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How Do Firms Finance Investment?

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A large body of literature has found that in countries with weak institutions firms are able to obtain less external financing, resulting in lower growth.  Indeed, even simple cross-country comparisons of firm financing patterns can be quite revealing.  In a paper co-authored with Thorsten Beck and Vojislav Maksimovic, this is exactly what we do.  Using data from the World Bank’s Enterprise Surveys dataset (WBES) for 48 countries, we investigate what proportion of firm investment is financed externally, and, of this external finance, how much of it comes from different sources, such as bank and equity finance, leasing, supplier credit, development banks, and informal sources such as money lenders.

In our sample of firms, on average just over 40 percent of firm investment is externally financed.  Breaking external financing down into its parts, about 19 percent of all financing comes from commercial banks and 3 percent from development banks.  Another 7 percent is provided by suppliers and 6 percent through equity investment.  Leasing is another 3 percent, and less than 2 percent comes from informal sources.  More recent enterprise survey data for an expanded sample of countries and firms also suggest similar patterns (Figure 1).

Source: Enterprise Surveys, covering 71 countries

Our results show that, even after we control for various firm characteristics and country and institutional variables, smaller firms finance a lower proportion of their investment externally, particularly because they make use of bank finance to a lesser extent.  We would expect that small firms, facing informational asymmetries in financial markets, would rely more heavily on subsidized financing from government and financing from sources that rely on personal or commercial relations, such as trade credit or informal finance.  We would also expect that such sources would be more significant in countries with poorly functioning financial systems or weak property rights protection.

Our findings only partially confirm these prior expectations that small firms substitute bank finance with other sources of external finance, especially in countries with underdeveloped institutions and financial markets.  Controlling for firm and country characteristics, we do find that small firms use significantly more informal finance than large firms.  However, financing from such sources is very limited.  Thus, the use of informal financing does little to relax financial constraints faced by small firms in developing economies. Moreover, we find that small firms do not use disproportionately more leasing or trade finance compared with larger firms.  On the contrary, if anything, the opposite is true.  In particular, financing from leasing does not fill the financing gap of small firms in countries with underdeveloped institutions because the use of leasing finance is positively associated with the development of financial institutions and equity markets.

Surprisingly, small firms also do not finance their investment significantly more from government sources or development banks, despite the fact that programs focused on expanding small-firm finance are often an easy political sell.  More often than not, it is the larger firms that receive government or development bank funding.  Overall, these findings point out the limits to small firms’ ability to compensate for the underdevelopment of their countries’ financial and legal systems.  In these countries, alternative sources of finance either do not significantly fill the gap or, in the case of trade credit, are less prevalent.

Investigating the linkages between firm size and the impact of institutional development on financing patterns, we see that small firms benefit disproportionally from higher levels of property rights protection by using significantly more external finance, particularly from banks.  These results underline the importance of improving the institutional environment for increasing the access of small firms to external finance.  Hence one of the most effective ways of improving small firms’ access to external finance is likely to be through institutional reforms addressing the weaknesses in legal and financial systems.

Further reading:

Beck, Thorsten, Asli Demirguc-Kunt and Vojislav Maksimovic, “Financing Patterns around the World: Are Small Firms Different?” Journal of Financial Economics, Vol 89, No. 3, September 2008.


Asli Demirgüç-Kunt

Former Chief Economist, Europe and Central Asia Region

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