Financial Constraints, Working Capital and the Dynamic Behavior of the Firm

Financial constraints are widespread in developing countries, where even short term credit is limited. Finance held by firms as working capital is a substantial proportion of sales revenue, yet the role of working capital is largely neglected by existing models of financial constraints. I present a dynamic model of the firm that incorporates working capital by introducing a delay between factor payments and the receipt of revenue. In contrast with previous models, the working capital model predicts that firms under binding constraints will substitute between labor and capital in response to demand shocks, causing investment to be countercyclical. For firms near the margin of being constrained, constraints bind when positive production opportunities arise. Output growth is therefore constrained in response to positive shocks but not to negative shocks. Simulations suggest that models without working capital may understate the predicted effects of financial constraints on production efficiency, firm profit and growth over time. I test the predictions using the recently completed Bangladesh Panel Survey for manufacturing firms. Consistent with the theory, I find evidence that constraints bind when output price increases, that investment by constrained firms is countercyclical, and that output response to positive shocks is dampened for firms that are sometimes constrained. The results also are important for policy. In order to maximize growth, efforts to relieve credit constraints should be focused on periods when demand shocks are high. ∗Economist, South Asia Finance and Private Sector, World Bank. Email [email protected]. I am grateful to Albert Park, Dan Silverman, Jim Levinsohn, Jan Svejnar, Chris House for their advice, Mary Hallward-Driemeier at DECRG, World Bank for data and institutional background, Aneeqa Aqeel, Oli Coibon, Jane Dokko, Chris Kurz, Sara Lalumia, Rahul Mukherjee, Joo Youn Park, Bill Powers, Heidi Schierholz, Mine Senses, Lina Walker for their insightful comments and encouragement. I would also like thank seminar participants at the Universities of Michigan, Melbourne and the Minnesota International Economic Development Conference for their valuable input. All errors are my own.