Financial contracts, small firm growth, and job creation: experimental evidence from Uganda

We examine how key aspects of the most common form of financing-debt-may inhibit young firms' expansion. Starting a business entails learning and risk taking, implying that project returns to investment can start low but increase over time (in other words, be "backloaded") or be uncertain. Also, indivisible start-up costs often require large investments. Meanwhile, standard debt contracts available for micro-entrepreneurs from the formal or semi-formal financial sectors of many developing countries (such as microfinance) stipulate a constant repayment stream and caps on the initial loan size. The interaction of such features of the loan contract and the firm's production technology, may distort investment toward inputs that involve less learning, less uncertainty, and smaller projects; hampering firm growth. To shed light on the extent to which these theoretical mechanisms limit the effectiveness of microloans, we plan to collaborate with BRAC Uganda's Small Enterprise Lending Program to study the effect of the credit terms on starting firms' input use, profits, and repayment performance. As such, our project contributes to the DFID-ESRC Growth Research Programme's focus on Finance and Growth in Low Income Countries.

Small and medium-sized firms are the engines of the Ugandan economy, comprising over 90 % of the private sector and BRAC Uganda has been lending to such firms since 2008 through its Small Enterprise Lending Programme. The loans range from 2.5 million to 13 million Ugandan Shillings (630 to 3,300 GBP) and are repaid monthly with a maturity of 12 months at an annual interest rate of 25%. The research project will select, among firms applying for BRAC loans from mid-2014, a representative sample of 1600 firms to be part of a randomized experiment.

In order to investigate whether standard contractual terms in microloans from formal or semi-formal sources are restrictive for firms that face indivisible costs and/or are characterized by backloaded or uncertain project returns, we will (randomly) implement the following interventions for different groups of firms by: (i) changing the repayment frequency to distinguish the effects of uncertain project returns from those of backloaded returns; (ii) offering subsidies to ease the purchase of indivisible goods; and by (iii) offering consultancy services to shorten the learning process about the use of certain inputs to alleviate problems of backloadedness. We will survey these firms at baseline, upon completion of the loan-cycle (1-year after), at midline (2 years after baseline), and at endline (4-5 years after baseline) to measure the changes in firms' production and profits. In addition, we will use detailed and high frequency firm data to trace how the financial structure, a firm's learning curve, or the ease with which an indivisible good is acquired affects the use of machines and labor and how this in turn impacts profits and repayment performance. The project will provide unique evidence on the constraints caused by the interaction of financial structure and technology use that complements the recent emphasis on access to finance.