Elsevier

Economic Systems

Volume 45, Issue 3, September 2021, 100880
Economic Systems

Local institutions, external finance and investment decisions of small businesses in Vietnam

https://doi.org/10.1016/j.ecosys.2021.100880Get rights and content

Highlights

  • Local institutions are positively associated with fixed asset investment, negatively associated with non-fixed asset investment.

  • Formal finance is negatively associated with firm investment (both fixed asset investment and non-fixed asset investment).

  • Informal finance is positively associated with firm investment (both fixed asset investment and non-fixed asset investment).

  • The negative association between bank loans and firm investment becomes positive in regions with developed institutions.

  • The positive association between informal finance and firm investment becomes stronger in regions with developed institutions.

Abstract

This study investigates the impacts of local institutions, external finance, and their joint effects on firm investment in Vietnam. Investment decisions are classified into two categories: fixed asset investment and non-fixed asset investment. Analysing a set of 1.3 million firm-year observations of businesses in Vietnam (2006–2016), we find evidence that local institutions (both formal and informal) positively influence fixed asset investment but negatively affect non-fixed asset investment. Also, we find that informal loans are positively associated with both types of firm investment while bank loans are negatively associated with both types of firm investment. More importantly, we find that the quality of local institutions is able to moderate firms’ external financing behaviour, leading to increased investment values.

Introduction

Institutions are important in determining small business behaviours. The literature has shown that both formal and informal institutions significantly influence firms’ marketing activities (Dubova et al., 2017), cash balances and flows (Malinowska, 2019), as well as levels of innovativeness (Maksimov et al., 2017). In developing countries, where the formal institutional systems are underdeveloped and incomplete, informal institutions appear to be even more germane to shaping the ‘rules of the game’ (Steer and Sen, 2010). As such, recent studies have examined the relative importance of formal and informal national institutions for the performance of the entrepreneurial sector. However, a large body of the existing research assumes that institutions are homogenous within a country (Carbonara et al., 2016), with the result that most studies are conducted at the cross-country level. However, the local authorities in developing countries, due to the incompleteness of the formal institutions, may interpret and execute national legislation differently, leading to substantial heterogeneity in the quality of institutions across a country’s regions (Nguyen et al., 2018). Unfortunately, the issues related to local institutions have not been adequately addressed in the extant literature.

Access to finance is also key to determining small business behaviour. Small firms, due to their liabilities of newness and smallness, may find it difficult to secure sufficient external finance for their venturing activities (Carreira and Silva, 2010). Financing constraints are even more severe in developing countries because of their immature financial systems and the lack of alternative equity markets such as crowdfunding, business angels, and venture capital. In this situation, bank loans appear to be the only feasible external source of financing for the majority of small businesses. However, the banking systems in developing countries are typically controlled by state-owned banks, whose primary operational objective is to support state-owned firms, often to the detriment of privately-owned firms (Du et al., 2015). Faced with this situation, small businesses are ‘forced’ to rely on informal finance to support their venturing activities (Beck et al., 2015). Even though the relative importance of informal finance over formal finance has been widely investigated, the analysis is rarely conducted in conjunction with considering the role played by local institutions when explaining firm investment decisions.

Given these gaps in the literature, in this study we propose a framework that examines the roles of local institutions, external finance, and their joint effects on firm investment. The framework is novel in the following respects.

First, as well as examining fixed asset investments, we take into account non-fixed asset investments, such as obtaining additional working capital and repairing fixed asset investments (i.e., there is no increase in the number of fixed assets). Non-fixed asset investments are important to small businesses because small firms are typically not capital-intensive (Beck et al., 2013). As such, they must regularly invest in non-fixed asset projects to maintain their business operations. It is therefore important to take into account both the fixed asset investments and non-fixed asset investments of small businesses.

Second, we go beyond the national formal institutions (laws and regulations) by including the informal institutions (the local norms and practices of doing business) and the institutions of governance (the governance quality of local governments) in the model. The downgrade of the unit of analysis from national to local institutions is essential in the context of small businesses since their operations are mostly bounded by their local markets (Nguyen et al., 2018). Arguably, it is therefore reasonable to expect that the surrounding institutional factors are more relevant than the very broad and general national institutions to small business investment (Charron et al., 2014).

Third, on the finance side of the model, instead of following previous studies (Johnson et al., 2002) that employ bank loans as the sole representative of external finance, we also take into account informal credit (i.e., borrowing from relationship-based sources, such as friends and family). We expect that the inclusion of informal finance in the model will better explain small business investment decisions.

More importantly, our model also accounts for the potential interaction effects between local governance and external finance in determining firm investment. This consideration is based on recent literature showing that institutional and financial variables may not be independent of each other (Hasan et al., 2017). As such, we argue that the conventional comparison of the relative importance of institutions and external finance (Johnson et al., 2002) is unable to yield a meaningful conclusion. Rather, we suggest that the association between external finance and firm investment may change with the local institutional settings.

Analysing a set of 1.3 million firm-year observations of private small businesses in Vietnam (2006–2016), we find some evidence showing that local institutions (both formal and informal) are positively associated with firm fixed asset investment but negatively associated with non-fixed asset investment. In terms of external finance, informal loans are positively associated with firm investment, while bank loans are negatively associated with firm investment. This could be attributed to the underdeveloped banking systems in Vietnam. More importantly, our findings suggest that improved institutional quality (both formal and informal) positively influences the relationship between external finance and firm investment. Specifically, the negative effect of bank loans will become positive in regions with stronger institutional settings, while the positive effect of informal loans will be strengthened.

This study offers a set of important suggestions for policymakers who are concerned with boosting firm investment in developing countries where both the institutional settings and the financial systems are underdeveloped.

Section snippets

Institutions

Institutions are human-made ‘rules of the game’ that shape the incentives and behaviours of economic agents (Williamson, 2000). The ‘rules of the game’ can be formal or informal. Formal institutions are written ‘rules’, such as constitutional frameworks, legislative systems, and regulations. The informal institutions are the implicit ‘rules’, such as norms, values, and customs. Both formal and informal institutions have been found to be essential to shaping entrepreneurship. Because

Data

The empirical setting of this study is Vietnam. To test the proposed hypotheses, we employ the Annual Enterprise Survey dataset provided by Vietnam General Statistics Office (GSO). The survey was first conducted in 2000 and the dataset is updated annually. By regulation, all businesses with more than 10 employees are required to participate in the survey. For businesses with fewer than 10 employees, a sample is randomly selected to participate in the survey. The dataset provides comprehensive

Main results

Regression results are reported in Table 2, Table 3. The test statistics reveal that there are no serious problems with the model specification. Table 2 presents the results of fixed asset investment. In general, it is found that local governance quality and the existence of the pro-entrepreneurship norms in the South of Vietnam are positively associated with firm investment in fixed assets. As such, hypothesis H1 is supported. It is noteworthy that the effect of pro-entrepreneurship norms (the

Discussion and conclusion

This study investigated the importance of local institutions, external finance, and their joint effects on the investment decisions of small businesses. The context of analysis is Vietnam, a developing country with incomplete institutional settings and underdeveloped financial systems. This study builds on the work of Johnson et al. (2002) and Cull and Xu (2005) about the relative importance of institutional environments and access to external finance on firm investment decisions. We expanded

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