DOES FINANCE IMPROVE BUSINESS PERFORMANCE IN THE INFORMAL ECONOMY?

This study investigates the impact of financial capital (microfinance) on the performance of micro-enterprises in the informal economy. The theoretical basis for this study is the Schumpeterian notion that entrepreneurs are able to create value due to their ability to make new resource combinations, of which financial capital is one of the most important and easily convertible resources. To test our hypotheses we apply a cross-sectional unique dataset of microenterprises in the informal sector in Ecuador. We observe how the provision of microloans, as a measure of financial capital, allows micro-entrepreneurs to multiply their income generating opportunities and achieve a higher return on equity (ROE). In addition, greater debt financing is positively related to the operating efficiency, measured as return on assets (ROA). Critical to the decision to exploit an entrepreneurial opportunity is also the entrepreneur's financial literacy, and we find that entrepreneurs with a higher financial literacy achieve higher performance than others. However, an important observation is that growth comes at the expense of performance up to a certain size, implicating that diminishing economies of scale negate the positive effects of debt financing in the informal sector. Our results suggests that lending is best suited for firms with an asset size greater than USD 129.000. This has an important policy implication in that growing the size of a small business, through increased debt financing, may not necessarily lead to enhanced overall performance.