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 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. 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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