Credit Constraints and Productive Entrepreneurship in Africa

Mina Baliamoune-Lutz, Zuzana Brixiová and Léonce Ndikumana

African Economic Conference 2011 African Development Bank and

Economic Commission for AfricaAddis Ababa, October 25-28

Introduction Theoretical framework: Firm creation and growth

hinge on matching the searching entrepreneurs with production technologies and access to credit. Limited credit due to the lack of collateral slows the creation

of new private businesses and growth of the existing ones Two empirically important results:

1. Access to investment capital is a binding constraint which prevails even in the presence of excess liquidity in the banking sector. A key factor to access to credit is the shortage of collateralizable assets.

2. Legal rights and informational depth in credit markets are shown to support entrepreneurship.

The model is applied to Africa where financial frictions are due to the limited collateral and a weak legal framework.

The issue is particularly relevant for Africa’s SMEs.

Overview of the theoretical literature

Brixiova (2010): Non-financial constraints to firm creation in Africa’s LICs (skill shortages of potential workers and entrepreneurs.)

Brixiova and Kiyotaki (1997): How credit constraints slow new private firms in transition economies.

Kiyotaki and Moore (1997): The role of credit constraints in economies where the productive asset can be also used as collateral and entrepreneurs can withdraw their human capital from their projects.

Aghion, Fally and Scarpetta (2007): The effect of private credit availability and stock market capitalization on firm entry and growth in advanced and emerging economies.

Overview of the empirical literature

Positive link between Finance and growth: King and Levine (1993); Levine(1997); Rajan and Zingales, (1998); Beck and Demirgüç-Kunt (2008). In the case of African countries: Link between financial

development and growth is not robust (e.g., Baliamoune-Lutz and Ndikumana, 2007; Baliamoune-Lutz, 2011).

Liquidity constraints and role of wealth in enabling the creation and growth of firms (e.g., Evans and Leighton, 1989; Gentry and Hubbard, 2000; Hurst and Lusardi, 2008; and Moore, 2004).

Credit constraints and entrepreneurship Effects of finance on entrepreneurship Role of legal institutions in easing financial

constraints and promoting efficient credit markets: Djankov et al. ( 2007) find that “both creditor protection through the legal system and information sharing institutions are associated with higher ratios of private credit to GDP, but that the former is relatively more important in the richer countries.”

Credit constraints and entrepreneurship The impact of information sharing on easing liquidity

constraints. The empirical results are rather mixed.

Information sharing facilitates access to credit (Jappelli and Pagano, 2002; Djankov et al., 2007; Brown et al., 2009).

Wider information sharing led to less access to bank credit for SMEs in Mexico (Negrin, 2001),

Information sharing is associated with creditors granting smaller loans and demanding more guarantees (Doblas-Madrid and Minetti, 2009; US data).

Brown and Zehnder (2007) conclude that, because borrowers anticipate that a good credit record improves their access to credit, information sharing leads to a rise in repayment rates.

Credit constraints and entrepreneurship Protection of lenders and borrowers: Do better legal rights

increase access to credit?Levine (1998): Countries that have rigorous contract

enforcement, and where legal systems effectively protect the rights of creditors, have better developed banks.

Demirgüç-Kunt and Maksimovic (1998): The proportion of firms that use long-term external financing is larger in countries which have efficient legal systems.

Qian and Strahan (2005): Strong creditor protection is associated with more concentrated ownership of loans, lower interest rates, and longer maturities.

Haselmann et al. (2010): The supply of bank credit increased after a legal change. Changes in collateral law are more important than changes in bankruptcy law for increases in bank lending.

Empirical literature focusing on African economiesSimtowe et al. (2009): Credit constraints have a

negative and significant impact on the amount of land allocated to hybrid maize in rural regions in Malawi.

Dercon and Christiaensen (2010): The possibly low consumption outcomes when harvests fail discourage the application of fertilizer in Ethiopia (in addition to the ex-ante credit constraints).

• The authors note that “[t]he lack of insurance or alternative means of keeping consumption smooth leaves some trapped in low return, lower risk agriculture, one of the mechanisms through which poverty perpetuates itself in agrarian settings.”

Empirical literature focusing on African economies

Related to the use of collateral Fenske (2011): Whereas the link between land

tenure and investment (in West Africa) is significant for fallow and tree planting, it is less robust for the use of labor and other inputs (e.g., manure and chemical fertilizer).

Brasselle et al. (2002): No systematic influence of land tenure security on investment in Burkina Faso. These results seem to suggest that land tenure may not ease credit constraints as land in African countries may not serve as sufficiently adequate collateral.

Figure A5. % of Firms Identifying Access to Finance as a Major Constraint

0 10 20 30 40 50 60 70 80

EritreaSouth Africa

ZambiaBotsw ana

LesothoGabon

Egypt, Arab Rep.Morocco

Sierra LeoneLiberia

Cape VerdeAngola

MadagascarKenya

Congo, Rep.Mauritius

ChadMali

SenegalAlgeria

Mozambique

Malaw iNigeria

CameroonTogoNiger

GhanaCôte d'Ivoire

BeninCongo, Dem. Rep.

Burkina Faso

Source of data: Enterprise survey, World Bank's Enterprise database (based on various years during

2007-2010)

Source of data: Enterprise survey, World Bank's Enterprise database (based

on various years during 2002-2010)

Figure A1

Estimation equationENTi,t =

α0 + α1LAWi,t + α2CREDITi,t + α3LIQi,t + β'Z + εi,t

Sample of 20 African countries over the period 2005-09.Variables ENT (entrepreneurship): Proxied by ‘new business density’

(new business registrations per 1,000 people aged 15-64.) LAW: Strength of legal rights index; measures the degree to

which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus facilitate lending.

CREDIT : Depth of credit information index; measures rules and practices affecting the coverage, scope and accessibility of credit information available through either a public credit registry or a private credit bureau.

LIQ: Bank liquid reserves to bank assets ratio. (The first 3 variables are from WB Doing Business database and

LIQ is from WDI database)

Figure 1. Strength of legal rights and entrepreneurship

2

3

1

0

2 4 6 8 10 Strength of legal rights index (0-10)

New business density (fitted values)

Figure 2. Depth of credit information and entrepreneurship

0

2

1

0 2 4 6 Depth of credit information index (0-6)

New business density (fitted)

2

4

50 60 70 80 90 100 Loans requiring collateral (%)

New business density (fitted)

Figure 3. Loans requiring collateral (%) and new business density

02

46

81

0

50 100 150 200 250Value of collateral needed for a loan (% of the loan amount)

New business density (fitted)

Figure 4. Value of collateral and new business density

20

40

60

80

50 100 150 200 250Value of collateral needed for a loan (% of the loan amount)

% of Firms identifying access to finance as a major constraint (fitted)

Figure 5. Value of collateral and finance as a major constraint

new

bu

sine

ss

dens

ity

cost

of

busi

ness

st

art-

up

proc

edur

es

(% o

f G

NI

per

capi

ta)

bank

liq

uid

rese

rves

(%

) cr

edit

to

priv

ate

sect

or

(% G

DP

) st

reng

th

of le

gal

righ

ts

cost of business start-up

-0.319

bank liquid reserves (%)

-0.334

-0.283

credit to private sector (% GDP)

0.343

-0.359

-0.338

strength of legal rights

0.037

-0.202

-0.172

0.188

depth of credit information

0.117

-0.346

0.186

0.616

0.116

Table 1. Correlations

Table 2. Pooled-data estimates

Dependent variable: New business density (1) (2) (3) (4) (5) (6) (7) income (log) 0.681***

(0.24) 1.017***

(0.33) 1.89*** (0.58)

2.66*** (0.58)

2.24*** (0.48)

1.28*** (0.27)

1.17*** (0.70)

strength of legal rights

0.135*** (0.05)

0.132** (0.05)

0.271** (0.10)

0.28** (0.12)

3.65*** (1.06)

1.76** (0.85)

1.62** (0.77)

public credit registry coverage (% of adults)

0.196*** (0.09)

0.178* (0.09)

0.153 (0.13)

depth of credit information

-0.414** (0.18)

-0.68*** (0.24)

-0.49*** (0.17)

1.441 (1.01)

0.463 (0.73)

0.623 (0.74)

bank liquid reserves to bank assets ratio (%)

-2.449* (1.28)

-4.75*** (1.39)

-3.891*** (0.96)

strength of legal rights_squared

-0.264*** (0.07)

-0.133** (0.06)

-0.12** (0.06)

depth of credit -0.354 -0.174 -0.271

Dependent variable: New business density

(1) (2) (3) (4)

income (log) 2.153*** 0.978** 2.388*** 1.003** strength of legal rights 3.82*** 1.78* 3.89*** 1.78* depth of credit information 0.993*** 0.495*** 0.959*** 0.493*** bank liquid reserves/bank assets ratio

-1.162*** -1.07*

strength of legal rights_squared -0.278** -0.148* -0.280** -0.148* depth of credit information_squared

-0.186*** -0.089** -0.175*** -0.089**

credit to private sector (% of GDP)

0.009 0.009

Cost of business start-up procedures (% of GNI per capita)

0.003

0.0003

No. of obs. 42 73 42 73 Wald chi2 Prob > chi2

53.58 (0.00)

30.59 (0.00)

53.02 (0.00)

30.20 (0.00)

R-squared Within Between Overall

0.60 0.63 0.65

0.26 0.44 0.43

0.60 0.65 0.67

0.26 0.44 0.43

Table 3. Random-effects GLS estimates

Summary and policy implications1. The quality of legal rights has a positive impact on ‘new

business’ density, our proxy for entrepreneurship. More interestingly, the relationship is shown to be non-linear, depicting an inverted-U shape.– The estimated coefficients suggest a turning point of the index

of the quality of legal rights in the range of 6-6.9 (on a range of 0-10). Only four countries in the sample have an index above 7.

– This suggests that the majority of African countries would benefit from policies leading to improvements in the quality of legal rights as this will promote entrepreneurship.

Summary and policy implications

2. We find an inverted-U shaped relationship between new business density and the depth of credit information– The turning point of the index of the depth of credit market

information is about 2.75. Only three countries have an index above 3.

– This suggests that African countries can gain substantially from policy interventions aimed at developing information on borrowers and creditors, as this would facilitate identification of profitable activities and increase access to credit for new entrepreneurs.

Emphasis should be on three interventions:

(1) design and enforcement of legal rights especially targeting collateralizable assets;

(2) fostering competition in the banking sector, both in terms of ownership of banks and access to credit;

(3) developing and strengthening institutions and mechanisms for access to creditor and borrower information.

It is particularly important to design and enforce property rights that enable entrepreneurs to utilize their physical assets, such as land, to secure bank loans.

Since new and upcoming entrepreneurs are viewed as highly risky by banks; they are unlikely to secure the needed capital to support their investment needs.

Given the high social returns to supporting entrepreneurship, the costs associated with the risk inherent to lending to new productive activities should be spread across the society.

This could be done through the design of loan guarantee schemes, with explicit and detailed provisions to ensure that the loans supported by the schemes are directly financing new investments and trade activities.

The analysis and results in this study suggest that while African economies may be lagging behind in terms of innovation and entrepreneurship, this may be alleviated by targeted policy interventions that promote improvements in the legal rights and the depth of credit market information as these will increase access to credit.