How Important are credit constraints for small firm growth?

Globalisation has heightened the process of informalisation in developing countries. In India, there has been a significant expansion of the informal sector since the radical economic reforms of 1991, and at present, out of the 485 million workers in India, 86 per cent of them are in the unorganised and informal sector. The informal sector is the largest employment provider in the manufacturing sector in India. One major concern is its low productivity and efficiency despite its growing share in employment and output. The lack of upward progression of firms within the sector is believed to be a major hindrance affecting productivity in the manufacturing sector. Own-account manufacturing enterprises (OAMEs) employing family labour still dominate over Non-directory manufacturing establishments (NDMEs) and the Directory manufacturing establishments (DMEs) employing at least one hired labourer. The presence of such a large number of micro sized household enterprises along with their lack of growth is often attributed to credit constraints that do not allow these firms to increase in size (Hurst and Lusardi 2004).

In this study, the researchers specifically focus on the role of finance constraints in determining the lack of transition of firms from the very small family firms (OAMEs) which are the predominant type of firm in the informal sector to the larger firms that employ non-family labour (DMEs and NDMEs). There is an extensive literature on the importance of the finance constraint on firm growth, but this literature is mostly confined to developed countries, and where the evidence exists for developing countries, it is for the formal sector alone. We know surprisingly little about the role of finance constraints on firm growth in the informal sector. This is a surprising omission, given the dominance of informal firms in the manufacturing sectors of India and many other developing countries. In this paper, Raj and Sen use a very rich data-set based on unit level data drawn from the nationally representative surveys of the informal manufacturing sector undertaken by the NSSO. They test for finance constraints on informal firm growth using a variety of estimation methods including ordered logit and multinomial logit models. They also use the unit level data for the econometric analysis, paying particular attention to endogeneity concerns with our measure of the finance constraint. Raj and Sen supplement the unit level analysis with panel data analysis of 364 districts over the period 1995-2010, where they estimate the effects of financial development on firm transition at the district level.

Raj and Sen find strong and robust evidence that finance constraints play an important role in firm transition from OAMEs, to NDMEs, then to DMEs. However, finance constraints seem to matter for the NDME-DME transition than the OAME-NDME transition. Firm capabilities seem to matter significantly too – e.g firms which maintain accounts are twice as likely to make the transition versus firms which do not. Moreover, firms which work as sub-contractors are 30 per cent more likely to make the transition. They also find that access to electricity, the firm’s location in urban areas and whether the firm has experienced an expansion in its operations previously matter greatly in firm growth. District characteristics also matter – firms in districts with low levels of human capital (share of pop primary and less educated) and social disadvantage (SC/ST share in pop) less likely to make transition. Interestingly, State assistance (loans, training, marketing, etc.) does not seem to matter so much.