Credit Constraints and Investment Finance: Some Evidence from Greece

Credit management is a key factor in the amount of funds available for private investment. It is often the cornerstone of financial reforms that aim to increase industrial growth. This paper examines the impact that interest rate policies could have on the investment sector in Greece.

The financial markets of Greece are underdeveloped. Due to the virtual absence of bond and equity markets, the private sector is dependent on bank credit for external financing. Bank credit is heavily subsidized, and both the deposit rates and the lending rates set by the Bank of Greece have been predominantly negative in terms of real value since 1973.

The lack of funds would restrict credit availability and limit private industrial investment. Deleau’s (1987) survey data on private manufacturing firms do not support that expectation. The majority of firms in the survey do not believe that a lack of funds is a barrier to investment. In effect, even negative real interest rates do not provide an effective subsidy. This is a bit of a mystery. The “naive explanation” implies that the return on capital across firms and different types of productive activities has consistently been negative. However, this explanation is difficult to maintain.

Here, we argue that the puzzle only arises if you think of bank loans as the sole long-term financing source. Imagine a company that operates within a credit-controlled environment. In addition to borrowing money, it can also finance its borrowing through corporate savings (retained profit). The firm will use profit retention to finance its investment if borrowing is repeatedly rationed. Visualize this firm optimizing its investment budget, profit retention rate, and debt servicing costs together.

The model of credit-constrained investment financing is different from a naive one where firms are passively adjusting their budgets to the amount of borrowing. The saving function determines how much banks can loan to firms. I represent the ex-ante investing function. Ex-post investment functions I am the minimum of both ex-ante saving and investment. When interest rates are low, i and r are greater than 0.

Figure 1 shows the ex-post investing function for firms that optimally select financing methods relative to credit constraints. The amount of savings that households have is what banks can loan. Corporate savings are a function sp which decreases in r. Ex ante as well as ex-post, investment equals = I + sp. This means that ir = 0 when shr + sp > 0. Even at real interest rates of -10 percent, our point estimates indicate that this is the case for investments in Greek manufacturing.

Investment Function with Corporate Savings

To make our argument empirically persuasive, we must establish that corporate saving is both a major component and a discretionary one of investment financing. Figures 3, 4, and 5 provide evidence in this regard. Figure 5. shows that, in the past, the percentage of investment funded by retained earnings varied from more than 80 percent during the 1960s to less than 50 percent during the 1980s. Figures 4 and 3 show that corporate savings have a similar time course to investment. This apparent parallel movement indicates its importance as a discretionary source. Figure 5. shows that corporate savings have been declining over time. Tsoris (1984″) and Deleau (1987) have also noted the high debt of Greek manufacturing companies. This increase is attributed to declining profitability, which has led to a reduction in real investment.

Greece: Real investment and corporate savings (1970 prices), 1964-1986

According to the empirical analysis, the increase in the product-wage rate in manufacturing is a major factor in this decline in profitability. This long-term rise in wages was a result of government policies aimed at raising workers’ standard of living. In this context, the questions to be answered are those that deal with the design and implementation of financial reforms when redistributive policies are present.

We do not deal with a related set of issues, but we are interested in the role that interest rate subsidies play in the absence of securities markets. This is largely due to institutional factors, including the legal framework protecting investors’ rights. The availability of subsidized credit can, however, support and perpetuate existing “family-based enterprises,” which don’t need to give up control to increase their capital with equity financing.

The redistributive policies are the reason why questions about equity financing are so important. If equity was the predominant source of funding, real wage increases could have very different effects on firms’ investment activities. To take advantage of this effect, a policy must concentrate financial reforms primarily on the securities markets and not on debt markets, which are of limited effectiveness.

Modeling Investment Decisions

The Company–Credit Limitations

Consider a firm with a certain technology. It uses capital, k, and labor, l, to produce a product, x. The firm is faced with a different product price each period. It also faces wage rates and the cost of the investment. Capital needs time to accumulate, so investment decisions must be made one period ahead. The firm has a capital stock at the beginning of each period. It decides its level of output and employment, i. In addition, i is the amount of investment.

The firm can finance investment by either borrowing long-term from the bank sector or by using retained profits. For simplicity, we assume that all borrowing during the period must be fully repaid within the period so that the repayment time is equal to the time needed for the firm to build its productive capacity. We consider a scenario where real interest rates on capital are kept low. This means that the company is limited in the amount it can borrow at the stated rate.

Dividends are paid to shareholders who own the company. Profits are retained for new investments or distributed as dividends. We do not include constraints such as working capital requirements or short-term borrowing. The shareholders must decide on both the rate of dividend payout and the amount invested in each period while taking into consideration the credit limit the company faces. Since the bank informs the company about its borrowing limit, both investment and dividend payouts result from the same decision.