Informal financing choice in SMEs: do the types of formal credit constraints matter?

Abstract

We examine how SMEs choose alternative external finance when their access to formal finance is constrained in an emerging market context. We find that when constraints to formal credit for an SME increase (decrease) over time, the firm's behavior changes accordingly by selectively shifting toward (away from) certain types of informal credit. Specifically, when a firm avoids formal credit because of perceived difficulties in application process, it seeks alternatives from the owner’s family and friends and private money lenders. When the interest rate is perceived to be too high, the firm prefers trade credit and the owner’s family and friends. Trade credit appears to be the most likely substitute of formal finance for firms with bad credit history. Lastly, firms that are denied short-term loans may find emergency funding from private money lenders. Our findings suggest that certain types of informal credit may be more appealing than formal credit in certain cases.

RÉSUMÉ

Nous examinons comment les PME choisissent d’autres sources de financement externe lorsque leur accès au financement formel est limité dans un contexte de marché émergent. Nous constatons que lorsque les contraintes au crédit formel pour une PME augmentent (diminuent) avec le temps, le comportement de l’entreprise change en conséquence, celle-ci s’éloignant sélectivement de certains types de crédit informel. Plus précisément, lorsqu’une entreprise évite le crédit formel en raison d’une perception de difficultés liées au processus de demande, elle cherche des solutions de rechange auprès de la famille et des amis du propriétaire, et de prêteurs privés. Lorsque le taux d’intérêt est perçu comme trop élevé, l’entreprise préfère le crédit commercial, et la famille ou les amis du propriétaire. Le crédit commercial semble être le substitut le plus probable du financement formel pour les entreprises présentant de mauvais antécédents de crédit. Enfin, les entreprises confrontées aux refus de prêt à court terme peuvent trouver un financement d’urgence auprès de prêteurs privés. Nos conclusions suggèrent que, dans certains cas, certains types de crédit informel peuvent être plus attrayants que le crédit formel.

Keywords:

• Financial constraints
• informal credit
• trade credit
• private lenders
• family and friends

Mots-clés:

• Mots-clés:
• contraintes financières
• crédit informel
• crédit commercial

JEL classification:

• D22
• G32
• L26

Acknowledgements

All authors have equal contributions. We would like to thank two anonymous reviewers at the Journal of Small Business & Entrepreneurship, Michael Troege at ESCP Europe, Nguyen Justin Hung at Victoria University of Wellington and participants at VICIF 2019, Le Tuan Bach, Nguyen Thi Hoang Anh, Chu Mai Linh, Nguyen Thi Mai Anh at Foreign Trade University, HCMC Campus for their valuable comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the authors.

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

1 Nominal GDP per capita in Vietnam was roughly USD607 and USD2052 in 2004 and 2014, respectively.

2 Note that in the final dataset, roughly two-third of all firm-years did not apply for formal loans, thus, the value of DENIED is missing in these observations. Only 4114 firm-years answered whether they had been denied by the bank, among which 700 (14.5%) reported being denied. For the purpose of our tests, in which we want to examine the different financing behavior between firm-years that are denied and other firm-years, including those who did not apply, we treat these missing values as zero.

3 See “Arrests raise loan sharks higher on social agenda” in Vietnam Investment Review on 12 December 2018, https://www.vir.com.vn/arrests-raise-loan-sharks-higher-on-social-agenda-64534.html

4 This figure presents mean changes in the use of informal sources conditional on changes in financial constraints. See Table 1 for variable descriptions.

Additional information

Funding

Hang Thu Nguyen and Hiep Manh Nguyen received funding from the Corporate Finance and Investment Research Project of Foreign Trade University of Vietnam.

Notes on contributors

Hang Thu Nguyen

Hang Thu Nguyen is at Foreign Trade University HCMC Campus. The current research interests are corporate finance and emerging market finance. Email: [email protected].

Thuy Thu Nguyen

Thuy Thu Nguyen is at Ministry of Education and Training of Vietnam. The current research interests are corporate finance and emerging market finance. Email: [email protected].

Xuan Le Phuong Dang

Xuan Le Phuong Dang is at Queensland University of Technology and Foreign Trade University HCMC Campus. The current research interests are social capital and household outcomes. Email: [email protected].

Hiep Manh Nguyen

Hiep Manh Nguyen is at ESCP Europe and Foreign Trade University HCMC Campus. The current research interests are corporate finance and emerging market finance.