Financing Constraints: A New Test and an Application to Developing Countries

I propose a new test for the existence of …nancing constraints that can be applied to a variety of settings. The approach builds on tests based on investment-cash ‡ow sensitivities and deals with two major criticisms of the standard approach. First, I use a real measure, namely …rm productivity, to control for investment opportunities instead of a proxy for the …nancial measure Q. Theoretically, …rm productivity predicts investment in an economy in which only real characteristics matter, and it is not subject to the criticisms that have been raised about Q as a control for investment opportunities. This allows me to test for the uncontroversial prediction that in the absence of …nancing constraints the reaction of investment to changes in cash ‡ow is not di¤erent from zero when investment opportunities are controlled for. In addition, productivity can be estimated using most standard …rm-level data sets while Q cannot, which makes the suggested test more widely applicable, in particular to small …rms and to developing country settings. Second, in the empirical part, I use the …rm managers’ own assessments of their di¢ culty to obtain outside …nancing as a measure of the wedge between the internal and the external cost of …nancing. I apply the test to uniquely suited …rm-level data covering 31 countries. The empirical …ndings are consistent with …nancial constraints signi…cantly constraining …rm growth. I am especially grateful to Jeremy Stein for detailed comments. I would also like to thank Steve Berry, Shawn Cole, Nicola Fuchs-Schündeln, Rustam Ibragimov, Sendhil Mullainathan, Sam Thompson, Chris Timmins, Chris Udry and seminar participants at several workshops and seminars. Address: Department of Economics, Harvard University, Littauer Center, 1875 Cambridge Street, Cambridge, MA 02138. Email: [email protected]. An earlier version of this paper was circulated as “Testing for the Existence of Financing Constraints in Developing Countries’Manufacturing Firms”.