Stock market, credit market, and heterogeneous innovations

• Published date: 01 March 2023
• Author: Xun Wang
• Date: 01 March 2023
• DOI: http://doi.org/10.1111/irfi.12390

ORIGINAL ARTICLE

Stock market, credit market, and heterogeneous

innovations

Xun Wang

China Center for Economic Research, National School of Development, Peking University, Beijing, China

Correspondence

Xun Wang, China Center for Economic

Research, National School of Development,

Peking University, Beijing, China.

Email: xunwang@nsd.pku.edu.cn

Abstract

The relative importance of credit market development and

stock market development in boosting innovation remains a

long-standing debate issue. In this study, we document how

different types of financial markets development affect het-

erogeneous innovations. Using a broad sample across

42 developed and emerging economies and a generalized

difference-in-differences identification strategy, we find that

stock market development leads to significantly higher sub-

stantive innovation, especially in young and small firms, but

has negative impact on incremental innovation. Conversely,

credit market development promotes incremental innovation,

especially in mature and large firms, but has negative impact

on substantive innovation. Further analyses indicate that

stronger shareholder protection enhances the positive impact

of stock market on substantive innovation, while stronger

creditor rights enhance the promoting effect of credit market

on incremental innovation, and even turn the negative impact

of credit market on substantive innovation into positive. Our

paper provides new insights into the heterogeneous effects of

credit market and equity markets on the real economy.

KEYWORDS

credit market, creditor rights, heterogeneous innovations,

shareholder protection, stock market

JEL CLASSIFICATION

G10, O16, O30

Received: 4 January 2022 Revised: 13 July 2022 Accepted: 22 August 2022

DOI: 10.1111/irfi.12390

© 2022 International Review of Finance Ltd.

International Review of Finance. 2023;23:103–129. wileyonlinelibrary.com/journal/irfi 103

1|INTRODUCTION

There has been a long-standing debate on the different roles of equity and credit markets in promoting economic

performance. While positive relations between financial markets development and economic growth has been theo-

retically demonstrated and cross country evidence has been empirically identified (Beck et al., 2000; Levine, 2005;

Rajan & Zingales, 1998), the relative importance of equity and credit market on innovations remains an open ques-

tion (Brown et al., 2017). Although better access to external equity finance tends to foster innovation due to its

advantage of funding innovative investment, literature still fails to reach a consensus on credit market and innova-

tion. For example, findings in Brown et al. (2013), Hsu et al. (2014) among others, suggest credit market development

has little or even negative effects on innovation. On the other hand, Amore et al. (2013) finds credit supply through

banking deregulation plays a key role in manufacturing firms' innovation. Mann (2018) shows that strengthening

creditor rights are associated with more debt financing and then more R&D investment. Further, comparatively few

empirical evidence connects the types of financial markets and heterogeneous innovations.

In this paper, we evaluate the relative merits of equity market and credit market development on heterogeneous

innovations. Akcigit and Kerr (2018) highlights the substantial distinctions of innovations in their types and qualities,

and distinguish two forms of innovative inputs that firms undertake. Firms undertake external or exploration R&D to

create new products and technologies, while firms undertake internal or exploitation R&D to improve existing prod-

uct line. Accordingly, we distinguish two types of innovative outputs that firms undertake: substantive and incremen-

tal, based on the nature of patents. According to the World Intellectual Property (WIPO), utility patents represent

substantive and sometimes radical innovations because they are granted for major inventions and discoveries of

technology. Conversely, utility model patents relate to more marginal improvements and minor inventions as they

are granted primarily for small improvements to existing products and adaptations of existing technology. Therefore,

based on Hall and Ziedonis (2001), Akcigit and Kerr (2018) and Chua et al. (2019), among others, we consider utility

patents as substantive innovations, and utility models as incremental innovations (Table A1 provides definitions and

examples for unitility patent and utility model).

Our main idea is that stock market development is particularly important for investment in substantive innova-

tion because the higher risk and probability of failure of substantive innovation sharply limits firm's ability to use

external credit finance. In contrast to new product and technology inventions, investment in minor improvements of

existing technology and products are typically less risky, and often has collateral value when the products or existing

patents could be pledged, making them much easier to access to external debt finance. Then we expect credit market

development may have an advantage in incremental innovations aiming at improving existing product lines and

technologies.

We test these ideas by exploring how the types of domestic financial markets affects industry-level utility pat-

ents and utility models, measured at both patent counts and citations levels. Using multiple measures of equity and

credit financing, we focus on four main empirical predictions that to the best of our knowledge, have not been

explored previously. First, we expect better developed stock market financing to have a positive effect on substan-

tive innovations while has a negative effect on incremental innovations. Second, we conversely expect better devel-

oped credit market has a negative effect on substantive innovations while has a positive effect on incremental

innovations. Third, we expect stock market financing to have stronger effect on small and young firms, and credit

market access to favor larger and more mature firms in financing innovation. Finally, we expect legal investor protec-

tions in stock market enhance the promoting effects of stock market access on substantive innovation while stronger

creditor rights to alleviate the discouraging effects of credit market on substantive innovation and to enhance the

promoting effects of credit market access on incremental innovation.

To evaluate these predictions, we employ the generalized difference-in-differences approach put forward by

Rajan and Zingales (1998) to identify the causal links between financial development and industrial sectors growth.

As argued by Rajan and Zingales (RZ), if financial development facilitates economic growth, it should have a greater

effect on the growth of industries that are more dependent on external finance. This insight can naturally extend to

104 WANG