Inside the production function: The effect of financial contracts on growing firms’ technology use
It is widely accepted that access to credit is an important engine for growth. Credit rationing is also believed to be a common feature of developing credit markets, because of weak legal institutions and a lack of collateral.
This project examined how key aspects of the most frequent form of financing, debt, constrain the expansion of young and newly established firms using a randomised field experiment.
Starting a business entails learning and uncertainty, implying that project returns tend to be backloaded or uncertain. Moreover, indivisible start-up costs usually require large initial investments. Features of the standard debt contract, such as a constant repayment stream and caps on the initial loan size, may distort investment toward the use of inputs that involve less learning, less uncertainty, and smaller project size.
In cooperation with BRAC Uganda and their Small Enterprise Lending Program, the project provided experimental evidence on the effect of credit contract terms on starting and newly established firms’ use of inputs, profits, and repayment performance. In particular, the research team wanted to understand whether the contractual terms are particularly restrictive for firms with backloaded or uncertain project returns and large fixed costs.
In a follow-up project grant funded by the ESRC until March 2021, Madestam will investigate the long-term effect of supply-side contractual features such as loan caps and constant repayment schedules for firms. These credit conditions impact growth performance and have wider employment outcomes. Therefore, research will again focus on small- and medium-sized enterprises in Uganda in collaboration with BRAC to examine if standard debt contracts limit the effectiveness of microloans in driving job creation and enterprise expansion. This will provide unique evidence on how loan contracts can be redesigned to better support firm growth and employment opportunities in the private sector.