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Firm Size and the Impact of the Credit Crunch on Enterprise

Financing in Emerging Markets

Julia Korosteleva

University College London, UK

Natalia Isachenkova

Kingston University London,

UK

Yulia Rodionova

De Montfort University, UK

Notes for Presentation at the 20th Anniversary of the New Economic School Conference

Moscow, Russia

15 December 2012

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Motivation

The paper looks at

Finance for Real Investment in Small and Medium-sized Entreprises

– SMEs - in the emerging markets of Europe and Central Asia

during the 2007-2009 global financial crisis

• Financing Constraints or Access to Finance and their Determinants

• Sources of Investment Finance and their Determinants

• Emphasizes the interactions of Firm Size and Crisis and of Firm Size and Trade Credit

The Rationale:

Expanding access to finance presents a policy challenge that captures attention, e.g.

Fraser (2009): empirical evidence that the UK SMEs face tighter constraints during the crisis

Rehman (2011): for the UK firms - reports a decline in trade credit during the crisis

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Motivation

• SMEs finance in emerging markets in crisis times is particularly interesting since

the small business sector is credited with innovation, job creations, reduction of income inequality …

• Gorodnichenko and Schnitzer (2010), Klapper et al. (2002),

Pissarides et al. (2003), Beck et al. (2005) demonstrate

adverse implications of financing constraints for productivity growth at both micro

and macro levels, and economic growth

• Didier et al. (2011): A big impact of the crisis on exports and production, on the international

payments in the emerging markets of Europe and Central Asia

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Theory

Determinants of Credit Constraints

Bernanke and Gertler (1995), Bernanke, Gertler & Gilchrist (1998),

Tornell and Westermann (2005) offer results consistent with RBC theory

SMEs face tighter financing constraints during crises when banks are less willing to lend

Determinants of Capital Structure

Modigliani-Miller’s Irrelevance in a frictionless world draws our attention to the importance

of understanding financial / market frictions such as contracting costs and information costs

For emerging markets’ small firms there are compelling reasons to believe

the assumptions of the Modigliani-Miller (1958) theory are violated based on

asymmetric information and transaction costs considerations due to opaqueness

- lack of detail in business accounts, short track records …

Trade-off Theory

firms pick leverage by weighing the benefits (e.g. tax-deductibility)

and costs (e.g. financial distress costs) of an additional unit of debt

Pecking Order Theory

Information costs of issuing lead to Retained Earnings being preferred to Debt,

and Debt being, in turn, followed by Fresh Equity

Theories tend to derive overlapping predictions – difficult to design clear empirical tests

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Research Questions

• For the emerging Europe and Central Asia, does the inverse relationship

between Firm Size and Financing Constraints hold?

• For the emerging Europe and Central Asia, does the inverse relationship

between Firm Size and Financing Constraints hold for the crisis years?

Pecking order Theory suggests relevance of Trade Credit Finance

Cook (1999) shows that Trade Credit determines financing constraints in Russian firms

• Whether SMEs of the emerging Europe and Central Asia could lessen

financing constraints through:

increasing Trade Credit finance / increasing Operating Financial Leverage OR

increasing Owners Contribution / Fresh Equity Finance ?

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Empirical Design: Data, Sample, and Explanatory Variables

Firm-level data come from 2002-2009 BEEPS

Business Environment and Enterprise Performance Surveys, project of WB and EBRD

12,807 firms covering 26 transition economies of Europe and Central Asia

89.3 % of the firms are SMEs with fewer than 250 employees

• Firm-level variables: Firm’s Size and Age, Social Capital, Pressure to Innovate,

Being an Exporter, Internationally Certified Product(s), Started, and remained, as

Privately Owned, Being Foreign-Owned

• Institutional Variables:

- Indicator of Financial Development:

one-year lagged domestic credit to private sector over GDP

from World Development Indicators (WB)

- Property Rights Protection:

one-year lagged indicator of effective constraints imposed by the executive

from Polity IV

• Crisis: a dummy for Years 2008 and 2009

• Controls: Industry and Country

Business Cycle as measured by a one-year lagged GDP growth rate,

Economic Development as measured by GDP per capita

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Empirical Design: Dependent Variables and Causality

• Perceived tightness Financing Constraints:

A dummy variable is created using responses to the question

‘Does Access to Finance – BOTH availability and cost of finance - present

No Obstacle, a Minor Obstacle, Moderate Obstacle, Major Obstacle, Very Severe Obstacle

to the current operations of the firm ?’

Major Obstacle and Very Severe Obstacle are coded as ‘1’

• Financing Choices: Six indicators of are created using responses to the question

‘… Estimate the proportion of the establishment’s total purchase of fixed assets

in the reference year that was financed from each of the following sources:

1. Internal funds or retained earnings

2. Owners’ contribution or issued new equity shares

3. Borrowed from private banks

4. Borrowed from state-owned banks

5. Purchases on credit from suppliers and advances from customers

6. Other (moneylenders, friends, relatives, non-banking financial

institutions etc) ..’

We term ‘Other’ Informal Finance

That gives us the shares of each of the capital type sought when financing

real assets

• Causality: measurement of financing choices comes before measurement of constraints

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Dependent Variables: Financing Constraints are a Major OR Severe

Obstacle to the Current Operations of the Firm:

SMEs vs. Large Firms, %

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Dependent Variables: Sources of Finance for Fixed Assets

Investment in SMEs, %

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Empirical Results: Perceptions of Financing Constraints as a Major

OR Severe Obstacle to the Current Operations of the Firm:

Estimates from the Full Sample

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Empirical Results: SURE Model of Financing Choices of Firms:

Estimates from the Full Sample Addressing the selection bias problem.

The inverse Mill’s Ratio from the

1st stage investment equation that models choice

to invest in fixed assets, is added as a control

to the 2nd stage SURE equation. ‘Investment ‘

Instrumented with the rate of capacity utilization.

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Empirical Results: SURE Model of Financing Choices of Firms:

Estimates from the Sample of SMEs Addressing the selection bias problem.

The inverse Mill’s Ratio from the

1st stage investment equation that models choice

to invest in fixed assets, is added as a control

to the 2nd stage SURE equation. ‘Investment ‘

Instrumented with the rate of capacity utilization.

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Empirical Results: Impact of Use of Trade Credit for Real Investment on

Perceptions of Financial Constraints: Estimates from the Sample of SMEs ‘Use of Trade Credit’ is the relative percentage of purchases of fixed assets on credit

from suppliers and advances from customers.

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Conclusions

SMEs appear to report tighter financial constraints

The crisis makes less pronounced the differences in perceived financing constraints between small and larger firms

In SMEs, increasing the proportion of Trade Credit in the financing mix, seems to lessen perceived financing constraints

Trade credit channel seems important for overcoming financing constraints in the emerging markets of Eastern Europe and Central Asia