Firms’ Financing Choices and Firm Productivity: Evidence from an Emerging Economy

Emerging economies can compete in the global markets only through productivity improvements. Most firms in developing economies are inefficient, making misallocation of resources highly likely. Finance is not only a factor of production but also a facilitator of other factors of production. When finance is misallocated, the aggregate productivity and firm competitiveness deteriorate. Formal financial intermediaries are expected to mitigate misallocation through efficient screening. Small firms, that form most of the firms in developing economies, often do not have enough information to facilitate efficient screening. Under these circumstances, are formal lenders able to allocate capital efficiently? What are the factors that determine access to finance and firm productivity? Does access to finance improve firm productivity? This study attempted to answer these questions by analysing Indian small firms. In the first stage of the analysis, Data Envelopment Analysis was used to estimate relative efficiency, which was used in a simultaneous equations model in the second stage. The results indicated that despite the lenders preferring highly efficient firms, external finance was detrimental to productivity. The interest of the formal lender is in the quick and safe repayment of the loan whereas the return on productivity improvements can only be realised in the long-term. It is argued that this mismatch causes formal finance to hamper the productivity of funded firms. Without facilitating productivity improvements, external finance cannot provide sustainable growth and firms cannot compete in the global markets. Consequently, the country may never graduate to the next stage of economic development.