How Financial Market Development Can Encourage Innovation Activity

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		Research & Policy Briefs
		From the World Bank Malaysia Hub
No. 52
	November 1, 2021
	How Financial Market Development Can Encourage Innovation Activity

Yu Cao

Innovation is crucial to improving productivity and fostering sustainable growth, especially among countries that are moving toward or are at the cutting edge of technological advances (technology frontier). Innovation is usually underfinanced due to its high uncertainty nature and market failures caused by mismatches in information about the value of an investment between inventors and outside investors (information asymmetry). The development of financial markets can reduce such frictions and channel financing to innovation. The Brief first examines the recent trend in innovation activities in advanced and emerging markets economies, and then explores the underlying mechanisms through which financial market development may encourage innovation at both the firm and aggregate levels. Lastly, this Brief discusses the relevant policies that can be implemented by policy makers to boost innovation activities.

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Innovation is Important for Productivity Growth

Innovation is the main source of technological progress. It plays an important role in productivity growth, particularly for advanced market economies and countries transitioning to high-income status (Cirera and Maloney, 2017). Countries that move up towards high-income status gradually lose their comparative advantages in cheap labor. Structural changes (such as the reallocation of resources from agriculture to manufacturing), physical capital investment, and technology adoption and imitation can no longer serve as main engines for economic growth. International evidence suggests that as a country moves closer to the technology frontier, productivity growth needs to be driven by innovation (Zilibotti, 2017).

Innovation activities can be affected by numerous factors such as innovation capacity, human capital accumulation, and financial development. This brief focuses on the financial development channel. It first examines the recent trend in innovation activities and quality among advanced and emerging market economies. Then, it discusses how a nation's financial development can affect innovation activities. Lastly, it compares relevant policies in the Republic of Korea and China to discuss what policymakers in

emerging markets could do to encourage innovation, achieve technological advancement, and foster long-run economic growth.

The Rise in Innovation Activities among Advanced and Emerging Market Economies

Innovation activities can be measured by innovation input (such as expenditure on research and development, R&D) and innovation output (such as patents). Patenting is a result of successful innovation. The richness of patent data (that is, each patent's citation by other patents, the technology fields it covers, claims, and so on) allows different dimensions of innovation, such as innovation types and quality, to be measured.

Innovation quality can be measured by the social returns and originality of patents. Following Hall, Jaffe, and Trajtenberg (2001), a patent's social returns can be approximated by indexes covering external citations (the number of subsequent patents that depend on the original patent's technology) and generality (the range of technology fields a patent's subsequent patents cover). These indexes are calculated based on each patent's citation, technology field, and patent offices (see box I for details). Table 1 compares innovation activities across different country groups in two periods.

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Table 1: Comparing Innovation Activities across Different Country Groups

			1995 to 2005			2005 to 2015
	Measure	Advanced	Emerging		Advanced	Emerging
	Market	China	Market	China
(Percent, unless specified)	Economies	Economies	Market	Economies
			(exclude China)			(exclude China)
R&D to GDP ratio	1.65	0.50	0.91	1.89	0.56	1.74
Patent per Ten Million People (number)	154.46	4.32	11.73	184.82	5.77	89.57
Share of Invention and Utility Patents	0.87	0.72	0.67	0.88	0.74	0.67
Share of Domestic Patents	0.58	0.82	0.92	0.49	0.78	0.95
Share of Patents Filed Abroad	0.42	0.18	0.08	0.51	0.22	0.05
Share of PCT Patents	0.12	0.08	0.03	0.17	0.11	0.02
Quality of	1. Share of Patents with	0.50	0.45	0.51	0.50	0.43	0.44
Foreign Citation
PCT	2. External Citation	0.76	0.59	0.70	0.75	0.54	0.62
Patents
3. Generality	0.95	0.77	0.87	0.92	0.76	0.69
	4. Originality	0.98	0.87	0.91	0.99	0.88	0.81

Source: Data for R&D-to-GDP ratio is from the World Bank World Development Indicators (WDI) dataset. Data on patent quantity, patent share, and patent quality are from the author's own calculation based on the European Patent Office's PATSTAT Global dataset and the World Intellectual Property Organization (WIPO) dataset. Note: The country groupings exclude oil-based economies. The index of External Citation is calculated as the median of external citations received by patents filed by inventors in each country group divided by the median of each U.S. patent's external citation. Similarly, the index of Generality (or Originality) is the median of each patent's generality (or originality) divided by the median of each U.S. patent's generality (or originality).

Affiliations: East Asia and Pacific Chief Economist Research Center, World Bank.

Acknowledgements: The author thanks Ergys Islamaj and Norman V. Loayza for valuable comments and suggestions.

Objective and disclaimer: Research & Policy Briefs synthesize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent.

How Financial Market Development Can

Encourage Innovation Activity

Differences in patent examination protocols and patent laws lead to variation in granting probability and differing trajectories of the accumulation of citations for patents filed with different patent offices. Thus, to draw valid comparison across countries, this Brief uses only patents filed under the Patent Cooperation Treaty (PCT).

A comparison of the 1995-2005 period to the 2005-2015 period reveals that innovation input and output have both increased in advanced economies and emerging market economies. Patent per ten million people increased by 377 percent in the emerging market

Box I. Computing Innovation Quality using Patent Data:

Patent quality can be measured in terms of a patent's social return and originality. A patent's social return is usually approximated by external citations, importance, and generality. A patent's external citation is calculated by summing forward external citations received by each patent. External citations are citations that are made by patents applied by other assignees. A patent's importance is calculated as a weighted sum of its own external citations and external citations in its subsequent patents. A patent's generality measures the range of technology fields covered by a patent's subsequent patents. Patents will have higher social returns if they are cited by more subsequent patents or by subsequent patents that span a wide range of technology fields. A patent's originality is measured using its backward citations and their corresponding technology field. Backward citations are the number of patents a patent cites. A Patent is more original if its backward citations cover a wide range of technology fields.

All these measurements require counting each patent's forward or backward citations. However, there is a huge variation in accumulation of citations. First, patents in different technology fields or application years have different probabilities of being cited.

From Financial Development to Innovation

Unlike tangible investment, an intangible investment such as an R&D investment has some unique features that affect firms' ability to raise external financing. First, information asymmetry exists between innovators and outside investors. The complexity in R&D/innovation make it difficult for outside investors to learn the quality and true value of firms' innovation projects. Second, the returns on innovation are highly uncertain. This uncertainty makes it hard for investors to write a contract to finance innovation that can cover various contingencies. Third, intangible assets created by innovation are hard to quantify as collateral for debt financing. These features of R&D investment lead to credit rationing that limits the available funds to firms and raises their financing cost (Hall and Lerner, 2010). Such financial frictions can drive innovation below its socially optimum level. Financial development encourages innovation by reducing frictions faced by innovative firms and potential entrants. A growing body of research examines the link between financial market development and innovation.

Credit market development and innovation

The literature finds the impact of credit market development on innovation to be ambiguous. Supporters of the bank-based financial

2 system believe that powerful banks can induce firms to reveal

economies but only by 20 percent in advanced economies. The increase in patent quantity among emerging market economies is driven mostly by the patent surge in China. Patents applied for by applicants in the emerging market economies received fewer external citations and are less general and original than patents applied for by applicants in the advanced economies. Such differences in patent quality have increased in the 2005-2015 period, despite a rapid increase in patent quantity in the emerging market.

For instance, some patents in industries like information and communications technology (ICT) are inherently more likely to be cited by subsequent patents. Second, the latest patents have a shorter period to accumulate citations than patents that were granted decades ago. Citations of patents that are granted near the last year of the available data are thus truncated (the truncation problem). Third, differences in patent examination protocols may lead to variation in citation counts even for the same patent that is granted in different patent offices. Patent examiners may be biased toward domestic patents from their home countries (the home bias issue). One common practice to partially account for this heterogeneity proceeds in two steps. First, each patent's forward citation is counted within a specific time window, such as three years or five years. If using a three-year window, patents that were granted in the most recent three years need to be discarded. This normalization can control for the truncation problem. Some researchers may also exclude self-citation or domestic citation to address the home-bias problem. Second, each patent's citation is adjusted by dividing the mean citation per patent in the same cohort for the application year, technology class, patent office, and country. These adjustments control for the shifts in the trajectory of patent accumulation caused by changes in patent policy and fluctuations in technology.

private information and thus overcome the information asymmetry problem. However, opponents of the bank-based financial system argue that banks with great market power can extract information rents and reduce firms' incentive to undertake innovative projects (Rajan, 1992). In addition, because collateral is needed in debt financing, banks have inherent biases toward established firms and conservative investment involving tangible capital. Such biases would discourage entry and stymie innovation. Hsu et al. (2014) find that a country's credit market development is negatively associated with subsequent innovation growth at both the industry and aggregate levels.

Recent studies have found that the impact of credit market development on innovation depends on the nature of credit expansion. Credit market development can encourage innovation if it leads to a competitive banking industry or enhances protection over creditors. Interstate bank deregulation, which allowed banks to establish branches beyond the state boundaries, encourages innovation by decreasing banks' local market power and lowering financing cost faced by firms, Chava et al. (2013) find. In contrast, intrastate bank deregulation, which only allowed banks to establish branches outside cities boundaries but within the state, discourages innovation, since it increases the bargaining power of local banks and damages their lending relationships to firms, Hombert and Matray (2017) show. Mann (2018) finds that allowing patents to

Research & Policy Brief No.52

Figure 1. The Effect of Financial Market Development on the Quality and Quantity of Innovation

While equity market development helps improve innovation quantity and quality over time,

credit market development has ambiguous impacts.

Marginal impact on innovation activity

0.1

		One standard deviation increase in stock market capitalization to GDP ratio
0.08		One standard deviation increase in domestic credit to private sector to GDP ratio

0.06

0.04

0.02

0
-0.02
	Total	External citation	Generality	Originality	% apply by	% apply by	Entry rate
-0.04	applications				entrants	top 5% firms
-0.06
	Patent Quantity	Patent Quality Measure (median)	Innovation Activity Distribution

Source: Patent information is from the European Patent Office's PATSTAT dataset. Other country-level indicators are from the World Bank Development Indicators (WDI).

Note: The sample is a five-year panel consisting 31 advanced economies and 30 emerging market economies from year 1986 to year 2015. The dependent variable are different measurements of innovation activities shown in the x-axis. The definition and calculation of external citations, generality and originality can be found in Box I. % apply by entrants is the share of patent applications filed by entrants. % apply by top 5% firms are firms at the top 5 percent of the granted patent stock distribution. Entry rate is calculated as the number of entrants divided by existing inventors. Bar heights represents the sizes of the estimated marginal impact on innovation activities indexes from the stock market development (yellow bar) or from the credit market development (blue bar). Whiskers represent 95 percent confidence interval.

serve as collateral for debt financing mitigates financial frictions faced by firms. Stronger creditor rights over pledged patents encourage innovation by increasing the value of collateral values and firms' financing capacity.

Equity market development and innovation

Unlike debt financing, equity financing allows investors to share the upside returns for successful innovation and does not require collateral. Equity financing is favored by firms with greater amounts of intangible assets. Better access to external equity finance encourages firms to invest in R&D. Brown, Fazzari, and Petersen (2009) find that the rapid increase in privately financed R&D in the late 1990s and early 2000s in the U.S. largely benefited from the stock market boom in the same period. Firms in industries that are more dependent on external financing can benefit more from equity market development. Hsu, Tian and Xu (2014) show that growth in market capitalization encourages patent applications, especially applications filed by firms in high-tech industries and financially dependent industries.

The development of the equity market can also encourage the entry of firms in sectors that are more dependent on external financing (Klapper Laeven, and Rajan, 2006), and enhance subsequent growth for small-sized innovative firms (Aghion, Fally, and Scarpetta, 2007). Venture capital is an important source of financing and encouraging innovations among start-ups, because it can overcome the agency problems between managers and investors through effective monitoring, board representation and financing according to the stage of the investment (stage financing) (Chemmanur, Krishnan, and Nandy, 2011). Small and young firms

have a stronger incentive to invest in breakthrough innovation and are more likely to undertake radical innovation (Kerr, Nanda, Matthew Rhodes-Kropf, 2014). The development of the financial market can improve innovation quality at the aggregate level by encouraging entrants and innovation among small and medium enterprise (SMEs).

Figure 1 extends Hsu, Tian, and Xu (2014)'s work to show the different marginal impacts of credit market development and equity market development on innovation and quality, as measured by various indexes. Equity market development (measured by the ratio of stock market capitalization to GDP) is positively associated with the growth rate in innovation quantity and quality, the entry rate of inventors, and the share of patents applied by new entrants and non-top innovators (those on the 95 percentiles of the total granted patent distribution) in the subsequent period. However, credit market development (measured by the ratio of domestic credit to the private sector to GDP) has ambiguous impacts on innovation in subsequent periods. Whether credit market development encourages or discourages innovation depends on whether such development increases or decreases bank competition. Bank's inherent bias toward established firms increases the share of patent applications filed by top innovators and discourages entry.

Government Policies that Encourage Innovation through Financial Market Development

The previous discussion shows that financial market development,
especially equity market development, is vital to innovation.
Governments can implement a series of policies to encourage
innovation by reforming their financial sectors.	3

How Financial Market Development Can

Encourage Innovation Activity

Figure 2. R&D and Patent Activity in Korea, Early 1990s-2017

R&D activity and the quantity and quality of patent applications soared and the distance to

the US technological frontier narrowed

Number of R&D Centers (thousands)

a. R&D and R&D centers in Korea

40

35

30

25

20

15

10

5

0

19902000 2002 2004 2006 2008 2010 2012 2014 2016

R&D centers run by SMEs

R&D centers run by LEs

R&D to GDP ratio (right scale)

4.8
4.3
3.8	Percentage
3.3
2.8
2.3
1.8

Patent applications (tens of thousands)

b. Patent application filed by Korean assignees

and patent quality

35

30

25

20

15

10

5

0

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

Invention patents

Industrial design patents

Utility patents

Distance to US frontier (right scale)

0.6	frontier
0.7	technology
0.5
0.4
0.3	to US
0.2
0	Distance
0.1

Source: Data on R&D centers are from Korean Industrial Technology Association. Data on patent applications are from the World Intellectual Property Organization (WIPO). Data on the distance to the US frontier are from the author's own calculation based on the European Patent Office's PATSTAT Global dataset.

Note: Distance to US Technology Frontier is measured as one minus the median external citation received by per PCT patent adjusted toward US median. LE = large enterprise; PCT = Patent Cooperation Treaty; R&D = research and development; SMEs = small and medium enterprises.

Korea's experience in financial liberalization and supporting technology financing during the 1990s provides valuable lessons for many developing countries. Throughout the 1980s and 1990s, Korea undertook a series of reforms to deregulate its financial market, such as removing controls on interest rate and capital allocation, and abolishing directed state lending to specific sectors, such as heavy and chemical industries. Such deregulation has increased the competitiveness of the banking sector, improved resource allocation, and encouraged innovation in Korea (Ang, 2010). The Korea Technology Finance Corporation (KOTEC) was established to provide financial support to innovative SMEs, such as credit guarantee schemes. KOSDAQ-Korea's equivalent of NASDAQ in the United States-was launched to provide SMEs with better access to public finance. Together with Korea's industrial policy-concentrating on R&D in the information and communications technology (ICT) and the high-tech sector, the reform in its financial market facilitated financing for innovative firms and encouraged their innovation activities, especially among SMEs. The R&D centers run by SMEs increased by eleven-fold from 1990 to 2000 (figure 2, panel a), while the patent applications by Korean inventors surged in the 2000s (figure 2, panel b). During the same period, the distance between the United States and Korea technological frontier dropped, reflecting a significant improvement in innovation quality among Korean patent applicants.

China follows a similar trajectory. R&D investment increased by fifteen-fold from 2002 to 2018, to around 2 percent of GDP in 2018 (see figure 3, panel a). R&D expenditure by firms increased from 64 percent in 2002 to 79 percent in 2018. Patent quantity grew rapidly after 2006 and patent quality improved significantly from 2006 to 2010 (see figure 3, panel b). This R&D and patent explosion in China can be partially attributed to the governments' effort in building a

4 multiple-layer capital market to support the financing of innovations

(Ding and Li, 2015). In early 2000s, several special stock markets were established for SMEs and innovative firms to improve access to public finance. These equity markets include but are not limited to the SME Board in Shenzhen Stock Exchange (SZSE), the ChiNext Growth Enterprise Market within SZSE, and the National Equities Exchange and Quotations (NEEQ) market for high-tech firms. Early-stage innovation is usually underfunded due to its high uncertainty and unclear market potential. Starting in 2005, the Chinese government established several government-backed venture capital funds to co-invest with private venture capital funds in innovative firms at early and start-up stages. As China's and Korea's experiences show, government-sponsored venture capital could overcome market failure and boost innovation to an efficient level. But too much government intervention in funded enterprises may lead to underperformance in innovation (Brander, Du and Hellmann, 2015).

Building a market-oriented financial system is important for innovation. This process can be interrupted by negative exogenous shocks, such as recession. Policies that are implemented to sustain economic growth during a recession might distort a country's development trajectory and delay its transition into an innovation-led economy (Zilibotti, 2017). For instance, the credit expansion program introduced by the Chinese government to cope with recession in 2008 reallocated capital and R&D resources back to state-owned sectors (Cong et al, 2019) and crowded out private investment. Capital reallocation toward private sectors is believed to be the key factor that drove China's high productivity growth before 2008. Reversing this reallocation process increases financial constraints for the private sector, lowering its innovation activities and thus China's growth potential. To mitigate such distortions, policy makers in China and around the world should phase out stimulus policies and support programs when recession ends.

Research & Policy Brief No.52

Figure 3. R&D and Patent Activity in China, Early 2000-2017

R&D and patent activity exploded in China, and the distance to the US technological frontier narrowed greatly.

R&D Expenditure (Renminbi, billions)

a. R&D Expenditure in China

1600

1400

1200

1000

800

600

400

200

0

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

R&D expenditure by government

R&D expenditure by corporate

R&D to GDP ratio (right Scale)

2.4

2.1

1.8	Percentage
1.5
1.2
0.9

b. Patent application filed by Chinese assignees and patent quality

applicationsPatent(tens of thousands)	2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011	2012 2013 2014 2015 2016 2017	0.7	UStoDistancetechnology frontier
	400
	350			0.6
	300			0.5
	250			0.4
	200			0.3
	150
			0.2
	100
	50			0.1
	0			0

Invention patents

Industrial design patents

Utility patents

Distance to US frontier (right scale)

Source: Data on R&D expenditure are from the National Bureau of Statistics of China. Data on patent applications are from the World Intellectual Property Organization (WIPO). Data on the distance to the US frontier are from the author's own calculation based on the European Patent Office's PATSTAT Global dataset.

Uncertainties can negatively affect irreversible investment like R&D investment. Firms become cautious and hold back on innovation when faced with uncertainty or when uncertainty increases. Cong and Howell (2020) find that the temporary suspension of initial public offerings (IPOs) in China reduces innovation activities for affected firms, which has delayed their IPO date. Due to the cumulative nature of R&D, reduction in R&D during the suspension period can lower innovation in the long run. To avoid such a decrease in innovation, it is important to keep policies consistent as reforms in financial market are underway.

Conclusion

A well-functioning financial market can spur long-run economic growth by screening innovative activities and relocating resources to the most productive firms. The development of financial market,

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