Do Firms Want to Borrow More? Testing Credit Constraints Using a Directed Lending Program

Abstract

This paper uses variation in access to a targeted lending program to estimate whether firms are credit constrained. The basic idea is that while both constrained and unconstrained firms may be willing to absorb all the directed credit that they can get (because it may be cheaper than other sources of credit), constrained firms will use it to expand production, while unconstrained firms will primarily use it as a substitute for other borrowing. We apply these observations to firms in India that became eligible for directed credit as a result of a policy change in 1998, and lost eligibility as a result of the reversal of this reform in 2000. Using firms that were already getting this kind of credit before 1998, and retained eligibility in 2000 to control for time trends, we show that there is no evidence that directed credit is being used as a substitute for other forms of credit. Instead the credit was used to finance more production-there was a large acceleration in the rate of growth of sales and profits for these firms. We conclude that many of the firms must have been severely credit constrained, and that the marginal rate of return to capital was very high for these firms.

Keywords: Banking, Credit Constraints, India

JEL Classification: O16, G2