The,Investment,Path,Small,Firm DIY The Investment Path of Small Firms in Developed and Developi

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The Investment Path of Small Firmsin Developed and Developing EconomySmallfirms tend to be partially dependent on bank lending to finance their growth. Aportion of small firms reaches the capital markets and may use public financingto grow their businesses. Those who do go public may still rely at least inpart on bank lending to finance their growth. As such, there are two ways inwhich foreign portfolio investment may reach the small firm: (i) direct route - through the capital markets, and (ii) indirect route - through banks who will in turn invest in or be able toextend more credit to such firms.(i)The Direct Path of Investment:Ifcompetition for a scarce resource, such as capital, improves the investment environmentthrough superior transparency, disclosure and/or corporate governance – an effectiveimprovement in the investment environment, the set of firms in which foreign investorsconsider investing is increased to include some firms who previously had difficultyobtaining financing due to information asymmetry and/or agency costs. This impliesan improvement in the allocation of capital which has been associated with marketdevelopment. Small firms with their informationally opaque nature may beincluded in this marginal group of firms. This is relevant due to the challengeof small firms in accessing capital in any form. Firms perceived as‘investible’ who need external financing should realize an increasedprobability of domestic capital issuance with an accompanying increase inforeign portfolio investment. An increase in the probability of capitalissuance stems from the increase in supply of capital and is not identified asdue to foreign or domestic investors. I examine whether the level of foreign portfolioinvestment helps to ease the financial constraints of small firms. More explicitlystated, ‘The probability of capital issuance for small firms issignificantly positively related to the level of foreign portfolio investmentof a country (e.g. the financial constraints of small firms are relaxed)’.            Beyond whether a firm issues, Iexamine the type of security a firm issues. Inasmuch as small firms aretypically debt-laden, the ability to issue equity could be perceived to be agreater alleviation of financing constraints since there are no fixed paymentsassociated with this form of capital. This ‘choice’ of capital form, therefore,becomes informative. Not much has been written in the international arena examiningthe feasibility of capital choice for constrained firms. Korajczyk and Levy, inthe year 2003, provide an examination of capital structure choice for bothfinancially constrained and financially unconstrained firms in the UnitedStates. Although solely a domestic study, the main result in Korajczyk andLevy’s work is that constrained firms issue what they can when they are able.There isn’t any compelling reason, beyond an increased disclosure andgovernance at the firm-level, that would lead us to believe that these firms wouldbe able to access equity as a result of the increase of the supply of capitalavailable to firms, domestically or internationally. We should see thatalthough small firms will indeed see an easing of their financial constraints,this easing would mainly be in the form of debt capital. To that end, Ihypothesize the following: ‘Conditional on firms issuing capital, theprobability of small firms issuing equity capital will not be significantlypositively related to foreign portfolio investment’.(ii)The Indirect Path of Investment:Forthose firms who are dependent on bank lending and/or remain unable to accesspublicly issued securities, the ‘direct’ path of foreign portfolio investmentis irrelevant. An ‘indirect’ path through financial institutions instead isrelevant. The theory behind this path of investment stems from the bank-lendingtheory of monetary policy and related concepts. Kashyap and Stein, in the year 2000,is particularly relevant in that they find that small banks are particularlysensitive to monetary policy. This is relevant since small banks are mostlikely to be the banks to serve small firms. The lending theory finds that moneysupply tightening (expansion) appears to decrease (increase) the ability ofbanks to loan funds based on the relative illiquidity of their balance sheets.What this implies is that if there is a positive money shock into a country,bank balance sheets become relatively more liquid thus enabling them toincrease the amount of credit extended to the public. Although this moneysupply augmentation is due to monetary policy in Kashyap and Stein’s research paper,this theory could be extended to consider a different source of ‘money supply’– in this case foreign portfolio inflows. An increase in the liquidity of thebank’s balance sheet through increased outside investment enables banks to lendin the same manner as if there were a change in money supply caused by monetarypolicy5. More concisely stated, ‘The liquidity of bank balance sheets, aswell as the amount of domestic credit, are significantly positively related tothe level of foreign portfolio investment of a country’.