Financial Development, Financial Constraints and Firm Investment: Cross- Country Evidence Varouj Aivazian* University of Toronto Eric Santor ‡ Bank of Canada Preliminary Draft – Not to be Cited Abstract Previous studies using macroeconomic data have shown that financial development is positively correlated with higher growth (Levine, 1997). Further work at the industry level reveals that financial development matters more for firms that are dependent on external finance (Rajan and Zingales, 1998). However, the effect of financial liberalization and development may differ widely across firms, given that intra-industry variation is often greater than inter-industry variation (MacKay and Phillips, 2002). Consequently, to accurately assess the effect of financial development, it is necessary to consider that those firms that can benefit from financial liberalization and development may be systematically different from those that cannot. This paper explores the links between financial development and investment growth at the firm level, across developed and developing countries. To accurately account for the effects of financial development on firm level performance, we introduce program evaluation techniques that properly account for the impact of the “treatment on the treated.” We find that failure to control for the effect of “participation” in financial development leads to biased estimates of the effect of financial development on investment growth. JEL Classification: O4, F3, G1 Key Words: financial development, financial constraints, investment *Varouj Aivazian, Department of Economics, University of Toronto, Toronto, Canada M5S 3G7 Tel: (416) 978-2375 Fax: (416) 978-6713 e-mail: aivazian@chass.utoronto.ca ‡ Eric Santor: International Department, Bank of Canada, 234 Wellington Ottawa Canada K1A 0G9. Tel : (613)782-7017 E-mail: esantor@bank-banque-canada.ca We would like to thank Michael Francis, Michael McIntyre, and Larry Schembri for very useful comments on an earlier draft. All remaining errors are our own. The views in this paper are those of the authors and do not represent the views of the Bank of Canada or its staff.