Ebook Firm Dynamics and Financial Development
Do small and large firms grow at different rates across countries? Many theoretical models of firm dynamics and financial frictions predict that small firms grow faster than large firms due to limited availability of credit for small firms. This prediction implies that the relation of firm size and growth should be systematically linked to the economy’s credit accessibility. Little is known, however, about the variation of firm growth across countries. Our paper fills this gap by studying how debt financing and growth vary with firm size across countries with different financial development.
We first analyze empirically the relation of firm size with debt financing and growth using firm-level data from 22 European countries. We document that small firms grow faster and finance their assets with less debt than large firms in less financially developed countries. We then develop a quantitative model where financial development drives firm growth and debt financing through the availability of credit. We assess the model’s prediction regarding the cross sectional firm growth, when firm size and debt usage are parameterized to those in the firm-level data. We find that financial development is quantitatively important in rationalizing the growth rates of firms across different sizes and countries.
Our empirical contribution consists of providing a systematic cross-country investigation of the relations of firm financing and growth with size. Our analysis is new in that we document these relations for comprehensive firm-level datasets that include a large number of small private firms across 22 European countries. We focus on the relative behavior of firms of different sizes across countries with varying financial development. We first find that small firms grow faster than large firms. And this difference is stronger in countries that are less financially developed, as indicated by the ratio of private credit to GDP and the availability of credit information of consumers and firms. We also find that small firms in more financially developed countries use more debt financing than large firms relative to those in less financially developed countries. Importantly, these findings are robust to controlling for country, industry or age specific characteristics.
We then develop a quantitative dynamic model of heterogeneous firms where financial development interacts with firm growth and debt financing. The model identifies the mechanisms that link firm growth to financial conditions and allows a quantitative evaluation of the theory. In the model, firms borrow to finance their operations, but debt is unenforceable. Lenders limit firm debt because of default risk and incur a fixed credit cost when issuing loans. We proxy differences in financial development across economies with differences in fixed credit costs. High credit costs limit debt disproportionately for small firms, which makes their scale inefficient. These small firms grow faster as they can expand their scale. Hence, in the model small firms in less financially developed economies have less debt financing and higher growth rates, just as in the data.
The framework is a dynamic stochastic model that builds on Cooley and Quadrini (2001). Firms use a decreasing returns to scale technology to transform capital into output and face uncertain productivity. They finance capital and dividends with debt and profits and have the option to default on their debt. To compensate for default risk, lenders offer each firm a limited schedule of loan contracts. The restrictions on loans impact firms’ debt financing and capital choices. Increasing debt is useful for financing capital and dividends, but larger loans are also costly because of higher default risk. Hence, firms prefer to shrink their capital and become inefficiently small to avoid excessively large loans. Firms can also be small simply because the persistent component of their productivity is low.
The loan schedule systematically varies across firms and across economies. Each firm is offered a customized schedule that depends on its default risk, given the economy-wide credit cost. In any economy, small unproductive firms confront more adverse loan schedules than large productive firms because they have higher default incentives and the fixed credit costs are relatively more costly for their small loans. And in economies with high credit costs, debt contracts are restricted for all firms, but disproportionately limited for the small firms.
These features in loan schedules determine firm size and growth across economies. Small unproductive firms are more likely to be inefficient in scale than large productive firms, and especially so in economies with high credit costs. Firms of inefficient scale grow faster than those of efficient scale in response to good shocks because they use the additional output to increase their scale to a more efficient level. This implies that small firms grow faster in all economies, and particularly fast in economies with high credit costs. Hence, our model matches the first empirical regularity that small firms grow faster than large firms especially in less financially developed economies.
The debt financing patterns across economies are determined not only by the firm specific loan schedules but also by the history of shocks. Unproductive small firms face the most restrictive schedules, which tend to lower the equilibrium level of debt of small firms. But inefficient small firms have larger loans due, as they have built up debt after a history of bad shocks. These dynamics tend to increase the equilibrium level of debt of small inefficient firms. Hence, small firms can have higher or lower levels of debt than large firms. Nonetheless, as credit costs increase, the restrictions on loan contracts become so severe for the small unproductive firms that the level of debt of small versus large firms decreases. Thus, our model can match the second empirical regularity that the difference in debt financing of small and large firms decreases in less financially developed economies.
We quantitatively evaluate the model implications in rationalizing the cross sectional financing and growth patterns jointly. We calibrate our model using the firm-level data of Bulgaria and the United Kingdom as representative countries with weak and strong financial development. Our calibration strategy consists of choosing the credit costs and the preference and technology parameters to match the financing patterns observed in the cross section of firms in each country. Specifically, the calibrated credit costs for Bulgaria equal 0.08% of output for the average firm. For the UK these costs are zero. We then evaluate the model’s predictions on growth rates for firms of different sizes. The results show that our model can deliver quantitatively the relationship between sales growth and firm size observed in the data in both countries.
For Bulgaria, we calibrate the debt to asset ratios of firms as in the data: for the mean size firm to be 0.53 and for small firms in the first asset quintile to be 0.45. The model then delivers the observed sales growth patterns of 0.77 for the small firms and 0.40 for the large firms in the fifth asset quintile. For the United Kingdom, we calibrate the debt to asset ratios of firms as in the data: for the mean size firm to be 0.84 and for small firms in the first asset quintile to be 1.18. The model generates a growth rate of 0.17 for small firms and 0.08 for large firms. These rates are similar to those observed in the data: 0.23 for small firms and 0.05 for large firms. Hence, we conclude that accessibility to credit is an important determinant of the observed differential growth rate across firms.
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