Inside the Production Function: The Effect of Financial Contracts on Growing Firms' Technology Use. Evidence from a field experiment in Uganda.

Lead Research Organisation: University of Stockholm
Department Name: Research Liaison Office

Abstract

We examine how key aspects of the most common form of financing-debt-may inhibit young firms' expansion. Starting a business entails learning and risk taking, implying that project returns to investment can start low but increase over time (in other words, be "backloaded") or be uncertain. Also, indivisible start-up costs often require large investments. Meanwhile, standard debt contracts available for micro-entrepreneurs from the formal or semi-formal financial sectors of many developing countries (such as microfinance) stipulate a constant repayment stream and caps on the initial loan size. The interaction of such features of the loan contract and the firm's 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 microloans, we plan to 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. As such, our project contributes to the DFID-ESRC Growth Research Programme's focus on Finance and Growth in Low Income Countries.

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 Programme. The loans range from 2.5 million to 13 million Ugandan Shillings (630 to 3,300 GBP) and are repaid monthly with a maturity of 12 months at an annual interest rate of 25%. The research project will select, among firms applying for BRAC loans from mid-2014, a representative sample of 1600 firms to be part of a randomized experiment.

In order to investigate whether standard contractual terms in microloans from formal or semi-formal sources are restrictive for firms that face indivisible costs and/or are characterized by backloaded or uncertain project returns, we will (randomly) implement the following interventions for different groups of firms by: (i) changing the repayment frequency to distinguish the effects of uncertain project returns from those of backloaded returns; (ii) offering subsidies to ease the purchase of indivisible goods; and by (iii) offering consultancy services to shorten the learning process about the use of certain inputs to alleviate problems of backloadedness. We will survey these firms at baseline and upon completion of the loan-cycle (1-year after) to measure the change in firms' production and profits. In addition, we will use detailed and high frequency firm data to trace how the financial structure, a firm's learning curve, or the ease with which an indivisible good is acquired affects the use of machines and labor and how this in turn impacts profits and repayment performance. The project will provide unique evidence on the constraints caused by the interaction of financial structure and technology use that complements the recent emphasis on access to finance.

Planned Impact

The results of our research will be relevant for four key stakeholder communities.

First, members of BRAC's Small Enterprise Lending and Microfinance Programmes are likely to benefit and use our findings to improve the design of credit products to better meet the needs of business owners. As described in our Case for Support, the research aims to shed light on what contractual features enable greater benefit, in terms of firm growth and profitability, for borrowers of the programme. These findings will be communicated to BRAC program officers, which will be facilitated by our existing networks within BRAC. BRAC currently operates in Bangladesh, Pakistan, Sri Lanka, Uganda, Tanzania, South Sudan, Liberia, Sierra Leone and Haiti. Its Small Enterprise lending Program is expanding rapidly throughout its regions of operations. As a result, there is great potential for the research findings to shape BRAC's lending operations both in Uganda and in other countries where BRAC operates. In particular, to continue building our relationship with BRAC and to make sure that the findings are communicated to them at every stage of the project, we plan to undertake the following steps: (i) travel to Uganda to meet and work with programme management at the start of the project; (ii) conduct regular visits to Uganda and to Bangladesh to meet with programme management; (iii) conduct presentations and prepare reports on our findings to BRAC management; and (iv) provide training for program officers.

The second community of stakeholders comprises of civil society and policymakers, in particular those are working on expanding credit access to the poor. The output of our research will provide insights on how to design microfinance products to achieve maximal effectiveness in terms of firm growth and profitability. As such, microfinance institutions and policymakers are among the key stakeholders that may benefit from this research. To ensure that our results are disseminated within this community we will organize stakeholder workshops, participate in relevant events, and use our existing network connections with the civil society and policymakers working on microfinance.

The third community to benefit from our work will be local researchers and members of the research team in Uganda that will directly or indirectly benefit from our capacity building efforts. These efforts will contain different modes of training and experience opportunities for local researchers. These include training that will be provided to the local research manager, the local research team, enumerators, and a training session on developments in microfinance research that will be offered to local researchers and students.

Last but not least, the fourth stakeholder group to benefit from our findings is existing or potential entrepreneurs in search of better credit opportunities to establish or expand their businesses. As the end users of BRAC's and other MFIs' loan products, these individuals will benefit directly from improvements in the design of loan products resulting from the findings of our research. We will pay particular attention to improving credit access to female entrepreneurs. For this, in addition to investigating how household-level constraints affect the success of female versus male entrepreneurs and disseminating our findings to BRAC and other MFIs (as described above), we will collaborate with BRAC to conduct a publicity campaign for Small Enterprise Loan among SMEs, targeting female entrepreneurs.

Publications

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Description Microfinance has been heralded as an effective pro-poor policy instrument to ease the problem of credit rationing. However, recent evaluations of mainstream microfinance products have found little evidence of the transformative effects initially claimed by its proponents. In this project, we examine one possible reason for the limited impact of traditional microfinance: the lack of flexibility needed for poor borrowers to start or expand a business.

The departure point for our work is the idea that starting or expanding a business entails learning how to use inputs efficiently, such as hiring additional workers. Also, there is often uncertainty about demand that is harmful for small business 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 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 may distort firm investment toward inputs that involve less learning, less uncertainty, and smaller projects; hampering firm growth.

Using the grant from the DFID-ESRC Growth Research Programme we implemented a randomized control trial designed to measure to what extent contractual features of debt inhibit firm expansion. For this, we collaborated with the NGO BRAC Uganda's Small Enterprise Lending Program (SEP). The standard contract offered by SEP stipulates monthly repayments during a 12-month loan cycle, starting one month after loan disbursement. To investigate if the standard contractual terms are restrictive for firms, we implemented an experimental research design that increased contractual flexibility, allowing borrowers to restructure up to two repayments out of twelve at any point during loan cycle. Our sample includes 2,410 borrowers (clients) across Uganda, active in services and manufacturing, who applied for a loan from SEP during the period October 2014 and April 2016. Our data collection effort involved three different stages: a baseline survey, bi-monthly business diaries, and an end-line survey collected 12 months past baseline.

We find that flexible loan contracts, allowing borrowers to postpone repayments for two of the twelve months, has a statically significant and quantitatively meaningful effect on firms' employment practices. Firms offered more flexibility increased the number of employees by over 10 percent. In particular, the firms hired more regular workers with higher experience compared to the control group. The treated firms also had a greater number of paid employees.
We further find that increased flexibility led to greater spending on bulky investments such as machines. Treated firms more than doubled their investment spending on machines relative the control group.

Our findings imply that offering loans with greater repayment flexibility has important implications for firms' hiring and investment decisions. Going forward it will be central to understand how persistent these changes are and whether they generate sustainable firm growth.
Exploitation Route We know from previous work that product innovation or policy experimentation plays a key role in alleviating poverty. As such, introducing novel yet simple features within the realm of microfinance carries the promise of reducing poverty as well as enhancing small business growth. Our research shows that contractual design can matter. From an academic point of view the findings can be extended in a number of directions. A natural next step is to investigate how flexibility in financial contracts affect the credit market as whole - will it attract a different group of clients not previously interested in microfinance? Our results also highlight an under-researched domain: the connection between financial and labor markets. Finally, increased flexibility maybe be important in other contractual relations such as insurance, land, and labor markets. From a policy perspective, our results most directly speak to our main our partnering organization BRAC as well as other stakeholders providing microfinance services. BRAC has since the inception of our project launched a similar program in Bangladesh to further understand the role of flexibility within microfinance. Here, our work can help raise awareness among NGOs and development policymakers about the importance of the contractual features of debt design.
Sectors Financial Services, and Management Consultancy,Government, Democracy and Justice