Finance has long been viewed by researchers and entrepreneurs alike as the most important constraint to microenterprises in low- and middle-income countries. As a result, the literature on constraints to capital is more established and extensive that that on most other constraints. In seminal work, Rajan and Zingales (1998) show that sectors that are capital intensive are under-represented in countries with less-developed capital markets. They show that in such countries, sectors that rely more on external finance grow more slowly and have lower rates of entry.  This is a clever identification of the effect of financial constraints across a large number of high- and middle-income countries.[1]

In most low-income countries, the majority of people employed in urban economies work in enterprises with fewer than five employees. A large share of these are owners of the enterprises, often working by themselves or employing only unpaid workers from their immediate family. Recent research provides evidence on both the opportunities and limitations of providing capital to urban microenterprises. In several contexts, research has shown that the profits of such enterprises increase substantially following investments of capital. The returns have been found to exceed the interest rates charged by microlenders. That is the positive side of the story. But the data also show that capital injections alone are not enough to generate sustained growth of enterprises. In other words, capital can raise the level of the business, but not the rate of growth.  Moreover, the evidence indicates that standard microcredit models do not lead to changes even in the level of enterprise profits.

We continue to learn as new evidence is generated, and this note offers a snapshot of the state of knowledge at the time of writing. The most compelling recent research on capital and microenterprises uses an experimental methodology. The state of the research on capital in microenterprises can be summarised as follows. Evidence from several experiments assigning grants to randomly selected enterprises indicates that the marginal return to capital is high, on average, for these enterprises. In contrast, randomised experiments providing standard loans to microenterprises show little or no effect of loans on enterprise profitability or sales. Recent work attempting to reconcile these somewhat conflicting results suggests that enterprise owners taking loans choose safer, lower-return investments. The terms of the loan contract (Fischer 2013; Field et al. 2013) lead them to avoid riskier, higher-return investments. Ongoing work explores contracts that involve more risk-sharing, using equity or state-dependent debt payments. There are fewer studies on the effect of capital injections in larger firms. There are a couple of notable exception to this, which we discuss below.

 

[1] The sample used by Rajan and Zingales is limited by the availability of data on accounting standards, and hence excludes the lowest-income countries.

 

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