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Giving Credit Its Due

A multicountry analysis by Cristina Arellano, Yan Bai and Jing Zhang suggests that healthy credit markets are crucial to efficient operation of a nation's firms—both large and small.

December 1, 2009


Giving Credit Its Due

As the financial crisis took hold around the world last year, policymakers struggled to reestablish the smooth functioning of credit markets. And when the International Monetary Fund assesses a nation’s economic strength, it pays close attention to financial market development. But how exactly do healthy financial markets—those with plenty of liquidity and minimal frictions—facilitate the growth of firms? What happens to company financing decisions and growth rates when capital flow is restricted by poorly functioning credit markets?

In their July 2009 revision of staff report 392, “Firm Dynamics and Financial Development,” Minneapolis Fed senior economist Cristina Arellano, visiting economist Yan Bai of Arizona State University and Jing Zhang of the University of Michigan (Zhang not in above photo) explore the interplay of firm dynamics and financial markets, hoping to better understand the mechanisms that impede or encourage business growth. They do so by analyzing thousands of firms in a cross-section of countries whose financial markets vary in depth and sophistication. They then build a model economy where access to credit and risk of loan default are the mechanisms that might help explain variation in how firms finance their growth.

Both empirical analysis and the theoretical model confirm that well-functioning credit markets are critical determinants of firm finan-cing patterns and growth rates. “In less financially developed countries,” write Arellano, Bai and Zhang, “small firms grow faster and use less debt financing than large firms.” Their results suggest that when credit isn’t easily available, firms operate at inefficiently small sizes; conversely, as financial markets develop, providing more ready access to capital, firms borrow more and operate more efficiently.

Cross-country facts

The economists begin with an exploration of empirical reality, developing a comprehensive record of firm-level data from 22 European nations in 2004 and 2005. For firms, the major data points are size (book value of total assets), leverage (total liabilities over total assets) and growth (net real growth in sales from 2004 to 2005). For financial market development, the economists use two statistics for each of the 22 countries: a ratio of private credit to gross domestic product (higher ratios indicating better financial market development) and percentage of adults included in credit registries in 2005 (higher coverage showing better financial markets since lenders can more easily obtain borrower information).

The economists find wide variation among countries. Denmark has a credit-to-GDP ratio of 147 percent (indicating negative equity), while Romania’s ratio is just 11 percent. Credit coverage is 100 percent in Sweden but under 2 percent in Russia.

Differences in firm characteristics are also wide. The average (mean) Dutch firm has assets worth nearly 14 million euros, while the average Estonian company has a market value of less than 600,000 euros. Mean leverage is 0.92 in the Netherlands but just 0.42 in Estonia; the average growth rate is five times higher in Estonia than in the Netherlands (54 percent versus 11 percent).

Markets and firms

What do the data show regarding associations between financial market development and firm dynamics? The economists find that while on average, across all countries, small firms use more debt financing than large firms—that is, average small firm leverage ratios are higher—that doesn’t tend to be true of countries with relatively undeveloped financial markets. In those nations, the data reveal, small firms often use less debt financing—their leverage ratios are lower. This seems to make sense: Capital is less available in countries with undeveloped financial markets, and as credit costs and default risk rise, small firms tend to face more severe restrictions on loan contracts than large firms.

Less intuitively, the data reveal that small firms grow more quickly than large firms in nations with less-sophisticated financial markets. This, suggest the economists, is because small-firm growth is constrained by the high cost of credit in poor financial markets, so firms tend to operate at an inefficient scale; but when economies enjoy positive shocks, many small firms react by rapidly growing to more efficient size. Large firms, less credit-constrained, are likely to already be operating at an efficient scale.

In sum, they find that “small firms use less debt financing and grow disproportionately faster than large firms in countries with worse credit bureau coverage and lower ratios of private credit to GDP.”

Testing theory through a model

While their empirical analysis provides a solid picture of firm dynamics and financial markets, the theoretical basis is still unconfirmed. So the economists build a mathematical model to test their idea that patterns of firm growth and financing are affected by credit costs, which are higher in underdeveloped financial markets. By comparing this model’s predictions with actual data, the economists can gauge whether the access to credit that well-functioning financial markets provide truly plays a role in firm debt and growth dynamics.

After developing a general model, the economists calibrate it to resemble England and Bulgaria—again, economies with developed and underdeveloped financial markets, respectively. The test of theory is whether a calibrated model tying firm dynamics to financial markets can reproduce actual data for each country.

For Bulgaria, the results are almost dead-on. The data show a mean asset level of 51 thousand euros for Bulgarian firms; the model generates 52. The data show 0.53 sales growth from 2004 to 2005; the model also generates 0.53. Leverage ratios are 0.65 in the data and 0.60 from the model. The relationship between firm size and leverage ratio is also closely matched by the economists’ model, running from 0.45 for the small firms to 0.71 for the largest in the data, and from 0.47 to 0.68 in the model. Growth rates in the data run from 0.73 to 0.39; the model generates 0.77 to 0.40. The data-model fit couldn’t be much tighter.

The results are also good—but not quite as close—for the United Kingdom. While the match is nearly perfect for the mean asset, growth and leverage figures, the size-leverage and size-growth relationships are not as exact. “The fit is tighter for Bulgaria than for the UK,” they observe.

But overall, the model-data fits are remarkably close for both countries, supporting the theory that financial markets have a strong bearing on firm dynamics. Even after a further test to control for the importance of productivity differences in the two countries, the economists conclude: “The differential growth and leverage ratios across firms and economies are mostly driven by financial factors.”


Douglas Clement
Editor, The Region

Douglas Clement is a managing editor at the Minneapolis Fed, where he writes about research conducted by economists and other scholars associated with the Minneapolis Fed and interviews prominent economists.