# **1. Introduction**

Are rural economic agents credit constrained? This question is of interest not only to researchers but also to public officials whose policies influence the availability of funds in rural loan markets. Without access to external finance, entrepreneurs and enterprises cannot realize their full growth potential, resulting in slower economic growth for a country as a whole. Inability to obtain sufficient funds, or, in other words, credit constraints, is often cited as one of the main factors limiting firms’ operations and growth, especially so in countries with weak financial markets and institutions. In the case of Mexico, Chapter 2 shows that individual entrepreneurs and enterprises mention lack of credit as a constraint to their operations. The data from the World Business Environment Survey (WBES) illustrate the issue of access to financial services from the enterprise’ perspective.<sup>1</sup> Such data show that Mexican firms rate financing as more of an operational and growth constraint than for their counterparts in other Latin American countries. Moreover, they rate access to long-term loans, access to export finance, paperwork, and corruption of bank officials as greater obstacles than for enterprises in the Latin American region.<sup>2</sup> In the economic literature credit constraints (or credit rationing) are defined as a situation in which interest rates do not fully adjust to equalize the demand and supply of loans. Some borrowers are denied credit even though they are willing to pay market interest rates (or more), whereas apparently similar borrowers are able to obtain credit (Jaffee and Stiglitz, 1981). The borrowers who are denied credit (either fully or partially) are referred to as credit constrained. Thus, credit constraints arise as a response to asymmetric information problems that characterize loan contracts. On one side, the willingness of the borrower to accept higher interest rate signals their higher risk (and therefore higher probability of default), which leads to lender’s unwillingness to lend to these customers because of the perceived adverse selection effect. On the other side, obtaining a higher interest loan may decrease repayment incentives of the borrower and may induce them to take up riskier projects (the moral hazard effect). Both of these situations result in a case of credit constraint (that is, when interest rates do not adjust and there is an excess demand for loans). To solve the asymmetric information problem, lenders resort to different mechanisms to screen, monitor, and enforce credit contracts, such as collateral requirements, gathering of information, or monitoring activities. Less developed countries with poor financial sector infrastructure (such as poor credit information registries, poor collateral laws, and so forth) may see a stronger incidence of credit constraints.

Do credit constraints affect investment behavior? The linkage between investment behavior and credit constraints receives substantial attention among researchers and policymakers. By having a negative effect on the investment behavior of economic agents, credit constraints can influence firms’ growth potential, especially among small firms.<sup>3</sup> At the firm level, Demirguc-Kunt and Maksimovic (1998) calculated the proportion of firms growing faster than if using only internally generated funds. They find

> 1  Please note that the WBES is the first effort to collect consistent cross-country survey data from a representative sample of firms in the manufacturing, service, and other sectors. However, this survey is very restricted in the number of firms for each country, and thus its findings should be interpreted as anecdotic evidence.

> 2 See the WBES interactive dataset for individual questions for Mexico and other countries at <u>http://info.worldbank.org/governance/wbes/index1.html.</u>

> 3 Extensive literature exists on the linkage between aggregate investment and economic growth at the macro level. This discussion is omitted here because our main interest is at firm or household level.  See for example Levine (1997), Rajan and Zingales (1998), and Beck and others (2000).

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