Academic journal article Economic Perspectives

Financial Constraints and Entrepreneurship: Evidence from the Thai Financial Crisis

Academic journal article Economic Perspectives

Financial Constraints and Entrepreneurship: Evidence from the Thai Financial Crisis

Article excerpt

Introduction and summary

Poorly functioning financial markets can limit entry of new firms and lead to inefficient production in existing firms. Small-scale entrepreneurs that have limited access to formal financial markets may be particularly affected by financial constraints. Despite this, small entrepreneurial firms are an important source of innovation, jobs, and economic growth in both developed and developing countries. In the U.S., 44 percent of the private work force is employed in small firms, which account for approximately 50 percent of non-farm gross domestic product (GDP). (1) Striking similarities exist between small firms in the U.S. and those in developing countries. In Thailand, for example, small firms employ 60 percent of the work force and account for approximately 50 percent of GDP. (2) Investment from banks and other formal financial institutions is typically limited in small firms. Thus, in both the U.S. and Thailand, two-thirds of the initial investment in small firms comes from savings and funds from family and friends. (3)

Outside investment in small firms may be limited for a number of reasons, including the difficulty of providing credible information to investors about the expected profitability of a planned investment project or the entrepreneurial skill of a potential borrower. This type of problem is typically called asymmetric information. In addition, the provision of a loan may reduce the incentives for an entrepreneur to exert the necessary effort to make a project successful, since the profits of a successful project will have to be shared with investors. This type of problem is called moral hazard. Asymmetric information and moral hazard are concerns in both developed and developing economies. However, these problems are likely to be acute in developing economies where financial markets are less efficient.

When financial markets are less developed, entrepreneurial activity may also be vulnerable to events like the Asian Financial Crisis. This crisis began in July 1997 when the Thai government abandoned its policy of pegging the value of Thailand's currency, the baht, to a basket of developed countries' currencies heavily weighted to the U.S. dollar. The Asian Financial Crisis led to widespread turmoil in international financial markets and to recessions in many Asian countries. In the wake of the crisis, the Thai economy entered a period of marked contraction. In 1997 Thailand's GDP fell 1.5 percent, and in 1998 it fell 11 percent. (4)

At the same time, entrepreneurial activity in Thailand increased. In the 12 months following the onset of the crisis, data from a survey we conducted reveal that the number of business households more than doubled (see figure 1). In the spring of 1997, approximately 11 percent of survey households operated a business. One year later, the percentage had tripled, with more than 30 percent of the survey households operating a business. By studying entrepreneurial activity in Thailand before, during, and after the financial crisis, we can enhance our understanding of entrepreneurship and financial constraints generally, and improve our understanding of the role of small businesses during a period of economic contraction.

[FIGURE 1 OMITTED]

We use new longitudinal data from rural and semi-urban Thailand to examine the factors that influence entrepreneurial activity in the pre-crisis and crisis periods. The data cover an interval from the spring of 1997 to the spring of 2001, so we are also able to gain some insight into the post-crisis period. We are particularly interested in entrepreneurial activity during the crisis period.

Before the crisis, we find that wealthier households are more likely to start businesses and that they invest more in these businesses than their less wealthy counterparts (Paulson and Townsend, 2004). During the crisis, however, the positive correlation between entrepreneurial activity and wealth disappears. …

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