Financing constraints are an important research subject in the economic literature, which attempts to explain why firms do not undertake profit maximizing investment, i.e. why they do not expand their capital stock if return to capital is above the market interest rate (Hubbard, 1998). Credit constraints now figure prominently in macroeconomic analysis, and there is strong evidence from cross country regressions that underdeveloped financial systems are associated with poor investment and growth. The microeconomic evidence, especially from the developing country data, remains limited. Establishing evidence of credit constraints from microeconomic data is difficult, because measuring the return to capital is complicated by unobserved factors such as entrepreneurial ability and demand shocks, which are likely to be correlated with capital stock.
This paper identifies a natural experiment based on a firms decision to invest in a private electric generator. Reinikka and Svensson (2002) demonstrated that firms tend to invest in own electric power generators in countries with unreliable public power supply. Supply shocks to public power supplies are generally uncorrelated with an individual firms market conditions and entrepreneurial ability. This study exploits these exogenous public power supply shocks to identify the effect of financing constraints on firms investment.
First, a theoretical model is developed to derive profit maximizing conditions of a risk neutral firm choosing whether to acquire a private generator to hedge against unreliable public power supply. The model predicts that financing constraints will reduce firms expected return from the generator. Thus, holding other things constant, firms with better access to credit will be more likely to install the generator if the power outages are frequent. The predictions of the theoretical model are then tested empirically on firm level data from Sub Saharan African countries. Endogenous switching regression and the difference in differences methods are used to obtain consistent estimates and overcome the measurement and the identification problems.
The results show that firms with better access to credit are more likely to own a private generator in the areas where public power supply is unreliable. Also, the firms are more likely to respond to the power outage shocks and privately install generators if they operate in the countries with more developed financial systems or during the periods of rapid domestic credit growth. Consistent with the predictions of the theoretical model, these findings suggest that financing constraints can significantly restrain firms ability to find a replacement for deficient public services.
The rest of this study is organized as follows. The second section reviews the existing literature. The third section presents a theoretical model, which attempts to explain the effect of financing constraints on firms choice of electric generator. The fourth and fifth sections discuss data and stochastic specification. The sixth section presents findings based on the analysis of the World Bank enterprise survey data. The last section outlines main conclusions of this study.
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Financial Constraints and Firms Investment: Results of a Natural Experiment Using Power Interruption
