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. Innovation is Important for Productivity Growth emerging markets could do to encourage innovation, achieve technological advancement, and foster long-run economic growth. Innovation is the main source of technological progress. It plays an important role in productivity growth, particularly for advanced The Rise in Innovation Activities among Advanced market economies and countries transitioning to high-income status (Cirera and Maloney, 2017). Countries that move up towards and Emerging Market Economies high-income status gradually lose their comparative advantages in Innovation activities can be measured by innovation input (such as cheap labor. Structural changes (such as the reallocation of expenditure on research and development, R&D) and innovation resources from agriculture to manufacturing), physical capital output (such as patents). Patenting is a result of successful investment, and technology adoption and imitation can no longer innovation. The richness of patent data (that is, each patent’s serve as main engines for economic growth. International evidence citation by other patents, the technology fields it covers, claims, and suggests that as a country moves closer to the technology frontier, so on) allows different dimensions of innovation, such as innovation productivity growth needs to be driven by innovation (Zilibotti, types and quality, to be measured. 2017). Innovation quality can be measured by the social returns and Innovation activities can be affected by numerous factors such originality of patents. Following Hall, Jaffe, and Trajtenberg (2001), a as innovation capacity, human capital accumulation, and financial patent’s social returns can be approximated by indexes covering development. This brief focuses on the financial development external citations (the number of subsequent patents that depend channel. It first examines the recent trend in innovation activities on the original patent’s technology) and generality (the range of and quality among advanced and emerging market economies. technology fields a patent’s subsequent patents cover). These Then, it discusses how a nation’s financial development can affect indexes are calculated based on each patent’s citation, technology innovation activities. Lastly, it compares relevant policies in the field, and patent offices (see box I for details). Table 1 compares Republic of Korea and China to discuss what policymakers in innovation activities across different country groups in two periods. Table 1: Comparing Innovation Activities across Different Country Groups 1995 to 2005 2005 to 2015 Emerging Emerging Measure Advanced Market Advanced Market China 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 1. Share of Patents with 0.50 0.45 0.51 0.50 0.43 0.44 Quality of Foreign Citation PCT Patents 2. External Citation 0.76 0.59 0.70 0.75 0.54 0.62 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 economies but only by 20 percent in advanced economies. The variation in granting probability and differing trajectories of the increase in patent quantity among emerging market economies is accumulation of citations for patents filed with different patent driven mostly by the patent surge in China. Patents applied for by offices. Thus, to draw valid comparison across countries, this Brief applicants in the emerging market economies received fewer uses only patents filed under the Patent Cooperation Treaty (PCT). external citations and are less general and original than patents A comparison of the 1995-2005 period to the 2005-2015 period applied for by applicants in the advanced economies. Such reveals that innovation input and output have both increased in differences in patent quality have increased in the 2005-2015 advanced economies and emerging market economies. Patent per period, despite a rapid increase in patent quantity in the emerging ten million people increased by 377 percent in the emerging market market. Box I. Computing Innovation Quality using Patent For instance, some patents in industries like information and Data: communications technology (ICT) are inherently more likely to be cited by subsequent patents. Second, the latest patents have a Patent quality can be measured in terms of a patent’s social return shorter period to accumulate citations than patents that were and originality. A patent’s social return is usually approximated by granted decades ago. Citations of patents that are granted near the external citations, importance, and generality. A patent’s external last year of the available data are thus truncated (the truncation citation is calculated by summing forward external citations problem). Third, differences in patent examination protocols may received by each patent. External citations are citations that are lead to variation in citation counts even for the same patent that is made by patents applied by other assignees. A patent’s importance granted in different patent offices. Patent examiners may be biased is calculated as a weighted sum of its own external citations and toward domestic patents from their home countries (the home bias external citations in its subsequent patents. A patent’s generality issue). One common practice to partially account for this measures the range of technology fields covered by a patent’s heterogeneity proceeds in two steps. First, each patent’s forward subsequent patents. Patents will have higher social returns if they citation is counted within a specific time window, such as three are cited by more subsequent patents or by subsequent patents years or five years. If using a three-year window, patents that were that span a wide range of technology fields. A patent’s originality is granted in the most recent three years need to be discarded. This measured using its backward citations and their corresponding normalization can control for the truncation problem. Some technology field. Backward citations are the number of patents a researchers may also exclude self-citation or domestic citation to patent cites. A Patent is more original if its backward citations cover address the home-bias problem. Second, each patent’s citation is a wide range of technology fields. adjusted by dividing the mean citation per patent in the same All these measurements require counting each patent’s forward cohort for the application year, technology class, patent office, and or backward citations. However, there is a huge variation in country. These adjustments control for the shifts in the trajectory of accumulation of citations. First, patents in different technology patent accumulation caused by changes in patent policy and fields or application years have different probabilities of being cited. fluctuations in technology. From Financial Development to Innovation private information and thus overcome the information asymmetry problem. However, opponents of the bank-based financial system Unlike tangible investment, an intangible investment such as an argue that banks with great market power can extract information R&D investment has some unique features that affect firms’ ability rents and reduce firms’ incentive to undertake innovative projects to raise external financing. First, information asymmetry exists (Rajan, 1992). In addition, because collateral is needed in debt between innovators and outside investors. The complexity in financing, banks have inherent biases toward established firms and R&D/innovation make it difficult for outside investors to learn the conservative investment involving tangible capital. Such biases quality and true value of firms’ innovation projects. Second, the would discourage entry and stymie innovation. Hsu et al. (2014) find returns on innovation are highly uncertain. This uncertainty makes it that a country’s credit market development is negatively associated hard for investors to write a contract to finance innovation that can with subsequent innovation growth at both the industry and cover various contingencies. Third, intangible assets created by aggregate levels. innovation are hard to quantify as collateral for debt financing. These features of R&D investment lead to credit rationing that limits Recent studies have found that the impact of credit market the available funds to firms and raises their financing cost (Hall and development on innovation depends on the nature of credit Lerner, 2010). Such financial frictions can drive innovation below its expansion. Credit market development can encourage innovation if socially optimum level. Financial development encourages it leads to a competitive banking industry or enhances protection innovation by reducing frictions faced by innovative firms and over creditors. Interstate bank deregulation, which allowed banks to potential entrants. A growing body of research examines the link establish branches beyond the state boundaries, encourages between financial market development and innovation. innovation by decreasing banks’ local market power and lowering financing cost faced by firms, Chava et al. (2013) find. In contrast, Credit market development and innovation intrastate bank deregulation, which only allowed banks to establish branches outside cities boundaries but within the state, discourages The literature finds the impact of credit market development on innovation, since it increases the bargaining power of local banks innovation to be ambiguous. Supporters of the bank-based financial and damages their lending relationships to firms, Hombert and system believe that powerful banks can induce firms to reveal Matray (2017) show. Mann (2018) finds that allowing patents to 2 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. 0.1 One standard deviation increase in stock market capitalization to GDP ratio One standard deviation increase in domestic credit to private sector to GDP ratio 0.08 Marginal impact on innovation activity 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 have a stronger incentive to invest in breakthrough innovation and faced by firms. Stronger creditor rights over pledged patents are more likely to undertake radical innovation (Kerr, Nanda, encourage innovation by increasing the value of collateral values Matthew Rhodes-Kropf, 2014). The development of the financial and firms’ financing capacity. market can improve innovation quality at the aggregate level by encouraging entrants and innovation among small and medium Equity market development and innovation enterprise (SMEs). Unlike debt financing, equity financing allows investors to share the Figure 1 extends Hsu, Tian, and Xu (2014)’s work to show the upside returns for successful innovation and does not require different marginal impacts of credit market development and equity collateral. Equity financing is favored by firms with greater amounts market development on innovation and quality, as measured by of intangible assets. Better access to external equity finance various indexes. Equity market development (measured by the ratio encourages firms to invest in R&D. Brown, Fazzari, and Petersen of stock market capitalization to GDP) is positively associated with (2009) find that the rapid increase in privately financed R&D in the the growth rate in innovation quantity and quality, the entry rate of late 1990s and early 2000s in the U.S. largely benefited from the inventors, and the share of patents applied by new entrants and stock market boom in the same period. Firms in industries that are non-top innovators (those on the 95 percentiles of the total granted more dependent on external financing can benefit more from patent distribution) in the subsequent period. However, credit equity market development. Hsu, Tian and Xu (2014) show that market development (measured by the ratio of domestic credit to growth in market capitalization encourages patent applications, the private sector to GDP) has ambiguous impacts on innovation in especially applications filed by firms in high-tech industries and subsequent periods. Whether credit market development financially dependent industries. encourages or discourages innovation depends on whether such development increases or decreases bank competition. Bank’s The development of the equity market can also encourage the inherent bias toward established firms increases the share of patent entry of firms in sectors that are more dependent on external applications filed by top innovators and discourages entry. financing (Klapper Laeven, and Rajan, 2006), and enhance subsequent growth for small-sized innovative firms (Aghion, Fally, Government Policies that Encourage Innovation and Scarpetta, 2007). Venture capital is an important source of financing and encouraging innovations among start-ups, because it through Financial Market Development can overcome the agency problems between managers and The previous discussion shows that financial market development, investors through effective monitoring, board representation and especially equity market development, is vital to innovation. financing according to the stage of the investment (stage financing) Governments can implement a series of policies to encourage (Chemmanur, Krishnan, and Nandy, 2011). Small and young firms 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 a. R&D and R&D centers in Korea b. Patent application filed by Korean assignees and patent quality Patent applications (tens of thousands) 40 4.8 Distance to US technology frontier 35 0.7 Number of R&D Centers (thousands) 35 30 0.6 4.3 30 25 0.5 3.8 Percentage 25 20 0.4 20 3.3 15 0.3 15 10 0.2 2.8 10 5 0.1 2.3 0 0 5 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 0 1.8 90 00 02 04 06 08 10 12 14 16 19 20 20 20 20 20 20 20 20 20 Invention patents R&D centers run by SMEs Industrial design patents R&D centers run by LEs Utility patents R&D to GDP ratio (right scale) Distance to US frontier (right scale) 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 (Ding and Li, 2015). In early 2000s, several special stock markets technology financing during the 1990s provides valuable lessons for were established for SMEs and innovative firms to improve access to many developing countries. Throughout the 1980s and 1990s, public finance. These equity markets include but are not limited to Korea undertook a series of reforms to deregulate its financial the SME Board in Shenzhen Stock Exchange (SZSE), the ChiNext market, such as removing controls on interest rate and capital Growth Enterprise Market within SZSE, and the National Equities allocation, and abolishing directed state lending to specific sectors, Exchange and Quotations (NEEQ) market for high-tech firms. such as heavy and chemical industries. Such deregulation has Early-stage innovation is usually underfunded due to its high increased the competitiveness of the banking sector, improved uncertainty and unclear market potential. Starting in 2005, the resource allocation, and encouraged innovation in Korea (Ang, Chinese government established several government-backed 2010). The Korea Technology Finance Corporation (KOTEC) was venture capital funds to co-invest with private venture capital funds established to provide financial support to innovative SMEs, such as in innovative firms at early and start-up stages. As China’s and credit guarantee schemes. KOSDAQ—Korea’s equivalent of NASDAQ Korea’s experiences show, government-sponsored venture capital in the United States—was launched to provide SMEs with better could overcome market failure and boost innovation to an efficient access to public finance. Together with Korea’s industrial level. But too much government intervention in funded enterprises policy—concentrating on R&D in the information and may lead to underperformance in innovation (Brander, Du and communications technology (ICT) and the high-tech sector, the Hellmann, 2015). reform in its financial market facilitated financing for innovative Building a market-oriented financial system is important for firms and encouraged their innovation activities, especially among innovation. This process can be interrupted by negative exogenous SMEs. The R&D centers run by SMEs increased by eleven-fold from shocks, such as recession. Policies that are implemented to sustain 1990 to 2000 (figure 2, panel a), while the patent applications by economic growth during a recession might distort a country’s Korean inventors surged in the 2000s (figure 2, panel b). During the same period, the distance between the United States and Korea development trajectory and delay its transition into an technological frontier dropped, reflecting a significant improvement innovation-led economy (Zilibotti, 2017). For instance, the credit in innovation quality among Korean patent applicants. expansion program introduced by the Chinese government to cope with recession in 2008 reallocated capital and R&D resources back China follows a similar trajectory. R&D investment increased by to state-owned sectors (Cong et al, 2019) and crowded out private fifteen-fold from 2002 to 2018, to around 2 percent of GDP in 2018 investment. Capital reallocation toward private sectors is believed (see figure 3, panel a). R&D expenditure by firms increased from 64 to be the key factor that drove China’s high productivity growth percent in 2002 to 79 percent in 2018. Patent quantity grew rapidly before 2008. Reversing this reallocation process increases financial after 2006 and patent quality improved significantly from 2006 to constraints for the private sector, lowering its innovation activities 2010 (see figure 3, panel b). This R&D and patent explosion in China and thus China’s growth potential. To mitigate such distortions, can be partially attributed to the governments’ effort in building a policy makers in China and around the world should phase out 4 multiple-layer capital market to support the financing of innovations 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. a. R&D Expenditure in China b. Patent application filed by Chinese assignees and patent quality Patent applications (tens of thousands) 1600 2.4 Distance to US technology frontier R&D Expenditure (Renminbi, billions) 400 0.7 1400 350 0.6 2.1 1200 300 0.5 1000 250 Percentage 1.8 0.4 200 800 0.3 150 600 1.5 0.2 100 400 50 0.1 1.2 200 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 0 0.9 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Invention patents R&D expenditure by government Industrial design patents R&D expenditure by corporate Utility patents R&D to GDP ratio (right Scale) 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 especially the development of equity market, can encourage R&D investment. Firms become cautious and hold back on innovation by reducing the financial frictions that firms face. Firms innovation when faced with uncertainty or when uncertainty in developing countries may grow quickly at an early stage of increases. Cong and Howell (2020) find that the temporary development through technology adoption and with government suspension of initial public offerings (IPOs) in China reduces subsidies. When they move up to the technology frontier, countries innovation activities for affected firms, which has delayed their IPO need to change their investment-led growth strategy into an date. Due to the cumulative nature of R&D, reduction in R&D during innovation-led growth strategy to further increase their the suspension period can lower innovation in the long run. To avoid productivity. 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