Credit Rationing in Informal Markets: The Case of Small Firms in India

Using a unique dataset combining panel data of reported financial information for a sample of small and medium enterprises in India with data from a survey of the same firms regarding the role of relationships in supply of inter-firm credit, the present study examines the availability and importance of relationship-based informal credit for small firms given their total credit needs. We find that the firms that are unsuccessful in generating internal funds or bank loans appear to have better access to relationship-based credit. However, we also find persistent evidence of rationing of relationship-based credit, including credit driven by business relationships as well as social relationships. All firms in our sample face an upward-sloping credit supply function, while firms with limited collaterizable assets face an interest-inelastic supply curve. Though relationships mitigate information asymmetry problems between borrowers and lenders, our investigations suggest that moral hazard concerns still constrain credit supply. Credit providers decline credit when the interest rate reaches a critically high level and the heavy debt repayment obligations limit the borrowers’ stake in the debt-financed projects. This is the first study to document rationing of informal credit. Our findings have important research and policy implications. This paper was presented at the inaugural workshop of CAFIN, April 25-26, 2014. We are grateful to the authors for permitting us to include it in our working paper series.