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The Role of Finance and Microentrepreneurship in the Informal Economy

  • Stockholm School of Economics & NLA University College Hauge School of Management

Abstract and Figures

In the mid-1970s, microfinance began a new era of growth, pioneered by the work of Professor Muhammad Yunus and the Grameen Bank, with a mission to eradicate poverty from the face of the earth. VIdeo: Presently, more than 200 million individuals globally have a microfinance loan, compared to 13 million in 1997 (Reed, Marsden, Ortega, Rivera, & Rogers, 2014). Microfinance is today synonymous with external entrepreneurial finance in the informal economy, and it is beginning to reach magnitudes where significant population groups are being affected. However, research has struggled to find support for the argument that microfinance helps individuals get out of poverty (Roodman & Morduch, 2013), and critiques by some journalists and researchers have been harsh on microfinance (Bateman & Chang, 2012; Heinemann, 2013). This thesis therefore adresses several firm-level drivers and issues of microenterprises, the modus operandi in the informal economy. The informal economy can be assumed to follow a similar entrepreneurship process (Shane & Venkataraman, 2000) to the formal economy, although it is also somewhat more isolated, since few buyers from the formal economy ever buy goods or services from the informal economy (Böhme & Thiele, 2012). Further, many microentrepreneurs in the informal economy become involved in similar business activities to their friends and neighbors, particularly construction, wholesale and retail trade, and restaurants. This creates an environment where competition is high and where it may also be difficult for entrepreneurship opportunities to exist, especially if the cost of borrowing capital is excessively high. Through the rise of microfinance institutions, capital can potentially be provided at more affordable interest rates than those offered by local loan sharks. If money is not available, engaging in trade or general business activities will involve high transaction costs, which hinder the formation of entrepreneurial opportunities even further. By introducing money as a medium of exchange, transaction costs are lowered, thus enabling more entrepreneurial opportunities to exist. The same holds true for the increased use of mobile money. Discovering an entrepreneurial opportunity requires keeping a close eye on the market and understanding what customers need. This study was performed on microentrepreneurs in Ecuador, clients of Banco D-Miro, who have been running a business over some years and can be assumed to be somewhat experienced at this. A common characteristic for all individuals in our sample is that they have at one point approached microfinance institutions to seek a loan for their microenterprise. We argue that that act is a symbol that this individual is following an entrepreneurial process and has decided that taking out a loan is a priori good for their business. In addition, our sample includes individuals who previously have had a loan, but are not longer clients. To sum up, there are a number of key lessons learned from this thesis: 1. Risks of failure leads to risk aversion in borrowers Those who decide to take on debt earn a higher ROA and have higher sales growth as a form of insurance against the risk of default. These results are partly based on prospect theory (Kahneman & Tversky, 1979) which suggests that since individuals tend to exaggerate the fear of failure in comparison to a sure gain. In the informal economy, we see a high variability in performance level. 2. Microdebt has no impact on ROA or growth, but impacts profits positively The panel study shows that in microenterprises a higher leverage is positively related to increased profits, but has no impact on the operating efficiency (ROA) or sales growth. This implies that the provision of microdebt is adding more income to the microentrepreneurs, income that will be used on improved housing or education. However, using debt does not improve the operating efficiency nor does it help the business grow, thus hindering the poor microentrepreneur on his or her path out of poverty. The resource-based view (Barney, 1991) predicted that resources are key to the performance, as have others researchers (D. S. Evans & Jovanovic, 1989) but as shown here in the informal economy, microdebt is only impacting profits, not ROA or sales growth. These findings imply that microdebt as a resource is not helping the microenterprises create a competitive advantage, but it does add extra income to the bottom line. 3. Firms face a curvilinear (concave) relationship between size and performance My findings indicate a curvilinear (concave) relationship between the size of the microenterprise and ROA on the one hand and between size and profits on the other. No affect is measured on sales growth. This findings illustrates the challenge of growing a small business. As the size increases, the profits and profitability may actually decrease initially and later increase, but before the microentrepreneur will likely have given up long before reaching that stage. This links to previous resources that suggest diminishing economies of scale (Armendáriz & Morduch, 2010), a finding contrary to observations of formal firms. However, my findings suggest that the relationship is concave and the positive economies of scale, as Adam Smith once predicted, kick in at a later stage. 4. Human capital investments (education/age) are not enhancing performance The results show no impact from education on microenterprise performance. In fact, the other parameter of human capital, experience (measured as age), is seen to be negatively correlated which could be a cohort effect, or may illustrate that younger microentrepreneurs take more risks than older. This suggests that human capital in the informal economy is not a resource that helps microentrepreneurs improve performance. 5. The relationship between debt and performance is negatively moderated by number of employees The cross-sectional study shows a negative moderating effect on the relationship between leverage and performance, such that leverage has less impact on performance in smaller firms than larger firms. In previous studies (Honig, 1998) it was found that the relationship varied depending on number of employees. This study achieved somewhat similar results. 6. Both entrepreneur characteristics and firm characteristics matter in the decision to finance Drawing inspiration from human capital theory and the resource-based view, the results indicate that, contrary to previous research, entrepreneur characteristics matter more in the informal economy than in the formal economy. I find that being older, not married, and more financially literate increases the likelihood that microdebt will be undertaken. Traditional firm characteristics such as size, asset structure, and performance (ROA) are also positively linked to the decision to finance. For the informal economy, it was found that growth intent was also a key driver in the decision to finance, which is typically not found in research in formal economies. In terms of leverage, those who are financially more literate are more likely to take on more debt. Among the firm characteristics, it was again found that size and performance impacts leverage positively, but it was also found that asset structure is negatively related with leverage. 7. Financial literate microentrepreneurs achieve higher ROA and profits The findings show a strong positive relation between financial literacy and ROA and between financial literacy and profits, suggesting that financially literate microentrepreneurs make better investment decisions. This illustrates again how a key resource, in this case a skill, helps microentrepreneurs earn higher returns. However, when relating to sales growth, financial literacy was not seen to have any impact. Perhaps other skills such as marketing (Webb, Morris, et al., 2013) are more important for growth. 8. Knowing successful role models helps the microentrepreneur achieve higher ROA My results show a significant relationship between those microentreprenurs who indicate that they know a succesful role model and their performance in terms of ROA, suggesting that the role model has a positive impact on the operating effiency and perhaps the microentrepreneurs’ ability to make more sound investments. The purpose of this thesis was to address the impact of microfinance on microenterprise performance in the informal economy through research-based theory (Barney, 1991) and human capital theory (Becker, 2009), as well as an exploration of the impact of financial literacy (Lusardi & Mitchell, 2014) and role models (Bosma et al., 2012). In addition, this thesis also investigated the role of entrepreneur (e.g., human capital and financial literacy) and firm characteristics in financial decision making. The essays are summarized in the introduction of this thesis and are also illustrated in Figure 5 relative to how they fit in with entrepreneurship theory. By positioning the practice of microfinance within entrepreneurship theory, I try to better explain successes and failures in using microfinance, and the critical interplay between the environment and the individuals. My thesis sheds light on the role microdebt has in relation to entrepreneur characteristics. I argue that while microdebt enhances ROA and profits, it does not affect sales growth. The thesis shows the importance of understanding the characteristics of the microentrepreneur and that relevant skills, such as financial literacy, do have an impact on the bottom line of microenterprise. After all, economic and social development is not created by external sources from above, but through “its own initiative, from within” (Schumpeter, 1934, p. 63).
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