Financial development and firms’ financing constraints a study of manufacturing firms in vietnam

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FINANCIAL DEVELOPMENT AND FIRMS’ FINANCING CONSTRAINTS:
A STUDY OF MANUFACTURING FIRMS IN VIETNAM

BY

VU THI KHANH

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, MAY 2015


UNIVERSITY OF ECONOMICS
HO CHIMINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

FINANCIAL DEVELOPMENT AND FIRMS’ FINANCING CONSTRAINTS:
A STUDY OF MANUFACTURING FIRMS IN VIETNAM

A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

VU THI KHANH

Academic Supervisor:

DR.LE VAN CHON

HO CHI MINH CITY, MAY 2015


Declaration

“This is to certify that this thesis entitled “Financial development and firms’ financing
constraints: A study of manufacturing firms in Vietnam”, which is submitted by me in
fulfillment of the requirements for the degree of Master of Art in Development
Economics to the Vietnam – The Netherlands Programme (VNP).
The thesis constitutes only my original work and due supervision and
acknowledgement have been made in the text to all materials used.”
Vu Thi Khanh

Acknowledgments

This thesis would not have been possible without the support and the
encouragement from many people. I would like to make a sincere effort in portraying
my deep sense of gratitude in the form of words.
I owe a debt of gratitude to my supervisor, Dr. Le Van Chon for his great
generosity and dedication in sharing his wisdom, stimulating my critical thinking skills
and guiding me to rethink and to deconstruct my thesis topic. He was also not afraid of
time-consuming to explain econometric methods as well as data processing techniques
to me. Moreover, he took time to diligently review my final thesis draft and help me
correct errors and inappropriate words usages. Furthermore, I am grateful to Ass.Prof
Nguyen Trong Hoai and Dr. Tran Tien Khai for their valuable comments and
suggestions for my concept note and thesis research design. Thank to Dr. Pham Khanh
Nam for his enthusiasm of helping me collecting data. I must show my gratitude
toward all lecturers VNP who have broadened my perspectives and encouraged me to
think harder and deeper about the complexity of the world’s realities.
Next, I wish to express my thank you to all my friends here at VNP. Together
we have walked and struggled through this whole treasured journey of learning and
shared memorable and priceless moments. Then, I want to say thanks to VNP officers
as well as VNP librarian for their support of comfort lab room and study materials.
Finally, I dedicate my thesis to my parents and my brother who are always
besides me and never stop supporting me.


Abbreviations
ADB

: The Asian Development Bank

BTA

: The U.S.-Vietnam Bilateral Trade Agreement

DM

: Demirguc-Kunt and Maksimovic

GDP

: Gross domestic production

GSO

: General statistics office of Vietnam

HNX

: Hanoi Stock Exchange

HOSE

: Ho Chi Minh Stock Exchange

IMF

: The International Monetary Fund

LLY

: Liquid liabilities ratio

PCG

: Private credit to GDP ratio

SMEs

: Small and medium enterprises

SOEs

: State-owned enterprises

SVG

: Stock market total valued traded to GDP

UK

: The United Kingdom

UN

: The United Nations

UPCoM

: Unlisted public company market

US

: The United States of America

VAR

: Vector Autoregression

VES

: The Vietnam Enterprise Survey

WB

: The World Bank


Abstract
Using panel data from the Vietnamese Enterprise Survey (VES) from 20062012, this thesis aims to analyze the relationship between financial development and
financing constraints of firms in Vietnam. The Euler equation approach is applied to
model firms' investment. Investment sensitivity to cash-flow is employed as the
variable to test for the existence of financing constraints. To control for endogeneity
and firm heterogeneity, I utilize the first difference GMM estimation proposed by
Arellano and Bond (1991). There is robust evidence that Vietnamese manufacturing
firms face financing constraints and that financial development significantly relaxes
firms' dependence on internal funds for investment. In addition, although smaller firms
suffer more severe financing constraints, their constraints are alleviated more than
those of larger firms in the presence of financial development.

Keywords: Financial development, Financing constraints, Corporate Investment

Table of contents
Chapter 1: Introduction ................................................................................................. 1
1.1 Problem statement .................................................................................................... 1
1.2 Research questions ................................................................................................... 3
1.3 The scope of the study .............................................................................................. 3
1.4 The structure of the study ......................................................................................... 3
Chapter 2: Literature review .......................................................................................... 4
2.1 Sources of investment financing. ............................................................................. 4
2.1.1 External financing ................................................................................................. 4
2.1.2 Internal financing ................................................................................................. 5
2.2 Financing constraints on firms ................................................................................. 8
2.2.1 Definition .............................................................................................................. 8
2.2.2 Measurement of financing constraints on firm ..................................................... 8
2.3 Financial development and financing constraints on firms ..................................... 9
2.4 Conclusion .............................................................................................................. 14
Chapter 3: Model specification ................................................................................... 16
3.1 Investment modeling .............................................................................................. 16
3.1.1 Euler investment equation approach ................................................................... 16
3.1.2 Detecting the presence of firm’s financing constraints using Euler equation .... 24
3.2 Financial development measurement ..................................................................... 25
3.3 Empirical model to evaluate the impact of financial development on firm
investment .................................................................................................................... 28
Chapter 4: Financial development in Vietnam ............................................................ 30
Chapter 5: Empirical results ......................................................................................... 37
5.1 Data ........................................................................................................................ 37


5.1.1 Sample and variable construction ....................................................................... 37

5.1.2 Descriptive (Initial relationship) ........................................................................ 40
5.2 Estimation technique: GMM dynamic panel estimation ....................................... 44
5.3. Regression results .................................................................................................. 46
Chapter 6: Conclusion ................................................................................................ 51
6.1 Main findings .......................................................................................................... 51
6.2 Policy implications .................................................................................................. 52
6.3 Limitations and further research ............................................................................. 52
References ..................................................................................................................... 53
Appendix ....................................................................................................................... 60


List of tables
Table 2.1: Share of financing sources in two industries in the United Kingdom ......... 6
Table 2.2 The proportion of financing sources according to different firm sizes ......... 6
Table 5.1: Firm level variable definitions ................................................................... 38
Table 5.2: Panel data structure ................................................................................... 39
Table 5.3 The descriptive statistics of the key variables for the whole data sample .. 41
Table 5.4 Median value of the key variables by different firm types ......................... 41
Table 5.5 Correlation matrix ....................................................................................... 42
Table 5.6 Mean values of the key variables by manufacturing industries .................. 42
Table 5.7 Mean values of the key variables by years .................................................. 43
Table 5.8 Regression results using first difference GMM estimation......................... 47
Table 5.9 Scenario analysis of firm’s size on investment –cash flow........................ 50


List of figures
Figure 4.1 The mono-tier banking system in Vietnam before banking reforms ......... 31
Figure 4.2 Structure of the two-tier banking system in Vietnam (after May 1990) ... 31
Figure 4.3 Brief on the Vietnamese banking system .................................................. 32
Figure 4.4 Liquid liabilities (M3) as % of GDP of some countries ............................ 33

Figure 4.5 Credit to the economy ............................................................................... 34
Figure 4.6 Private credit to GDP of some countries ................................................... 34
Figure 4.7 Stock Market Capitalization as % of GDP ................................................ 35

List of appendix
Appendix 1 Banking system development progress from 1990’s .............................. 61
Appendix 2 Stock market development process from 1990’s .................................... 63
Appendix 3 Boxplot chart for each variable (IK,SK,CFK) by industries ................... 66
Appendix 4 Scatter chart for each variable (IK, SK, CFK) by industries ................... 66


Chapter 1: Introduction
1.1 Problem statement
The study of financial development-economic growth nexus, which is originated
from Schumpeter (1912), has attracted many scholars’ concerns. The significant
positive correlation has been proved in a number of empirical studies such as Cameron
(1967), Goldsmith(1969), McKinnon (1973), Levine (1997), Levine and Zervos
(1998), Beck et al. (2003), Huang (2010, 2011) etc. In an indispensable research,
Levine and King (1993) asserted that economic growth is influenced by the financial
development in the last 10 to 30 years. However, the question is in what mechanism
financial development stimulates economic growth. A prevailing research direction is
to investigate the potentially prudent effects of financial development on firms’
investment, pointing to the seriousness of firm’s financing constraints, under the
country financial development background.
According to Modigliani and Miller (1958), external finance perfectly
substitutes internal finance and firm’s investment decisions do not depend on its
financing choices under the strict assumption of perfect capital markets. Unfortunately,
perfect capital market apparently does not exist in reality. According to Stiglitz&Weiss
(1981) and Myers &Majluf (1984), firms have to tackle difficulties of suffering higher
cost of external fund due to credit risk and asymmetric information as providers of

external finance normally find it very costly to evaluate firms' investment
opportunities. Therefore, firms have to resort to internal finance generated through
cash-flow and retained earnings. But their investment is subject to fluctuations in cashflow. In other words, firms face financing constraints. Rajan and Zingales (1996)
argued that financial development induces more efficient reallocation of funds and
mitigates the external financing constraints. In better-functioned financial systems, not
only the transaction cost of saving and investing is lower but the problem of
asymmetric information is alleviated. With the financial market development, some
1


empirical studies combine cross-country and firm panel data to investigate diverse
features of the connection between financial development and the extent at which
firms’ reliance on internal finance. Love (2003), processing a panel data of 5,000 firms
in 36 developed and developing countries, proved that financial development lightens
the reliance of firms’ investment on internal fund, especially in small firms. Using the
same data but the different method, Love and Zicchino (2006) pointed out that in
countries with less developed financial systems, firms face financing constraints more
seriously. This also holds at the regional level. Sarno (2005) compared southern with
northern regions of Italy and found that in less financially developed southern regions,
small and medium enterprises (SMEs) harshly suffered credit constraints. At provincial
level, O’Toole and Newman (2012) investigated the effect of firms’ financing
constraints on investment opportunities in Vietnam by using the firm panel data taken
from the Vietnam Enterprise Survey (VES) from 2002-2008 and observe that
provincial financial development in Vietnam eases investment financing constraints.
This study is similar in spirit to O’Toole and Newman (2012) in analyzing the
relationship between financial development and firms’ investment in Vietnam. Of
particular interest is the role of financial development via financing constraints on the
firms’ financing investment. However, there are some extensions from O’Toole and
Newman (2012). Firstly, Euler equation approach is employed to model firms’
investment. Secondly, investment sensitivity to cash-flow is employed as the variable

to test for the presence of financing constraints, differing from O’Toole and Newman
(2012) that used the ratio of investment fund by internal fund to total investment
finance. Thirdly, data in this study cover a more recent period of time from 2006-2012.

2


1.2 Research questions
This study is to find out the impact of financial development on firms’
investment. By applying quantitative research to a panel data of firms in Vietnam,
this thesis aims to address two main research questions:
1. Does financial development prompt investment or relax financing
constraints of Vietnamese manufacturing firms?
2. How does financial development affect investment of different types of
firms?
1.3 The scope of the study
The study will examine relationship between financial development and firms’
financing investment in the case of Vietnamese manufacturing firms. The firm panel
data for this research is taken from VES from 2006 to 2012. Meanwhile, the macro
data of financial development is gathered from World Development Indicators of
World Bank’s database.
1.4 The structure of the study
The paper contains 6 main chapters. Following this first chapter of introduction,
chapter 2 presents the critical literature review on sources of investment financing, firm
financing constraints, and the impact of financial development on financing
constraints. Next, model specification in chapter 3 specifies the methodology to test the
presence of firm financing constraints using Euler equation approach as well as the
empirical model to examine the effect of financial development on financing
constraints on firms. Chapter 4 gives a brief overview of financial sector development
in Vietnam. Then, the result of the study is presented in chapter 5 which contains three

main parts. The first part concentrates on estimation technique, the second variable
construction as well as data collection and the third regression results. Finally, chapter
6 concludes the main findings, limitations and further researches.
3


Chapter 2: Literature review
2.1 Sources of investment financing.
For the purpose of this study, investment refers to capital expenditure (Capex),
which is measured by spending on plant, property and equipment. Basically, firm’s
investment is financed by using two sources of finance: internal finance and external
finance. Internal finance, i.e. self-financing, may consist of four main components: past
profits which are not distributed to shareholders; additional capital from the owners;
depreciation and amortization. Besides taking the advantages from itself when
collecting internal sources for investment, firm might also use external source from
loans of banks and other financial institutions or the issue of new equity. This section is
divided into two subsections: the former covers external financing and the later internal
financing.
2.1.1 External financing
Early in mainstream economic point of view, external financing is viewed as a
source of firm financing and financial institutions, especially banks has been proved to
play a virtual role in financing investment. Schumpter (1912) believed that an
entrepreneur must borrow to afford his new business if his purchasing power is not
strong enough. In this case, “he cannot become an entrepreneur by previously
becoming a debtor”. In addition, he considered the banker as the key agent in this
process. Later, it is widely accepted by many authors when investigating financegrowth relationship that investment financing comes from the financial system
(King&Levine, 1993; Levine & Zervos, 1998; Levine et al., 2000; Warchtel, 2003
etc.). In econometric model of finance-growth, they use the share of broad money
supply and private credits to gross domestic products (GDP) as the proxies of financial
development. The findings state that there is a significantly positive relationship

between financial development and economic growth. Therefore, they jump to a

4


conclusion that a developed financial system could promote long-term economic
growth by the channel that financial intermediaries provide credits to finance firms’
development plans.
However, there are some economists arguing these results. Arestis (2004; 2005)
and Guirat and Pastoret (2009) raised a serious question that what type of loans that
financial intermediaries offer firms, long-term or short-term. It is clear that the role of
short-term loans is to facilitate firms’ cash-flow rather than to finance investment.
Hence, when choosing proxies for financial development, authors need to take into
consideration the type of credit or loans. Nevertheless, this seems to be missing in the
two proxies, the share of broad money supply and private credits to GDP, in the
previous studies. Another argument is coming from commercial banks’ difficulty in
mandating long-term credits. Apparently, most recent commercial banks’ sources
come from short-term deposits.
2.1.2 Internal financing
Table 2.1 Share of financing sources in two industries in the United Kingdom (UK)
All samples

Chemicals
and Electrical
allied industries
Engineering

Retentions

91.0

89.7

117.3

Trade Credit

1.5

-2.2

-11.9

Bank credit

2.7

-2.2

-20.4

Long-term liabilities and issues of shares

4.8

14.7

15.0

100.0

100.0

100.0

Total

Note: The total sample refers to the period 1949-84; chemicals and allied and electrical engineering
industries relate to the period 1949-82.
Source: Goudie and Meeks (1986) in Mayer (1990)

5


There is a vast literature discussing the importance of internal finance sources.
According to Sweezy (1968), the firm’s profits growth mainly contributes to the capital
accumulation gain for the purpose of production expansion. Moreover, Mayer (1990)
used firms’ data in the United States (US) from 1970-1985 to provide an empirical
evidence that in this case, firms mostly rely upon internal sources. The result is similar
to the study of British firms of chemical and electrical engineering industries from
1949-1984 that bank loans and bond securities do not play a significant role to fixed
investment financing (see Table 1). Instead, bank loans which are considered as the
main source of external finance mostly contribute to firms’ working capital.
Using the same data of two industries in UK but with the different approach,
Mayer (1990) examined the variation of capital structure according to the firm size.
Table 2 points out that large firms seem to require more on internal financing in
comparison with external financing.
Table 2.2 The proportion of financing sources according to different firm sizes
Retention

Banks, Short-term loans
and trade creditors

All companies
Large
70.9
Medium and Small
52.6
Chemicals
Large
70.5
Medium and Small
50.3
Electrical companies
Large
79.4
SMEs
60.4
Source: Business Monitors (M3) in Mayer (1990)

Issues of Shares and
Long-term Debt

Other
sources

23.2
45.7

5.7

1.3

.2
.3

20.2
50.5

7.6
3.8

1.6
- 4. 7

19.4
37.4

3.1
2.4

- 1. 9
.1

Corbett and Jenkinson (1997) provided another evidence to support the Mayer’s
findings by analyzing the source of finance of three developed countries including
Germany, the US and the UK from 1970-1994. The study shows that in the period
1970-1994, the firms in these countries mostly rely on the internal source of finance
with the average proportion of the internal finance and total fixed investment of 78.9

6

percent in Germany, 93.3 percent in the UK and 96.1 percent in the US. These are
stories in developed countries.
What happens in the countries with the state control over financial systems? In
these countries, state development banks and other state owned banks follow low
interest rate policies to stimulate investment (Singh, 1998), especially in the early stage
of development. The poof indicates that the most fundamental source of finance for
fixed investment comes from internal finance; however the share of long-term bank
loans are still high compare to the rate in developed countries mentioned above.
Choosing Japan before becoming a developed country in 1990’s as the case of state
control over financial system, Tsuru (1993)figured out that the share of internal
financing over gross manufacturing investment accounted for 60 percent in the late
1950s, increasing to 75 percent in the late 1970’s and around 100 percent in the late
1980’s. The long-term bank loans covered the rest of investment financing, and had
continued declining from 1950’s. China is a typical example for the country with the
financial system regulated by the government. Specially, the Chinese government plays
a central role in the financial system. It is demonstrated that the proportion of the total
assets of state-owned commercial banks and development banks to total banks’ asset
accounts for roughly 60 percent. Mlachila and Takebe (2011) argued that due to the
government regulation, these banks can lend lower interest rate to firms, especially
with state-own enterprises investing in construction, logistic and heavy manufacturing.
2.2 Financing constraints on firms
2.2.1 Definition
According to Modigliani-Miller (1958), firm’s capital structure is irrelevant to
its value in perfect market. In other words, external finance perfectly replaces internal
finance. However, in financial friction or imperfect financial market, this is not true.
External finance is more expensive than internal finance due to asymmetric

7

information, transaction costs and agency problems (Fazzari et al.,1988, Mayer, 1990,
Schiantarelli, 1995, Blundell et al., 1996). Kaplan and Zingales (1997) suggested that a
firm faces financing constraints when its costs or accessibility to external sources
become barriers preventing the firm from profitable investment projects. Laeven
(2003) summarized a large body literature to introduce a definition of financing
constraints on firms that a firm’s investment is considered as financially constrained if
an unexpected increase in internal funds leads to a higher level of investment spending.
2.2.2 Measurement of financing constraints on firm
In order to test the existence of financing constraints on firms, Euler investment
equation approach and q investment model are commonly applied in most empirical
studies. Both two approaches contain their own advantages and disadvantages.
The q model originates from Tobin (1969) and is developed to q-investment
model by Hayashi (1982). Fazzari et al. (1998) first introduced the procedure to test the
presence of financing constraints on firm using q-investment model. If all markets are
perfectly competitive, a firm’s production and installation functions exhibit constant
returns to scale, and stock markets are strongly efficient, then a firm’s investment only
depends on marginal q which is equal to average q. However, when these strict
assumptions are not satisfied, the q model is not a good proxy for firm investment
(Hayashi, 1982).In the improvement process of q investment model with a novel
approach, Abel and Blanchard (1986) tried to predict the expected present value of the
current and future profits produced by an additional unit of fixed capital. The
advantage of this approach is that it does not use stock price data. However, the
disadvantage of this approach is that a certain stochastic process on the variables needs
to be assumed.
Another approach is Euler investment equation, which is a necessary condition
for an optimal policy employed by a firm which seeks to maximize its value. The first-

8

order conditions for investment remove the shadow cost of capital from the Euler
equation. The Euler investment equation is first introduced by Albel (1980), and
applied by many authors with different adjustments (White, 1992; Hubbard, Krashyap
& White, 1995; Bond & Meghir, 1994; Harris, Schiantarelli & Siregar, 1994, Gilchrist
& Himmelberg, 1999; Love, 2003; Laeven, 2003; Forbes, 2007, Chan et al., 2012,
etc.). The Euler investment equation does not use stock price data and not have to
assume linear homogeneity of the net revenue function. Moreover, it does not require
to assume a certain stochastic process on the variables as in the q investment model as
in the q investment model and the Abel and Blanchard (1986) model. Nevertheless, the
Euler equation needs to assume and adjustment cost function and a firm’s smoothing
investment expenditures over time.
2.3 Financial development and financing constraints on firms
Basically, financial sector development occurs if financial instruments, markets
and intermediaries are less prone to market asymmetry information, limited
enforcement and transaction costs. However, Čihák et al. (2013) argued that if only
capture the ease of market imperfection, the financial development measurement
should cover the actual function of financial development to the whole economy.
Therefore, many authors (Merton, 1992; Demirguc-Kunt & Levine, 1996;DemirgucKunt&Maksimovic, 1998; Rajan & Zingales, 1998; Levine, 2005; Čihák et al., 2013
etc.) adopted a broader definition of financial development as improvements in five
key financial functions, including: “(1) producing and processing information about
possible investments and allocating capital based on these assessments; (2) monitoring
individuals and exerting corporate governance after allocating capital; (3) facilitating
the trading, diversification, and risk management; (4) mobilizing and pooling savings;
and (5) easing the exchange of goods, services, and financial instruments.” As the
result, barriers to access to banking sector have been reduced and capital market has
been triggered. The gap between external and internal source of finance has gradually

9

lowered, and the firm’s entry to banking sector has been stimulated. In other words, it
is commonly thought that under the existence of financial development, costs of capital
for firms are decreased, and barriers for firms to external sources are gradually
removed. After all, from theoretical point of view, with the presence of financial
development firms’ financing constraints are ameliorated and their investment
increases.
The empirical examination of the relationship between financial development
and firms’ investment is of contemporary concerns. The current empirical findings of
financial development and financing constraints nexus in developing countries are still
ambiguous. Demirguc-Kunt and Maksimovic (1998, DM) used cross country firmlevel data to investigate whether financial development affects the degree to which
firms are constrained from investing in profitable growth opportunities. Using the same
indicators to measure financing needs among firms in different countries, DM casted
doubt on Rajan and Zingales (1998) who used industry level data to investigate the tie
between financial development and economic growth. DM argued that it would be
precise if those differences are addressed at firm level data. Firstly, DM computed the
rate for individual firm at which firm can grow in two cases (1) it is only funded by
internal sources and (2) both internal funds and short term loans are employed. Then,
the proportion of firms whose growth rates are in excess of the maximum rate that firm
use only internal fund is calculated. It is denoted as Pr_faster. Based on this, the
proportion of firms in each country relying on external fund would be estimated. In
order to examine the impact of financial development on firm’s growth, DM run the
cross country regression:
Pr_fasterit = β1FDi,t+ β2CVi,t + εi,t (1)
in which FD is financial development, CV a set of control variables and ε the
disturbance term.

To measure financial development variables, DM use a set of

financial indicators including the ratio of market capitalization to GDP, the total value
10


of shares traded divided by market capitalization and the rate of bank assets to GDP.
For control variables, DM employed the different mix of macroeconomic variable such
as economic growth, inflation, the average market to book value of firms in the whole
economy, total amount of subsidies from government to firms, the average ratio of net
fixed assets over total assets, the real GDP per head, the law and order tradition of the
economy. Finally, they found that the proportion of firms whose growth rates are in
excess of the maximum rate that firm use only internal fund is positively related to
financial development and legal system variables. Applying the same approach, but
extending the sample data of the largest listed manufacturing firms in 26 countries,
Beck et al. (2001) confirm the findings.
However, Love (2003) stated that the firms’ investment opportunities in
different time and countries are not mentioned in DM’s approach. She asserted that to
test whether financial development enhances the allocation of capital within a country,
growing firms need to be identified, given their investment opportunities. She used
pooled cross country firm-level data in an investment model based on the Euler
equation approach. It embodies financing constraints by parameterizing the shadow
cost of external funds as a function of the firm’s cash-flow which is built on Gilchrist
and Himmelberg (1999). This approach is widely applied by Chan et al. (2012), Forbes
(2007), Harrison, Love and McMillan (2004) when they analyze the effect of finance
reform, financial liberalization or banking reform on firms’ investment decision. For
financial development proxies, five standardized indices, including GDP, total value
traded over GDP, total value traded over market capitalization, M3/GDP, financial
depth (credit to private sector to GDP) from Dermirguc-Kunt and Levine (1996) are
combined into a single measure. This index is standardized to have the mean of zero
and the standard deviation of one. Love used a panel data of 5,000 large, publicly
traded firms in 36 countries. Her evidence indicates that financial development makes

11


investment of firms, especially small ones, less sensitive to internal finance. This is in
line with the theory and many previous studies.
Leaven (2003) conducted the study of firm-level data from 13 developing
countries to examine the difference of investment sensitivity to cash-flow. The levels
of liberalization scaled from 1 to 6 are different across countries. He found that
although investment is largely constrained by cash flow with both firms, there are
different effects of financial liberalization on small and large firms. Small firms are
found to be more financially constrained before liberalization and less financially
constrained after liberalization in comparison with large firms. Large firms also are
found to face more financially constrained after liberalization. It might come from the
fact that large firms often receive incentives from the state such as directed credit
program of state development banks or other preferential loans which must be scaled
down after liberalization.
A different approach is represented by O’Toole and Newman (2012). Despite of
the same purpose of study the influence of financial development on firms’ investment
financing via financing constraints, they differed from previous studies in some points.
Firstly, O’Toole and Newman (2012) proposed using fundamental q model based on
Gilchrist and Himmelberg (1995) and applied empirically by Love and Zicchino (2006)
with following procedure:
xit = Axit – 1 + 𝜗𝑖 + 𝜃𝑡 + 𝜀𝑖𝑡
Qit = (c’[I - 𝜑A]) xit

(1)
(2)

In which xit includes a proxy for the firms' marginal value product of capital. In this

research, a sale to capital ratio has been used as a proxy for the marginal product of
capital. This is a valid proxy under constant return to scale of Cobb- Douglas
production structure as detailed in Galindo, Schiantarelli, & Weiss (2007). 𝜃𝑡 and 𝜗𝑖
represent time and firm specific effects, respectively. The vector autoregression is used

12


to estimate the coefficient matrix A which is then included in equation (2). The
marginal value product of capital ratio is identified by vector c, 𝜑 represents the
combined discount and depreciation rate. O’Toole and Newman (2012) argue that the q
model might be flexible because it relates investment to the firm’s individual
investment opportunities. Secondly, firm’s financing composition mix is the first time
defined by using the differential cost of capital relating to the financing options
available to firms. Thirdly, financial development indicators are calculated at
provincial level based on Vietnam Enterprise Survey data before these added in the
firm’s investment model. Provincial financial development indicators here are
classified into three families, including financial depth, state intervention and the
degree of market financing in the economy. The idea is taken from Guariglia and
Poncet (2008) in China due to the similarity between Chinese and Vietnamese
economies. To investigate the impact of financial development on firm’s investment,
financial development indicators are interacted with firm’s financing composition mix.
O’Toole and Newman’s results support the view that financial development reduces
firms’ financing constraints though credit expansion or through more efficient credit
allocation. However, the impact differs across firms. Financial development has
significant influences on domestic private firms, but negligible effects on foreign
invested firms.
In consistent with the findings in previous studies, Harris, Schiantarelli &
Siregar (1994) for the case of Indonesia, Gallego and Loayza (2001) for the case of
Chile, Gelos and Werner (2002) for Mexico, they both jump to the conclusion that

financing constraints are relaxed for small firms but not for large ones after financial
development. However, the empirical findings of the relationship between financial
development and firms financing constraints have not been conclusive. Using the same
method in Love (2003) but only examining the financial development in single
country, China and Chile, respectively, Chan et al. (2012) and Forbes (2007) found

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interesting findings. Financial reforms in China do not benefit SMEs and SOEs in
terms of alleviating the financing constraints. This also occurs similar to the case of
Chile in the capital control period from 1991 to 1998. Chile small firms suffered
significant financing constraints which did not appear before and after the capital
control (Forbes, 2007). Jaramillo et al. (1996) found an insignificant relationship
between financial development and firm’s investment when examining the case of
Ecuador.
2.4 Conclusion
To conclude, in order to investigate the effect of financial development on
firms’ investment, the recent approach widely used is via analyzing firms’ financing
constraints. The problem is that how to formulate the firms’ investment and through
which the tie between financial development and firms’ financing constraints is
clarified. Q model and adjusted Euler specification model are two main approaches of
modeling firms’ investment. Formulating financial development indicators is also of
concern. Many different indicators are employed to represent financial development,
and they have varied in different studies. Most of them are financial depth, the ratio of
market capitalization to GDP, the total value of shares traded divided by market
capitalization and the rate of bank assets to GDP, M3/GDP. The impact of financial
development on financing constraints on firms is still ambiguous. Most empirical
studies show that financial development has positive impact on firms’ investment,
relaxing firms’ financing constraints. Nonetheless, several studies in some developing

countries point out a contradictory result that firms seem to not benefit from the
financial development process.
In this paper, Euler investment equation approach is employed to detect the
presence of financing constraints on firms due to its outstanding advantages in
accordance with Vietnamese firm data and economy context. The model specification
and hypotheses development will be presented in the next chapter.
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Chapter 3: Model specification
This chapter contains three main parts. The first part displays the theoretical
framework to model investment. As mentioned in the previous part, Euler investment
equation approach as well as how to use it to test for the presence of financing
constraints would be presented. The second part discusses the measurement of
financial development indicators. The final part specifies the model which is expected
to test the impact of financial development on firm investment.
3.1 Investment modeling
3.1.1 Euler investment equation approach
Since the first introduction in Abel (1980), the investment Euler equation
approach has been widely used by many authors (White, 1992; Hubbard, Krashyap&
White, 1995; Bond & Meghir, 1994; Harris, Schiantarelli & Siregar, 1994, Gilchrist &
Himmelberg, 1999; Love, 2003; Laeven, 2003; Forbes, 2007, Chan et al., 2012). The
equation is acquired after reorganizing first order conditions when solving the
maximizing firm’s value problem.
In this paper, the investment model based on Euler equation approach closely
follows models in previous studies, especially Laeven (2003) and Bond & Meghir
(1994). The firm is assumed to maximize its present value, which is the sum of the
expected discounted value of dividends subject to the capital accumulation and external
financing constraints.
Let 𝑉𝑡 be the firm value at time t, 𝐷𝑡 the dividend paid to shareholder at time t,

𝑗

𝑡
and 𝛽𝑡+𝑗
= ∏𝑖=1(1 + 𝑟𝑡+𝑖−1 )−1 the j–period discount factor for j≥ 1 where 𝑟𝑡 is the

risk-free expected rate of return and 𝛽𝑡𝑡 = 1. Then, the function of firm value at time t
𝑡
is 𝐸𝑡 ∑∞
𝑗=0 𝛽𝑡+𝑗 𝐷𝑡+𝑗 , the expected value of present values of future dividend payments

conditional on time t information. Let П𝑡 = ∏𝑡(𝐾𝑡 , 𝐿𝑡 , 𝐼𝑡 ) denote the profit function

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