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Inside the Production Function: The Effect of Financial Contracts on Growing Firms' Technology Use

flexible loans

  • Researchers:
    • Selim Gulesci, Andreas Madestam (Stockholm University), Francesco Loiacono (IIES), Miri Stryjan (Aalto University)

  • Partners:
    • BRAC

  • Location:
    • Uganda

  • Sample:
    • 2340 firms

  • Timeline:
    • 2014-2020

  • Theme:
    • Microcredit contracts and firm productivity

  • Description:
    • We examine how key aspects of the most common form of financing -debt- may inhibit young firms' expansion. While access to credit is crucial for firm growth, SMEs in developing countries are often credit constrained. Even when they have access to credit, the types of loans available to them are not very suitable for productive investments. Starting or expanding a business entails learning how to use inputs efficiently, such as hiring additional workers. There is often uncertainty about demand that is harmful for small businesses without adequate resources. This implies that revenues not only are volatile but that it takes time to build up a revenue stream, as returns are back-loaded. Another concern is large and indivisible startup costs in the form of bulky investments such as machines. Meanwhile, most debt contracts available to micro-entrepreneurs in developing countries (often offered through MFIs) involve constant repayments starting shortly after loan disbursement and loan sizes that are capped because of information asymmetries. The implication is that these contractual features, together with firms’ production technology, may distort investment toward inputs that involve less learning, less uncertainty, and smaller projects; hampering firm growth. 

      To shed light on the extent to which these theoretical mechanisms limit the effectiveness of credit, we collaborate with BRAC Uganda's Small Enterprise Lending Program to study the effect of the credit terms on starting firms' input use, profits, and repayment performance. Small and medium-sized firms are the engines of the Ugandan economy, comprising over 90% of the private sector and BRAC Uganda has been lending to such firms since 2008 through its Small Enterprise Lending Program. The loans range from 2.5 million to 20 million Ugandan Shillings and are repaid monthly with a maturity of 12 months at an annual interest rate of 25%. We collaborate with the program in order to examine the effect of credit contract terms on starting and newly established firms’ use of inputs, profits, and repayment performance. Using a randomized-controlled trial methodology we ask whether standard contractual terms, such as constant and monthly repayments and small initial loan amounts, are particularly restrictive for firms with specific constraints.
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