January 2008, David McKenzie
Half or more of the labor force in most developing countries finds employment in small and informal firms. A central question for policymakers is whether these firms hold the potential for income growth for their owners, or whether they merely represent a source of subsistence income for low-productivity individuals unable to find alternative work. The rapid increase in development funding being channeled to microfinance organizations is based on the belief that these firms can earn high returns to capital if given the opportunity. However, critics argue that attention should instead be directed towards creation of wage jobs to pull people out of subsistence self-employment.
Our ability to assess the extent to which a lack of capital is a constraint on business profitability is complicated by the fact that firms which have more capital stock or greater access to credit are likely to also differ in many other ways from firms with less capital stock. The higher profits earned by firms with more capital may therefore simply reflect that owners of firms with more capital have better entrepreneurial skills than those with less capital, or that they have increased their capital investments in response to growing demand for their products.
Two recent randomized experiments in Sri Lanka and Mexico provide a way to resolve this problem, and credibly identify the return to capital. Grants of between US$100 and US$200 were given to randomly selected subsets of microenterprises in each country. We can then compare the profits of firms which were randomly chosen to receive this additional capital to the profits of similar firms which did not receive this additional capital. We find:
Real returns to capital of 5.7 percent per month in Sri Lanka, substantially higher than the market interest rate.
Real returns to capital of 20 to 33 percent per month amongst small retail firms in Mexico, much higher than market interest rates.
We can then examine which types of firms benefited most from the favorable treatment, which can help to explain why returns are so high.
In Sri Lanka, returns to capital are higher for entrepreneurs who are more severely capital constrained - those with higher ability and with fewer other wage workers in the household that can provide a source of liquidity. Returns do not vary with risk aversion or uncertainty, suggesting it is not the case that firms choose not to undertake high return investments because they involve too much risk.
Returns are also highest in Mexico for firms that say finance is a constraint to their business growth, and lower for firms that have previously had formal loans or supplier credit, again consistent with the proposition that credit market imperfections restrict firms from taking productive investment opportunities.
Returns in Sri Lanka are much higher on average for males than for females – they average over 9 percent per month for men, but are zero or slightly negative on average for females. Ongoing work is investigating the reasons for these low returns for females.
High returns to capital imply that the average microenterprise has the ability to pay the high interest rates charged by some microfinance organizations, such as Compartamos, the largest pure micro-lender in Mexico, which charges an average annual interest rate of 105%. The high returns suggest it is not the cost of capital, but limited access to capital, that is the issue.
These high returns also suggest that firms can start small, reinvest profits earned, and grow. As a result, it seems that although credit constraints lead to an inefficient allocation of capital, they will not cause poverty traps.
Finally, the results do suggest that the owners of these firms do have viable investment projects, and are not just making subsistence returns, implying that the government should aim to reduce barriers to growth in this sector, rather than solely focusing attention on creation of wage jobs.
This work is the first step in a series of related studies which consider the barriers to small firm growth. Ongoing work is considering the role of gender in microenterprise performance, the recovery of the microenterprise sector after the tsunami in Sri Lanka, and the determinants of which microenterprises make the jump sole-entrepreneurship to employer.
On returns to capital in microenterprises
De Mel, Suresh, David McKenzie and Christopher Woodruff (2007) “Returns to Capital in Microenterprises: Evidence from a Field Experiment”, World Bank Policy Research Working Paper 4230.
McKenzie, David and Christopher Woodruff (2006) “Do entry costs provide an empirical basis for poverty traps? Evidence from Mexican Microenterprises” Economic Development and Cultural Change, 55(1): 3-42.
McKenzie, David and Christopher Woodruff (2007) “Experimental Evidence on Returns to Capital and Access to Finance in Mexico”, Paper presented at the World Bank Access to Finance conference, March 2007.
On measuring profits in small informal firms
De Mel, Suresh, David McKenzie and Christopher Woodruff (2007) “Measuring microenterprise profits: Don’t ask how the sausage is made”, World Bank Policy Research Working Paper 4229.