Productivity Is a Question of Credit

An expanding supply of credit is a powerful incentive for productivity, but expansions of credit can be counterproductive if they are not sustainable.

Latin American financial systems have managed to correct many of their old problems of inefficiency, which stemmed from governments which intervened too much, regulated badly and neglected oversight. Evidence of these improvements is that Latin American banks have come out of the world financial crisis unscathed. However, the depth of the Latin American credit systems continues to be very shallow by international standards, and in many countries, they have not regained the levels achieved in the early 1980s.

Scarce credit is one of the reasons why there are firms with such varied levels of productivity, especially in the small and medium-sized sector. Due to lack of access to credit, the most productive firms cannot expand and the less productive cannot make the technological changes and investment needed to increase their productivity. As a result, in sectors where small firms predominate, productivity is heavily dependant on access to credit. A study on Colombia[1] found that in the small business sectors, a 14% increase in the amount of credit received during a decade produced increases of 50% in productivity.

Lack of credit has another damaging effect on productivity because it weakens incentives for informal firms to comply with tax and labor regulations. This affects productivity by allowing unproductive firms to survive and stay in business since their costs are lower than their formal peers. Expansion of credit can make a major contribution to formalizing employment, as shown by a study of the Brazilian experience from mid-2004 to the outbreak of the world financial crisis four years later[2]. In that period the percentage of workers with formal employment contracts rose from 38% to 45% and credit for formal firms from 15% to 24% of GDP. This was not just a coincidence: the sectors most dependent on credit – due to their need for investment and cash flows – were precisely those with the highest rate of formalization of their labor force.

An increased supply of credit can be a powerful incentive for productivity. But credit growth can be damaging for productivity, if it is not sustainable. This lesson, which some developed countries are now assimilating, is an old one for Latin America. There are two main reasons why a sudden credit crunch can harm productivity in the long term. First, episodes of credit drought delay the investments needed to introduce the new technologies which would increase productivity; that delay is difficult to recoup in the future. Second, when credit disappears, firms which are forced to close are not necessarily the most unproductive, but in general, the smallest, including as many productive as unproductive. A small firm has to be 3 1/2 times more productive than a large one in order to have the same probability of surviving a credit drought. If credit crises are frequent, efficient small firms have no more probability of surviving than inefficient ones.

How to achieve more credit and financial stability? Although the Latin American economies have been relatively successfully in surviving the world financial earthquake, many of them face three immediate challenges. The first is to urgently correct the fiscal deficits, which were created during the international crisis by the fiscal stimulus packages and the decline in tax revenue as they are a threat to macroeconomic stability. The second is to beef up financial supervision since many companies which were weakened by the recent recession may be at risk of defaulting. And the third is to strengthen creditors’ property rights so that banks can lend with collateral to small- and medium-sized firms. This is perhaps the most difficult step, but also the most necessary, in the effort to get credit systems to contribute more to growth of productivity.

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[1] Prepared by Eslava, Galindo, Hofstetter, and Izquierdo for the report “The Era of Productivity: How to Transform the Economies from their Foundations”,  just released by the Inter-American Development Bank (Palgrave, 2010).     

 
[2] Produced by Catao, Pagés, and Rosales for the same report.     


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