Small businesses and liquidity constraints in financing business investment: Evidence from Shanghai's manufacturing sector

When firms experience financial hierarchy, external finance, if at all avai lable, is substantially more expensive than internal finance. Factors such as transaction costs, agency problem, and asymmetric information have creat ed such a hierarchy. Stiglitz and Weiss (1981) argue that asymmetric inform ation between firms and potential suppliers of external finance creates adv erse selection and moral hazard problems in the credit market in developed market economies. This problem of a higher cost of external finance is comm only thought to be more serious for small firms because they are more disad vantaged than their larger counterparts in accessing external fiance due to several factors: (1) Public information on small firms is generally not av ailable and leads to the even greater problem of asymmetric information, i. e., more severe adverse selection and moral hazard problems. These informat ion problems have excluded small firms from bond and share markets. (2) Due to the lack of available means of external finance, small firms rely more heavily on bank loans than their larger counterparts. In addition, as small firms are more interested in cultivating stable relationships with a few b anks in order to secure a stable supply of credit, these banks become virtu al monopolies by lending to small businesses and exercise their market powe r in lending to small firms. Most of existing research considers only small firms in market economies; l ittle research has been done to understand the relationship between firm si ze and investment financing in any economy in transition. This paper makes a contribution to the literature by studying the relationship between firm size and liquidity constraints by using a firm level data of manufacturing enterprises in Shanghai during the period of 1989-1992. We consider whether small manufacturing firms in Shanghai are constrained by the availability of liquidity compared with their larger counterparts when they are financin g their fixed investment. In a transforming economy such as China (or other similar transition economies), external finance relies heavily on loans fr om banks that are fully owned by the state. Due to historical reasons, allo cations of credit are always biased in favor of state-owned enterprises. Su ch a 'lending bias' imposes an extra cost on small Chinese enterprises in f inancing investment as the majority of them are not state-owned. In such an environment, our empirical results show that small manufacturing firms in Shanghai are actually less liquidity-constrained than their large r counterparts in financing their fixed investment. This surprising result is rather different from what people normally predict based on the experien ce in market economies. We suggest three possible explanations for this pec uliar finding: (1) The composition of various firm size classes plays an im portant role in explaining the result: Non-state enterprises which are fast growing and efficient dominate the small firm classes. Their successes in the markets helps them to generate enough internal funds to smooth their in vestment over time. (2) The presence of heavy indebtedness of large state-o wned enterprises may deprive them of sufficient cash available for investme nt decision. Given that state-owned enterprises have been making heavy loss es, the central and regional governments have a liquidity problem in satisf ying their hugh liquidity demands. (3) Small enterprises in non-state secto rs can rely on the informal credit market to obtain funds for investment al though they are excluded from the state banking system. However, the further trade liberalization in terms of eliminating tariffs a nd quotas caused by China's bid of joining the WTO will erode the profits o f these small enterprises as imported goods will be supplied at lower price s. In addition, further reforms in financial sectors may also affect the su pply of external finance to small enterprises in nonstate sectors. The cons equence may lead to a tight liquidity constraint for small enterprises in C hina. (C) 2000 Elsevier Science Inc.