RETURNS TO CAPITAL IN RETURNS TO CAPITAL IN MICROENTERPRISES: EVIDENCE MICROENTERPRISES: EVIDENCE

FROM A FIELD EXPERIMENTFROM A FIELD EXPERIMENT

Chris Woodruff, UC San DiegoChris Woodruff, UC San Diego(With David McKenzie and Suresh de (With David McKenzie and Suresh de

Mel)Mel)

October 2006October 2006

The projectThe project

We estimate returns to capital for We estimate returns to capital for a set of very small household a set of very small household enterprises.enterprises.

No paid employees, capital of less No paid employees, capital of less than $US 1000 (~lower 25% of than $US 1000 (~lower 25% of distribution of self employed in Sri distribution of self employed in Sri Lanka)Lanka)

Returns to capital in Returns to capital in microenterprises --Why do we care?microenterprises --Why do we care?

Large portion of urban labor Large portion of urban labor market is self-employed. About market is self-employed. About one-third in Sri Lankaone-third in Sri Lanka

What is the potential for growth What is the potential for growth of these enterprises?of these enterprises?

Even absent sustained growth, Even absent sustained growth, what is the potential for what is the potential for increasing incomes among these increasing incomes among these individuals?individuals?

Why might returns be high or low?Why might returns be high or low?

Low returns:Low returns:– Minimum scale of investment / non-Minimum scale of investment / non-

convex production sets convex production sets High returns: High returns:

– Capital constraintsCapital constraints– Risk / uncertaintyRisk / uncertainty

Evidence on returns to capital in Evidence on returns to capital in enterprises enterprises

Among others:Among others: Banerjee and Duflo 2003 (74%)Banerjee and Duflo 2003 (74%) Bigsten et al (30%)Bigsten et al (30%) Udry and Anogol 2006 (60%)Udry and Anogol 2006 (60%) McKenzie and Woodruff 2006 McKenzie and Woodruff 2006

((10%/month)10%/month)

What is wrong with existing What is wrong with existing evidence?evidence?

Some from cross section: Worry about Some from cross section: Worry about conflating ability and capital investmentconflating ability and capital investment

Some from loan programs: Measure Some from loan programs: Measure only for the self-selected sample that only for the self-selected sample that applies for creditapplies for credit

McKenzie and Woodruff suggests that McKenzie and Woodruff suggests that returns are high in the broad sample of returns are high in the broad sample of firms, yet take up rates for loan firms, yet take up rates for loan programs are lowprograms are low

The ExperimentThe Experiment

Randomized experiment where we Randomized experiment where we provide grants to enterprises to create provide grants to enterprises to create exogenous variation in capital stockexogenous variation in capital stock

Selected 618 firms in three districts in Selected 618 firms in three districts in southern Sri Lanka (Kalutara, Galle, southern Sri Lanka (Kalutara, Galle, Matara)Matara)

– Sample drawn from block-to-block census Sample drawn from block-to-block census in selected GNsin selected GNs

Surveyed first in March 2005, then Surveyed first in March 2005, then quarterly since (5 waves used in the quarterly since (5 waves used in the paper – now up to 7 waves)paper – now up to 7 waves)

The ExperimentThe Experiment

Firms in three zones: Firms in three zones: 1)1) Suffered direct damage from Suffered direct damage from

tsunamitsunami

2)2) In coastal zone, but no damageIn coastal zone, but no damage

3)3) Farther inlandFarther inland In this paper, we exclude firms In this paper, we exclude firms

directly affected by the tsunamidirectly affected by the tsunami

The enterprisesThe enterprises

All had less than 100,000 SLR All had less than 100,000 SLR ($US1000) in capital (not counting land ($US1000) in capital (not counting land and buildings) in baseline survey and buildings) in baseline survey

Half in retail, the other half in Half in retail, the other half in manufacturing / services (clothing, manufacturing / services (clothing, lace, bamboo, food products)lace, bamboo, food products)

Sri Lanka: capital shockSri Lanka: capital shock

After the first and third round of the After the first and third round of the survey, randomly selected firms were survey, randomly selected firms were given capital shockgiven capital shock– ~$100 or ~$200, in cash or equipment~$100 or ~$200, in cash or equipment– 59% of firms received treatment59% of firms received treatment

Larger treatment is:Larger treatment is:– About 75% of median capital stockAbout 75% of median capital stock– About 6 months of reported earningsAbout 6 months of reported earnings

Use grants rather than loans because Use grants rather than loans because we want to measure the full spectrum we want to measure the full spectrum of firmsof firms

Capital ShockCapital Shock

Baseline survey asked what firms Baseline survey asked what firms would purchase if they had:would purchase if they had:

% Inventories% Inventories5,0005,000 68%68%10,00010,000 59%59%15,00015,000 49%49%Most Most profitableprofitable 17%17%Median most profitable investment is 25,000; Median most profitable investment is 25,000;

2/3rds say less than 30,000; 20,000 is enough 2/3rds say less than 30,000; 20,000 is enough for 42% of the firms to make their most for 42% of the firms to make their most profitable investmentprofitable investment

Capital ShockCapital Shock

About 55% of the in-kind About 55% of the in-kind treatments were inventoriestreatments were inventories

Of the cash treatments invested Of the cash treatments invested in the enterprise, about 2/3rds in the enterprise, about 2/3rds were spent on inventorieswere spent on inventories

Pre-treatment meansPre-treatment means

Post-treatment meansPost-treatment means

Estimate FE regressionEstimate FE regression

Also consider revenues, log profits

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ResultsResults

Median 7000 3000

Table 4: Effect of Treatment on Revenues and Profits

(2) (4) (7) (9)

Revenues ProfitsFE FE FE FE

0.177*** 3058*** 0.126*** 531.369**

Hours worked -0.0003 12.7 0.001 3.3

Wave effects yes yes yes yes

Observations 1812 1812 1795 1795Number of groups 383 383 383 383

Log profits

Treatment amount (0, 1, 2)

Log revenues

ResultsResults

Effect of Treatment on Profits

5 rounds 5 rounds 7 rounds 7 rounds1% trim 1% trim

Profits ProfitsFE FE FE FE

568.7** 614.4** 712.5*** 557.1***

Wave effects yes yes yes yes

Observations 1857 1834 2575 2531Number of groups 383 383 383 383

Profits

Treatment amount (0, 1, 2)

Profits

InterpretationInterpretation

10,000Rs treatment increases 10,000Rs treatment increases profits by 560-712Rs. i.e. a 5.6-profits by 560-712Rs. i.e. a 5.6-7.1% return7.1% return

Log specification gives around 4% Log specification gives around 4% return.return.

Non-linearities in returns?Non-linearities in returns?

5 rounds 5 rounds 7 rounds 7 rounds

1% trim 1% trim

813.3** 731.5** 851.2* 575.9**

1022.4** 1172.2*** 1357.0** 1100.9***

F-test p-value 20,000 = 2*10,000 effect 0.480 0.623 0.725 0.929

Observations 1858 1835 2576 2534Number of firms 383 383 383 383

Profits

Treated amount 10,000 Rps

Tests for Linearity of Impact

Treated amount 20,000 Rps

Cash vs Equipment Cash vs Equipment TreatmentsTreatments Cash was given without restrictions, Cash was given without restrictions,

told they could purchase anything they told they could purchase anything they wanted, for themselves, household, wanted, for themselves, household, business, or otherbusiness, or other

Asked owners what they had done with Asked owners what they had done with treatmenttreatment

Approximately 58% of cash was Approximately 58% of cash was invested in business, additional 12% invested in business, additional 12% saved, 6% used to repay loans.saved, 6% used to repay loans.

Cash vs. equipment treatmentsCash vs. equipment treatments

Cash vs Equipment Treatments5 rounds 5 rounds 7 rounds 7 rounds

1% trim 1% trimProfits Profits

FE FE FE FE523.4* 527.0** 889.1** 633.7***

Equipment Amount 613.2** 700.5*** 537.3 482.0***

F-test of equality p-value 0.811 0.501 0.413 0.543

Observations 1857 1834 2575 2531Number of groups 383 383 383 383

Cash Amount

Profits Profits

Higher profits or Higher profits or higher higher reportedreported profits?profits? Possible concern is that this might just reflect a Possible concern is that this might just reflect a

change in reporting of profits:change in reporting of profits:1) Perhaps treated firms trust us more and so are less 1) Perhaps treated firms trust us more and so are less

likely to underreportlikely to underreport– Address this by looking at reporting done after Address this by looking at reporting done after

treatment for sales in periods before treatmenttreatment for sales in periods before treatmenti)i) Asked March 2005 sales in Round 1, and then re-asked Asked March 2005 sales in Round 1, and then re-asked

about these in Round 2, after some firms were treated.about these in Round 2, after some firms were treated.=> No significant differences between groups in ratios=> No significant differences between groups in ratios

ii) Second group of firms were treated in November, ii) Second group of firms were treated in November, interviewed at start of October and in January. interviewed at start of October and in January. Compare ratio of October sales (asked Jan) to Compare ratio of October sales (asked Jan) to September sales (asked Oct) for treated vs untreatedSeptember sales (asked Oct) for treated vs untreated

=> again find no significant difference between groups.=> again find no significant difference between groups.

Higher profits or Higher profits or higher higher reportedreported profits?profits?2) Perhaps then firms overreport profits after 2) Perhaps then firms overreport profits after

treatment, since they want to show us that treatment, since they want to show us that giving them money is good?giving them money is good?

- If this was the case, we would expect them to If this was the case, we would expect them to overreport the share of the cash treatment overreport the share of the cash treatment invested in businessinvested in business

- But on average say about 55-65% invested in But on average say about 55-65% invested in business, and return we get from cash business, and return we get from cash treatment is 2/3treatment is 2/3rdrd return from equipment return from equipment treatmenttreatment

=> Appears that treated firms are not => Appears that treated firms are not overreportingoverreporting

Results so far:Results so far:

Real returns 5-6% per monthReal returns 5-6% per month No evidence inconsistent with No evidence inconsistent with

linearity of returnslinearity of returns Only small decay over timeOnly small decay over time Returns are much higher than Returns are much higher than

interest rates on micro loans (3-7% interest rates on micro loans (3-7% per year)per year)– What “explains” this gap?What “explains” this gap?

Females vs MalesFemales vs Males

Many microfinance organizations Many microfinance organizations concentrate on lending to womenconcentrate on lending to women

Is there any evidence to support Is there any evidence to support them having higher returns?them having higher returns?

See that women invest lower See that women invest lower share of the cash treatment in share of the cash treatment in business on average (67% vs business on average (67% vs 88%, p=0.08).88%, p=0.08).

Males vs FemalesMales vs Females

Gender and Treatment Effect5 rounds 5 rounds 7 rounds 7 rounds

1% trim 1% trimProfits Profits

FE FE FE FE782.4** 835.9*** 807.9** 795.5***

Amount*Female -667.9 -588.3* -467.3 -715.9**

Observations 1857 1834 2575 2531Number of groups 383 383 383 383

Profits Profits

Amount

What do the firms say What do the firms say are their constraints?are their constraints?

Table 7: What do Firms Report as Constraints to Growth?

% of firms reporting that this is a constraint

Lack of Finance 92.7 CREDITLack of Inputs 53.8 MARKETLack of Demand 34.5 RISKINESSLack of Market Information 15.9 OF RETURNSLack of Clear Ownership of Land 15.7Economic policy uncertainty 15.1Costs of hiring new employees 11.2Poor quality roads 8.1Lack of trained employees 6.8Legal regulations 6.3Poor quality electricity and phone 3.7High crime rates 1.6High tax rates 1.0

How do firms finance How do firms finance existing business?existing business? Only 3.1% have bank accountOnly 3.1% have bank account 89% got 89% got nono start-up funding from bank start-up funding from bank

or microfinanceor microfinance 71% relied entirely on own savings and 71% relied entirely on own savings and

family for start-up fundsfamily for start-up funds 83-100% of firms making purchases of 83-100% of firms making purchases of

equipment between waves used only equipment between waves used only own savings and family to finance thisown savings and family to finance this

Internal capital market of household is Internal capital market of household is major source of funds.major source of funds.

Heterogeneity of returnsHeterogeneity of returns

Model of capital constraints, risk and Model of capital constraints, risk and uncertainty. uncertainty.

Household has endowment of assets, earns Household has endowment of assets, earns money from market labor of other household money from market labor of other household members. members.

Can finance capital stock through borrowing, Can finance capital stock through borrowing, and through its internal capital market and through its internal capital market

With well-functioning credit and insurance With well-functioning credit and insurance markets, will choose capital stock such that markets, will choose capital stock such that marginal return to capital = market interest ratemarginal return to capital = market interest rate

With missing markets, marginal return to capital With missing markets, marginal return to capital will exceed market ratewill exceed market rate

Heterogeneity of returnsHeterogeneity of returns

Predictions:Predictions:– Returns lower when capital constraints less Returns lower when capital constraints less

severesevere More workers in household (baseline)More workers in household (baseline) Lower entrepreneurial ability (measures: education; Lower entrepreneurial ability (measures: education;

digit span test; self-efficacy; time solving maze)digit span test; self-efficacy; time solving maze) Higher wealth (durable assets)Higher wealth (durable assets)

– Returns higher when more risk and Returns higher when more risk and uncertaintyuncertainty

CRRA estimated with lottery exerciseCRRA estimated with lottery exercise Uncertainty from subjective distn of profitsUncertainty from subjective distn of profits

Heterogeneity of returnsHeterogeneity of returns

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Heterogeneity of returnsHeterogeneity of returns

Table 9: Treatment Effect HeterogeneityDependent Variable: Log Profits

(1) (2) (3) (6) (7) (8)Treatment Amount 0.126*** 0.238*** 0.131*** 0.118*** 0.125*** 0.201**

Interaction of Treatment Amount with:Number of Workers -0.0946**

Asset Index -0.00428

Broad Entrepreneurial Ability 0.0926***

Risk Aversion -0.00995

Uncertainty -0.136

ConclusionsConclusions

Shocks to capital were large and random, Shocks to capital were large and random, and hence uncorrelated with abilityand hence uncorrelated with ability

Suggested returns 4-8% per monthSuggested returns 4-8% per month No evidence of non-linearities in returnsNo evidence of non-linearities in returns Returns higher where capital constraints Returns higher where capital constraints

bind tighterbind tighter No evidence returns affected by risk, No evidence returns affected by risk,

uncertaintyuncertainty