnerability to short-term capital flows. At the level of the firm, the indication is that Portugal has financial development indicators that are below those of Greece, Spain, the EU average and the average for the East Asian economies. Interestingly, the firm level data corroborates the picture of the Portuguese financial system as strongly biased towards the use of bank finance and against own equity and stock market issues.

36

Figure II Liquid Liabilities to GDP 1.6

share of GDP

1.4 1.2 1 0.8 0.6 0.4 0.2 1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

0

year Portugal

Spain

Greece

European Union

East Asia

Figure III Stock Market Capitalization to GDP

share of GDP

1.6 1.4 1.2 1 0.8 0.6 0.4

19 78 19 79 19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94

0.2 0

year Portugal

Spain

Greece

European Union

East Asia

Figure IV Private Bond Market Capitalization to GDP 0.35

share of GDP

0.3 0.25 0.2 0.15 0.1 0.05 0 1990

1991

1992

1993

1994

1995

1996

1997

year Portugal

Spain

Greece

European Union

East Asia

37

4.31 4.43 3.92 4.41

4.88

4.23 5.71 2.59 5.48

7.36

1.11

0.12 0.49 -0.46 0.43

FinanceAggregate

Note: See the Data Appendix for sources and definitions.

Portugal Spain Greece European Union Asian Tigers

FinanceSize

FinanceActivity

1.00

1.00 1.00 0.00 0.69

FinanceDummy

-1.07

-4.26 -2.71 -4.47 -2.65 -0.32

-2.66 -1.55 -1.62 -1.30 1.00

-1.49 -0.30 -0.92 -0.13 1.00

0.00 0.00 0.00 0.46

Structure- Structure- Structure- StructureActivity Size Aggregate Dummy

Table V Financial System

0.02

0.04 0.04 0.04 0.03

Net Interest Margin

1.04

0.63 0.72 0.40 0.71

Private Credit

0.41

0.02 0.06 0.02 0.10

Total Value Traded

38

20.80 0.00 13.00 10.81 24.23

81.70 49.00 70.00 59.19 31.25

Note: See the Data Appendix for sources and definitions.

Portugal Spain Greece European Union Asian Tigers

Percentage Assets Government Owned

Five-Bank Concentration Ratio 11.70 11.00 5.00 16.29 25.00

Percentage Foreign Owned 100.00 100.00 50.00 66.15 100.00

2.40 0.60 1.50 0.78 8.07

2.50 2.00 2.00 2.43 3.00

2.00 2.00 1.00 2.07 2.00

Percentage of Bank Onsite Supervisors Top 10 Rated Supervisors Examination Employed by Internationally per Institution per Bank Last Bank Industry 5 Years

Table VI Bank Supervision

1.00 1.00 1.00 1.00 0.50

39

Explicit Deposit Insurance

Table VII Finance and the Firm Operating Income Variability Portugal Spain Greece European Union Asian Tigers

0.87 0.77 0.46 0.69 0.41

Total Debt to Long Term Debt Short Term Debt Net Working Market Value of to Market Value to Market Value Capital to Total Equity of Equity of Equity Assets 0.59 0.29 0.17 0.39 0.83

0.22 0.10 0.01 0.16 0.19

0.37 0.19 0.16 0.23 0.65

0.05 0.12 0.18 0.17 0.11

Note: See the Data Appendix for sources and definitions.

4. Institutions and Growth: An Empirical Exercise The most recognized framework to analyze economic growth is the neoclassical growth model. First developed in Solow (1956), this theory proposes to explain a country’s rate of economic growth by several factors, including its current level of capital per worker. One of its major implications is that, all else equal, a higher level of capital per capita implies slower growth as the marginal product of an additional unit of capital decreases with capital per worker. As countries accumulate more capital (relative to labor) the marginal product of the extra capital decreases and growth tapers off.72 Countries which differ in a fundamental characteristic such as the production function and the savings rate also differ as to the point at which growth tapers off, i.e. the steady-state level of income per capita. But the distance of a country relative to its own steady-state always affects its rate of economic growth. This is the so-called convergence effect. The initial level of income per capita is used as a proxy to measure empirically the importance of the convergence effect. For this reason, a sensible examination of the influence of an economic or social variable on economic growth needs to control for a country’s initial level of income per capita. Contrary to the neoclassical theory of growth, endogenous growth theory highlights the importance of technological progress to economic growth, that is, the different rates at which countries may grow in steady-state. The focus is thus shifted towards identifying the causes of technological progress.73 In endogenous growth theory, the preeminent candidate to explain technological progress is the scale of the market: larger scale makes innovation more profitable and accelerates the rate of technological progress. For the purposes of the recent paper it would make sense to interpret institutions as one of the factors that alters the effective scale of the market. As laws become clearer and more efficient, as financial markets grow deeper and more sophisticated and firms operate in a governance framework that fosters the efficient use of capital and labor, the number of transactions and the effective scale of the market should increase. 72 73

Barro and Sala-i-Martin (1995) provide an extensive survey of the basic model and extensions. Aghion and Howitt (1998) review the literature on endogenous growth.

40

In this paper, we choose to conduct our empirical exercise in the context of the neoclassical growth theory, for two reasons. First, this is the simpler and more widely spread framework, allowing a clearer evaluation of our results in the context of previous results in the literature. Second, there is a gaping lack of empirical support for the role of scale in economic growth so that the empirical relevance of endogenous growth theory is less clear. The interpretation of the role of institutions in terms of scale is, consequently, of lesser relevance. This section uses data on institutions, most presented in the above section, to investigate which institutions matter and how much they matter for economic growth. Since institutions tend to change slowly and what we care for is long-term growth, we use average yearly growth in the 1960-1995 period as our dependent variable to be explained.74 As right hand-side variables we always use the level of country GDP per capita in 1960 to assess the convergence effect. In addition, and in succession, we enter the various institutional measures of interest as right-hand side variables. Our empirical specification is thus:

Growth GDP 1960-95 = ≡0 + ≡1 . GDP 1960 + ≡2. Institution Several of the institutional measures used in this paper were available only for later sub-periods, sometimes only for the 1990-1995 period. For reasons of lack of data availability and because institutions tend to change slowly over time, we use the indicators for the 1990’s as proxies for a country’s level of institutional development in the whole 1960-1990 period. We can interpret our results as assessing the longterm relationship between institutions (evolving slowly over time) and growth, which is volatile in the short-run but more precisely measured in the long-run, measured over several decades. Our exercise allows the identification of the institutions that affect growth significantly, in statistical or in economic terms. The results are grouped by area and category of the indicators and presented in Tables XII through XIX below. We present the results for Ordinary Least Squares estimates but correct standard errors to be heteroskedastic-consistent. The objectives of the empirical exercise described above should be stated beforehand. Our aim is not to determine causality. Given the broad scope of the current study as well as the variety of institutions under scrutiny, we leave the test of specific causality relationships to future studies. Instead our main aim is to suggest patterns of correlation between indices of institutional development and average longterm growth.75 We will interpret statistical significance of the coefficient on the institutional index as pointing towards an association between institutional development and economic growth. If, in a given policy area – legal, corporate governance and financial systems – we find that regression coefficients tend to come

74

Other definitions of the dependent variable were used and the qualitative results do not change appreciably. 75 The breadth and scope of the paper also determined our choice not to present robustness results and not adding additional control variables beyond the initial income per capita level. The small sample sizes - due to limited availability of data on institutions – and the difficulty in measuring some of the institutional indices support our choice of a simple and unencumbered empirical specification that captures broad patterns of relation.

41

out as statistically and economically significant, we will conclude that reform in this area is likely to deliver important growth benefits. The first tables present results for the legal system, from aggregate performance indicators to specific characteristics of tenant eviction and bounced check collection procedures. Table XII shows that all aggregate legal performance indicators are associated with growth in the predicted way. Since higher levels denote better institutions the positive regression coefficients suggest that improving legal institutions is associated with higher growth. All the indicators with the exception of judicial efficiency have statistically significant coefficients, and even the former is almost significant. Better rule of law, lower corruption, lower risk of expropriation and of contract repudiation, and better citizen access to justice all foster growth. Respect for contractual agreements – low expropriation and repudiation risks – seem to have the strongest impact on growth, followed by a predictable legal framework characterized by a strong rule of law and low corruption. Tables XIII and XIV present the relationship between the procedural characteristics of check collection and tenant eviction and economic growth. The first noticeable regularity is the significance of virtually all procedural characteristics of the check collection procedure, the exception being defendant protection and the written versus oral legal bias of the law. In contrast, for the case of tenant eviction only statutory regulation of evidence and the dispute resolution indices matter for economic growth. These results suggest that indeed our exercise is not spurious as check collection - the procedure more directly connected with economic transactions – is the indeed the one that more directly correlates with rates of growth. All these specific indices grow in the direction of less efficiency and efficacy so that the negative sign suggests that lower efficiency of legal procedures leads to lower average growth over time. Overall, legal indices are strongly related to economic growth at the aggregate and the disaggregated levels, suggesting legal institutions are key to long-term economic development. Tables XIV and XV present regression results for corporate governance indices, the first set related to the power relations between firm stakeholders and the second set related to the opening and closing of firms. Our findings suggest that the first group of governance indicators is generally not statistically significant as a determinant of long-term growth. Only the indicators of the percentage of share ownership required to call a general meeting, the average size of the three largest shareholders and the quality of accounting standards seem to matter. Nevertheless, these three indicators matter in a way that is compatible with the most common prior: higher minimum shares to call a general meeting lower growth, as well as more concentrated ownership and worse accounting standards. In contrast, all measures indicating a barrier to opening a firm are associated with lower growth. A larger set of required procedures, higher time, dollar or total cost all associate with slower growth. The addition of one more procedure as a necessary requirement to open a firm is associated with a 0.10 percent decrease in average yearly growth. Thus, the apparently small difference between Portugal and the EU - three required procedures – may have an economically important impact on growth. On the other hand, the number of bankruptcies is totally unrelated with long-

42

term growth in this sample. It seems that it is the ease with which a firm is opened that most determines the quality of the existing pool of firms and the rate of economic growth. Tables XVII through XIX analyze the relation between financial indicators and growth, assessing the importance of the depth of the system, the bank versus stock market bias and indicators of firm financial health. We find that all indicators related with the depth of the financial system affect growth and that higher financial depth is positively related to growth. By contrast, only one of the indicators related to the structure of the financial system – bank-based versus stock-market based – is significantly related to economic growth. This is in line with previous results in the literature, showing that it is the development of the financial system and not its structure that matter for economic development. Other indicators of the general performance of the financial system relate significantly with country growth and the sign of the estimated coefficient is also as expected: higher net interest margins lower growth while more private credit, higher value traded in the stock market and more non-bank credit all increase growth. Table XVII shows that the nature of bank supervision and regulation do not seem to be important determinants of an economy’s growth after the convergence effect is taken into account. The percentage of banks rated internationally and the existence of an explicit deposit insurance scheme are the only indicators that are significantly associated with growth. In contrast, bank concentration, government ownership, the intensity and independence of supervision and the nature of funding for the deposit insurance scheme are not important for long-term growth. As to disaggregated financial indicators at the level of the firm we find that total debt and short-term debt as a share of equity positively impact growth. None of the other factors significantly affect growth, even if higher income variability and the availability of long-term debt come out with the expect signs and approach significance. Table XIX on firm finance shows that only the level of short-term debt is significantly related to economic growth: the higher the access to short-term financing through banks the higher the rate of growth. At the firm level, a lower variability of operating income, higher working capital per assets and even more long-term financing do not seem to higher growth in the aggregate economy. The gist in terms of finance is that financial sophistication and depth matter while financial structure – stock markets versus banks - and firm level indicators do not. A summary of our empirical results could run as follows. Institutions matter for growth and their impact is quantitatively important. As far as the legal system is concerned, both the general performance indicators and very specific procedural characteristics are important. Aggregate indicators of corporate governance do not seem to relate strongly to growth but faster and cheaper procedures to open a business firm do. Finally, as far as the financial system is concerned it is key that there is wide access to capital but whether that is achieved through the banking system or the stock market is not relevant. Most of the disaggregated indicators are not important, the exception being the actual interest margin and the availability of short-term debt seem particularly key.

43

(2) -0.0004 -3.97 0.48 3.55 48 0.34

(1) -0.0006 -6.40 0.58 6.52 48 0.56

Institutional Indicator

Number of Observations R2 0.72

48

1.03 9.40

-0.0006 -8.47

(3)

0.72

48

0.89 9.10

-0.0005 -7.97

(4)

Risk of Contract Expropriation Repudiation

0.21

53

0.16 1.49

-0.0001 -6.49

(5)

Judicial Efficiency Index

0.13

70

0.21 3.14

-0.0002 -2.60

(6)

Citizen's Access to Justice

Note: The description of each variable and its source are explained in the Data Appendix. t –statistics are presented in the even rows using heteroskedastically-consistent standard errors. The first row of the Table designates the institutional indicator used as independent variable.

Initial Income

Corruption

Rule of Law

Dependent Variable: Growth of Real per capita GDP 1960-1995

Table XII Performance of the Legal System

44

(2) -0.0001 -5.35 -1.41 -2.57 80 0.12

(1)

-0.0001 -4.35

-1.07 -0.98

80 0.08

Institutional Indicator

Number of Observations R2

80 0.09

-0.38 -1.73

-0.0001 -4.44

(3)

Log of Duration

80 0.12

-1.29 -2.13

-0.0001 -5.37

(4)

Index Professionals -Laymen

80 0.08

-1.15 -1.18

-0.0001 -4.91

(5)

Index WrittenOral

80 0.10

-0.93 -1.70

-0.0001 -5.07

(6)

Index Legal Justification

80 0.11

-2.12 -2.44

-0.0001 -6.17

(7)

Index Statutory Regulation of Evidence

80 0.09

-1.04 -1.79

-0.0001 -4.22

(8)

Index Control of Superior Review

80 0.11

-0.27 -2.02

-0.0001 -5.54

(9)

Dispute Resolution Index

45

Note: The description of each variable and its source are explained in the Data Appendix. t –statistics are presented in the even rows using heteroskedasticallyconsistent standard errors. The first row of the Table designates the institutional indicator used as independent variable.

Initial Income

Index Mandatory Time Limits

Index Defendant Protection

Dependent Variable: Growth of Real per capita GDP 1960-1995

Table XIII Procedures for Check Collection

(2) -0.0001 -4.76 -1.02 -1.66 80 0.09

(1)

-0.0001 -3.57

-1.15 -1.22

80 0.08

Institutional Indicator

Number of Observations R2

80 0.07

0.18 0.77

-0.0001 -4.08

(3)

Log of Duration

80 0.07

-0.32 -0.63

-0.0001 -4.71

(4)

Index Professionals -Laymen

80 0.06

0.24 0.24

-0.0001 -4.60

(5)

Index WrittenOral

80 0.06

-0.10 -0.16

-0.0001 -4.76

(6)

Index Legal Justification

80 0.11

-2.11 -2.45

-0.0001 -6.21

(7)

Index Statutory Regulation of Evidence

80 0.07

-0.62 -1.15

-0.0001 -4.22

(8)

Index Control of Superior Review

46

80 0.08

-0.23 -1.83

-0.0001 -5.28

(9)

Dispute Resolution Index

Note: The description of each variable and its source are explained in the Data Appendix. t –statistics are presented in the even rows using heteroskedastically-consistent standard errors. The first row of the Table designates the institutional indicator used as independent variable.

Initial Income

Index Mandatory Time Limits

Index Defendant Protection

Dependent Variable: Growth of Real per capita GDP 1960-1995

Table XIV Procedures for Tenant Eviction

-0.0002 -2.82 -6.18 -2.29 47 0.18

-0.0001 -1.93

0.57 0.94

48 0.11

Institutional Indicator

Number of Observations R2

48 0.09

0.10 0.68 47 0.11

0.17 1.12

-0.0001 -2.03

(4)

(3) -0.0002 -2.49

Creditor Rights

Anti Director Rights

44 0.27

-4.57 -2.82

-0.0003 -3.41

Mean 3 Largest Shareholders (5)

40 0.31

0.05 2.84

-0.0003 -3.31

46 0.10

-0.02 -0.08

-0.0002 -2.25

Accounting Market Standards Capitalization 10 Largest (6) (7)

Note: The description of each variable and its source are explained in the Data Appendix. t –statistics are presented in the even rows using heteroskedasticallyconsistent standard errors. The first row of the Table designates the institutional indicator used as independent variable.

Initial Income

Percentage General Meeting (2)

One Share One Vote (1)

Dependent Variable: Growth of Real per capita GDP 1960-1995

Table XV Firm Governance Indicators

47

Table XVI Opening and Closing a Firm Dependent Variable: Growth of Real per capita GDP 1960-1995 Number of Procedures

Time

Cost

Cost and Time

Percentage Bankruptcies

(1)

(2)

(3)

(4)

-0.0001 -1.15

-0.0001 -1.21

0.0000 -0.26

-0.0001 -1.36

(5) (6) -0.0002 -1.78

Institutional Indicator

-0.10 -1.97

-0.02 -2.04

-0.01 -6.13

-0.61 -1.95

0.66 0.06

Number of Observations R2

68 0.06

68 0.07

68 0.03

67 0.09

33 0.12

Initial Income

Note: The description of each variable and its source are explained in the Data Appendix. t – statistics are presented in the even rows using heteroskedastically-consistent standard errors. The first row of the Table designates the institutional indicator used as independent variable.

48

-0.0002 -2.68

1.11 2.91

41 0.36

0.36 4.24

41 0.43

Institutional Indicator

Number of Observations R2

41 0.42

0.95 3.68

-0.0003 -3.13

41 0.39

1.71 3.95

-0.0002 -2.89

41 0.20

0.35 2.47

-0.0002 -2.14

41 0.04

0.02 0.06

-0.0001 -1.11

41 0.09

0.31 1.15

-0.0001 -1.50

41 0.05

0.35 0.68

-0.0001 -1.26

54 0.18

-33.03 -2.72

-0.0001 -1.93

60 0.22

2.57 3.36

-0.0002 -3.35

(10)

Private Credit

50 0.16

3.17 1.75

-0.0002 -2.35

Total Value Traded (11)

42 0.19

4.96 2.74

-0.003 -2.63

NonBank Credit (12)

49

Note: The description of each variable and its source are explained in the Data Appendix. t –statistics are presented in the even rows using heteroskedasticallyconsistent standard errors. The first row of the Table designates the institutional indicator used as independent variable.

Initial Income

-0.0003 -3.39

Finance- Finance- Finance- Finance- Structure- Structure- Structure- Structure Net Activity Size Aggregate Dummy Activity Size Aggregate -Dummy Interest Margin (1) (2) (3) (4) (5) (6) (7) (8) (9)

Dependent Variable: Growth of Real per capita GDP 1960-1995

Table XVII Financial System Indicators

-0.0001 -5.32 -0.01 -1.23 65 0.09

-0.0004 -0.58

-0.01 -1.01

65 0.02

Institutional Indicator

Number of Observations R2

59 0.08

-0.005 -0.25

-0.0001 -5.06

(3)

Percentage Foreign Owned

59 0.33

0.02 4.20

-0.0001 -6.79

(4)

Percentage of Top 10 Rated Internationally

63 0.10

0.10 1.30

-0.0001 -4.18

(5)

61 0.08

-0.02 -0.39

-0.0001 -5.55

(6)

70 0.07

-0.09 -0.30

-0.0001 -4.12

(7)

Bank Onsite Supervisors Supervisors Examination Employed by per per Bank Last Bank Industry Institution 5 Years

50

121 0.06

0.87 2.75

-0.00004 -2.01

(8)

Explicit Deposit Insurance

Note: The description of each variable and its source are explained in the Data Appendix. t –statistics are presented in the even rows using heteroskedastically-consistent standard errors. The first row of the Table designates the institutional indicator used as independent variable.

Initial Income

(2)

(1)

5 Bank Percentage Concentration Assets Ratio Government Owned

Dependent Variable: Growth of Real per capita GDP 1960-1995

Table XVIII Bank Regulation

-0.0002 -2.92 1.24 3.20 44 0.29

-0.0002 -4.07 -0.85 -1.43 43 0.26

Initial Income

Institutional Indicator

Number of Observations R2

44 0.23

3.21 1.41

-0.0003 -3.87

(3)

44 0.30

1.67 3.56

-0.0002 -2.54

(4)

44 0.19

0.45 0.13

-0.0002 -3.31

(5)

Note: The description of each variable and its source are explained in the Data Appendix. t –statistics are presented in the even rows using heteroskedastically-consistent standard errors. The first row of the Table designates the institutional indicator used as independent variable.

(2)

Total Debt to Long Term Debt Short Term Debt Net Working Market Value of to Market Value to Market Value Capital to Total Equity of Equity of Equity Assets

(1)

Operating Income Variability

Dependent Variable: Growth of Real per capita GDP 1960-1995

Table XIX Firm Finance Indicators

51

5. Strategies for Institutional Reform in Portugal “It must be remembered that there is nothing more difficult to plan, more doubtful of success, nor more dangerous to manage, than the creation of a new system. For the initiator has the enmity of all who would profit by the preservation of the old institutions and merely lukewarm defenders in those who would gain by the new ones.” Machiavelli The paper now turns to an examination of the different options for institutional reform in Portugal. The objective is to evaluate the benefits of each possible reform in light of the empirical results from the previous section and of the development of Portuguese relative to EU institutions. The methodology we adopt is simple and suggestive. For each institutional indicator – whether in the legal, governance or finance areas - we construct three reform related indices: the Impact on Growth, the Required Reform Effort and the Efficiency of the Reform Effort indices. The Impact on Growth index is measured as the product of the regression coefficient difference by the actual difference between the institutional index i in Portugal and in the EU as a whole so that:

Impact on Growth i = [Institution i, Portugal – Institution i , EU Average] * Regression Coefficient i This index measures the yearly increase in per capita growth – for the period 1960-1995 - that would likely result from an institutional reform that elevates Portugal to the European Union level in the area assessed by this specific institutional indicator. Evidently, a higher Impact on Growth index indicates a more promising reform and so suggests these reforms should be undertaken. A shortcoming of the Impact on Growth index is that it abstracts completely from the “cost of reform”, i.e., it ignores whether bringing Portugal to the EU level is more or less hard for each specific issue considered. We thus find useful to compute a second index, the Required Reform Effort index. It tries to compute the “cost of reform” by using the relative position of Portugal and the EU average for each institution divided by the Portuguese level. It is based on the values of each institutional index i for Portugal and for the European Union average:

Required Reform Effort i = Absolute [Institution i , Portugal – Institution i , EU Average] / Absolute [Institution i , Portugal] Thus, this index measures the absolute institutional change that Portugal needs to undertake to achieve the EU average level, relative to the current absolute Portuguese index. It is always positive and is measured as the percentage change required.76 It is a measure of the “cost of reform” and a higher value indicates a higher required effort to reform the specific institution. 76

In the few cases where the institutional index takes the value 0 for Portugal the denominator becomes the EU average rather than the Portuguese level so that an index of 1 results, The

52

In contrast with the Impact on Growth index, the Required Reform Effort index now totally ignores the impact on growth of the specific reform. Our third and last index is the Efficiency of Reform index. It combines the previous two indices by diving the impact on growth by the required reform effort and thus providing a measure of the yearly growth increase per unit of required reform effort. It is computed for a move of Portugal to the EU average level for an institution i:

Efficiency of Reform i = Impact on Growth i / Required Reform Effort i A higher index on Efficiency of Reform denotes a higher percent increase in economic growth per unit of reform effort, simplistically a higher “bang for the buck”. The value of 1 denotes an increase of 1 percent in yearly economic growth for each reform effort of 100 percent, that is, an effort that overcomes a Portuguese institutional index that is half the EU average index. Tables XX, XXI and XXII present an evaluation of the reform potential for different legal, corporate governance and financial reform indicators. The first two columns present the value of the index for Portugal and for the European Union average, the third column the difference between the previous two and the fourth the regression coefficient from Tables in the previous section. The growth impact of reform, the required reform effort and the efficiency of the reform effort indices are then presented in the three last columns. The name of the indices for which the regression coefficient is statistically different is noted with an asterisk and the whole row of data noted in bold. As can be easily noted, different reform issues correspond to widely different impacts on yearly growth, different reform efforts and, importantly, very different efficiency of reform.

interpretation remains clear: the “maximum” reform effort is required for Portugal to achieve EU levels in this issue.

53

Table XX Law and Reform Impact on Growth, Required Reform Effort and Efficiency of Reform

Rule of Law** Corruption** Risk of Expropriation** Contract Repudiation** Judicial Efficiency Index Citizen's Access to Justice** Index Defendant Protection Index Mandatory Time Limits** Log of Duration** Index Professionals-Laymen** Index Written-Oral Index Legal Justification** Index Statutory Regulation of Evidence** Index Control of Superior Review** Dispute Resolution Index** Index Defendant Protection Index Mandatory Time Limits Log of Duration Index Professionals-Laymen Index Written-Oral Index Legal Justification Index Statutory Regulation of Evidence** Index Control of Superior Review Dispute Resolution Index**

(1) Index

(2)

(3) (2)-(1)

(4)

(5) (4)*(3)

(6) (3)/(1)

(7) (5)/(6)

Portugal

European Union

Difference

Coefficient

Impact on Growth

Required Effort

Efficiency of Reform

8.68 7.38 8.90 8.57 5.50 7.50 0.20 0.80 5.80 1.00 0.75 1.00 0.38 1.00 5.13 0.50 0.80 6.04 0.67 0.75 1.00 0.50 0.67 4.58

8.97 8.65 9.42 9.06 8.56 7.88 0.47 0.27 5.30 0.64 0.78 0.69 0.25 0.72 3.89 0.62 0.29 5.21 0.57 0.76 0.67 0.27 0.62 3.72

0.29 1.27 0.52 0.49 3.06 0.38 0.27 -0.53 -0.50 -0.36 0.03 -0.31 -0.13 -0.28 -1.24 0.12 -0.51 -0.83 -0.10 0.01 -0.33 -0.23 -0.05 -0.87

0.58 0.48 1.03 0.89 0.16 0.21 -1.07 -1.41 -0.38 -1.29 -1.15 -1.93 -2.12 -1.04 -0.27 -1.15 -1.02 0.18 -0.32 0.24 -0.10 -2.11 -0.62 -0.23

0.17 0.61 0.53 0.43 0.49 0.08 -0.29 0.75 0.19 0.46 -0.04 0.60 0.27 0.30 0.33 -0.14 0.52 -0.15 0.03 0.00 0.03 0.48 0.03 0.20

0.03 0.17 0.06 0.06 0.56 0.05 1.36 0.66 0.09 0.36 0.04 0.31 0.33 0.28 0.24 0.24 0.64 0.14 0.15 0.01 0.33 0.46 0.07 0.19

5.03 3.54 9.17 7.63 0.88 1.58 -0.21 1.13 2.20 1.29 -0.86 1.93 0.81 1.04 1.39 -0.58 0.82 -1.09 0.21 0.18 0.10 1.06 0.42 1.05

54

Table XXI Corporate Governance and Reform Impact on Growth, Required Reform Effort and Efficiency of Reform (1) Index Portugal

One Share One Vote Percentage General Meeting** Anti Director Rights Creditor Rights Mean 3 Largest Shareholders** Accounting Standards** Market Capitalization 10 Largest** Number of Procedures** Time** Cost** Cost and Time** Percentage Bankruptcies

0.00 0.05 3.00 1.00 0.52 36.00 0.03 12.00 76.00 0.18 0.49 0.00

(2) European Union 0.07 0.10 2.50 1.93 0.45 63.62 0.29 9.00 36.57 0.16 0.31 0.02

(3) (2)-(1) Difference

(4) Coefficient

0.07 0.05 -0.50 0.93 -0.07 27.62 0.26 -3.00 -39.43 -0.02 -0.18 0.02

0.57 -6.18 0.10 0.17 -4.57 0.05 -0.02 -0.10 -0.02 -0.01 -0.61 0.66

(5) (4)*(3) Impact on Growth

(6) (3)/(1) Required Effort

(7) (5)/(6) Efficiency of Reform

0.04 -0.29 -0.05 0.16 0.32 1.38 -0.01 0.30 0.79 0.00 0.11 0.01

1.00 0.93 0.17 0.93 0.14 0.77 8.51 0.25 0.52 0.10 0.37 1.00

0.04 -0.31 -0.30 0.17 2.38 1.80 0.00 1.20 1.52 0.00 0.30 0.01

55

Table XXII Finance and Reform Impact on Growth, Required Reform Effort and Efficiency of Reform (1) Index Portugal

Finance-Activity** Finance-Size** Finance-Aggregate** Finance-Dummy** Structure-Activity** Structure-Size Structure-Aggregate Structure-Dummy Net Interest Margin** Private Credit** Total Value Traded** Operating Income Variability Total Debt to Market Value of Equity** Long Term Debt to Market Value of Equity Short Term Debt to Market Value of Equity** Net Working Capital to Total Assets** 5 Bank Concentration Ratio Percentage Assets Government Owned Percentage Foreign Owned Percentage of Top 10 Rated Internationally** Bank Supervisors per Institution Onsite Examination per Bank Last 5 Years Supervisors Employed by Bank Industry Explicit Deposit Insurance**

4.23 4.31 0.12 1.00 -4.26 -2.66 -1.49 0.00 0.04 0.63 0.02 0.87 0.59 0.22 0.37 0.05 81.70 20.80 11.70 100.00 2.40 2.50 2.00 1.00

(2)

(3) (2)-(1)

(4)

(5) (4)*(3)

European Difference Coefficient Impact on Growth Union 5.48 4.41 0.43 0.69 -2.65 -1.30 -0.13 0.46 0.03 0.71 0.10 0.69 0.39 0.16 0.23 0.17 59.19 10.81 16.29 66.15 0.78 2.43 2.07 1.00

1.25 0.10 0.31 -0.31 1.61 1.36 1.36 0.46 -0.01 0.08 0.08 -0.18 -0.21 -0.06 -0.15 0.12 -22.51 -9.99 4.59 -33.85 -1.62 -0.07 0.07 0.00

0.36 1.11 0.95 1.71 0.35 0.02 0.31 0.35 -33.03 2.57 3.17 -0.85 1.24 3.21 1.67 0.45 0.45 -0.01 -0.01 -0.01 0.02 0.10 -0.02 0.87

0.45 0.11 0.30 -0.53 0.56 0.03 0.42 0.16 0.38 0.20 0.25 0.15 -0.25 -0.19 -0.24 0.05 -10.13 0.10 -0.05 0.17 -0.03 -0.01 0.00 0.00

(6) (7) (3)/(1) (5)/(6) Required Efficiency Effort of Reform 0.29 0.02 2.59 0.31 -0.38 -0.51 -0.91 1.00 0.29 0.12 3.96 0.21 0.35 0.27 0.39 2.37 0.28 0.48 0.39 0.34 0.67 0.03 0.04 0.00

56

1.52 4.78 0.11 -1.71 -1.49 -0.05 -0.46 0.16 1.32 1.62 0.06 0.74 -0.73 -0.71 -0.62 0.02 -36.77 0.21 -0.12 0.50 -0.05 -0.25 -0.04 0.00

Figures V, VI and VII present the ten “most promising” issues for reform according to each of the three criteria used: impact on growth, required effort and efficiency of reform. In other words, we present in succession the ten issues for which raising the Portuguese level to European Union levels raises growth levels the most, the ten for which the required effort is the lowest and the ten for which the efficiency of reform is highest. Note, therefore, that there are four reasons why an institutional reform strategy may not be recommended for Portugal in this exercise. First, if Portugal is at a level of institutional development in a specific category that is above the average level for the EU - that is, Portugal has better institutions than the EU in this area - we consider that a non-prioritary area of reform. Second, any institutional indicator that was not associated with economic growth in a statistically significant way is not a candidate for recommended reform. Third, when there is a statistically significant impact of reform on growth, the economic impact may be too small to make the reform effort promising. Finally, even when a given institution is significantly related to growth – statistically and economically – if Portugal is very far from the EU average level, this reform area is considered to require too much of a “reforming effort”. In Figure V we find that the two most growth enhancing reform issues are in the corporate governance area. However, six out of the nine most promising reforms in terms of induced growth increase relate to the legal system. Again, as far as the required reform effort is concerned, five out of the six reform items requiring the least effort from Portuguese institutions are in the legal area. The indices computing the growth impact and the required reform effort show that two issues each of the finance and corporate governance areas are within the ten reforms most promising reforms. Interestingly, the finance and corporate governance reform items that have the most growth impact and the least required effort are aggregate and disaggregated level measures respectively. In contrast, in the legal area both aggregate and disaggregated institutional indicators are classified within the ten most promising. Figure VII presents the efficiency of the required reform index. The three most efficient reform indices relate to legal issues, namely the risk of expropriation, the risk of contract repudiation and the rule of law indices. All are aggregate measures of the efficacy of the legal system. Three other legal indices are among the ten most efficient reforms to undertake: decreasing the level of corruption to European Union levels is the fifth most efficient; improving the Index of Legal Justification and the Logarithm of duration of the check collection procedure are the seventh and eighth most efficient. Increasing the depth of the financial system and decreasing the ownership concentration are also efficient reforms. A gauge of the actual impact of reform is revealing: the five most efficient reforms deliver from 0.3 to 0.9 percent extra growth per year for each 10 percent increase in the institution index towards the European Union level. For a relatively small effort in reform, Portugal can obtain important gains in terms of growth. These results give us reasons to believe that institutional reform is an important instrument to foster Portuguese economic growth . Looking at the results more finely, one concludes that the legal system is the most promising area for reform, both in its general workings – measured by aggregate indices – or in the specific procedures governing it. Reform in the corporate governance and financial areas is also important but while overall change in the workings of the financial system is most promising, very specific issues in firm governance reform come out as the most promising.

57

Figure V Growth Impact of Reform Finance-Activity Index Professionals-Laymen Index Statutory Regulation of Evidence Eviction Risk of Expropriation Structure-Activity Index Legal Justification Corruption Index Mandatory T ime Limits T ime Accounting Standards 0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

Percent Growth per year Law

Governance

Finance

58

Figure VI Required Reform Effort

Corruption

Mean 3 Largest Shareholders

Private Credit

Cost

Log of Duration

Risk of Expropriation

Contract Repudiation

Citizen's Access to Justice

Rule of Law

Finance-Size 0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

0.18

0.20

Percent Law

Governance

Finance

59

Figure VII Efficiency of Reform

Private Credit

Accounting Standards

Index Legal Justification

Log of Duration Mean 3 Largest Shareholders Corruption

Finance-Size

Rule of Law

Contract Repudiation

Risk of Expropriation 0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

Percent Growth per Effort Law

Governance

Finance

60

6. Conclusions This paper evaluates Portuguese institutional development in light of the experience of Spain, Greece, the European Union and the high-growth East Asian economies. Three areas are scrutinized, the legal, corporate governance and financial systems. The outcome of reforming Portuguese institutions by elevating them to EU levels is assessed along three dimensions: the impact on growth, the required reform effort and the efficiency of the reform effort. Our analysis shows that Portugal is generally below European Union levels of institutional development and even more distant from East Asian levels in all areas – legal, governance or financial. While on some issues Portuguese institutions are more developed than their Spanish counterparts, there are as much instances where the reverse is true. As compared to Greece, Portugal tends to benefit from better developed institutions. As to institutional reform, we find that the legal area is the most promising as improvement in different issues delivers a large increase in growth per unit of effort. This is true for very aggregate as well as disaggregated indices of legal development. More than half of the ten institutional indices that best foster growth and that require the least reform effort are legal indices. But indices from the corporate governance and financial areas are also present among the most effective and least expensive reforms to undertake. Our conclusion is that reform in all three areas is necessary and probably needs to be undertaken simultaneously. The high growth impact per reform effort required suggests that institutional reform is sufficient to bring Portuguese economic growth to substantially higher levels. Portugal has recently experienced a slowdown in economic growth that hinders the convergence process vis-à-vis richer countries in the European Union. The fact that institutions change very infrequently and very little strongly suggests that the low level of development of Portuguese institutions severely constrains the growth rate of the economy. A comprehensive and sustained reform effort may be the missing necessary condition for Portuguese growth to resume at higher rates. And decisively reduce the income gap with other European Union countries.

61

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Data Appendix Rule of Law Source: Computed from Data in La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Assessment of the law and order tradition in the country produced by the country-risk rating agency International Country Risk (ICR). Average of the months of April and October of the monthly index between 1982 and 1995. Scale from 0 to 10, with lower scores for less tradition for law and order.(We changed the scale from its original range going from 0 to 6). Corruption Source: Computed from Data in La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: ICR’s assessment of corruption in government. Lower scores indicate “that high government officials are likely to demand special payments” and “illegal payments are generally accepted throughout lower levels of government” in the form of “bribes connected with import and export licences, exchange controls, tax assessment, policy protection, or loans.” Average of the months of April and October of the monthly index between 1982 and 1995. Scale form 0 to 10, with lower scores for higher levels of corruption (we changed the scale form the original range going from 0 to 6). Risk of Expropriation Source: Computed from Data in La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: ICR’s assessment of the risk of “outright confiscation” or “forced nationalization”. Average of the months of April and October of the monthly index between 1982 and 1995. Scale from 0 to 10, with lower scores for higher risks. Contract Repudiation Source: Computed from Data in La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: ICR’s assessment of the “risk of a modification in a contract taking the form of a repudiation, postponement, or scaling down” due to “budget cutbacks, indigenization pressure, a change in government, or a change in government economic and social priorities.” Average of the months of April and October of the monthly index between 1982 and 1995. Scale from 0 to 10, with lower scores for higher risks. Enforceability of Contracts Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: Assessment of the “efficiency and integrity of the legal environment as it affects business, particularly foreign firms” produced by the country risk rating agency International Country Risk (ICR). It may be “taken to represent investors’ assessment of conditions in the country in question.” Average between 1980 and 1983. Scale from 0 to 10, with lower scores representing lower efficiency levels. Efficiency of the Judicial System Source: Computed from Data in La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Assessment of the “efficiency and integrity of the legal environment as it affects business, particularly foreign firms” produced by the country risk rating agency International Country Risk (ICR). It may be “taken to represent investors’ assessment of conditions in the country in question.” Average between 1980 and 1983. Scale from 0 to 10, with lower scores representing lower efficiency levels. Citizen's Access to Justice Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: Assessment of the extent to which citizens are “equal under the law, do they have access to an independent, nondisciminatory judiciary, and are they respected by the security forces”. Scale from 0 to 10. The higher the rating the greater the degree of equality under the law”. Index Defendant Protection Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: Measures the protection granted by the procedural law to the tenant and his/her family, by reducing the disparity in means and legal representation between landlord and tenant. The index ranges from 0 to 1, where higher values mean a higher level of defendant protection, while 0 means a lower level. For the Eviction case the index is formed by the normalized sum of the following variables : (i) mandatory legal aid by law or by court or administrative order, (ii) attorney fees are fixed or limited by statute, court or administrative regulation, (iii) judge has the independent legal obligation to investigate facts, (iv) tenant’s economic situation is considered at judgment, and (v) tenant’s economic situation considered at enforcement. For the Check case the index is formed by the normalized sum of the following variables: (i) mandatory legal aid by law or by court or administrative order, (ii) attorney fees are fixed or limited by statute, court or administrative regulation, (iii) judge has the independent legal obligation to investigate facts, (iv) attachment of defendant’s property only after judgment, (v) transfer of defendant’s property only through public auction, and (vi) mandatory exclusion of defendant’s essential survival assets. Index Mandatory Time Limits Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project”

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Description: The index measures the presence of mandatory time limits in the procedure. The index is calculated as the average of the following variables: (i) term for admission, (ii) term to present evidence, (iii) term to present defense, (iv) term for judgment, (v) term for compliance, (vi) term for notification of judgment. The index ranges from 0 to 1, where higher values mean more mandatory deadlines. Available for two legal cases: tenant eviction and collection of a bounced check. Administrative Procedure Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: The variable equals one if there is a generally available procedure for eviction or check collection before an administrative officer, which may be used as a substitute to the judicial procedure, and which does not imply any judicial involvement (such as issuance of warrants) or the participation of a housing or debt-collection tribunal. The variable equals zero otherwise. Index Professionals-Laymen Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: The index measures whether the resolution of the case provided would rely mostly in the intervention of professional judges and attorneys, as opposed to the intervention of other types of adjudicators and lay people. The index is formed by the normalized sum of the following variables: (i) general jurisdiction court, (ii) professional vs. non-professional judge, and (iii) legal representation is mandatory. The index ranges from 0 to 1, where higher values mean a higher intervention of professionals. Available for two legal cases: tenant eviction and collection of a bounced check. Index Written-Oral Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: The index measures the written or oral nature of the actions involved in the procedure, from the filing of the complaint, until the actual enforcement. The index is calculated as the number of stages carried out mostly in a written form over the total number of applicable stages, and it ranges from 0 to 1, where higher values mean higher prevalence of written elements. Available for two legal cases: tenant eviction and collection of a bounced check. Index Legal Justification Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: The index measures the level of legal justification required in the process. The index is formed by the normalized sum of the following variables : (i) complaint must be legally justified, (ii) judgment must be legally justified, and (iii) judgment must be on law (not on equity). The index ranges from 0 to 1, where higher values mean a higher use of legal language or justification. Available for two legal cases: tenant eviction and collection of a bounced check. Index Statutory Regulation of Evidence Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: The index measures the level of statutory control or intervention of the administration, admissibility, evaluation and recording of evidence. The index is formed by the normalized sum of the following variables : (i) judge can not introduce evidence, (ii) judge can not reject irrelevant evidence, (iii) out-of-court statements are inadmissible, (iv) mandatory prequalification of questions, (v) oral interrogation only by judge, (VI) only original documents and certified copies are admissible, (vii) authenticity and weight of evidence defined by law, and (viii) mandatory recording of evidence. The index ranges from 0 to 1, where higher values mean a higher statutory control or intervention. Available for two legal cases: tenant eviction and collection of a bounced check. Index Control of Superior Review Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: The index measures the level of control or intervention of the appellate court’s review of the first-instance judgment. The index is formed by the normalized sum of the following variables : (i) enforcement of judgment is automatically suspended until resolution of appeal, (ii) comprehensive review in appeal, and (iii) interlocutory appeals are allowed. The index ranges from 0 to 1, where higher values mean a higher control or intervention. Available for two legal cases: tenant eviction and collection of a bounced check. Dispute Resolution Index Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: An independent procedural action is defined as a step of the procedure, mandated by law or court regulation, that demands interaction between the parties or between them and the judge or court officer (e.g., filing a motion, attending a hearing, mailing a letter, or seizing some goods). We also count as an independent procedural action every judicial or administrative writ or resolution (e.g., issuing judgment or entering a writ of execution) which is legally required to advance the proceedings until the enforcement of judgment. Actions are always assumed to be simultaneous if possible, so procedural events that may be fulfilled in the same day and place are only counted as one action. To form the index, we: (1) add the minimum number of independent procedural actions required to complete all the stages of the process (from filing of lawsuit to enforcement of judgment); and (2) normalize this number to fall between zero and one using the minimum and the maximum number of independent procedural actions across the countries in the sample. The index takes a value of zero for the country with the minimum number of independent procedural actions, and a value of one for the country with the maximum number of independent procedural actions. Available for two legal cases: tenant eviction and collection of a bounced check. Duration

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Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2001), “Legal Structure and Judicial Efficiency: the Lex Mundi Project” Description: The variable measures the total average duration in calendar days of the procedure under the factual and procedural assumptions provided. It results form the sum of: (i) duration until completion of service of process, (ii) duration of trial, and (iii) duration of enforcement. Available for two legal cases: tenant eviction and collection of a bounced check. One Share One Vote Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Equals one if the Company Law or Commercial Code of the country requires that ordinary shares carry one vote per share, and zero otherwise. Equivalently, this variable equals one when the law prohibits the existence of both multiple-voting and non-voting ordinary shares and does not allow firms to set a maximum number of votes per shareholder irrespective of the number of shares she owns, and zero otherwise. Proxy by Mail Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description:Equals one if the Company Law or Commercial Code allows shareholders to mail their proxy vote to the firm, and zero otherwise. Shares Not Blocked Before Meeting Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Equals one if the Company Law or Commercial Code does not allow firms to require that shareholders deposit their shares prior to a General Shareholders Meeting thus preventing them from selling those shares for a number of days, and zero otherwise. Cumulative Voting or Proportional Representation Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Equals one if the Company Law or Commercial Code allows shareholders to cast all of their votes for one candidate standing for election to the board of directors (cumulative voting) or if the Company Law or Commercial Code allows a mechanism of proportional representation in the board by which minority interests may name a proportional number of directors to the board, and zero otherwise. Oppressed Minorities Mechanism Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Equals one if the Company Law or Commercial Code grants minority shareholders either a judicial venue to challenge the decisions of management or of the assembly or the right to step out of the company by requiring the company to purchase their shares when they object to certain fundamental changes, such as mergers, assets dispositions and changes in the articles of incorporation. The variable equals zero otherwise. Minority shareholders are defined as those shareholders who own 10 percent of share capital or less. Preemptive Rights to New Issues Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Equals one when the Company Law or Commercial Code grants shareholders the first opportunity to buy new issues of stock and this right can only be waved by a shareholders’ vote, and zero otherwise. Percentage General Meeting Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: It is the minimum percentage of ownership of share capital that entitles a shareholder to call for an Extraordinary Shareholders’ Meeting. It ranges from one to 33 percent. Mandatory Dividend Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Equals the percentage of net income that the Company Law or Commercial Code requires firms to distribute as dividends among ordinary stockholders. It takes a value of zero for countries without such restriction. Anti Director Rights Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: An index aggregating the shareholder rights which we labeled as “anti-director rights.” The index is formed by adding 1 when: (1) the country allows shareholders to mail their proxy vote to the firm; (2) shareholders are not required to deposit their shares prior to the General Shareholders’ Meeting; (3) cumulative voting or proportional representation of minorities in the board of directors is allowed; (4) an oppressed minorities mechanism is in place; (5) the minimum percentage of share capital that entitles a shareholder to call for an Extraordinary Shareholders’ Meeting is less than or equal to 10 percent (the sample median); or (6) shareholders have preemptive rights that can only be waved by a shareholders’ vote. The index ranges from 0 to 6. Restrictions for going into reorganization. Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Equals one if the reorganization procedure imposes restrictions, such as creditors’ consent, to file for reorganization. It equals zero if there are no such restrictions. Bankruptcy and No automatic stay on secured assets Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Equals one if the reorganization procedure does not impose an automatic stay on the assets of the firm upon filing the reorganization petition. Automatic stay prevents secured creditors to gain possession of their security. It equals zero if such restriction does exist in the law.

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Secured creditors first Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Equals one if secured creditors are ranked first in the distribution of the proceeds that result from the disposition of the assets of a bankrupt firm. Equals zero if non-secured creditors, such as the Government and workers, are given absolute priority. Management Does Not Stay Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Equals one when an official appointed by the court, or by the creditors, is responsible for the operation of the business during reorganization. Equivalently, this variable equals one if the debtor does not keep the administration of its property pending the resolution of the reorganization process, and zero otherwise. Legal Reserve Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: It is the minimum percentage of total share capital mandated by Corporate Law to avoid the dissolution of an existing firm. It takes a value of zero for countries without such restriction. Creditor Rights Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: An index aggregating different creditor rights. The index is formed by adding 1 when: (1) the country imposes restrictions, such as creditors’ consent or minimum dividends to file for reorganization; (2) secured creditors are able to gain possession of their security once the reorganization petition has been approved (no automatic stay); (3) secured creditors are ranked first in the distribution of the proceeds that result from the disposition of the assets of a bankrupt firm; and (4) the debtor does not retain the administration of its property pending the resolution of the reorganization. The index ranges from 0 to 4. Mean 3 Largest Shareholders Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: The average percentage of common shares owned by the three largest shareholders in the ten largest non-financial, privately owned domestic firms in a given country. A firm is considered privately owned if the State is not a known shareholder in it. Accounting Standards Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Index created by examining and rating companies’ 1990 annual reports on their inclusion or omission of 90 items. These items fall into 7 categories (general information, income statements, balance sheets, funds flow statement, accounting standards, stock data and special items). A minimum of 3 companies in each country was studied. The companies represent a cross-section of various industry groups where industrial companies numbered 70 percent while financial companies represented the remaining 30 percent. Market Capitalization 10 Largest Source: Computed from La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1998), “Law and Finance” Description: Capitalization of the ten largest non-financial, privately owned domestic firms in a given country. A firm is considered privately owned if the State is not a known shareholder in it. Number of Procedures Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2000), “The Regulation of Entry” Description: The number of different procedures that a start-up has to comply with in order to obtain a legal status, i.e. to start operating as a legal entity. Time Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2000), “The Regulation of Entry” Description: The time it takes to obtain legal status to operate a firm, in business days. A week has five e business days and a month has twenty-two. Cost Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2000), “The Regulation of Entry” Description: The cost of obtaining legal status to operate a firm as a share of per capita GDP in 1999. It includes all identifiable official expenses (fees, costs of procedures and forms, photocopies, fiscal stamps, legal and notary charges, etc). The company is assumed to have a start-up capital of ten times per capita GDP in 1999. Cost and Time Source: Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, (2000), “The Regulation of Entry” Description: The cost of obtaining legal status to operate a firm as a share of per capita GDP in 1999. It includes all identifiable official expenses (fees, costs of procedures and forms, photocopies, fiscal stamps, legal and notary charges, etc) as well as the monetised value of the entrepreneur’s time. The time of the entrepreneur is valued as the product of Time and per capita GDP in 1999 expressed in per business day terms. The company is assumed to have a start-up capital of ten times the GDP per capita level in 1999. Percentage Bankruptcies Source: Klapper, Leora (2001), “Bankruptcy Around the World: Explanations of its Relative Use” Description: Total number of bankruptcies as a percentage of total number of firms. Finance-Activity

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Source: Thorsten Beck and Ross Levine (2001), “New Firm Formation and Industry Growth: Does Having a Market- or BankBased System Matter?” Description: Logarithm of (Total value traded as share of GDP and claims on private sector by financial institutions as share of GDP) Finance-Size Source: Thorsten Beck and Ross Levine (2001), “New Firm Formation and Industry Growth: Does Having a Market- or BankBased System Matter?” Description: Logarithm of (Market capitalization and claims on private sector by financial institutions as share of GDP) Finance-Aggregate Source: Thorsten Beck and Ross Levine (2001), “New Firm Formation and Industry Growth: Does Having a Market- or BankBased System Matter?” Description: First principal component of Finance-Activity and Finance-Size Finance-Dummy Source: Thorsten Beck and Ross Levine (2001), “New Firm Formation and Industry Growth: Does Having a Market- or BankBased System Matter?” Description: Dummy variable that takes the value 0 if total value traded as share of GDP and claims on private sector by financial intermediaries as share of GDP are less than the respective sample mean, 1 otherwise Structure-Activity Source: Thorsten Beck and Ross Levine (2001), “New Firm Formation and Industry Growth: Does Having a Market- or BankBased System Matter?” Description: Logarithm of (Total value traded divided by claims on private sector by commercials banks) Structure-Size Source: Thorsten Beck and Ross Levine (2001), “New Firm Formation and Industry Growth: Does Having a Market- or BankBased System Matter?” Description: Logarithm of (Market capitalization divided by claims on private sector by commercials bank) Structure-Aggregate Source: Thorsten Beck and Ross Levine (2001), “New Firm Formation and Industry Growth: Does Having a Market- or BankBased System Matter?” Description: First principal components of Structure-Activity and Structure-Size Structure-Dummy Source: Thorsten Beck and Ross Levine (2001), “New Firm Formation and Industry Growth: Does Having a Market- or BankBased System Matter?” Description: Dummy variable that takes the value 1 if Structure-Aggregate is above the median, 0 otherwise Net Interest Margin Source: Barth, James, Gerard Caprio and Ross Levine (2001c), “Banking Systems Around the Globe: Do Regulation and Ownership Affect Performance and Stability?” Description: Private Credit Source: Barth, James, Gerard Caprio and Ross Levine (2001c), “Banking Systems Around the Globe: Do Regulation and Ownership Affect Performance and Stability?” Description: Total Value Traded Source: Barth, James, Gerard Caprio and Ross Levine (2001c), “Banking Systems Around the Globe: Do Regulation and Ownership Affect Performance and Stability?” Description: Non-Bank Credit Source: Barth, James, Gerard Caprio and Ross Levine (2001c), “Banking Systems Around the Globe: Do Regulation and Ownership Affect Performance and Stability?” Description: Operating Income Variability Source: Stijn Claessens, Simeon Djankov, Tatiana Nenova (2001), “Corporate Risk around the World” Description: Cash flow risk: Operating income variability Total Debt to Market Value of Equity Source: Stijn Claessens, Simeon Djankov, Tatiana Nenova (2001), “Corporate Risk around the World” Description: Financial leverage: Total debt to equity Long Term Debt to Market Value of Equity Source: Stijn Claessens, Simeon Djankov, Tatiana Nenova (2001), “Corporate Risk around the World” Description: Financial leverage: Long-term debt to equity. Short Term Debt to Market Value of Equity computed from data in Stijn Claessens, Simeon Djankov, Tatiana Nenova (2001), “Corporate Risk around the World”.

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Net Working Capital to Total Assets Source: Stijn Claessens, Simeon Djankov, Tatiana Nenova (2001), “Corporate Risk around the World” Description: 5 Bank Concentration Ratio Source: Barth, James, Gerard Caprio and Ross Levine (2001b), “The Regulation and Supervision of Banks Around the World – A New Database” Description: Legal Origin Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, (1999), “The Quality of Government” Description: Identifies the legal origin of the company law or commercial code of each country. Equal 1 of the origin is English common law, two if the origin is the French commercial code, three if the origin is the German commercial code, four is the origin is Scandinavian civil law, and five if the origin is Socialist civil law. Percentage Assets Government Owned Source: Barth, James, Gerard Caprio and Ross Levine (2001b), “The Regulation and Supervision of Banks Around the World – A New Database” Description: Government Owned Banks. Percentage Foreign Owned Source: Barth, James, Gerard Caprio and Ross Levine (2001b), “The Regulation and Supervision of Banks Around the World – A New Database” Description: Foreign Bank Ownership. Percentage of Top 10 Rated Internationally Source: Barth, James, Gerard Caprio and Ross Levine (2001b), “The Regulation and Supervision of Banks Around the World – A New Database” Description: Percent of 10 Biggest Banks Rated by International Rating Agencies. Bank Supervisors per Institution Source: Barth, James, Gerard Caprio and Ross Levine (2001b), “The Regulation and Supervision of Banks Around the World – A New Database” Description: Supervisors per Bank Onsite Examination per Bank Last 5 Years Source: Barth, James, Gerard Caprio and Ross Levine (2001b), “The Regulation and Supervision of Banks Around the World – A New Database” Description: Onsite Examination Frequency Supervisors Employed by Bank Industry Source: Barth, James, Gerard Caprio and Ross Levine (2001b), “The Regulation and Supervision of Banks Around the World – A New Database” Description: Likelihood Supervisor Moves into Banking Explicit Deposit Insurance Source: Barth, James, Gerard Caprio and Ross Levine (2001b), “The Regulation and Supervision of Banks Around the World – A New Database” Description: Takes value 1 if there is an explicit deposit insurance scheme.

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