The Investment Path of Small Firms in Developed and Developing Economy

The Investment Path of Small Firms in Developed and Developing Economy

Small firms tend to be partially dependent on bank lending to finance their growth. A portion of small firms reaches the capital markets and may use public financing to grow their businesses. Those who do go public may still rely at least in part on bank lending to finance their growth. As such, there are two ways in which foreign portfolio investment may reach the small firm:

(i) direct route - through the capital markets, and

(ii) indirect route - through banks who will in turn invest in or be able to extend more credit to such firms.

(i) The Direct Path of Investment:

If competition for a scarce resource, such as capital, improves the investment environment through superior transparency, disclosure and/or corporate governance – an effective improvement in the investment environment, the set of firms in which foreign investors consider investing is increased to include some firms who previously had difficulty obtaining financing due to information asymmetry and/or agency costs. This implies an improvement in the allocation of capital which has been associated with market development. Small firms with their informationally opaque nature may be included in this marginal group of firms. This is relevant due to the challenge of small firms in accessing capital in any form. Firms perceived as ‘investible’ who need external financing should realize an increased probability of domestic capital issuance with an accompanying increase in foreign portfolio investment. An increase in the probability of capital issuance stems from the increase in supply of capital and is not identified as due to foreign or domestic investors. I examine whether the level of foreign portfolio investment helps to ease the financial constraints of small firms. More explicitly stated, ‘The probability of capital issuance for small firms is significantly positively related to the level of foreign portfolio investment of a country (e.g. the financial constraints of small firms are relaxed)’.

            Beyond whether a firm issues, I examine the type of security a firm issues. Inasmuch as small firms are typically debt-laden, the ability to issue equity could be perceived to be a greater alleviation of financing constraints since there are no fixed payments associated with this form of capital. This ‘choice’ of capital form, therefore, becomes informative. Not much has been written in the international arena examining the feasibility of capital choice for constrained firms. Korajczyk and Levy, in the year 2003, provide an examination of capital structure choice for both financially constrained and financially unconstrained firms in the United States. Although solely a domestic study, the main result in Korajczyk and Levy’s work is that constrained firms issue what they can when they are able. There isn’t any compelling reason, beyond an increased disclosure and governance at the firm-level, that would lead us to believe that these firms would be able to access equity as a result of the increase of the supply of capital available to firms, domestically or internationally. We should see that although small firms will indeed see an easing of their financial constraints, this easing would mainly be in the form of debt capital. To that end, I hypothesize the following: ‘Conditional on firms issuing capital, the probability of small firms issuing equity capital will not be significantly positively related to foreign portfolio investment’.

(ii) The Indirect Path of Investment:

For those firms who are dependent on bank lending and/or remain unable to access publicly issued securities, the ‘direct’ path of foreign portfolio investment is irrelevant. An ‘indirect’ path through financial institutions instead is relevant. The theory behind this path of investment stems from the bank-lending theory of monetary policy and related concepts. Kashyap and Stein, in the year 2000, is particularly relevant in that they find that small banks are particularly sensitive to monetary policy. This is relevant since small banks are most likely to be the banks to serve small firms. The lending theory finds that money supply tightening (expansion) appears to decrease (increase) the ability of banks to loan funds based on the relative illiquidity of their balance sheets. What this implies is that if there is a positive money shock into a country, bank balance sheets become relatively more liquid thus enabling them to increase the amount of credit extended to the public. Although this money supply augmentation is due to monetary policy in Kashyap and Stein’s research paper, this theory could be extended to consider a different source of ‘money supply’ – in this case foreign portfolio inflows. An increase in the liquidity of the bank’s balance sheet through increased outside investment enables banks to lend in the same manner as if there were a change in money supply caused by monetary policy5. More concisely stated, ‘The liquidity of bank balance sheets, as well as the amount of domestic credit, are significantly positively related to the level of foreign portfolio investment of a country’.