Why Does the Law Matter? Investor Protection and its Effects on Investment, Finance, and Growth

Investor protection is associated with greater investment sensitivity to q and lower investment sensitivity to cash flow. Finance plays a role in causing these effects; in countries with strong investor protection, external finance increases more strongly with q, and declines more strongly with cash flow. We further find that q and cash flow sensitivities are associated with ex post investment efficiency; investment predicts growth and profits more strongly in countries with greater q sensitivities and lower cash flow sensitivities. The paper’s findings are broadly consistent with investor protection promoting accurate share prices, reducing financial constraints, and encouraging efficient investment. IN THIS PAPER, WE study how investor protection affects firm-level resource allocations. Our analyses center on two hypotheses. Our first hypothesis is that stock prices more strongly predict both investment and external finance in countries with stronger investor protection laws. Tobin (1969) shows in a frictionless setting that marginal q predicts real investment. In this framework high marginal q firms should, all else equal, also raise the most capital as these firms invest more. We use average q (q) as a proxy for marginal q, and test whether investment and external finance are more sensitive to q in countries with stronger investor protection laws.

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