Finance and Development: A Tale of Two Sectors
Income differences across countries primarily reflect differences in total factor productivity (TFP). More disaggregate data suggest that the TFP gap between rich and poor countries varies systematically across industrial sectors of the economy. For example, less developed countries seem particularly unproductive in manufacturing. We develop a quantitative framework to explain the relationship between aggregate/sector-level TFP and financial development across countries. Financial frictions distort the allocation of capital and talent across production units, adversely affecting measured productivity. In our model, sectors with larger scales of operation (e.g., manufacturing) have more financing needs, and are hence disproportionately vulnerable to financial frictions. Our quantitative analysis shows that financial frictions account for a substantial part of the observed cross-country differences in output per worker, aggregate TFP, sector-level relative productivity, and capital to output ratios.