Financial Development and Innovation in Small Firms

Authors: Siddharth Sharma
Source: The World Bank, August 2007 

Firm-level data from a cross-section of 57 countries is used to study how financial development affects innovation in small firms. The author finds that relative to large firms in the same industry, R\&D spending by small firms is more likely and sizable in countries at higher levels of financial development. The estimates imply that among firms doing R\&D in a country like Romania, which is at the 20th percentile of financial development, a 1 standard deviation decrease in firm size is associated with a decrease of 0.7 standard deviations in R\&D spending. In contrast, this decrease is only 0.2 standard deviations in a country like South Africa, which is at the 80th percentile of the distribution of financial development. Small firms also report producing more innovations per unit R\&D spending than large firms, and this gap is narrower in countries at higher levels of financial development. As a robustness check, the author shows that these patterns are stronger in industries inherently more reliant on external finance.

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