American Economic Association

Property Rights and Finance Author(s): Simon Johnson, John McMillan, Christopher Woodruff Source: The American Economic Review, Vol. 92, No. 5 (Dec., 2002), pp. 1335-1356 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/3083253 Accessed: 02/03/2010 11:22

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http://www.jstor.org PropertyRights and Finance

By SIMON JOHNSON,JOHN MCMILLAN, AND CHRISTOPHERWOODRUFF*

Whichis the tighter constrainton private sector investment:weak property rights or limited access to externalfinance? From a survey of new firms in post-communist countries, we find that weak property rights discouragefirms from reinvestingtheir profits, even when bank loans are available. Whereproperty rights are relatively strong,firms reinvest theirprofits; where they are relativelyweak, entrepreneursdo not want to investfrom retained earnings. (JEL D23, P23)

Property rights are fundamental: entrepre- Levine,1997; Raghuram Rajan and Luigi Zingales, neurs will not invest if they expect to be unable 1998). Is external finance, in addition to secure to keep the fruits of their investment. Country- property rights, necessary for entrepreneursto level studies consistently show that less secure invest, or is property-rightssecurity all that is property rights are correlated with lower ag- needed? Broad cross-countrystudies cannot an- gregate investment and slower economic swer this question because effective protection growth (Stephen Knack and Philip Keefer, for propertyrights is positively correlatedwith 1995; Paolo Mauro, 1995; Jakob Svensson, the use of externalfinance. For example, Rafael 1998; Daron Acemoglu et al., 2001). The mi- La Porta et al. (1997, 1998, 2000) show more croeconomic evidence is more limited, but Tim- external finance is available when there is a othy Besley (1995), for example, finds in Ghana stronger legal system in general and more ef- a significant link between property rights and fective protection of investors in particular, investment. while Asli Demirguii-Kuntand Vojislav Mak- Secure propertyrights may be necessary for simovic (1998) find that firms invest more from entrepreneurialinvestment, but are they suffi- externalfunds in countrieswith secure property cient? External finance could also matter for rights. investment and growth, for if bank credit is not Recent experience in EasternEurope and the available it may be hard for entrepreneursto former Soviet Union offers an experiment that take advantage of new opportunities.There is can help disentangle the effects of property evidence that a well-functioning financial sys- rights and external finance. Although all these tem contributesto investmentand growth (Ross former communist countries have relatively weak institutional environments, there is con- siderablevariation in the extent to which prop- * Johnson: Sloan School of Management,MIT, 50 Me- erty rights are protected.For example, Timothy morial Drive, Cambridge, MA 02142 (e-mail: sjohnson@ Frye and Shleifer (1997) and Shleifer (1997) mit.edu);McMillan: GraduateSchool of Business, Stanford evidence that the Russian 518 provide government University, Memorial Way, Stanford, CA 94305 acts like a entre- (e-mail: [email protected]);Woodruff: Grad- "grabbinghand," discouraging uate School of InternationalRelations and Pacific Studies, preneursfrom investing, while the Polish gov- University of California-San Diego, La Jolla, CA 92093 ernment does not. In general, property rights (e-mail: [email protected]).We thank Timothy Besley, have proven more secure in Polandthan in other Bengt Holmstrom, Takeo Hoshi, James Rauch, Andrei of Eastern and the former Soviet and two referees for Todd parts Europe Shleifer, anonymous comments, Union. Within Mitton for help with the Worldscope data, Mark Schanker- countries, also, there is variation man for help in facilitating the surveys, and the European in both the perceived security of propertyrights Bank for Reconstructionand Development for funding the and in the access to bank credit. Given these surveys in Poland, Slovakia, and Romania,and the National countries' banking systems, small firms are able Council for Soviet and East EuropeanResearch for funding to borrow if can the surveys in Russia and Ukraine. For support, Johnson only they provide adequate thanks the MIT EntrepreneurshipCenter and McMillan collateral.Owning collateralis thereforea good thanks the StanfordGraduate School of Business. proxy for at least having the possibility to 1335 1336 THEAMERICAN ECONOMIC REVIEW DECEMBER2002 borrow. Firm-level evidence from these post- credit leads to more investment for these firms. communist countries thereforeallows us to de- Secure propertyrights are therefore also suffi- termine whether secure propertyrights are (a) cient for investment. In fact, the firms in our necessary, (b) sufficient, or (c) necessary and sample with weak perceived propertyrights and sufficient for investment by entrepreneurs. high levels of unreinvestedprofits do not want Our data come from a 1997 survey of re- to borrow. cently formed and relatively small manufactur- Part of the explanation for these results is ing firms in five transition countries: Poland, that, for the firms in our sample, retainedearn- Romania, Slovakia, Ukraine, and Russia. The ings have consistently been large, and therefore perceived securityof propertyrights and the use have been a source of potential investment of bankcredit vary considerablyboth across and funds. Many of these new firms are extremely within these countries.As an outcome variable, profitablebecause the relatively hostile business we focus on the amountentrepreneurs choose to environment creates barriers to entry and be- reinvest out of their profits. This provides a cause the partially reformed economy offers robust measure of investment, as our survey entrepreneurslucrative unfilled niches.2 High work indicates, that is comparableacross firms. profits mean that entrepreneurshave the re- Our approachhas two parts, both of which sources they need for expansion, without need- are designed to be straightforwardto implement ing to borrow. The issue is not whether in countries where standardfinancial informa- entrepreneurshave enough resources,but rather tion is hard to obtain. First, we explain the data whether they want to invest their retainedearn- we were able to obtain, putting particularem- ings or instead consume these earnings,perhaps phasis on what our investigation shows is a outside the country. reasonableway to ask questions about sensitive At the low level of institutionaldevelopment financialinformation and property-rightsissues of the countries in our sample, secure property (Section I).1 Second, we test whether secure rights are both necessary and sufficient to in- propertyrights are sufficient for investment by duce investment by entrepreneurs.The avail- entrepreneurs(Sections II and III). ability of bank loans surely mattersfor growth, The entrepreneursin our sample reinvest less but perhaps only once propertyrights are per- of their retained earnings when they perceive ceived to be secure. If propertyrights are inse- their propertyrights to be insecure, irrespective cure, it is immaterialwhether or not finance is of whether they own the collateral that is gen- available.Our findingsthus add empiricaldetail erally needed to obtain credit. This effect is to the view that certainmarket-supporting insti- large. Those entrepreneursin our sample with tutions will work only after other institutions the least secure propertyrights invest nearly 40 have been built (McMillan, 1997; Shleifer and percent less of their profits than those with the Vishny, 1998). most secure propertyrights (specifically, entre- Because our survey covers only firms already preneurs with the least secure perceived prop- in existence, we cannot infer anythingabout the erty rights reinvest 32 percent of their profits, relativeimportance of propertyrights and finance while those with the most secure reinvest 56 for potential entrepreneurswho are considering percent). Secure property rights are necessary entry. We focus instead on entrepreneurswho for the entrepreneursin our sample to take are already in business with small-scale opera- full advantageof opportunitiesto invest. More- tions. Our question is: under what conditions over, we find that the absence of bank finance does not prevent the entrepreneursin our sam- from for ple investing. Controlling property 2 to new entrants to have been com- there is no evidence that access to bank High profits appear rights, mon in the early stages of reform in the formerly planned economies. China's newly entering rural firms had an av- erage rate of profit on of 40 percent in 1978, the 1 capital For more detail on the survey see AppendicesA, B, and first year of reform; in subsequent years this profit rate C, which are on the American Economic Review web site: fell as China's marketizationproceeded (Barry Naughton, (www.aeaweb.org/aer).The questionnaireand the complete 1995, p. 150). Anecdotal evidence that early entrants in raw data are available at (http://www-irps.ucsd.edu/faculty/ Poland earnedhigh profits is given in Johnson and Gary W. cwoodruff/data.htm). Loveman (1995). VOL. 92 NO. 5 JOHNSONET AL.: PROPERTYRIGHTS AND FINANCE 1337 will these entrepreneursreinvest their profits to characteristics of the firms in our regression make their businesses grow? analysis.

I. The Data B. The Questions

A. The Sample The survey design incorporatedboth experi- ence of previous surveys on these topics and the We surveyed private manufacturingfirms in results of pilot studies we carried out in each May and June of 1997 in Russia and Ukraine country. The pilots tested precisely how people and from September to December of 1997 in understood various questions and established Poland, Slovakia, and Romania.3 The survey the best ways to ask about sensitive informa- was designed to find similar relatively small tion. For the purposes of this paper, the most firms in comparablecities in all five countries. importantissue was how to ask about profits We chose the countries explicitly to look for and their reinvestment. variation in institutionalconditions. The previ- We expected respondentswould be reluctant ously available cross-countryevidence, for ex- to answer questions about the specific nominal ample from EuropeanBank for Reconstruction amounts of profits and investments, and we and Development (EBRD, 1996) and Shleifer found this to be the case. However, they were (1997), suggested that propertyrights were less more willing to answerquestions posed in terms secure in countries furtherto the East. We in- of ratios. We also found that respondentsfound tentionally surveyed only firms that were going it much easier to answer questions that posed concerns, in order to focus on investment deci- this ratio in terms of a closed-end question sions by firms that had managed to enter an listing various ranges from which they could industry and survive. Other researchers have choose. For example, our key question was: found that weak propertyrights increase barri- "How much did you reinvest out of profits dur- ers to entry (Simeon Djankov et al., 2002). ing 1996?"We offered respondentssix choices: Daniel Berkowitz and David N. DeJong (2002) 0 percent, 1-10 percent, 11-25 percent, 26-49 find variationacross Russian regions in the rate percent, 50-75 percent, or more than 75 per- of formationof new firms is associated with the cent. Both the use of ratios and the closed degree of local political supportfor reform.This categories represent compromises. We obtain paper looks instead at the effects of weak prop- much higher response rates: in the case of rein- erty rights on entrepreneurialinvestment condi- vestment rates, the response rate exceeded 94 tional on entry having occurred. percent.4 But we have only categorical rather The sample includes about 300 manufactur- than continuous data. As a result, our regres- ing firms with between seven and 270 employ- sions will be orderedprobits. ees in each country; the total sample size for Previous research indicated that for particu- most variables is about 1,400 observations. larly sensitive issues, for example relating to Some of the firms were startedfrom scratchand bribes and other issues linked to security rights, others were spun off from state enterprises, the response rate was higher when we posed the which probably reflects characteristics of the questions in terms of asking about "firms in population of firms. In our sample for Poland, your industry" rather than the entrepreneur's Romania, and Slovakia, start-upsfar outnumber own firm.5 Our assumption, based on other spin-offs; in Russia and especially Ukraine, spin-offs predominate. We control for these 4 For questions where the range of potential responses ranged too widely to use categories, we did ask for specific 3 We chose these three countrieson the basis of country- nominal amounts. In these cases-for example, when we level measures that indicated substantialvariation in insti- asked firms how much capital they invested in the firm at tutional environment. The survey is described in more start-up-response rates were much lower. detail in Appendix A, and Appendix C summarizesour key 5This way of asking about sensitive issues, such as questions about finance, profits, investment, and property property rights and undergroundeconomic activity, was rights. (These Appendices are available at (www.aeaweb. developed by Daniel Kaufmann in his earlier empirical org/aer).) work; see, for example, Joel Hellman et al. (2000). The 1338 THEAMERICAN ECONOMIC REVIEW DECEMBER2002

TABLE 1-PERCEIVED SECURITY OF PROPERTY RIGHTS

All Survey result countries Poland Slovakia Romania Russia Ukraine 1) Percentageof respondentswho say firms 37.3 20.1 38.2 20.0 91.2 86.9 make extralegal payments for government (1,117) (298) (306) (315) (114) (84) services 2) Percentageof respondentswho say firms 37.9 19.3 42.2 17.0 91.7 87.5 make extralegal payments for licenses (1,128) (300) (303) (317) (120) (88) 3) Percentageof respondentswho say firms 24.4 7.9 14.9 0.6 92.9 88.8 make payments for protection (1,163) (302) (308) (320) (126) (107) 4) Percentageof respondentswho say firms 14.0 0.4 3.0 19.1 80.0 76.9 make unofficial payments for ongoing (805) (234) (236) (267) (55) (13) registration 5) Percentageof respondentswho say firms 19.2 2.8 12.1 21.8 67.9 91.2 make unofficial payments for fire/sanitary (881) (254) (248) (289) (56) (34) inspection 6) Percentageof respondentswho say firms 12.9 0.8 2.5 17.3 75.6 85.0 make unofficial payments for tax (843) (247) (242) (289) (45) (20) inspection 7) Tax payments to governmentas a 18.9 15.5 16.4 17.2 26.9 28.0 percentage of sales for firms in industry (1,130) (277) (278) (321) (119) (135) 8) Percentageof respondentswho say courts 31.6 27.1 32.1 13.1 44.2 45.4 cannot be used to enforce contracts (1,470) (303) (308) (321) (269) (269) Number of entrepreneurssurveyed 1,471 303 308 321 269 270

Note: The numberof observationsis given in parenthesesbelow each response level.

experience, is that answers to this question re- Only one in five entrepreneursin Poland and flect the entrepreneur's own experience.At least Romania said firms make extralegal payments one respondentconfirmed this, telling our sur- for services or licenses. The response rates for vey firm that he knew the questions were de- these questions are well above 98 percentin the signed to "disguisethe fact that [the survey] was three Eastern European countries, but are 40 after information about his own firm." He re- percent or less in Russia and Ukraine. One sponded to the questions anyway. reasonableinterpretation of a refusal to answer the question, in this context, is that the entre- C. Measuring Property Rights preneur makes these payments and-for obvi- ous reasons-does not want to discuss them. The entrepreneur'sbeliefs about the security We also asked whetherfirms make payments of his or her property rights are indicated by for "protection"of their activities, finding a responses to several survey questions.We asked similarpattern of responses across the countries entrepreneursfirst whether firms in their indus- (in the third row of Table 1). We chose not to try make "extralegalpayments" for government ask directly about whether firms made pay- services, and second whether firms in their in- ments to organizedcrime, because we expected dustrymake "extralegalpayments" for licenses. that most entrepreneurswould not admit this. More than 90 percent of the Russian entrepre- However, the indirect question probably picks neurs and almost 90 percent of Ukrainian en- up whether a firm believes it is likely to be trepreneurs answered affirmatively to these subject to extortion by some form of mafia- questions (see the first two rows of Table 1). although we would caution that anecdotal evi- dence suggests this sort of organized crime often operates with the tacit protectionof some results seem consistent with available cross-country evi- local governmentofficials. dence and across surveys. For further measures of property-rights se- VOL. 92 NO. 5 JOHNSONET AL.: PROPERTYRIGHTS AND FINANCE 1339 curity, we asked entrepreneurswhether they property rights than do the two former Soviet make "unofficial" payments for specific ser- Union countries. Courts are less reliable in re- vices: paymentsfor renewing theirbusiness reg- solving commercial disputes in Russia and istration,and payments to fire, sanitary,and tax Ukraine, and interactionswith the government inspectors (see the fourth, fifth, and sixth rows are also more costly in these countries. This is of Table 1). Though the response rates to these consistent with the existing evidence that the questions are lower, the patternis the same. A regulatory environment in Eastern Europe is majorityof entrepreneursin Russia and Ukraine less hostile to business activity than in the say such payments are common, while a minor- former Soviet Union (see, for example, Frye ity of entrepreneursin the other three countries and Shleifer, 1997). say the same. We use these detailed corruption Entrepreneurs'perceptions of the security of measuresto check the robustnessof results from property rights may vary within a country for our basic regression. three reasons. First, different firms may face Official payments to government are also different realities. Interactionwith the govern- higher in Russia and Ukraine, where tax pay- ment may be more frequent in some industries ments are more than one quarterof sales, com- than in others. Activities may vary in the ease paredto about a sixth of sales in EasternEurope with which they can be hidden from govern- (see the seventh row of Table 1).6 We control ment bureaucrats.And some entrepreneursmay for tax payments as a percent of sales to see have connections that allow them to avoid ex- whether this is a direct disincentive to invest. tortion. In our data, for example, entrepreneurs We do find some evidence that investmentrates who previously worked as high-level entrepre- are negatively impacted by higher tax rates, neurs in state-owned enterprisesare less likely though in contrast to other results, the tax rate to say bribes are paid. Second, entrepreneurs findings are not robust. may differ in their perceptions. This is espe- Using courts to enforce contractswith trading cially likely in an economy undergoing deep partnersis a logically distinct activity from pro- reform, where institutions and circumstances tecting propertyrights. Nevertheless the effects change quickly. We find, for instance, that older on investment are similar. Inadequatecontrac- entrepreneursare less likely to say bribes are tual enforcementcould put firms' profits at risk paid. Third, the responses may reflect some and make them reluctant to invest. Asked other characteristicof the firm or the entrepre- whether courts could be used to enforce an neur. In our regressions we control for as many agreement with a customer or supplier, most characteristicsas possible, but some unobserved firms in all of the countries said they could. attributesmay matterfor investment. Affirmative answers to this question ranged from 87 percent in Romania to 56 percent in Ukraine (see the last row of responses in Ta- D. An Index of the Insecurity ble 1). of Property Rights Overall, Table 1 shows that the five countries fall into two distinct groups-the three East Table 2 shows the correlations among our Europeancountries have relatively more secure property-rights measures for individual firms in all five countries. Not surprisingly, most are highly correlated. Extralegal payments for 6 We asked entrepreneursto reporttaxes as a percent of services and extralegal payments for licenses total sales. Firms in Eastern Europe and the former Soviet have a correlation coefficient of 0.66, while Union routinely underreportsales to avoid taxes and extor- the correlation between for tion et In payments "protec- (Johnson al., 1997). separatequestions, entrepre- tion" and either of these measures is neurs indicatedthat the percentageof sales hidden by firms larger in their industryis about 41 percent in Ukraine, 29 percent than 0.50. in Russia, and around6 percent in the other three countries. For our regression analysis, we combine the It may be that some entrepreneursreported taxes and profits three main as a of official sales rather than total sales. If property-rightsquestions-extrale- percent so, for licenses, then the tax burden and profit rates will be overstated, gal payments extralegal payments especially for Russia and Ukraine.But this should not affect for services, and paying for protection-into an our analysis of reinvestmentrates. additive index of property-rightsinsecurity for 1340 THEAMERICAN ECONOMIC REVIEW DECEMBER2002

TABLE2-CORRELATIONS AMONG VARIOUS INDICATORS FOR THE SECURITY OF PROPERTYRIGHTS

Payments for Payments for Payments for Index of Indicator services licenses protection propertyrights Firms make extralegal payments 0.66 for licenses (1,105, <0.01) Firms make payments for 0.52 0.54 protection (1,109, <0.01) (1,122, <0.01) Index of propertyrights 0.87 0.87 0.79 insecurity (1,099, <0.01) (1,099, <0.01) (1,099, <0.01) Courts cannot enforce contracts 0.1 0.11 0.22 0.15 (1,117, <0.01) (1,117, <0.01) (1,163, <0.01) (1,099, <0.01) Tax payments as a percentage 0.24 0.24 0.31 0.29 of sales for firms in industry (996, <0.01) (1,007, <0.01) (1,042, <0.01) (981, <0.01) Firms make unofficial payments 0.29 0.27 0.36 0.38 for ongoing registration (775, <0.01) (783, <0.01) (789, <0.01) (769, <0.01) Firms make unofficial payments 0.33 0.32 0.29 0.39 for fire/sanitaryinspection (840, <0.01) (843, <0.01) (857, <0.01) (830, <0.01) Firms make unofficial payments 0.36 0.34 0.32 0.43 for tax inspection (816, <0.01) (818, <0.01) (828, <0.01) (806, <0.01) Firm had loan before 1996 0.15 0.16 0.26 0.20 (1,072, <0.01) (1,082, <0.01) (1,115, <0.01) (1,055, <0.01) Firm has collateral -0.05 -0.03 -0.03 -0.05 (997, 0.13) (1,006, 0.28) (1,040, 0.28) (980, 0.09)

Notes: Correlationsare for all five countriescombined. The numberof observationsand significance level are in parentheses. each firm. The property-rightsindex we con- as a monopoly extortionist. If they compete structranges from 0 to 3, with 3 indicatingthat with each other, however, their total bribes will, the entrepreneurssaid all three payments were by prisoners'-dilemmalogic, exceed the bribe- common, 2 indicatingan affirmativeresponse to maximizing amount. The data show the effects two of the payments, 1 indicatingan affirmative of corruptionare additive, as discussed below response to one of the payments, and 0 indicat- (Section III), suggesting the rate of total bribes ing an affirmativeresponse to none. A higher might exceed what even the bribe-takerswould value of this index therefore represents less want. secure propertyrights. A belief that courts are not effective in en- An alternativeindex for propertyrights inse- forcing contracts is positively correlated with curity would equal one if firms make any one the corruptionmeasures, but the correlationis of the three types of payments and zero other- smaller. The correlationbetween courts and the wise. Either of these indexes can be justified index for insecurity of property rights is 0.15. theoretically. While this correlationmay seem low, it proba- The additive index is appropriateif respond- bly reflects the fact that believing the courts can ing affirmatively to more than one question enforce private contractsis quite different from indicates a greater level of insecurity than re- trustingthe governmentnot to expropriateyour sponding affirmatively to only one question. property. With regard to courts, the issue is The either/orindex is appropriateif one bribe- presumably whether judges are incompetent taker has the same effect as multiple bribe- or corruptible.With regardto security of prop- takers. According to the model of Shleifer and erty rights, the issue is to what extent members Vishny (1993), if two or more corruptbureau- of the executive feel constrainedto act respon- crats coordinate so as to maximize their total sibly and within the law. Even in environ- bribes, they will extract the same total amount ments where the executive is quite predatory VOL.92 NO. 5 JOHNSONET AL.: PROPERTYRIGHTS AND FINANCE 1341

TABLE 2-Continued.

Courts Taxes as a Bribes Bribes Bribes Loan before enforce percentage of sales registration fire/sanitary taxes 1996

0.11 (1,130, <0.01) 0.06 0.19 (805, 0.09) (756, <0.01) 0.03 0.17 0.49 (881, 0.40) (820, <0.01) (757, <0.01) 0.01 0.16 0.47 0.63 (843, 0.74) (789, <0.01) (734, <0.01) (811, <0.01) 0.06 0.15 0.16 0.16 0.08 (1,302, 0.02) (1,094, <0.01) (739, <0.01) (863, 0.01) (828, 0.02) -0.05 -0.04 0.08 0.03 0.04 0.30 (1,217, 0.08) (1,018, 0.25) (739, 0.03) (805, 0.37) (769, 0.29) (1,189, <0.01)

(Russia, for example), we see considerable will- ported after-tax profits are much higher in Rus- ingness on the part of entrepreneurs to rely on sia (21 percent) and Ukraine (18 percent), courts for the enforcement of contracts with where there has been the least progress with other entrepreneurs. economic reform, than in Poland (10 percent), In the main regressions, we use the effective- where the transition has progressed much fur- ness of courts alongside the index of prop- ther. Romania is in between (13 percent). Slo- erty rights. We also run regressions using vakia appears to be the outlier in this pattern, the components of the index separately. Finally, with profit rates much lower than in any of the an alternative index of property rights that other countries (6 percent).7 Entrepreneurs were we use in the regressions, ranging from 0 also asked to estimate profit rates after taxes in to 4, adds to the first index the measure of their industry, as a percent of sales. As we the ineffectiveness of courts (that is, we add would expect, the estimates of industry profits one if the entrepreneur thinks the courts can- and the firm's own profit rates are highly cor- not be used to enforce contracts and zero related (p = 0.41). At the country level, these otherwise). estimates, also shown in Table 3 (third line),

E. Reinvestment of Profits 7 Responses to questions about the entrepreneur'sown Initial entrants in transition economies often profits were provided in categories.Appendix B (at (www. earn large profits, which decline over time as aeaweb.org/aer))explains how the numbersin Table 3 were new firms enter (McMillan, 1997). Our data are calculated from these responses. The profit data are also in B to data consistent with this at the level. Table compared Appendix from the National Survey country of Small Business Finance, conductedin 1993 in the United 3 (second line) shows the firms' average profit States among similarly sized firms (Federal Reserve Board after taxes as a percent of sales in 1996. Re- of Governors, 1994). 1342 THEAMERICAN ECONOMIC REVIEW DECEMBER2002

TABLE 3-USE OF INTERNAL FINANCE

Measure Poland Slovakia Romania Russia Ukraine Number of firms 303 308 321 269 270 1996 profit after taxes, percentage of annual sales 9.9 5.7 12.9 20.6 18.0 Estimated industryprofit rate after taxes 11.1 10.0 13.4 17.6 14.3 Profit reinvestment,percentage of profits after taxes 52.6 42.3 52.8 38.8 29.6 Unreinvestedprofit, percentageof annual sales 4.8 3.6 5.7 11.7 12.3 Profit after taxes in first year of operation,for firms started in: 1989-1991 9.9 2.4 8.3 4.3 7.6 1992-1993 4.2 -0.2 7.8 4.5 6.6 1994-1996 2.1 -1.1 6.7 3.9 7.4

Start-ups: Number of firms 237 238 281 128 82 1996 profit after taxes, percentage of annual sales 10.5 6.0 13.4 20.8 19.0 Estimatedindustry profit rate after taxes 11.3 9.8 13.8 18.3 14.9 Profit reinvestment,percentage of profits after taxes 53.6 44.8 54.2 37.5 29.4 Unreinvestedprofit, percentage of annual sales 4.8 3.7 5.8 12.2 12.9

Spin-offs: Number of firms 66 70 40 123 183 1996 profit after taxes, percentage of annual sales 7.7 4.6 9.6 20.3 17.7 Estimatedindustry profit rate after taxes 10.1 10.6 10.5 17.1 14.0 Profit reinvestment,percentage of profits after taxes 49.0 33.7 42.5 39.4 29.6 Unreinvestedprofit, percentageof annual sales 5.0 3.5 5.0 11.2 12.1

Notes: Profit reinvestment as a percentage of profits excludes firms with zero or negative profits.In orderto make the data more comparableto the externalfinance data shown in Table 4, we assume that firms with negative or zero profits reinvest zero percent of sales and have unreinvestedprofits of zero percent of sales. Profit reinvestmentas a percentage of annual sales is calculatedby multiplying profits as a percentageof sales by profit reinvestmentas a percentageof profits. Unreinvestedprofits as a percentageof sales is calculated as profits as a percentage of sales times one minus profit reinvestment as a percentage of profits. See Appendix B at (www.aeaweb.org/aer)for more details on the calculations. indicate a similarpattern, but with less variation These profit rates are high relative to the across countries.8 available data for large firms in these countries. The best data are for Poland. According to the most recent data in Worldscope, average profit/ 8 Throughout, we use the reported rate of profit as a proxy for the firm's cash flow available for reinvestment.In reality, profits and cash flow may diverge for a number of on depreciationrecorded by the firms is not available from reasons, in particulardepreciation. However, information the survey. VOL. 92 NO. 5 JOHNSONET AL.: PROPERTYRIGHTS AND FINANCE 1343 sales for Polish firmsfrom all industriesis about respectively. Those enteringfive years later had 5 percent.9However, this average hides consid- average profit rates of 3.9 percent and 7.4 per- erable disparity.In particular,large firms oper- cent of sales, respectively. ating in sectors with substantial barriers to We also asked what fraction of 1996 profits entry, for example due to regulations,had prof- after taxes were reinvested in the firm. Polish its as a percent of sales that were comparableto and Romanianfirms reinvestedthe highest frac- the small firms in our sample. tion, slightly more than 50 percent on average These dataare consistentwith the idea thatthe (fourth line of Table 3). Reinvestment rates insecurityof propertyrights may deterentry into average about 40 percent in Slovakia and Rus- the small-firm sector (Djankov et al., 2002). In sia, and 30 percent in Ukraine."1We also com- addition,these partiallyreformed post-communist pute the profits entrepreneurschoose not to economies offer entrepreneurslucrative unfilled reinvest in their businesses (fifth line of Table niches. There is also presumablya survivorship 3). Unreinvestedprofits as a percentageof sales bias for small firms. We are measuringonly the are highest in Russia and Ukraine, where they firms that have not gone out of business (al- exceed 10 percent of sales, and lower in Roma- though arguably this should overstate the im- nia (5.9 percent of sales), Poland (5.2 percent), portance of external finance and understatethe and Slovakia (5.1 percent). In Russia and importance of expropriationrisk). Large firms Ukraine, where property rights are the least may not show such a bias because, in these secure, entrepreneursare on average the most countries, the governmentmay provide implicit reluctantto reinvest their profits. subsidies that prevent them from going out of Table 3 also divides these data into start-ups business. and spin-offs. Start-upsare more profitablethan Entrepreneursalso reportedprofits as a per- spin-offs in all five countries,though the differ- centage of sales duringtheir firm's firstfull year ence is much greater in Poland and Romania of operation.We show in Table 3 (see the sixth, than in the other three countries. Start-upsrein- seventh, and eighth lines) the average first-year vest a greater proportion of their profits than profitrates by countryand by year in which the spin-offs in Poland, Slovakia, and Romania. firms began operation.In Poland, firms started between 1989 and 1991, just after the reforms, F. External Finance reportedearning an averageof 9.9 percentof sales duringtheir first year of operation.First-year prof- The surveycontains three indications of having its were markedlylower-4.2 percentof sales- received bank credit.First, we asked firms what for firms startedin 1992 or 1993, and lower still their sources of start-upcapital were. A minority for the most recentgroup of entrants(2.1 percent of firms,ranging from 6.6 percentof Polish firms of sales for firms entering between 1994 and to 27 percentof Slovakianfirms, obtained part of 1996). These data are consistentwith our expec- their start-upcapital from bank loans (see the tationthat entryleads to lower profitrates. secondline of Table4). Second,we askedwhether A downward trend over time in profit rates they obtained a loan at some point in the past. for entrantsin their first year of business is also Over 90 percentof Russianfirms and 79 percent evident in Slovakia and Romania, though the of Ukrainianfirms say they have receivedloans at rate of fall is not as steep as in Poland. There is some time (thirdline of Table 4). Only half of even less difference across time in the profit Slovakianand Romanianfirms have had a loan at rates of start-up firms in either Russia or Ukraine.Firms enteringbetween 1989 and 1991 had rates of 4.3 average first-yearprofit percent 10T-tests the rate in the and 7.6 of sales in Russia and comparing profit early period percent Ukraine, (1990-1992) with the profit rate in the last period (1994- 1996) indicate that the drop in first-year profit rates is at the level in Poland (t = 3.38) and 9 significant 1-percent Worldscope also has data for Russia and Slovakia, in Slovakia (t = 2.96), but not in Romania (t = 0.99), although this is available for fewer firms. The average Russia (t = 0.30), or Ukraine (t = 0.61). profit-sales ratio in Russia for 1999 is 7.11 percent, al- l See Appendix B at (www.aeaweb.org/aer)for the de- though firms with substantial market power show higher tails of these calculations as well as some caveats to their profit rates. Almost all the Slovak firms show losses. interpretation. 1344 THE AMERICANECONOMIC REVIEW DECEMBER2002

TABLE4-SOURCES OF EXTERNAL FINANCE

Measure Poland Slovakia Romania Russia UkraineII Number of firms 303 308 321 269 270 Percentageof firms with bank loans at start-up 6.6 27.0 9.7 15.2 12.2 Percentage of firms with bank loans ever 70.0 51.0 49.8 92.4 79.0 Percentageof firms with bank loans in 1996 48.8 27.6 24.1 17.0 13.8 Percentageof firms with collateral at the time of interview 95.7 80.8 94.4 87.2 75.5 Average 1996 loan, percentage of annual sales All firms (no loan = 0 percent) 2.3 2.5 1.7 2.3 0.8 Firms with loans 4.8 10.6 7.3 24.7 13.4 Accounts payable, percentage of annual sales All firms 2.7 3.4 NA 0.1 0.7 Firms with 1996 loans 2.5 4.2 NA 0.04 0.3

Start-ups: Number of firms 237 238 281 128 82 Percentageof firms with bank loans: ever 72.2 42.4 46.6 95.4 81.9 in 1996 50.6 22.7 20.8 12.0 11.1 Average 1996 loan, percentage of annual sales (no loan = 0 percent) 2.5 2.0 1.7 1.7 1.3 Accounts payable, percentage of annual sales 2.5 3.2 NA 0.1 0.9

Spin-offs: Number of firms 66 70 40 123 183 Percentageof firms with bank loans: ever 62.1 80.0 72.5 89.4 78.5 in 1996 42.4 44.3 47.5 21.5 14.6 Average 1996 loan, percentage of annual sales (no loan = 0 percent) 1.5 4.4 2.2 2.8 0.6 Accounts payable, percentage of annual sales 3.2 4.0 NA 0.1 0.7

Note: For details of variable definitions, see Section II of the text. some point in the life of the enterprise.Third, we Although fewer firms in Russia and Ukraine asked whetherthey obtainedloans from banksin received loans than in the other three countries, 1996, the year before the survey. The greatest the average loan size was larger there. Loans percentageof currentborrowers was in Poland, average less than 5 percent of a borrower's where just under half (49 percent)of firms said hadloans in 1996. Abouta of firmsin they quarter broad was 37.5 of GDP in 28.9 Slovakia and Romania said had loans in money percent Poland, they percent in Romania, 13.1 percent in Russia, 71 percent in 1996, with lower percentagesin Russia (17 per- Slovakia, and 11.16 percent in Ukraine (EBRD, 1997). The cent) and Ukraine(14 percent).12 real money supply in Russia and Ukraine fell dramatically between 1991 and 1996, which partiallyaccounts for credit becomingharder to get in these two countries(EBRD, 1997). 12 There are no reliable comparabledata on credit to the Of course, our sample has quite different characteristics private sector across transition countries, but the ratio of from the large state or privatized firms that receive (or do broad money to GDP provides a rough indicator.In 1996, not receive) most of the credit in these transitioneconomies. VOL. 92 NO. 5 JOHNSONET AL.: PROPERTYRIGHTS AND FINANCE 1345 annual sales in Poland, more than 10 percent of An alternative source of external funds is annual sales in Slovakia and Ukraine, and al- credit received from other firms. We measure most 25 percent of annual sales in Russia. As a trade credit by the level of accounts payable result, the variationacross countries in the total reportedby firms (the eighth and ninth rows of funds provided by banks is small. Including Table 4). Trade credit is almost nonexistent in firms who do not receive loans, Slovakian firms Russia (0.1 percent of annual sales) and is low received the most credit in 1996, amountingto in Ukraine (0.7 percent), but is an important 2.5 percent of annual sales. In Poland and Rus- source of capital in Poland (2.7 percent) and sia, finance provided by banks represents 2.3 Slovakia (3.4 percent). Credit received from percent of annualsales, in Romania 1.7 percent, suppliers is comparable in size to credit re- and in Ukraine 0.8 percent. ceived from banks in Poland, Slovakia, and Even though Polish firms are much more Ukraine. Reliable data for this question are not likely to have obtaineda loan in 1996 than firms available for Romania.15 (For more on trade in the other four countries, the Polish credit credit, see Johnson et al., 2002, where we use markets are underdeveloped by western stan- trade credit as a measure of a firm's trust in its dards. In the United States, small and medium- trading partner.) sized firms are surveyed periodically by the Profit reinvestment is a larger source of in- Federal Reserve Board of Governors (FRBG). vestment capital than either bank funds or trade Among the 344 firms in the 1993 National Sur- credit in all five countries, as is seen by com- vey of Small Business Finances (NSSBF) that paringTables 3 and 4 (except that tradecredit is are manufacturerswith between ten and 270 bigger than profit reinvestmentin Slovakia). In employees, 84 percentreported having a loan at Poland, firms internally generate funds for in- the time of the survey. This level is substantially vestment averaging 9.9 percent of sales (Table higher than the 49 percentrate in Poland. More- 3, second line). Bank loans average 2.3 percent over, loan amounts were 16 percent of sales of sales for the whole sample and 4.8 percentof among the group of small U.S. manufacturers, sales for firms receiving loans in Poland (Table several times the levels in any of the countries 4, sixth and seventh lines). In contrast,we esti- we surveyed.13 mate that firms in Russia and Ukraine have Compared to a developed capital market, unreinvested profits averaging 12 percent of loans in our five countries are also much more sales (Table 3, fifth line). This suggests the likely to require collateral. While 20 percent of Russian and Ukrainian firms could have used bank loans obtainedby U.S. firms were without their unreinvestedprofits in productiveprojects collateral,less than 2 percent of the firms in our (earning high rates of return), but for some sample obtaining loans did so without collat- reason they chose not to. The potentialfor using eral. A lack of collateral, however, is not the retained earnings as a source of capital is seen main reason for less borrowing in our sample from the fact that, in all five countries, the than in the United States. More than 75 percent capital available from unreinvestedprofits ex- of firmsin each of the countries-and more than ceeds the capital provided by banks (compare 90 percent of firms in Poland and Romania- the fifth row in Table 3 with the sixth row in say they were able to offer collateral to banks. Table 4). At least in the minds of entrepreneurs,a lack of Table 2 shows correlationsbetween the var- collateral does not aDear to be a major con- ious measures of property rights on the one strainton borrowing. hand and variablesindicating access to credit on

13When lines of credit are excluded, loans were 5.8 likely to have collateral, then the numbersin Table 2 may percent of sales among the small manufacturersin the overstatethe availabilityof collateralin Russia and Ukraine. NSSBF survey. Both of these averages assign a value of Still, as a lower bound (taking all nonrespondentsas having zero to firms without loans. (See Appendix B, at (www. no collateral), the survey indicates that more than half of aeaweb.org/aer),for more discussion of the NSSBF data.) firms in Russia (53 percent) and Ukraine (57 percent) are 14 While the response rate to the collateral question was able to offer collateral. more than 99 percent in Romania, it was only 76 percent in 15Apparently respondents misunderstood what we were Ukraineand 61 percentin Russia. If nonrespondentsare less asking.This questionmay not have been translatedproperly. 1346 THEAMERICAN ECONOMIC REVIEW DECEMBER2002 the other. We would be concerned if access to dustries are faced with more investment oppor- capital is strongly correlated with security of tunities than are firms in declining industries. propertyrights, because that would make it dif- Production in a capital-intensive industry also ficult to disentangle access to credit from secu- necessitateshigher investmentlevels. More able rity of property. We measure the ability to entrepreneurswill find investments more prof- access credit in 1996 with two variables-an itable in any industry.All of these factors affect indication that the firm received a bank loan at the profitabilityof potential investments. some point before 1996, and an indication that Investmentdemand also depends on the abil- the firm has collateralthat can be used to obtain ity of entrepreneursto retain any profits they a loan. The correlationsindicate that firms with make. Entrepreneursmay be unwilling to invest less secure property rights are more likely to when returnsare insecure. The effect of entre- have had a loan before 1996. Firms with less preneurs' perceptions of propertyrights on in- secure property rights are less likely to have vestment decisions is the main issue we want to collateral to offer banks, but the correlationis explore. Suppose that the firm makes its invest- small and is significant only for the index of ment and borrowing decisions simultaneously, insecurityand for a lack of confidence in courts. and extortion,if it occurs, comes after any prof- Hence, we are not concernedthat our measures its are realized, so that firm's demand for in- of insecure property rights are proxying for a vestable funds is given by lack of access to credit.16 = I , G. Assessment (1) Id (T, s,, rL)

The cross-country evidence suggests that where rr represents expected (pre-extortion) propertyrights are an importantdeterminant of profits, s representsthe amount of those profits investment by entrepreneurs.In Poland, where that will be extractedby corruptbureaucrats or property rights are relatively secure, we find criminals, rt representsthe interest rate the en- high rates of reinvestment.In contrast,in Russia trepreneurcan earnby investing the firm's prof- and Ukraine, where property rights are weak, its outside the firm and rL the interest rate the we find that the level of unreinvestedprofits is entrepreneurpays on borrowed money. Invest- high; entrepreneursthere have the ability to do able funds may be obtained either internally much more investment than they actually do. from retained earnings or externally through The next question is whether these results hold credit markets.Thus: in the firm-level data when we control for char- acteristics of the firm and entrepreneur. (2) Id = R + Ld

II. A Framework for Investment Decisions where R representsreinvested earnings and Ld is the firm's demand for loans. This section lays out a simple frameworkthat The usual assumptionis that the value to the explains and defends the assumptions needed firm of internalfunds, rT,is less than the cost to for our regression analysis. A firm's desired the firm of external funds, rL. The wedge be- investment level is a function of both industry tween the two interest rates arises because en- and firm-specific factors. Firms in growing in- trepreneurshave better informationabout their prospects than outside lenders or investors. Lenders demand a to offset their in- 16 premium The correlationsbetween propertyrights and access to formational The difference be- credit are driven differences across countries. disadvantage. primarilyby tween r' and rLcreates a orderin which When Poland, Slovakia, and Romania are separatedfrom pecking Russia and Ukraine, insecure propertyrights are positively internal funds are exhausted first before exter- correlated with a lack of collateral. However, the correla- nal funds are obtained (Stewart C. Myers and tions are low, all below 0.11, and there is no correlation NicholasS. Majluf,1984; Lakshmi Shyam-Sunder between security of propertyrights and having had a loan and This idea was before 1996. In Russian and Ukraine,firms with less secure Myers, 1999). developed propertyrights are more likely to have collateralto offer and from the experience of firms in the United to have had a loan before 1996. States. The wedge between the value of internal VOL. 92 NO. 5 JOHNSONET AL.: PROPERTYRIGHTS AND FINANCE 1347 funds and the cost of external funds is likely to mate, relating the firm's willingness to reinvest be larger in transitioncountries than in devel- its profitsto its expected profitsand the security oped market economies because information of its propertyrights: sources are missing and investment uncertain- ties are much greater in transition countries. Informationasymmetries are thereforelikely to (4) R = I(rr, s, r') if Id< Ei be more severe. R if Id > Firms in transition economies have another =Ei Ei. reason to prefer internal financing in addition to borrower/lender information asymmetries. In our data, we will use explicit measures of Tr External financing makes it hard for firms to and s. Differences in rI across firms in the hide their activities from tax collectors or the sample will be subsumed in country/industry mafia. The effective cost of external finance control variables. in Russia is increased, according to Anna Mey- If the assumption that investment of inter- endorff (1998), by the fact that firms that apply nally generated funds is independentof access for a bank loan are more likely to have to pay to external funds were invalid, then investment their taxes. According to Richard Lotspeich of internaland external funds would need to be (1996), firms are reluctantto disclose informa- examined simultaneously. There are (at least) tion to banks for fear it will be leaked to the three reasons that investment of internal funds mafia. Given these conditions, the assumption might depend on access to externalfunds. First, that the value of internal funds is less than the rL may not be higher than rT if loans are sub- cost of externalfunds is a reasonableone to make sidized by the government.This does not appear in examiningthe investmentdecisions of firms. to be the case in our data. Subsidies were most The difference in cost of internaland external importantin loans to state-owned firms. There funds leads to a discontinuity between the in- are no state-ownedfirms in our sample. Only in vestment of internal funds and the decision to Romania do we find that interest rates paid by seek external funds. Investment projects must firms spun off from state-ownedenterprises are have an expected return (after extortion and lower than those paid by de novo start-ups.In adjusted for risk) comparableto rI to be prof- the remainingcountries, there are no significant itable when financed by internal funds, but a differences in loan rates between the two groups return comparableto rL to be profitable when of firms. Moreover, across the sample, loans financedby external funds. As a result, a firm's given by state banks have higher interest rates decision to invest internally generated funds is than loans given by private banks. In Poland made independentlyof a decision to seek exter- and Slovakia, where loans are equally divided nal finance. This allows us to estimate econo- between state and private banks, interest rates metrically an equation for reinvestment of are nearly the same, with rates from state banks profits independentof the demand for external very slightly higher than rates from private finance. banks. We represent the pecking-order hypothesis Second, entrepreneurs for whom property by supposingthat firm i has a maximumamount rights are insecure may prefer to invest bank of money that it is willing to reinvest out of its funds in their businesses and to divert internally currentprofits, Ei; this might be the total current generated funds to more secure accounts. This profit, or it might be strictly less than that. We implies that firms receiving loans should invest, assume Ei depends on entrepreneur-specific on average, a lower proportion of their own characteristics.Then the pecking-orderhypoth- profits than firms without loans. The data sug- esis implies: gest this is not the case. Among the most prof- itable firms (those with profits 10 percent or (3) Id = R if Id < Ei more of sales) who are investing less than half of their profits, loans are infrequent.Only 64 of Id = Ei + Ld if Id > Ei. 476 (13 percent)of these firmsreceived loans in 1996. On the other hand, 104 of the 259 (40 This gives us the main equation we will esti- percent)firms investing more than 75 percentof 1348 THEAMERICAN ECONOMIC REVIEW DECEMBER 2002

TABLE5-REINVESTMENT RATES, FIRMS WITH AND dependentof access to external finance appears WITHOUTLOANS to be reasonable for our data. In the next sec- tion, we examine the determinantsof the firm's Percentageof firms decision to reinvest from its profits [equation Firms with Firms without (4)]. The main hypothesis is that firms reinvest Reinvestmentratea loans in 1996 loans in 1996 less if they perceive their propertyrights to be 0-25 percent 26.0 33.0 more insecure. 26-49 percent 21.0 31.5 50-75 21.3 18.2 percent III. Determinants of Profit Reinvestment 76-100 percent 31.7 17.4

a Percentageof after-taxprofits. Security of property rights is positively correlated with profit reinvestment rates at the country level, as we saw in Section I. Rein- vestment rates are highest in Poland and their profits received loans.17 The survey does Romania, where extralegal payments and pay- not indicate whether a loan received in 1996 ments for protection are lowest and the reli- representednew capital, or a rollover of a loan ability of the courts is highest. Reinvestment from previous years. But we would expect that rates are lowest in Ukraine and Russia, where firms investing most of their profits are both extralegal payments are highest and courts more likely to roll over existing loans and more less effective. Reinvestment rates are af- likely to take out new loans. In eithercase, firms fected, however, by factors other than prop- that are investing aggressively will be more erty rights. likely to have a loan in 1996, as the data suggest. A. Basic Specification Finally, investment may be lumpy, with the minimal investment larger than retained earn- In this subsection, we estimate the reinvest- ings can accommodate.Given the level of tech- ment-demandequation (4), with the percentage nology used by small-scale manufacturersin of its profits a firm reinvests as the dependent these countries, however, it seems unlikely that variable and our property-rightsindices as in- investmentsare lumpy.Moreover, Table 5 shows dependent variables. Our data on reinvestment that 35 percent of firms without loans in 1996 rates are categoricalrather than continuous,and reinvested half or more of their profits, indicat- hence we use ordered probit regressions (al- ing that the lack of external finance does not though we have checked the robustness of our precludeinternally funded investment.(By com- results using alternative specifications). We parison,53 percent of firms with loans in 1996 control for factors affecting investmentdemand invested half or more of their profits.) Further other than property rights: the industry profit evidence on this is discussed in Section III, rate (as a proxy for expected investment oppor- where we use a firm's ability to offer collateral tunities more generally),18the age of the firm, and loans prior to 1996 as a measure of access access to external finance (represented by to loans in the 1996 reinvestment equation. If whether the firm had collateralizable assets), investments are lumpy then reinvestment entrepreneurcharacteristics, and other industry should be positively associated with collateral; effects. we find no significant interaction. Thus, examining reinvestment of profits in- 8 We do not use the firm's own profit rate due to concern about reverse causation: higher investment levels 17 Because of the categorical responses, we cannot de- might lead to higher rates of profits. Given our belief that termine how many firms obtained new loans and invested the manager's estimate of industry conditions is based on more than 100 percentof theirprofits, though it is likely that his own experience, use of industry profits does not com- some did. Just over a fifth of the firms reportedinvesting pletely eliminate endogeneity concerns. However, none of more than 75 percent of profits, the highest reinvestment the results we report are altered if we use the firm's profit category. In Poland, 35 percent of firms reportedinvesting rate during its first year of operation, or exclude all mea- at least 75 percent of profits. sures of profits. VOL. 92 NO. 5 JOHNSONET AL.: PROPERTYRIGHTS AND FINANCE 1349

TABLE6-ORDERED PROBITS FOR REINVESTMENT RATE IN 1996

Variable (1) (2) (3) (4) (5) (6) (7) (8) (9) Index for perceived insecurity of -0.17 -0.12 -0.12 -0.18 -0.0003 -0.18 -0.17 propertyrights (5.51) (3.39) (1.97) (2.83) (0.01) (2.87) (2.88) Dummy for believing courts -0.18 -0.18 -0.15 -0.11 -0.16 -0.45 -0.23 ineffective (2.01) (1.85) (1.31) (0.47) (1.32) (1.95) (1.85) Index for perceived insecurity of -0.17 propertyrights including (2.93) courts (four-elementindex) Estimated industryprofit rate 0.005 0.004 0.01 -0.02 0.01 0.01 -0.07 0.01 (1.13) (0.91) (1.80) (0.97) (1.81) (1.86) (1.55) (1.90) Log of firm age -0.25 -0.30 -0.25 -0.77 -0.25 -0.25 -0.35 -0.33 (3.34) (3.73) (2.35) (3.51) (2.36) (2.40) (1.22) (2.69) Dummy for being a start-up 0.30 0.35 -0.04 (2.80) (2.73) (0.15) Tax payments as a percentage of -0.01 -0.01 -0.004 -0.02 -0.004 -0.003 -0.002 sales (1.69) (1.68) (0.92) (1.50) (0.93) (0.86) (0.43) Dummy for collateral to offer -0.11 bank (0.64) Dummy for obtaining loan prior 0.14 to 1996 (1.57) Industrycontrols no yes yes yes yes yes yes yes yes Country controls no no yes yes yes yes yes yes yes Manager characteristicsincluded in regression no no yes yes yes yes yes yes yes Number of observations: 815 815 815 619 196 619 574 116 559 Chi-square: 30.3 236.2 570.4 722.9 28.3 314.6 549.2 98.8 263.6 Probability: <0.001 <0.001 <0.001 <0.001 0.005 <0.001 <0.001 <0.001 <0.001

Notes: Regressions are orderedprobits. The dependentvariable is the firm's profit reinvestmentrate, divided into categories, with a higher value indicating more investment as a percentage of profits (see Appendix B at (www.aeaweb.org/aer)for details). Numbers in parenthesesare t-statistics based on robust standarderrors. Country and industrycontrols are interacted when both are included. Manager controls are manager's age and education level, an indicator that the manager was previously a high-level managerin a state-ownedenterprise and an indicatorthat the managerhas previous experience in the private sector. Columns (1)-(6) present results for all five countries from regressions including: 1) all firms, without country and industry controls; 2) all firms, without country controls; 3) all firms, with country controls; 4) start-upsonly; 5) spin-offs only; 6) the four-element alternativeindex of security of propertyrights. Column (7) presentsresults from regressionsincluding only start-upsin Poland, Slovakia, and Romania.Column (8) presents results using all firms in Russia and Ukraine only. Finally, column (9) gives results for start-upswith loan variables, using data from all five countries. (See text for additionaldetails.)

Table 6 presents the results of these regres- from the regression sample firms that had zero sions. There are six categories of responses to or negative profits in 1996, since we are unable the reinvestment question, increasing in the rate to measure their reinvestment rate. We also of reinvestment. A positive coefficient indicates exclude firms not operating at the start of the that an increase in the level of the independent variable increases the chance that a firm is in a reinvestment We exclude higher category.19 similar to those reported. We prefer the ordered probit because it does not require the assumptionthat investment rates are exactly at the midpoint of the categories specified 19We have run all of the regressionsusing ordinaryleast in the survey. (See Appendix B at (www.aeaweb.org/aer) squares, using the midpoint of the reinvestmentcategories, for the details on the six categories of responses to the with robust standard errors. The results are qualitatively reinvestmentquestion.) 1350 THE AMERICANECONOMIC REVIEW DECEMBER2002 year in 1996. Both start-ups and spin-offs are The additive index can be used to create four included in the initial regressions (first and sec- dummy variables,the firstrepresenting an index ond columns). Recall that the questions on value of zero, the second representingan index which the key independentvariables are based value of one, and so on. When dummies repre- refer to payments made by firms in the respon- senting index values of three, two, and one are dent's industry. To be conservative, we there- used in place of the index (with the value zero fore report t-values based on standard errors being the base group), the coefficients are adjusted for clustering for 44 industry/country -0.35, -0.26, and -0.14, respectively. These groups. Adjusting for clustering has only a results suggest that the effects of corruptionare small effect on the standarderrors in these re- additive, perhaps because multiple affirmative gressions and does not affect the significance responses indicate stronger convictions on the level for any of our results. part of the entrepreneur.Alternatively, the bet- The first column of Table 6 includes only the ter performanceof the additive index may indi- index that representsthe insecurity of property cate that those extracting payments do not rights. Greater insecurity is associated with coordinate their activities, consistent with the lower levels of profit reinvestment, and this model of Shleifer and Vishny (1993). effect is highly significant. The second column The first two regressions do not control for adds the variablethat indicates the entrepreneur country effects. Since much of the variance in thinks courts are ineffective. Ineffective courts security of property rights is across countries are associated with lower levels of investment rather than within country, this measures the as well, an effect significant at the 0.05 level. full effect of property rights. However, there Additional variables added in the second col- may be other factors that vary across countries umn control for the entrepreneur'sestimate of and affect the demandfor investment.If so, then the industryprofit rate20 and tax rate, the log age these other country-level effects will be corre- of the firm in years, a dummy variable indicat- lated with our measures of propertyrights. The ing that the firm is a start-upand nine industry regressions in columns (3)-(9) control for dif- dummy variables. Older firms invest a lower ferences in each industryin each country using proportionand start-upsa higher proportionof 39 industry/countrydummy variables. We in- theirprofits. Higher tax rates are associatedwith clude interacted controls because the factors lower investmentrates, though the effect is sig- affecting investment demand in the food indus- nificant at only the 0.10 level. The regression try in Poland, for example, may differ from also controls for the age of the firm and whether factors affecting investmentdemand in the food the firm is a start-up. industryin Russia. Neither the index of property Ourindex for the insecurityof propertyrights rights nor the reliability of the courts is much is additive. An alternativeindex would take a affected by the inclusion of the industry/country value of one if firms make any one of the three dummies, though the index is now significant types of payments, and a value of zero other- only at the 0.05 level.21 wise. Both indices have theoretical merit, but the additive index explains the data better. The B. AlternativeSpecifications either/orindex is significant (3 = -0.27, t = 3.48), but has a lower t-value and results in a The regressions in columns (3)-(9) also in- lower X2(60.8 vs. 65.4 with the additive index). clude a set of four variables measuring entre- preneur characteristics.These variablesmeasure the of and work ex- 20 age, years schooling, prior We use the entrepreneur'sestimate of industryprofits of the The two work rather than the firm's own because we believe the perience entrepreneur. profits variablesindicate whetherthe entre- formerare more likely to representthe expected profitsfrom experience new investments. Additionally, own profits may be deter- mined in part by reinvestment,creating endogeneity prob- lems. Nevertheless, when we rerunall of the regressions in 21 Because response rates were lower in Russia and Table 6 with own profits replacing industryprofits, we find Ukraine, only 14 percent of the observationsin the regres- that own profits are significant everywhere that industry sions are firms in those countries.This may explain why the profits are significant.The property-rightsindex and courts country controls have only a small impact on the property- results are not affected. rights variables. VOL. 92 NO. 5 JOHNSONET AL.: PROPERTYRIGHTS AND FINANCE 1351 preneurpreviously was a high-level managerin rights measures both have the expected sign in a state-owned enterpriseand whether the entre- the three EasternEuropean countries. The index preneurhad prior experience in the private sec- is significant at the 0.01 level; the significance tor. The coefficients of these controls for of the effectiveness of courts falls below the entrepreneurcharacteristics (not shown on Ta- 0.10 level. In Russia and Ukraine,the effective- ble 6) indicate that investment rates are higher ness of courts is significant.The index of prop- for younger entrepreneurs(3 = -0.01, t = erty rights is not included in this regression 2.77 in the third-columnspecification) and for because there is not enough variation in the entrepreneurswho were previously high-level index in the Russia/Ukrainesample to make the managers at state-owned enterprises (3 = results meaningful. (Only three of 116 firms in 0.24, t = 2.98 in the third-columnspecifica- the sample answer "no" to any of the three tion). Education and private sector experience questions in the index!) have no significant effect. The ordered probit coefficients represent We split the sample, in the fourth and fifth changes in the probabilities of being in each columns, into firms that are start-upsand those category of investment. Hence, giving an eco- that were spun off from a state enterprise.For nomic interpretationof their magnitude is dif- start-ups, the coefficients are similar to those ficult. To gain a better picture of the effect of obtainedfor the whole sample, though the mea- propertyrights on investment, we calculate the sure of courts is not significantat the 0.10 level. probability of being in each investment cate- The industrytax rate is not significantin either gory conditional on different values of the subsample. However, the entrepreneur'sesti- property-rightsindex. We use the regression matedprofit rate for the industryis significantat reportedin the sixth column of Table 6, using the 0.10 level among start-ups. Among spin- the four-elementsecurity index. The results are offs, no variable measuringproperty rights has shown in Table 7. The bottom row of the table any effect on investment. The industry profit shows the weighted average reinvestment rate ratehas the wrong sign and is insignificant.There for each value of the index, using the midpoint are significantdifferences between the behavior of each reinvestment category. Firms with the of spin-offs and start-ups,with the regressions most secure propertyrights (those with an index doing a better job explaining the behavior of value of zero) have an average predicted rein- start-ups.Given that most of the spin-offs un- vestment rate of 55.1 percent; those with the derwent downsizing after being privatized, least secure property rights have an average other factors may play an important role in predictedreinvestment rate of 33.5 percent.The determiningreinvestment rates for these firms. most insecure firms' investment is therefore39 For the regressionsin the sixth, seventh,and ninth percent lower than the investment of the most columns we limit the sample to start-upfirms. secure firms. The regression in the sixth column uses an In sum, the index of property rights has a alternativeindex of security of propertyrights. significanteffect on firms' investmentrates, es- This alternative index ranges from zero to pecially among de novo start-ups.We find only four-it adds one to the original index if the weak evidence that tax rates affect investment entrepreneurthinks courts are ineffective for demand. The lack of robustness in the tax ef- enforcing contracts.As with the original index, fects may reflect a lack of variance in taxes a higher value represents less secure property across firms, since statutorytax rates vary only rights. The four-elementindex has the expected across countries.Alternatively, perhaps it is the negative sign, and is significantat the 0.01 level. clandestine and unpredictablenature of the un- Last, we divide the sample by region, first official payments, ratherthan just the fact that considering investment among start-upsin Po- some profits will be taken, that discourages land, Slovakia, and Romania (the seventh col- firms from investing. umn), and then considering all firms in Russia and Ukraine (the eighth column). (The number C. Access to Credit of start-upswith nonmissing responses in Rus- sia and Ukraine is too small for us to use only Our frameworkassumes that the decision to start-upsin this regression.) The two property- invest internallygenerated funds is independent 1352 THEAMERICAN ECONOMIC REVIEW DECEMBER2002

TABLE7-PREDICTED PROFIT REINVESTMENT RATE FROM THE ORDERED PROBIT RESULTS INTABLE 6, COLUMN(6)

Percentageof firms in investment category Insecurity of property-rightsindexa Profit reinvestmentrate (percent) All firms 4 3 2 1 0 0 3.3 9.2 6.5 4.4 3.2 1.9 1-10 13.7 25.0 21.0 16.6 13.6 10.4 11-25 10.9 14.9 14.0 12.4 11.1 9.5 26-49 20.2 21.3 21.8 21.3 20.6 19.2 50-75 21.0 16.1 18.4 20.3 21.4 22.0 76-100 30.8 13.5 18.3 25.0 30.2 36.9

Weighted investment rate: 49.9 33.5 39.0 45.3 49.8 55.1

Notes: We calculate the probability of being in each investment category conditional on differentvalues of the property-rightsindex. We use the regressionreported in column (6) of Table 6, utilizing the four-elementsecurity index (i.e., including belief in the effectiveness of the courts). The last row of Table 7 shows the weighted average reinvestmentrate for each value of the index, using the midpoint of each reinvestmentcategory. a Scale for insecurity of property-rightsindex ranges from 0 (most secure) to 4 (least secure). of access to external funds. It is possible, how- to 1996 provide an additionalindication of cred- ever, for internaland externalfunds to comple- itworthiness.In most cases (69 percent) where ment one another. If investment projects are firms had loans prior to 1996 and in 1996 as lumpy, then firms may need outside finance in well, the firmobtained both loans from the same order to undertakeinvestment projects at all. In bank. Given that our sample is limited to firms this case, those not receiving loans would not with positive profits in 1996, we believe these invest internalfunds either.We cannotinclude a two variables are good indications of access to direct measure of whether the firm has a loan credit.23Neither has a significant effect on the because the latent variable-investment de- rate of reinvestment (ninth column of Table mand-determines (at least in part) both rein- 6). The inclusion of the instrumentsfor bank vestment of profits and demand for loans. finance has little impact on the magnitude or Instead, we test for the importanceof loans by significance of the coefficient on the index of including variables that are correlatedwith ac- property-rightsinsecurity. The variablemeasur- cess to finance but that we expect are uncorre- ing the reliability of courts is now significantat lated, or only weakly correlated,with investment the 0.10 level. demand.22We include two variables, one indi- In unreportedregressions available from the cating that the firm has collateralizableassets, authors, we pursued an alternative test for an and the other indicatingthe firmreceived a loan interactionbetween security of property rights priorto 1996. Both of these variablesare strongly and use of external credit. We included the correlated with receiving a loan in 1996. Col- index of insecurityas an independentvariable in lateral is necessary for access to loans. Only six a regressionwith the receipt of a loan in 1996 as of 310 firms reportingloans in 1996 said they the dependentvariable. We found that the index did not provide collateral.Loans obtainedprior of insecurity has no effect on the likelihood a firm obtained a loan in 1996. This provides additional evidence that less secure property 22 Because investment opportunitiesmay be correlated rights did not encourageentrepreneurs to invest across time within a firm, we had some concern that either of these variables might be partiallyendogenous to current 23 reinvestmentrates. Their insignificance in the reinvestment Our results are consistent with those found by Andrzej equationsuggests that endogeneity of our measuresthrough Bratkowskiet al. (2000), who find for a sample of new firms temporal correlation of investment rates is not a serious in the Czech Republic, Hungary,and Poland that loans are problem. significantly associated with collateral and past loans. VOL. 92 NO. 5 JOHNSONET AL: PROPERTYRIGHTS AND FINANCE 1353

TABLE8-ORDERED PROBITS FOR REINVESTMENT RATE IN 1996: ALLFIVE COUNTRIES, START-UPS ONLY

Dummy variables (1) (2) (3) (4) (5) (6) Firms make extralegal -0.42 payments for services (4.33) Firms make extralegal -0.11 payments for licenses (0.84) Firms make payments -0.34 for protection (1.60) Firms make unofficial -0.40 payments-ongoing (3.04) registration Firms make unofficial -0.31 payments-fire and (2.45) sanitaryinspections Firms make unofficial -0.27 payments-tax (1.76) inspection Courts cannot be used -0.16 -0.14 -0.13 -0.21 -0.14 -0.20 to enforce contracts (1.39) (1.20) (1.13) (1.65) (1.21) (1.63) Controls included industry/ industry/ industry/ industry/ industry/ industry/ country country country country country country Manager characteristics yes yes yes yes yes yes Number of 619 619 619 499 538 529 observations: Chi-square: 428.4 339.8 235.2 512.3 470.2 169.1 Probability: <0.001 <0.001 <0.001 <0.001 <0.001 <0.001

Notes: All regressions are orderedprobits. The dependentvariable is the level of investment, divided into categories, with a higher value indicating more investment as a percentage of profits (see Appendix B at (www.aeaweb.org/aer)for details). All regressionsalso include the entrepreneur'sestimate of the industry profit rate and the age of the firm. Numbers in parentheses are t-statistics based on robust standarderrors. from bank funds rather than from their own the elements of the index, extralegal payments profits. In the regressions, both the availability for government services clearly have the most of collateral and receipt of loans prior to 1996 significant effect (the first column). Payments had large and significant effects on the likeli- for protection fall just below the 0.10 level of hood a firm received credit in 1996, suggesting significance, and paymentsfor licenses is insig- that banks' willingness to lend is an important nificant as well (the third and second columns, determinantof credit availability. The level of respectively). unreinvestedprofits also has a large and signif- The fourth, fifth, and sixth columns of Table icant effect on the likelihood a firm received 8 replace the components of our index with the credit. The last result suggests an indirect link responses to questions about bribes paid for between property rights and credit: firms per- specific services. All three types of bribes- ceiving propertyrights as insecure invest less, paymentsfor ongoing registration,payments for and so demand less credit. Low levels of ob- fire/sanitaryinspection, and payments for tax served credit may result from a lack of demand inspection-are negatively and significantlyas- as well as a lack of supply. sociated with reinvestment levels. The sample size in these regressions varies and is smaller D. Further Robustness Checks than the other regressions because the response rate for these questions is generally lower. The Table 8 reportsregressions that use the com- variable representingtrust in the courts has the ponents of the index one at a time. We use the correct sign in all of the regressionsreported on sample of start-upsin these regressions.Among Table 8, though it is insignificantin all but one 1354 THEAMERICAN ECONOMIC REVIEW DECEMBER2002 of the specifications (see the last row of coeffi- that were deterredfrom entering. Both failure cients in each column). and the decision not to enter presumablyreflect Our findings are also robust to alternative the insecurity of property rights. Additionally, ways of defining the dependentvariable. Ordi- because our regressionslook at the determinants nary least-squares regressions using the mid- of firms' marginalinvestment decisions in their point of the investment categories (i.e., five for current lines of activity, we cannot pick up the 1-10 percent category, eighteen for the possible intersectoraldistortions. For example, 11-25 percent category, and so on) produces certain industries might be especially suscepti- very similar results. Probits for over/under75 ble to extortion;the insecurityof propertyrights percent reinvestment or over/under 50 percent might cause entrepreneursto shun those indus- reinvestmentalso produce similar findings. tries. If capital is more susceptible to extortion than labor, weak propertyrights may also cause E. Caveats to Our Interpretation production to be inefficiently labor intensive. We have no way of determiningthe net effect of In the regressions, we treatproperty rights as the biases of opposite directions. exogenous to the investment decisions of our In summary:Weak perceived propertyrights firms. There are at least two reasons why this have a consistentlynegative effect on reinvest- may not be a valid assumption. First, higher ment in our regressions.The index of property investmentrates may lead to more secure prop- rights is significantin all subsamplesapart from erty rights, as in the model of Besley (1995). spin-offs.The measureof trustin courtshas a less While it is plausible that very large firms in robusteffect on reinvestment,but is significantfor post-communisttransition countries may endo- the full sample.The availabilityof collateralis not genously create property rights by becoming correlatedwith the reinvestmentof profits. "too big to fail," we do not view this as likely for our firms, given their relatively small size. IV. Conclusion Of more concern is the possibility that higher reinvestment rates and more secure property Firms' investment is affected by the per- rights may both reflect the optimism of the ceived security of propertyrights, as shown by responding managers. Managers may also at- both our cross-country data and firm-level re- tempt to justify an unwillingness to invest by gressions. Reinvestmentrates are lowest in Rus- saying that propertyrights are insecure.In either sia and Ukraine, where bribes for government of these cases, endogeneity of property-rights services and licenses are common, firms make security arises from our inability adequatelyto paymentsfor protection,and the courts are least controlfor managercharacteristics. We lack direct effective, and highest in Poland and Romania, measures of a manager's attitudes,but manag- where property rights are the most secure. ers who say propertyrights are less secure also Within countries, also, there is also significant say their own profits and their industry'sprofits variation,as our firm-level regressions indicate. are higher. Insecurity is also significantly cor- The entrepreneurswho perceive their property related with characteristicsof the managerthat rights to be the least secure reinvest 32 percent we can measure. For example, older managers of their profits,while those with the most secure and managerswho formerly worked as a high- propertyreinvest 56 percent.Insecurity of prop- level manager of a state-owned enterprise say erty rights, all else equal, reduces a firm's in- propertyrights are more secure. These correla- vestment by over a third. tions suggest there is an importantexogenous Most of the firms say they were able to offer component of our insecurity index. Neverthe- collateral to banks (more than three-quartersof less, the estimated impacts of insecurity on in- the firms in each of the countries). Lack of vestment may be overstated if unmeasured collateral, therefore, does not appear to have manager characteristicsare important. been a binding constrainton firms' investment. Alternatively,our regressioncoefficients may There are two reasons why, until now, external understatethe effects of property-rightsinsecu- credit has not been essential for private-sector rity. Since we surveyed existing firms, our sam- development. 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