Financial development, sectoral reallocation, and volatility: International evidence

This paper studies how financial development affects the volatility of GDP growth through the channel of sectoral reallocation. For 28 OECD countries over the period 1970-2007, we construct a benchmark industrial portfolio that minimizes the economy's long-term volatility for a given level of long-term labor productivity growth. We find that financial development substantially increases the speed with which the observed industrial composition of output converges toward the benchmark. To overcome endogeneity concerns, we exploit sectoral sensitivities to financial deepening and exogenous liberalization events.