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Firms in developing countries cite credit constraints as one of their primary obstacles to investment. Direct foreign investment may ease credit constraints by bringing in scarce capital. Alternatively, if foreign firms borrow heavily from domestic banks, they may crowd local firms out of domestic capital markets. Using firm data from the Ivory Coast, we test whether: (1) domestic firms are more credit constrained than foreign firms, and (2) whether borrowing by foreign firms exacerbates domestic firm credit constraints. Results provide support for both hypotheses. We also find that state-owned enterprises (SOEs) are less financially constrained than other domestic enterprises.

Firms in developing countries typically cite credit constraints as one of their primary obstacles to investment.1 Direct foreign investment may ease credit constraints by bringing in scarce capital. For example, domestically owned businesses in poor countries are much more likely to face credit constraints than multinational firms.2 This is one of the reasons policy makers in developing countries have eased restrictions on inward DFI and in many instances provide special incentives for DFI. Yet, if foreign firms borrow heavily from local banks, they may exacerbate domestic firm credit constraints by crowding them out of domestic capital markets.3 Apart from anecdotal and survey evidence, there is little empirical evidence on capital market imperfections and firm level investment in developing countries4. One reason for the limited empirical evidence is the difficulty in obtaining detailed firm-level data for these countries. Most of the existing evidence is difficult to interpret because these surveys are typically administered by institutions in a position to make loans such as the World Bank. Hence, firms have an incentive to report that they are credit constrained. Leading theorists, however, recognize the important role that capital market imperfections play in developing countries.5 There is also a large body of empirical evidence for developed countries that suggests that capital market imperfections play an important role in determining firm-level investment decisions.6 In this paper, we analyze whether incoming foreign investment in developing countries plays an important role in alleviating domestic firms’ credit constraints. We measure the impact of incoming direct foreign investment on domestic firms’ credit constraints using firm-level data for the Ivory Coast. Specifically, we use an augmented Euler investment model to test the following hypotheses: (1) domestic firms face different credit constraints than foreign firms, and (2) borrowing by foreign firms affects the credit constraints of domestic firms. We modify the standard Euler investment model by introducing a borrowing constraint and then use as proxies for the shadow value of the constraint two measures of financial distress, the debt to asset and interest coverage ratios. In the absence of such constraints, these financial variables should not play a role in determining future investment. Using this framework, we also explore the differential impact of DFI on the credit constraints of state-owned enterprises (SOEs) and private domestic firms. The results suggest that only domestic firms face credit constraints in the Ivory Coast. We also find evidence of crowding out. Specifically, we find that the share of foreign long-term borrowing at the sector level exacerbates domestic firms’ credit constraints and has no effect on foreign firms’ credit constraints. When we split domestic firms into public (government-owned) and private firms, we find that public firms’ investment decisions are not sensitive to debt ratios or the cost of debt. Nor is there any evidence that public firms are affected by foreign borrowing in domestic credit markets. We interpret this as evidence in support of the notion of a soft budget constraint for public firms. In contrast, private domestic firms appear more credit constrained than foreign firms and are crowded out by foreign borrowing. Finally, we find little evidence that this crowding out takes place via product markets. Why would borrowing by foreign firms crowd out domestic firms? One plausible mechanism by which this may happen is indirect. Foreign firms may simply be more profitable and/or have access to more collateral and thus be a better investment for lending institutions.7 A World Bank country economic report for Cote d’Ivoire (1978) suggests that local banks found lending to local enterprises more costly because they were generally considered more risky. This problem was compounded by the fact that interest rates were fixed, thus creating excess demand for loans and the likelihood of credit rationing. Because of interest rate ceilings, banks could not compensate for the extra cost of lending to domestic firms and hence preferred to lend to foreign firms.8 To determine why domestic firms are more credit constrained than foreign firms, we compare the profitability of domestic and foreign firms using standard ratio analysis. Overall, foreign firms are somewhat more profitable than domestic firms. Thus, it may be that given the choice, lenders prefer to lend to foreign firms. However, when we interact relative profitability with debt ratios and interest coverage, we find little evidence that it is relative profitability that is driving our results. Instead, the share of foreign borrowing remains significant. We conclude that the relative profitability of foreign firms is not driving our results. This paper does not attempt to calculate the implications of our results for overall welfare in Cote d’Ivoire. To properly account for the total impact of DFI on the host country, we would need to take into account the impact of foreign investment on domestic wages, profits, and employment; the role of foreign investors in promoting technology transfer; and the contribution of foreign investors to tax revenues. This is beyond the scope of this paper. However, we do compute the net impact of DFI on the availability of capital, adding together the inflows from equity purchases and foreign borrowing and subtracting the local borrowing of these firms. Because the majority of DFI in Cote d’Ivoire was financed locally, DFI did not represent a large increase in net capital flows to the economy. In fact, borrowing on local credit markets by foreign firms significantly exceeded the sum of equity purchases and foreign borrowing by these firms. From that perspective, total capital available to purely domestic firms actually shrank. Our contribution is twofold. First, we shed light on an important question in development economics: does DFI ease or exacerbate domestic firms’ credit constraints? Second, this paper provides an additional test of the approaches used by Fazzari, Hubbard, and Peterson (1988), Whited (1992), and Bond and Meghir (1994) to identify credit constraints. This literature relies on an observed correlation between investment and measures of internal (cash flow) or external (debt) funds, after controlling for other factors, to identify credit constraints. If there were no capital market imperfections, then a firm’s financial structure should have no impact on investment. Typically, as a test of the approach, this literature selects firms which are a priori likely to be credit constrained, such as small firms, firms with high debts, or firms paying out low dividends. Researchers then examine whether these firms exhibit higher correlations between either investment and cash flow (FHP), or between investment and debt to asset ratios and interest coverage (Whited, 1992). Kaplan and Zingales (1997) have criticized this approach, arguing that firms which are identified as credit constrained by FHP are in fact not constrained, based on company statements and balance sheet evidence.9 Our research provides additional support for both FHP and Whited (1992) by adding a new selection criterion: foreign ownership. One advantage of this approach is that ownership seems to provide a more exogenous criterion for splitting the sample than firm size or dividend policy, which has been the focus of previous studies on credit constraints. In developing countries, we would expect that firms with foreign equity participation (and hence preferential access to capital markets) should be less credit constrained, and consequently should exhibit no relationship between investment and the availability of (internal or external) funds. The remainder of this paper is organized as follows. Section 2 outlines the general approach used for testing for credit constraints and crowding out. Section 3 discusses the Ivorian banking sector and describes the data. Section 4 presents results of estimation. Section 5 explores the underlying reasons for the differences between domestic and foreign firms borrowing capabilities and also presents extensions on the basic results. Section 6 discusses the implications and Section 7 concludes.

In this paper, we attempt to answer a question, which has not been addressed elsewhere: does the entry of foreign enterprises in developing country credit markets hurt their domestic competitors? Although foreign investment conveys benefits by bringing in scarce capital, those benefits may be mitigated if foreign enterprises crowd out domestic enterprises in the local credit markets. Our results suggest a difference between the credit constraints faced by domestic and foreign firms. In addition, we find that one major reason why domestic enterprises are more credit constrained than their foreign counterparts in the same sector is due to crowding out by foreign entrants. Further, we find that one contributing factor is that foreign firms are more profitable and more liquid. Hence, foreign firms might be a better investment for local banks than domestic firms. Nevertheless, our results remain even after we control for the higher profitability of foreign enterprises. In other words, even after controlling for the profitability of foreign firms, domestic enterprises are still “crowded out” by their foreign competitors. We also examine the performance of state-owned enterprises (SOEs) relative to their private sector counterparts. For SOEs, debt to asset measures and interest coverage do not significantly affect investment, indicating that SOEs are not credit constrained. Nor is there any evidence that they are affected by foreign borrowing on domestic credit markets. These results suggest that SOEs are not credit constrained, perhaps because during this period they could be characterized by being subject to a soft budget constraint. In addition, SOEs are not crowded out by foreign enterprises of domestic credit markets, in contrast to their private sector counterparts. We explore whether our results on crowding out could be due to unobserved factors, such as increased competition from foreign enterprises or differences in firms’ size. Our results suggest that this is not the case. Although the Ivory Coast may be an unusual case, our empirical results suggest that policy makers should be cautious in assuming that foreign investors expand credit opportunities for domestic enterprises. In the Ivory Coast, foreign investors certainly eased credit constraints for firms with foreign investment, but firms which did not receive foreign investment became more credit constrained. These results are probably driven by a number of factors. First, interest rates were set below market rates, which led to credit rationing. This led foreign investors to borrow heavily on local credit markets, and at the same time encouraged banks to lend to less risky investors, since margins were low. Second, the banking sector was highly concentrated and dominated by firms with ties to French banks, which were probably biased towards lending to foreign firms.