Do Financially Constrained Firms Suffer from More Intense Competition by the Informal Sector? Firm-level Evidence from the World Bank Enterprise Surveys

This paper investigates the link between access to finance and competition by the informal sector. Access to finance is expected to be positively associated with a firm's competitiveness. Firms with access to finance are more capable to invest in innovation and technology and to hence escape the low-productivity segment where competition by informal firms is fierce. We use cross-sectional data from the World Bank Enterprise Surveys covering 42,000 firms in 114 developing and transition countries for the period 2006 to 2011 and take discrete responses on the perceived severity of financial constraints and informal competition for our empirical analysis. We find that financially constrained firms face significantly more intense competition by the informal sector and that this effect is economically large. The results are robust to using an objective measure of credit constraints and to controlling for unobserved heterogeneity in firms' productivity. They also hold when firm responses are demeaned and financial constraints are instrumented by country-industry-location-size averages. The paper extents the growing research on the determinants of the informal sector by the dimension of competition stemming from it and relates to the literature that views access to finance as an important engine of firm growth.