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

IMF Working Papers, June 1, 2004

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

Theoretical approach: a simple model that links equalized access to credit with reduced variation in expected marginal returns.
Empirical approach: construction and use of a new financial liberalization index combined with firm-level data from five emerging markets (India, Jordan, Korea, Malaysia, Thailand).
Key outcome variable: dispersion in Tobin’s Q across firms as a measure of allocative efficiency.

Financial liberalization is associated with a reduction in the dispersion of Tobin's Q across firms.
The evidence points to financial liberalization improving allocative efficiency, in contrast to financial deepening.
The "quality effect" is identified as the mechanism by which liberalization equalizes access to credit and thereby reduces variation in expected marginal returns.

Policies promoting financial liberalization can enhance allocative efficiency by improving the distribution of credit access across firms.
Emphasis on the nature of reform: liberalization (changes in access and constraints) appears more important for allocative outcomes than mere financial deepening (growth in financial size or volume).