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6FINANCIAL DEVELOPMENT AND FIRM INNOVATION: EVIDENCE FROM CENTRAL ASIAN COUNTRIES 1Dr Ravshan Khaydarov, 2Bakhodir Mamatkulov
-'Technological University Dublin, Ireland, Dr. 2Lead Consultant Infrasia Capital Ltd.
https://doi.org/10.5281/zenodo.11001901
Abstrsct. This study investigates the impact offinancial development on firm innovation in Central Asian (CA) countries, primarily focusing on Uzbekistan. Utilising data from the Business Environment and Enterprise Performance Survey (BEEPS) for 3,397 firms across four CA countries and employing Logistic and Ordered Logistic Regression models, we found positive effects of credit market development on firm innovation, contrary to the adverse impacts of equity market development. This finding challenges the traditional focus on equity markets for funding innovation, emphasising the pivotal role of credit markets in supporting innovation in Central Asian economies. The research provides valuable insights into the financial systems-innovation nexus in emerging markets, offering guidance for policymakers in CA countries and similar developing economies to foster innovation through economic reforms. Validated by an International Monetary Fund (IMF) -generated financial development measure, the results highlight the significance of developed credit markets over the dominance of bankfinancing in CA economies.
Keywords: Financial Development, Firm Innovation, Equity Market, Credit Market Development, R&D.
Background
The theoretical and empirical literature on innovation underlined that innovation is a key factor that provides a competitive advantage to a firm with an ultimate effect on a country's economic growth and sustainability [1]-[3]. However, innovation is not only a long-term and unpredictable process, but it also has a high credibility of failure [1], [4]. Financing firm innovation and providing a favourable ecosystem for businesses to grow innovatively mostly depends on the level of a country's economic development stage and its well-developed financial institutions [5], [6]. However, it varies worldwide, making it challenging for policymakers to design appropriate policy frameworks to support firm innovation. In developed economies, the stock market plays a crucial role in financing innovation [7]-[9]. Unlike developed economies, banks are the key players in financing businesses in emerging economies, including Central Asian (CA) countries, due to underdeveloped financial markets [2], [10], [11]. However, banks in these economies fail to meet the capital needs of the firms' innovative activities. For example, most businesses in transition economies, primarily small and medium enterprises (SMEs), face financial constraints to invest in their innovation activities [12], [13]. Thus, it requires a well-functioning financial market, which plays a key role in mobilising savings, allocating capital, evolving innovative projects, easing risk management and reducing financial costs.
This research contributes to understanding the impact of financial market development on firm innovation both empirically and theoretically based on the CA countries that gained their independence after the collapse of the Soviet Union (SU) [14]. The governments of these countries formulated and improved their institutional context through legislation and monetary and fiscal policies to support SMEs' needs. Porter [15] emphasised that countries in the transition period must use their territorial advantages, among others, to boost their economic growth and
sustainability of a country. CA countries have a historical origin and economic structure similar to the USSR [14]. Thus, these countries designed similar monetary, fiscal and industrial policies to improve the business ecosystem to support endogenous firms. Indeed, one of the similar political approaches for all CA governments is that they adopted state programs regarding the privatisation of state-owned enterprises and are gradually encouraging SMEs action [10].
Furthermore, the banks are the primary lenders to businesses in these countries. However, banks usually ignore providing the financial sources for the firm's innovation and government grants are not enough for all firms. Therefore, the CA governments are concentrating on developing financial markets since the financial system is vital in providing firms with capital from different formal sources to innovate their operations [10], [16]. For instance, Uzbekistan designed a program for 2020-2025 to improve its capital market, which is believed to fill a gap in the Uzbek financial system and provide a necessary source to boost a firm's product and process innovation [9], [11], [17]. There is a research gap in empirically quantifying the impact of financial development on firm-level innovation in CA countries. This research attempts to fill this gap and examines how financial development affects firm innovation in Kazakhstan, Kyrgyzstan, Tajikistan, and Uzbekistan. Utilising the latest data from the 2019 Business Environment and Enterprise Performance Survey (BEEPS), this study contributes to the existing literature by providing new insights into how financial development influences firm innovation within CA economies.
In light of the above, the following hypotheses were developed:
H1: Financial development significantly influences innovation activities within CA firms that rely heavily on external financing.
H2: In Central Asian countries, credit market development significantly enhances innovation for firms reliant on external financing.
H3: In Central Asian countries, the impact of equity market development on innovation is significant for firms reliant on external financing.
Research Methodology
Utilising the BEEPS1 2019 Enterprise Surveys data, this paper assesses firm innovation through measures such as product/service innovation, process innovation, and acquisition of intangible assets. The study employs Logistic Regression and Ordered Logit Regression to explore the impact of financial development, captured through equity and credit market developments, on these innovation indicators. The analysis controls for firm age, size, government ownership, foreign ownership, exporter status, and R&D spending, considering industry and country-specific effects. The total number of observations used in this study's empirical analyses is 3,397. The highest percentage of firms is concentrated in Kazakhstan and Uzbekistan, whereas the figures for Kyrgyzstan and Tajikistan are quite low.
The BEEPS dataset offers several advantages. Notably, it includes a significantly larger number of observations for Central Asian countries; for example, observations for Kazakhstan have increased by almost 2.5 times since the 2013 survey. Recent governance changes in Kazakhstan, Kyrgyzstan, and Uzbekistan have led to substantial reforms. Following the 2017
1 The Business Environment and Enterprise Performance Survey (BEEPS) is jointly conducted by the World Bank (WB) and the European Bank for Reconstruction and Development (EBRD). It gathers cross-country information critical for understanding the business environment in Eastern Europe (EE) and Central Asian (CA) countries. The data for Turkmenistan is not available in BEEPS database.
presidential decree2, a critical reform in Uzbekistan liberalised the foreign exchange policy, allowing the national currency to float freely against the US dollar, enhancing transparency and attracting foreign direct investments. These reforms impacted the climate for firm innovation and the accuracy of survey questionnaire responses, increasing the data's reliability.
Innovation Measures
Following Ullah [10], Verdier, Kersting, and Dabla-Norris [18] and a number of other literature that study the relationship between financial development and firm innovation in emerging market economies (EMEs), this research applies individual innovation variables NewProduct/Service, NewProcess, IntangibleAssets, License, and an index variable AggregateInn. These proxies capture not only firm-level innovations but also new-to-world innovations. All four individual innovation measures are dummy variables gathered by asking the respondents to answer the following survey questions:
NewProduct/Service - During the last three years, has this establishment introduced new or significantly improved products or services?
NewProcess - During the last three years, has this establishment introduced any new or significantly improved process?
IntangibleAssets - During the last three years, has this establishment purchased any trademarks, copyrights, patents, or other intangible assets?
License - Does this establishment at present use a technology license from a foreign-owned company, excluding office software?
For all the above variables, a value of one is assigned if the firm met the respective condition within the last three years prior to the survey and zero otherwise [19]. This includes introducing new or significantly improved products or services and processes, purchasing intangible assets, or using a technology license from a foreign-owned company, excluding office software. Following Ayyagari et al. [20] and Ullah [10], the AggregateInn index is generated to measure firm innovation. It represents both product/service and process as well as imitation/adaption-based innovation and is constructed by summing firm responses to the four abovementioned individual innovation activities.
Main Explanatory and Control Variables
Most of the existing literature in the field, starting from Rajan and Zingales [21], have used the ratio of stock market capitalisation plus domestic credit to GDP in measuring a country's overall financial development [20], [22]. The same approach is utilised in this study to estimate the relationship between financial development and firm innovation in CA countries. However, to analyse the impacts of equity market development and credit market development separately, following Djankov, McLiesh and Shleifer [23] and Hsu et al. [1] two independent proxies are generated for the equity market and credit market development. The proxy for equity market
development in country k is
_ _ Stock Market Capitalization^
EquitykEquityk =-^--(1)
i.e., a country k's stock market capitalisation ratio over its GDP. Stock market capitalisation is computed by summing the multiplications of shares' numbers and their corresponding prices. The proxy for credit market development in country k is
2 Decree of the President of the Republic of Uzbekistan No. DP-5177 of September 2, 2017 "On priority measures
of liberalizing foreign exchange policy"
Bank Credits
Creditk =---(2)
K GDPk v '
i.e., a country k's domestic credit provided by banking sector ration over its GDP.
These two variables will serve as the main explanatory variables in empirical analyses. Firstly, they are included in the regressions one by one to see the different effects of equity and credit market developments on firm innovation. Then, following Hsu et al. [1] as well as Rajan and Zingales [21] their summation is included as the proxy that shows the dependence of firm i in industry j in country k is ExternalDeptjk, to see the overall influence of financial development on firm innovation. Additionally, there are six controlling variables, namely Age, Size, Government, Foreign, Exporter and R&D. All these controlling variables are broad firm characteristics and are standard in the existing literature in the field [10], [20], [24]. The Age and Size of firm i in industry j and country k are transformed using the natural logarithm to mitigate the impact of outliers. Government Ownership, Foreign Ownership, Exporter Status, and R&D Expenses for firm i in industry j and country k are converted into dummy variables. Each variable takes the value one if the specific condition is met (e.g., any government or foreign ownership, being an exporter, or investing in R&D) and zero otherwise. In order to test the proposed research hypotheses, the following regression models are constructed. Model 1: Financial Development and Firm Innovation.
InnovationXijk = pQ+ P\FDk * ExternaDepijk + (3)
+p3SizelJk + p^ForeigniJk + p5GovernmentlJk + p6ExporteriJk + p7R&DiJk + Ij + Ck+ £iJk
Model 2: Impact of Equity and Credit Market Development.
InnovationXij k = Pq+ p1Equityk * ExternaDepijk (4)
* ExternaDepiik + P^^d^iik +p4SizeiJk + p5ForeigniJk + p6GovernmentlJk + p7ExporteriJk + p8R&DiJk + Ij + Ck+ £iJk
Where:
Innovationxt j k - either one of the four individual innovation indicators or the aggregate innovation index of the firm i in industry j in country k;
FDk - the financial development proxy of country k. It is derived by summing up the equations (1) and (2):
FDk = Equityk + Creditk; (5)
ExternaDepi j k - the level of dependence on external financial sources for the firm i in industry j in country k;
Equityk - equity market development in country k; Creditk - credit market development in country k;
Agetjk and Sizetjk - continuous control variables of firm i in industry j in country k; ForeignijikIGovernmentijikIExporterijikIR&.Dij k - dummy control variables of the firm i in industry j in country k; Pq - intercept;
Pi... p7 - the coefficients of the independent and control variables; Ij and Ck - vectors of industry and country fixed effects, respectively; £ij,k - error term of firm i in industry j in country k.
As the sample dataset consists of observations from eight different industries in four CA countries, the values of j ranges from one to eight, while the figure for k is from one to four:
j = 1,..,8; k = 1,..,4.
To consider the association between FDk and ExternaDeptjk discussed above, the interaction term is included in the regression. Corresponding to the H1 developed, the coefficient estimate of FDk * ExternaDepi:jk is expected to be positive and significant. In other words, it means that the financial development in an economy results in a greater extent of innovation in the firms that are dependent on external funds. Accordingly, to capture the effects of equity market development H2 and credit market development H3 separately, model 2 is developed.
Robustness checks
An alternative measure of financial development is utilised to examine the documented effects of financial development on firm innovation. Although a vast majority of literature in the field uses Equityk and Creditk (see equations 1 and 2) as a proxy for an economy's financial development, these indicators do not consider the complex multidimensional nature of financial development [25]. The "Financial Development Index" has been developed by the International Monetary Fund (IMF) Staff Discussion Note, which indicates the level of development of a country's financial institutions and financial markets in terms of their depth, access and efficiency. To investigate whether the results obtained from equations (5) are robust to an alternative proxy for financial development, the Financial Development Index - FDk is used.
Empirical Findings and Discussions
Descriptive Statistics
Access to financial resources is a major constraint in developing countries, where financial institutions often struggle to meet the capital needs of innovative firms due to poorly functioning financial markets. The four Central Asian countries analysed in this study—Kazakhstan, Kyrgyzstan, Tajikistan, and Uzbekistan—are among the emerging market economies with low financial development levels. The table below shows the financial development levels in these countries:
Table 1: Financial Development Level (CA Countries)
Equity Credit FD
Kazakhstan .27 .30 .57
Kirgizstan .04 .21 .26
Tajikistan .04 .23 .27
Uzbekistan .10 .30 .40
Here, Equity and Credit indicate equity and credit market development, as computed above (see equations 1 and 2). FD represents the level of financial development (equation 5). Values range from zero to one, where values closer to one indicate higher financial development in the respective country. As can be observed from Table 2, Kazakhstan has the highest level of development in all categories. According to the FD indicator generated in this research, the level of financial development for Kirgizstan and Tajikistan is virtually the same, while the figure for
Kazakhstan is twice as high.
Table 3: Firm Innovation (Across Countries)
New Aggregate
Product / New Intangibl License Innovation
Service Process e Assets (5)
(1) (2) (3) (4)
Kazakhstan .2530 .1370 .0632 .1187 .5634
Kirgizstan .4290 .2654 .1064 .2039 .9943
Tajikistan .2193 .0988 .1321 .1130 .5397
Uzbekistan .2960 .1751 .0720 .2244 .7710
Firm innovation indicators for the sample countries are illustrated in Table 4. The figures are the proportions of firms in each country that undertook innovation activities. According to the table, overall, firms in Kirgizstan are engaged in the most innovative activities, while firms in Kazakhstan and Tajikistan are the least innovative (column 5). In all countries, the highest proportion of the firms have introduced new product or service over the last three years (column 1), whereas acquiring trademarks, copyrights and patents is the least popular among firms. Respondent firms from eight major sectors across Central Asian countries are notably concentrated in specific industries. The highest number of firms are in the Food industry and non-metallic mineral products, around 36%, while the Machinery & Equipment and Fabricated Metal Products industries together involved approximately 15% of observations.
Correlation
A correlation matrix, Table 4, is constructed for all control variables to address potential multicollinearity issues and meet the third assumption of the Logistic Regression (LR) model. The analysis reveals no issues with perfect multicollinearity. This aligns with the recommendations of Tabachnick and Fidell [26] which confirm the appropriateness of the variables used. Notably, there are no negative associations between the variables mentioned.
Table 4: Correlation Matrix (Control Variables)
1 12 \3 14 \5
Age 1 1 1 1
Size .292 1
Foreign .013 .192 1
Government .137 .245 .070 1
Exporter .061 .279 .224 .083 1
R&D .045 .159 .040 .050 .135
Regression
The empirical findings, summarised in Table 7, indicate that the interaction term coefficient between financial development and external dependence is significant only for two innovation measures: acquiring intangible assets and licenses. Otherwise, the effect of financial development across CA countries is insignificant for new product/service, process, and aggregate innovation indicators. This suggests that financial development is not sufficiently promoting these types of innovation activities, leading to the rejection of H1, which posited that financial development
significantly influences innovation activities within CA firms heavily reliant on external financing. Findings from Model 2 indicate that equity market development and external dependence exhibit significant positive effects on intangible assets and licenses but significant negative effects on firm-level aggregate innovation. In other words, while equity market development facilitates the acquisition of technology licenses from foreign entities, it significantly hampers the acquisition of intangible assets and the overall innovation output, contradicting hypothesis H3, which is that equity market development fosters firm innovation in CA countries. This finding is consistent with Khaydarov's [11] analysis, which highlighted the limited role of equity markets in financing innovation in Uzbekistan's machine-building and chemical industries during the referenced period of 2013-2015. In contrast, credit market development significantly enhances aggregate innovation indicators, which aligns with hypothesis H2 and resonates with the research of Ayyagari et al. [27], who emphasised the pivotal role of bank financing in driving firm innovation. This outcome is consistent with the predominant role of banks as primary lenders in emerging market economies (EMEs). However, it is essential to recognise that credit availability does not always equate to the best option, as it can be costly and often necessitates collateral. Firms may find themselves compelled to seek loans from banks due to limited alternatives, particularly in the absence of a well-established equity market. For all other dependent factors, the interaction term coefficients of both Equityk * ExtcvnttDcpi i k and Cvcditk* ExtcvnttDcpi k were insignificant. Further robustness checks using the Financial Development Index as an alternative measure confirm the consistency of these findings. The robustness results closely mirror the primary analysis, reinforcing the reliability of the initial empirical outcomes.
Variables New Product/ Services New Process Intangible Assets License Aggregate Innovation
Reg Model Ml M2 Ml M2 Ml M2 Ml M2 Ml M2
Age 0.022 (.085) 0.020 (.085) 0.086 (.096) 0.086 (.096) -0.084 (.123) -0.084 (.123) -0.204** (.098) -0.211** (.098) -0.051 (.075) -0.053 (.075)
Size 0.005 (.056) 0.011 (.056) 0.127** (.061) 0.127** (.061) 0.060 (.081) 0.071 (.081) 0.268*** (.063) 0.290*** (.064) 0.171*** (.050) 0.184*** (.050)
Foreign -0.120 (.214) -0.127 (.214) -0.348 (.248) -0.348 (.248) -0.736** (.361) -0.736** (.361) 0.554** (.222) 0.537** (.223) -0.071 (.191) -0.083 (.191)
Government 0.258 (.381) 0.255 (.382) -0.663 (.454) -0.663 (.455) -0.223 (.574) -0.268 (.573) -0.363 (.420) -0.455 (.421) -0.297 (.337) -0.357 (.338)
Exporter 0.896*** (.187) 0.886*** (.187) 0.237 (.200) 0.237 (.200) 0.678*** (.242) 0.646*** (.243) 0.369* (.198) 0.338* (.199) 0.759*** (.166) 0.741*** (.166)
R&D 0.683*** (.191) 0.676*** (.191) 0.625*** (.199) 0.625*** (.199) 0.527** (.245) 0.515** (.245) 1.007*** (.196) 0.996*** (.198) 0.967*** (.173) 0.948*** (.173)
Equity* Dependence - -0.024 (.025) - 0.007 (.027) - -0.00528 - 0.80** (.031) - -0.049** (.023)
Credit* Dependence - 0.21 (0.13) - 0.007 (.014) - 0.24 (0.24) - 0.055 (.015) - 0.034** (.012)
Constant 0.707*** (.232) 0.723*** (.233) 1.851*** (.266) 1.851*** (.266) 2.005*** (.338) 2.032*** (.339) 1.990*** (.269) 2.054*** (.272) - -
Chi-square 11.972 (.152) 10.899 (.207) 13.283 (.102) 13.283 (.102) 4.593 (.800) 4.261 (.833) 6.033 (.644) 3.146 (.925) - -
Pseudo RA2 0.061 0.063 0.003 0.039 0.039 0.044 0.117 0.131 0.096 0.102
Table 2: Financial Development and Firm Innovation
*p<0.01, **p<0.05 and ***p<0.001.
Conclusion
In examining the relationship between financial development and firm innovation in Central Asia (CA), several key findings emerge. Despite the CA region's average financial development level of 0.44, which falls significantly below that of countries like the USA (0.90) , there are noteworthy variations among CA nations. Notably, Uzbekistan's lower equity market development contrasts with the government's efforts to develop the national capital market. Surprisingly, Kyrgyzstan demonstrates the highest average of aggregate innovation indicators among its neighbours, despite its underdeveloped equity and credit markets. The empirical findings reveal a significant positive association between financial development and the License innovation indicator, indicating heightened innovation levels in CA countries with more robust financial markets. However, equity market development exhibits a negative influence on Intangible Assets and Aggregate Innovation indicators, suggesting a detrimental effect on firms reliant on external funds. In contrast, credit market development demonstrates a significantly positive relationship with Aggregate Innovation, implying higher innovation levels with improved credit market development. This research contributes to our understanding of the link between financial development and firm innovation in CA economies, emphasizing the pivotal role of financial market development in fostering innovation and economic growth. The findings underscore the need for further measures by CA governments to stimulate firm innovation through financial market development, highlighting the importance of privatization and promoting exporter firms to ensure equitable access to well-functioning financial markets and foster innovation across sectors.
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