Fuel the Engine: Bank Credit and Firm Innovation

Whether bank credit is suitable to finance business innovation is a key financing question. Using a representative sample of 6,422 small firms across 22 emerging economies, we find that lack of access to credit stifles innovation, especially of the technologically “hard” type. This finding is not driven by sample selection and - given our instrumentation with the presence of local credit registers - it is ostensibly causal. Especially access to credit with longer duration and denominated in foreign currency spurs hard innovation. This detrimental impact of credit constraints on innovation activities is stronger in localities or sectors that are more dependent on external financing, and only holds for firms that are more limited in alternative sources of external financing, including small, private, or unaudited firms, receiving no government subsidy. We further found that institutional contexts can mitigate the negative impact of credit constraints, possibly via providing firms with more alternative financing means. Foreign or transactional banks, or banks in more diversified banking market are found to be better at promoting firm innovation. Lastly, bank credit enabling hard innovation is expected to foster future firm growth.