How do political connections affect the financial markets and the allocative efficiency of resources in less developed countries? A considerable body of literature argues that politically connected firms can obtain loans with more relaxed terms than non-connected firms (e.g. Khwaja and Mian 2005, Cole 2009, Faccio et al. 2006). Politically connected firms are also found to be more likely to default (Khwaja and Mian 2005, Cole 2009). These findings combined imply that politically connected lending may distort the allocative efficiency of resources and be detrimental to the economic development of those countries.
However, Li et al. (2008) find that whereas Chinese private firms of which entrepreneurs are members of the ruling Communist Party can borrow more from banks, their returns on equity are higher than other firms. This evidence implies that political connections of firms in China lead to more efficient allocation of resources. This is probably due to Communist Party membership alleviating problems resulting from asymmetric information in financial markets. That is, although credit information of firms may not effectively reach financial institutions, Communist Party membership signals a high ability of firm directors, as suggested by Li et al. (2007), and thus enables such firms to borrow more. Li et al. (2008) conclude that political connections of firms complement underdeveloped financial markets in China.
Political connections and SME financing: Evidence from Indonesia
Therefore, the role of political connections in economies where markets are underdeveloped is still unclear and may depend on their conditions. To provide new evidence in this debate, we recently conducted a study on small and medium-sized enterprise (SME) financing in Indonesia based on a unique survey of more than 300 firms across 17 cities (Fu et al. 2015). Indonesia is an interesting case for this analysis because of its high level of corruption – 25% of firms are expected to give gifts to receive an operating license, compared with 6%-7% in the Philippines and Vietnam (Figure 1).
Figure 1. Percentage of firms expected to give gifts to receive an operating license (OECD 2012)
We collected detailed information on firms’ political connections, including state ownership and ease of obtaining information from the government, and information on their bank finances, including whether they could receive the full loan amount for which they applied. Moreover, by utilising detailed personal information of owners, directors, or highly-ranked managers, such as their education background, religion, and personal relationship with politicians, we can explicitly control for the effect of their personal ability on firms’ productivity.
We find that loan applications of firms whose owners or directors have a personal relationship with any politician are more likely to be approved by state-owned banks. Moreover, such firms can receive the full loan amount applied for from banks more easily than other firms. Figure 2 shows that 30% of politically connected firms are credit-constrained (i.e. they cannot receive the full loan amount), while the share of credit-constrained firms is much higher (51%) among firms with no political connections. Moreover, labour productivity of politically connected firms that borrow from state-owned banks is lower on average. Our results thus indicate that politically connected lending may lead to an inefficient allocation of resources in the case of Indonesia.
Figure 2. Political connections and financial constraints (SMEs)
The Indonesian government implements policies to facilitate credits to SMEs with growth potential. However, our results suggest that such public credits are most likely to be given to unproductive but politically connected firms. The distorted allocation of resources may harm the economic growth of Indonesia and lead the economy into a middle-income trap. Possible solutions to this problem include reducing the political influence in state-owned banks (e.g. their privatisation), building SMEs’ credit information sharing system, and strengthening the ability of financial institutions to evaluate loan applications.
However, it should be emphasised that our results may not be generally applicable to other economies, as Li et al. (2008) find that this is not the case in China. Thus, further evidence is necessary to inquire under what conditions are political connections harmful or beneficial to the economic development of less developed countries.
Cole, S (2009), "Fixing Market Failures or Fixing Elections? Agricultural Credit in India", American Economic Journal: Applied Economics 1(1): 219-50.
Faccio, M, R Masulis, and J McConnell (2006), “Political Connections and Corporate Bailouts”, The Journal of Finance 61(6): 2597–2635.
Fu, J, D Shimamoto, and Y Todo (2015), “Can Firms with Political Connections Borrow More Than Those Without? Evidence from Firm-Level Data for Indonesia”, Research Institute of Economy, Trade and Industry (RIETI), available at http://www.rieti.go.jp/jp/publications/dp/15e087.pdf.
Khwaja, A, and A Mian (2005), “Do Lenders Favor Politically Connected Firms? Rent Provision in an Emerging Financial Market”, The Quarterly Journal of Economics 120(4): 1371–1411.
Li, H, P W Liu, J Zhang, and N Ma (2007), “Economic Returns to Communist Party Membership: Evidence from Urban Chinese Twins”, The Economic Journal 117(523): 1504–1520.
Li, H, L Meng, Q Wang, and L Zhou (2008), "Political Connections, Financing and Firm Performance: Evidence from Chinese private firms", Journal of Development Economics 87(2): 283-299.
OECD (2012), OECD Economic Surveys: Indonesia 2012. Vol. 2012, OECD Economic Surveys: Indonesia. OECD Publishing, available at http://www.oecd-ilibrary.org/economics/oecd-economic-surveys-indonesia-2....