market might. Most small or medium firms have a relationship with one bank, which they have built up over some time–they cannot expect to walk into another bank and get as much credit as they want. For that reason, their ability to finance investments they need to make does depend on the willingness of that one bank to finance them. In this sense the results we report below might very well reflect the specificities of the public sector banks, or even the one bank that was kind enough to share its data with us, though given that it is seen as one of the best public sector banks, it seems unlikely that we would find much better results in other banks in its category. On the other hand we do not have comparable data from any private bank and therefore cannot tell whether under-lending is as much of a problem for private banks. We will, however, later report some results on the relative performance of public and private banks in terms of overall credit delivery
Our identification of credit constrained firms is based on the following simple observation: if a firm that is not credit constrained is offered some extra credit at a rate below what it is paying on the market, then the best way to make use of the new loan must be to pay down the firm’s current market borrowing, rather than to invest more. This is because, by the definition of not being credit constrained, any additional investment will drive the marginal product of capital below what the firm is paying on its market borrowing. It follows that a firm that is not facing any credit constraint will expand its investment in response to additional subsidized credit becoming available, only if it has no more market borrowing. By contrast, a firm that is credit constrained will always expand its investment to some extent.
A corollary to this prediction is that for unconstrained firms, growth in revenue should be slower than the growth in subsidized credit. This is a direct consequence of the fact that firms are substituting subsidized credit for market borrowing. Therefore, if we do not see a gap in these growth rates, the firm must be credit constrained. Of course, revenue could increase slower than credit even for non-constrained firms, if the technology has declining marginal return to capital.
These predictions are more robust than the traditional way of measuring credit constraints as the excess sensitivity of investment to cash flow.10 Our approach inscribes itself in a literature
10 See e.g. Bernanke and Gertler (1989), Fazzari, Hubbard and Petersen (1998), and the criticism in Kaplan and Zingales (2000).