Emerging Market Firm Investment
External financing accounts for more than 40 percent of firm investment. Of this amount, 19 percent comes from commercial banks, 3 percent from development banks, and 6 percent comes from suppliers and equity investments, and 2 percent comes from informal sources. In addition to formal sources, a small portion of firms get financing from their own customers. In addition, firms use debt to finance additional investments, which they plan to reinvest in other areas of their business. While the proportion of firms financed with debt is not high, it is a significant source of financing for most emerging markets.
Although government and development bank funding are important sources of investment, small firms do not benefit significantly from these sources. Moreover, government funds are usually aimed at larger firms, which are less vulnerable to external factors. While such programs can be political and have a limited impact, they are not likely to achieve their objectives. Underdeveloped legal systems and financial systems make it difficult for small firms to make up for this lack of access to external finance. Hence, the alternative sources of finance are limited.
A large sample of firms shows that the financial constraints of firms affect their investment decisions. The highest creditworthiness firms are the most sensitive to internal funds, while lower creditworthiness firms are the least. These findings indicate that internal cash flow plays an important role in firm investment. However, a firm’s external financial structure plays a crucial role in determining its success. In a developing country, this problem has a greater impact on the success of small companies.
Large samples of firms show that financial constraints have a negative impact on firm investment. For example, firms with low financial constraints are sensitive to internal cash flow. In addition, firms with low internal creditworthiness are sensitive to the financial environment. And firms with high creditworthiness are more likely to receive government funding. Even though external debt is not a major obstacle to success, the relationship between financial constraints and firm investment is positive and robust. It may be time to look at alternative sources of finance.
In the absence of formal equity finance, private debt can be an important source of finance. Some equity firms finance misvalued companies with debt, thereby enhancing their value. Often, the equity firm will introduce new technologies or processes to increase profitability, while the debt-financed company may be sold to another equity firm or to a strategic buyer. Finally, the debt-financed investment of private firms is more effective than government loan and equity funds alone.
The extent of debt financing varies widely by firm size. In developing countries, government funding is disproportionately available to large firms. In developed countries, small firms face severe financial constraints, which may prevent them from investing. In such circumstances, alternative sources of finance are required. Increasing the share of debt in public firms is a way to boost investment in companies with debt. Besides, it will increase the firm’s valuation. This can help them attract more private loans.