Stigler’s (1971) classic paper on the theory of economic regulation states that “[w]ith its power to prohibit or compel, to take or give money, the state can and does selectively help or hurt a vast number of industries”.
Firms can use political connections to gain unfair advantage in the resource allocation process (e.g. de Soto 1989, Shleifer and Vishny 1994, Fisman 2001, Cingano and Pinotti 2009, Diwan and Haidar 2020, Titl and Geys 2019). While this unfair advantage can be gained in many different ways – lenient applications of regulations, lower tax rates, access to cheaper imported inputs, protection from foreign or domestic competition, or privileged access to public procurement, for example – there is evidence that the easier access to credit enjoyed by politically connected firms has important consequences for the allocation of capital, financial stability, and, possibly, fiscal costs.
Studies have examined the effect of easy access to credit in Italy (Sapienza 2004), Pakistan (Khwaja and Mian 2005), Indonesia (Leuz and Oberholzer-Gee 2006), Brazil (Claessens et al. 2008), and Malaysia (Bliss and Gul 2012). There is also a large body of literature that focuses on China and shows that political connections and affiliation with the communist party give firms greater access to loans, especially from state-owned banks (e.g. Li et al. 2008, Chen et al. 2014, and Peng et al. 2017).
The role of political connections might be particularly important in the formerly planned economies of emerging Europe. While Faccio (2006) shows that Russian firms have the highest degree of political connections, there is limited research on the links between political connections and access to credit for this group of countries. One exception is Hasan et al. (2017), who study the link between political connections and access to finance in Central and Eastern Europe. They find that politically connected Polish firms had easier access to credit in the aftermath of the Global Crisis.
In recent research (Bussolo et al. 2019), we use a proprietary database (see Bussolo et al. 2018 for details) that identifies politically connected firms for a large sample of firms from six central and eastern European economies and show that political connections ease credit constraints, distort capital allocation, and may have large welfare costs.
Our sample consists of about 460,000 firms, of which about 2,000 are classified as politically connected, over the period 2008–2013.
We document that politically connected firms:
- have higher leverage
- have lower profitability
- are less capitalised
- have lower marginal productivity of capital and
- have investment rates which are similar to unconnected firms.
The fact that connected firms have more debt, while having similar investment rates and lower marginal productivity of capital than unconnected firms, suggests that connected firms do not always borrow to invest and, when they do invest, they are likely to misallocate capital.
Privileged access to credit
Observing that connected firms are able to borrow more despite lower profitability, we examine whether such firms have privileged access to credit, even after controlling for all observable and unobservable firm-specific characteristics, including future profitability. We test this hypothesis of privileged access to credit by checking whether connected firms are less likely to rely on their own internally generated funds for undertaking investment.
For our sample as a whole, we find that internally generated funds are positively correlated with investment, indicating the presence of credit constraints for non-connected firms. In other words, firms with available internal funds tend to be firms that invest more: a firm able to increase its cash flow by 1% is also able to boost its investments by a half a percentage point. However, for politically connected firms in our sample, the same correlation is essentially zero, suggesting that connected firms may not be credit constrained at all.
This result is robust across countries in our sample and types of political connections – local, provincial, national, and for state-owned enterprises. It remains unchanged even after controlling for other firm characteristics such as age or size, which could reduce credit constraints.
Capital misallocation and welfare costs
The privileged access to credit enjoyed by politically connected firms could lead to a suboptimal allocation of capital and reduce economy-wide efficiency, if these firms are less productive than their unconnected peers. We find some evidence for this.
Specifically, we find that the negative correlation between leverage and the marginal product of capital tends to be stronger for politically connected firms. Moreover, we show that low-profitability firms tend to benefit the most from political connections, by experiencing disproportionally larger reductions of credit constraints.
Does the process of credit misallocation we documented have a quantitatively important effect on economic growth? A series of back-of-the-envelope counterfactual analyses suggest that it does. If connected firms did not receive preferential treatment, we could assume that both connected and unconnected firms would have the same level of leverage (in fact, the leverage of connected firms should be lower, given that they are less productive and profitable than unconnected firms, but we adopt a conservative assumption of equal leverage).
Therefore, all else equal, in a world with no connections we should observe a redistribution of credit from connected to unconnected firms. This redistribution is very large for Romania and Russia (15% and 40%, respectively) but negligible for other countries.
Figure 1 Counterfactual analysis: GDP (change in percentage points)
Next, we assume that this increase in leverage is translated into an increase in investment by firms equal to the country-specific correlation observed between leverage and investment among unconnected firms. Finally, we use the share of investment to GDP in our sample of countries to estimate the growth effect – a pure demand effect based on GDP accounting – of this counterfactual reallocation of credit. The black bars of Figure 1 capture this.
We have seen that connected firms tend to have low levels of profitability. It is therefore possible that if banks were not under pressure to lend to these firms, they could devote more resources to unconnected firms with higher levels of profitability. This could promote financial depth, and total lending to unconnected firms could increase by more than the reduction in credit to connected firms.
The grey, striped, and dotted bars of Figure 1 show what would happen to GDP if total credit to unconnected firms were to increase by 3%, 5%, or 10%, respectively. Under the most extreme scenario, GDP could increase between one-fifth of a percentage point and 1.4 percentage points across countries in our sample.
Our results are, thus, consistent with the idea that political connections distort capital allocation and have welfare costs.
Our evidence that access to credit is a channel through which political connections tilt the playing field does not imply that this is the only, or even the most important, channel. It is likely that firms with connections obtain additional benefits in terms of lenient applications of laws and regulations, lower effective tax rates, access to cheaper imported inputs, protection from foreign or domestic competition, or privileged access to public procurement (e.g. Cingano and Pinotti 2009). Future research could test some of these other mechanisms and explore whether their welfare costs of state capture are even larger.
Authors’ note: The views expressed in this column are those of the authors and do not represent the views of the IMF and the World Bank, their Executive Boards, or IMF and World Bank management.
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