Firm-level productivity is highly dependent on the presence of efficient financial markets. Easy access to finance expedites firms’ investments and facilitates physical and human capital accumulation as well as the development and adoption of new technologies (Redmond and Van Zandweghe 2016). By contrast, imperfectly functioning financial markets may lead to capital misallocation, with the consequence that firms unable to access credit forego productivity-boosting investment opportunities (Campello et al. 2010).
The fundamental consequence of credit rationing is that, for lack of alternatives, rationed firms often have to rely on internally generated resources to undertake new investments, meaning that their investment decisions become highly dependent on cash flow availability (Ayyagari et al. 2011). Credit constraints can therefore smother firms’ productivity, with the effects particularly relevant for smaller firms (Motta 2020). Larger firms have easier access to credit than smaller ones, as the former have more information to share with potential investors, more options to signal their performance, more assets that can be used as collateral in loans, and lower idiosyncratic and insolvency risks (Andrieu et al. 2018).
On top of firm size, credit rationing may be affected by the context in which firms operate. National macroeconomic conditions, development and regulation of the national financial sector, and quality of national institutions are fundamental factors influencing both firms’ access to credit (Andrieu et al. 2018) and performance (Bowen and De Clercq 2008). However, the local context is also relevant in this respect. This is particularly true for smaller rather than larger firms, as the latter can typically access financial intermediaries and capital markets on a national or even international scale, while the former are more dependent on local bank financing (Alessandrini et al. 2009).
Consequently, as smaller firms remain more dependent than larger ones on (local) bank lending and are also more credit rationed, they are also more inclined to rely on alternative, non-institutional sources of funding. They rely on trade credit for short-term financing (Ogawa et al. 2013) and on state subsidies (Gerritse and Rodríguez-Pose 2018) or informal sources of finance (Hanedar et al. 2014) to expand investment opportunities otherwise based solely on the available cash flow.
Hence, the quality of regional institutional conditions can contribute to lessen the credit constraints confronting many firms. High-quality local governments can directly contribute to enhance productivity at the level of the firm by guaranteeing, for example, market competition, a better rule of law, a more efficient system of contract enforcement, better protection of property rights, and lower corruption (Ganau and Rodríguez‐Pose 2019). But local governments can also indirectly support productivity improvements by alleviating the negative returns of credit constraints. High-quality local institutions can promote a ‘safe’ and stable local business environment, where increased reputation and trust among business partners (suppliers and customers) facilitates repeated production transactions and, through these, the emergence of inter-firm financial relationships (Cainelli et al. 2012). Trade credit represents a key alternative source of financing for firms to mitigate the credit constraint problem (Ganau 2016).
Yet the role of the regional institutions in influencing firms’ productivity, in general, and the credit constraints-productivity relationship, in particular, has received little attention. In our recent research (Rodríguez-Pose et al. 2020), we address this question by examining whether and to what extent the negative productivity returns of credit rationing are mitigated by high-quality regional institutions.
Does credit rationing hamper firms’ productivity? And does ‘good’ governance play any role?
If credit constraints prevent productivity improvements, why is it so difficult to remedy this problem? To answer this question, we study the mechanisms behind the relationship between credit constraints and firm-level productivity at local level, concentrating on the role played by regional institutional quality. This research exploits information on 22,380 manufacturing firms in 11 European countries – Belgium, Bulgaria, Czech Republic, France, Germany, Hungary, Italy, Portugal, Romania, Slovakia, and Spain- observed between 2009 and 2016.
The results highlight, first, that credit constraints are indeed a serious problem for European firms. This problem affects smaller firms, in particular, which consequently have to rely on internally-generated resources to finance new investments to a far greater extent than larger ones. Second, credit rationing stifles firms’ labour productivity, especially in the case of smaller firms. Third, the quality of regional governance is also a key factor in this relationship. High-quality regional institutions push productivity up directly and, as shown in Figure 1, play an indirect positive role in softening the negative productivity returns of credit rationing.
Figure 1 Credit constraints, labour productivity, and the moderation effect of regional institutional quality.
Note: The plot represents the estimated marginal effect of credit constraints on labour productivity at the various levels of regional institutional quality. The solid line refers to the estimated effects, while the dashed lines refer to the associated confidence intervals.
However, this indirect positive effect of local institutional quality highly depends on firm size. The negative productivity returns of credit constraints for the average micro- and small-sized firms located in a region at the bottom of the scale in terms of regional institutional quality are almost 32% and 20% higher than for micro- and small-sized firms in a region at the top of the scale, respectively. By contrast, this difference amounts to only 9% and 8.2% for medium- and large-sized firms, respectively. Overall, the negative productivity returns of credit constraints are almost three times greater for a micro-firm located in a region with the worst institutional quality than for a large one in a region with the best institutional quality.
For long, credit constraints have been deemed to be a major obstacle for firms to thrive. Hence, schemes aimed at supporting the capacity of commercial banks and other financial institutions to lend to firms – and, especially, to micro-, small-, and medium-sized ones – address an important market failure. They can make a crucial difference in terms of mobilising local potential and increasing productivity. However, in areas with low-quality institutions, incentivising financial institutions to lend to small firms would, on its own, not do the trick. Weak government quality not only affects the capacity of firms to operate in the market, but also contributes to limit their access to funding, for example by weakening the opportunities for trade credit through production transactions. Measures to facilitate access to credit need to be complemented with interventions to improve institutional quality, as both factors together are far more effective in reducing the negative returns of credit constraints and improving the productivity of European firms.
Author's note: Monica Brezzi was at CEB at the time of writing.
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