Journal of Small Business & Entrepreneurship

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Informal financing choice in SMEs: do the types of

formal credit constraints matter?

Hang Thu Nguyen, Thuy Thu Nguyen, Xuan Le Phuong Dang & Hiep Manh
Nguyen

To cite this article: Hang Thu Nguyen, Thuy Thu Nguyen, Xuan Le Phuong Dang & Hiep Manh
Nguyen (2019): Informal financing choice in SMEs: do the types of formal credit constraints
matter?, Journal of Small Business & Entrepreneurship, DOI: 10.1080/08276331.2019.1692441

To link to this article: https://doi.org/10.1080/08276331.2019.1692441

Published online: 04 Dec 2019.

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JOURNAL OF SMALL BUSINESS & ENTREPRENEURSHIP
https://doi.org/10.1080/08276331.2019.1692441

Informal financing choice in SMEs: do the types of formal

credit constraints matter?
Hang Thu Nguyena , Thuy Thu Nguyenb, Xuan Le Phuong Danga,c and
Hiep Manh Nguyena,d
a
Department of Finance, Foreign Trade University HCMC Campus, Vietnam; bHigher Education
Department, Ministry of Education and Training, Ha Noi, Vietnam; cSchool of Economics and
Finance, Business School, Queensland University of Technology, Brisbane, Australia; dDepartment of
Finance, ESCP Europe, Paris, France

ABSTRACT ARTICLE HISTORY

We examine how SMEs choose alternative external finance when Received 18 April 2019
their access to formal finance is constrained in an emerging market Accepted 8 November 2019
context. We find that when constraints to formal credit for an SME
KEYWORDS
increase (decrease) over time, the firm’s behavior changes accord-
Financial constraints;
ingly by selectively shifting toward (away from) certain types of informal credit; trade credit;
informal credit. Specifically, when a firm avoids formal credit private lenders; family
because of perceived difficulties in application process, it seeks and friends
alternatives from the owner’s family and friends and private money
lenders. When the interest rate is perceived to be too high, the firm MOTS-CLÉS
prefers trade credit and the owner’s family and friends. Trade credit Mots-cles: contraintes
appears to be the most likely substitute of formal finance for firms financi
eres; credit informel;
with bad credit history. Lastly, firms that are denied short-term credit commercial;
loans may find emergency funding from private money lenders.
Our findings suggest that certain types of informal credit may be JEL CLASSIFICATION
more appealing than formal credit in certain cases. D22; G32; L26;

ABSTRAIT
Nous examinons comment les PME choisissent d’autres sources de
financement externe lorsque leur acc
es au financement formel est
limite dans un contexte de marche emergent. Nous constatons que
lorsque les contraintes au credit formel pour une PME augmentent
(diminuent) avec le temps, le comportement de l’entreprise change
en consequence, celle-ci s’eloignant selectivement de certains types
de credit informel. Plus precisement, lorsqu’une entreprise evite le
credit formel en raison d’une perception de difficultes liees au proc-
essus de demande, elle cherche des solutions de rechange aupr
es
de la famille et des amis du proprietaire, et de pr^eteurs prives.
Lorsque le taux d’inter^et est perçu comme trop eleve, l’entreprise
pref
ere le credit commercial, et la famille ou les amis du proprie-
taire. Le credit commercial semble ^etre le substitut le plus probable
du financement formel pour les entreprises presentant de mauvais
antecedents de credit. Enfin, les entreprises confrontees aux refus
de pre^t
a court terme peuvent trouver un financement d’urgence
aupr
es de pr^eteurs prives. Nos conclusions sugg
erent que, dans
certains cas, certains types de credit informel peuvent ^etre plus
attrayants que le credit formel.

CONTACT Hiep Manh Nguyen nguyenmhiep@gmail.com 79 avenue de la Republique, 75011, Paris, France.
This article has been republished with minor changes. These changes do not impact the academic content of the article.
ß 2019 Journal of the Canadian Council for Small Business and Entrepreneurship/Conseil de la PME et de l’entrepreneuriat
2 H. T. NGUYEN

1. Introduction
Small and medium enterprises (SMEs) account for more than 50% of total employ-
ment in most countries and are an important contributor for GDP growth (Ayyagari,
Beck, and Demirguc-Kunt 2007; Beck, Demirguc-Kunt, and Levine 2005). Many
SMEs, however, report that financial constraint is a serious problem hindering their
growth, innovation and development (Beck and Demirguc-Kunt 2006; Beck et al.
2008; Berger and Udell 1998; Hall 2002). This problem is especially consequential in
developing countries (Sleuwaegen and Goedhuys 2002), where the financial system is
underdeveloped, and information asymmetry is high.
The most extreme form of financial constraints is supply-side credit rationing. Due to
information asymmetry, the bank refuses to lend even if the borrower is willing to pay
higher interest rates (Stiglitz and Weiss 1981). Additionally, borrowers can ration them-
selves from applying for loans due to apprehension of costly application process, expect-
ation of denial, or high interest rates (Kon and Storey 2003; Levenson and Willard 2000).
Otherwise, borrowers can access credit but with restrictions or with higher costs.
To acquire much needed capital, financially constrained SMEs must resort to
informal finance as a substitute for formal credit (Ayyagari, Demirguc-Kunt, and
Maksimovic 2008; Biggs and Shah 2006; Fisman and Love 2003; Petersen and Rajan
1997). Informal finance can come from various sources, such as family and friends,
private money lenders, or business partners. Notably, Casey and O’Toole (2014) are
pioneers in relating the types of financial constraints a firm faces to the specific types
of alternative finance it uses to mitigate funding shortage. They show that credit-
rationed SMEs in Europe are more likely to use trade credit to finance working cap-
ital and use intercompany lending to finance investment, whereas self-rationing SMEs
are more likely to seek government grants.
We contribute to the literature about the use of informal finance using a large
dataset of Vietnamese SMEs during a 10-year period. We test how SMEs choose
alternative external finance when their access to formal finance is constrained. We
confirm the finding in prior literature that financially constrained SMEs are more
likely to use informal finance, but also investigate the relationship in much more
detail. Similar to Casey and O’Toole (2014), we find that the specific types of finan-
cial constraints a firm faces dictate the types of alternative finance it uses. However,
because we use different dimensions of financial constraints, we are also able to add
new findings to the literature.
Specifically, we find that when a firm self-rations from formal credit because the
interest rate is perceived to be too high, it seeks alternatives in cheaper sources of
funding including trade credit and loans from the owner’s family and friends.
Moreover, we show that if an SME is discouraged from applying for formal loans due
to cumbersome application process, it is more likely to borrow from private money
lenders and the owner’s family and friends, where loans can be acquired without
going through complex paperwork. Furthermore, a firm that failed to service its debt
in the previous two years largely embraces trade credit, and does not find substitutes
from the owner’s family and friends. Lastly, a firm that is denied short-term loans
may find emergency funding from private money lenders.
 JOURNAL OF SMALL BUSINESS & ENTREPRENEURSHIP 3

Our findings are also interesting because we broaden the literature on the relation-
ship between financial constraints and financing behavior to a special developing
country setting. For over 30 years, Vietnam has transformed from a centrally planned
economy to a market-oriented economy where the financial system has been develop-
ing rapidly. Nevertheless, financial constraints remain one of the major obstacles to
SME development. As in our data, to the question “What are the major constraints
to the growth of the enterprise?” 31.05% firm-years responded “Shortage of capital/
credit.” To the question “How could the authorities’ best help the enterprise expand
and increase its profits?” 23.83% firm-years responded “By providing easier access to
credit.” Thus, Vietnam is an ideal country setting to examine SMEs’ financial con-
straints. Understanding how SMEs circumvent such difficulties using informal finance
is important for both market participants and policy making bodies.
The rest of the article is as follows: Section 2 reviews related studies; Section 3
describes data, variable construction and methodology; Section 4 shows testing
results; Section 5 concludes.

2. Literature review and hypotheses

Credit is indispensable for both the growth of the economy as a whole (Fufa and
Kim 2018; Grydaki and Bezemer 2013), and the success of individual businesses
(Kuzilwa 2005; Yusuf 1995). Obstacles to credit access have a consequential impact
on firm growth (Ayyagari, Demirguc-Kunt, and Maksimovic 2008) and innovation
(Hall 2002). A large body of literature has investigated the constraints to formal loans
and how to mitigate them (Ardic, Mylenko, and Saltane 2012; Beck and Demirguc-
Kunt 2006; Han, Fraser, and Storey 2009; Lee, Sameen, and Cowling 2015). However,
fewer studies have discussed informal financing sources as alternatives to for-
mal loans.
Informal finance often includes but is not limited to: trade credit, interpersonal
borrowing (i.e. from family and friends), and private money lenders (Allen, Qian,
and Xie 2019). Interpersonal lenders monitor borrowers through business relation-
ships or social networks, thus reduce adverse selection problems and moral hazards
(Allen, Qian, and Xie 2019; Petersen and Rajan 1997). Similarly, trade credit suppliers
have informational advantage automatically stemming from the input transactions
(Burkart and Ellingsen 2004, Petersen and Rajan 1997). Thus, they can grant trade
credit to opaque or distressed firms to whom banks are unwilling to lend. As such,
trade credit can be either a complement or a substitute of bank loans for firms with
less well-established banking relationships (Arslan and Umutlu 2009; Burkart and
Ellingsen 2004; Giannetti, Burkart, and Ellingsen 2011) or in poorly developed finan-
cial markets (Beck, Demirguc-Kunt, and Maksimovic 2008; Burkart and Ellingsen
2004; Fisman and Love 2003). Private money lenders are unlikely to be associated
with business or social networks or to possess informational advantage. To cover the
risk, they charge high interest rates and even use violence to enforce payment (Allen,
Qian, and Xie 2019; Banerjee and Duflo 2012).
Firms with constraints to formal finance tend to be more dependent on informal
credit (Casey and O’Toole 2014; Giannetti, Burkart, and Ellingsen 2011; Petersen and
4 H. T. NGUYEN

Rajan 1997), especially small firms (Nilsen 2002). This tendency is also significant
under the condition of monetary tightening (Yang 2011) or economic crisis (Garcia-
Appendini and Montoriol-Garriga 2013).
In the context of developing countries, firms rely mostly on internal fund and
informal credit markets (Demirguc-Kunt, 1992) due to underdeveloped banking sys-
tem and high information costs. Small firms are especially vulnerable to credit-ration-
ing because information asymmetry in these firms is high (Berger and Udell 1998;
Stiglitz and Weiss 1981). It can present relatively high administrative and investigative
costs to creditors (Tybout, 1983). Thus, we propose the following hypothesis.
H1: If a firm is constrained from formal credit, it is more likely to use informal finance.
Constraints to formal credit could take two forms of rationing: credit-rationing
and self-rationing (Casey and O’Toole 2014). A firm is credit-rationed if its loan
application is rejected (Stiglitz and Weiss 1981). Self- rationing firms actively avoid
applying for formal credit due to high borrowing costs, procedural difficulties, or
expectation of denial (Kon and Storey 2003; Levenson and Willard 2000). There have
been few empirical studies investigating relationship between the types of bank con-
straints and the types of alternative financing. Notably, Casey and O’Toole (2014)
demonstrate that the types of informal credit a firm uses correspond to the types of
formal credit constraints it faces. They show that credit-rationed SMEs in Europe are
more likely to use trade credit to finance working capital and use intercompany lend-
ing to finance investment, whereas, self-rationing SMEs are more likely to seek gov-
ernment grants. Casey and O’Toole (2014) identify credit-rationing firms by denied
loan applications, whereas self-rationing firms are those who avoid formal finance
due to high borrowing costs. In this article, we utilize other measures of financial
constraints including expectation of denial and apprehension of burdensome applica-
tion process (Kon and Storey 2003; Levenson and Willard 2000). We conjecture that
the specific types of financial constraints a firm faces may be associated with the
types of alternative finance it uses. Therefore, our study is expected to provide new
empirical evidence on this relationship in an emerging market context. We propose
the following hypothesis.
H2: The types of informal credit a firm uses correspond to the types of formal credit
constraints it faces.

3. Data and methodology

3.1. Data
We use the dataset from the “Survey of small and medium scale manufacturing enter-
prises (SMEs) in Vietnam.” This survey is conducted and compiled biennially from
2004 to 2014 by the Central Institute for Economic Management (the Ministry of
Planning and Investment), the Institute of Labor, Science and Social Affairs (the
Ministry of Labor - Invalids and Social Affair), the Development Economics Research
Group (the University of Copenhagen), and World Institute for Development
Economics Research (United Nations University). In the dataset, respondents
 JOURNAL OF SMALL BUSINESS & ENTREPRENEURSHIP 5

reported as either “manager” or “owner.” For simplicity, we refer to all of them

as “owner.”
The initial dataset has 15,818 firm-years. We account for outliers and data input
errors by removing firm-years with more than 500 labors, with sales or total assets
lower than VND50 million (
USD2200)1 with sales and total assets higher than
VND100 billion (
USD20 million). We further remove firm-years with return on
assets equals to or exceeds ±200%. This procedure results in a sample of 14,788
observations of 4992 firms in 6 years ranging from 2004 to 2014. Note that the gap
between each data year is two years.

3.2. Methodology
We conduct our hypothesis testing using the following models. First, we test the
probability of using informal credit of SMEs once they face formal financial con-
straints.
X
Use of Informal Financeit ¼ b0it þ b1it Financial Constraintit þ bnit Controlnit þ eit
(1)

Additionally, we run a first-differenced model to capture the changes in the use of

informal finance in relation with the changes in financial constraints in each firm
from year t to year t þ 2. This model is particularly relevant to examine the effects of
changes in financial constraints over time on use of informal finance over the same
period, and to mitigate the problem of omitted variables or unobservable effects
(Wooldridge 2015).

Change in the Use of Informal Financeit

X
¼ b0it þ b1it Change in Financial Constraintit þ bnit Change in Controlnit þ eit
(2)

When the dependent variable is binomial as in Equation (1), we fit our regressions
using probit model. When the dependent variable is multinomial as in Equation (2),
we fit our regressions using ordered logistic model.
In Equation (1), the use of informal finance is captured by several different varia-
bles. First, APPLYIN equals one if the firm applied for informal loans in the past two
years and zero otherwise. Second, three variables are used to represent each type of
informal finance reported in the survey. TRADE equals one if the firm reported posi-
tive trade payables and zero otherwise. F&F equals one if the firm reported that the
most important informal loan is from family and friends of the owner and zero
otherwise. PRILENDER equals one if the firm reported that the most important infor-
mal loan is from a private money lender and zero otherwise. APPLYIN is used to test
the first hypothesis; TRADE, F&F, and PRILENDER are used to test the
second hypothesis.
In the survey, we also have firm-years which reported that the most important
informal loan was from another enterprise. However, these firm-years account for
6 H. T. NGUYEN

only 309 observations (roughly 2%) in the final dataset. Unreported tests show no
statistically significant relationship between formal credit constraints and the use of
informal loans from other enterprises. Thus, we do not include this type of informal
finance in our analysis.
To measure financial constraints, we classify firms into credit-rationed firms and
self-rationing firms following Casey and O’Toole (2014). First, we use DENIED, a
dummy which equals one if at least one of their formal loan applications was rejected
in the two years preceding the survey and zero otherwise. Prior studies use this vari-
able to proxy firms that are credit-rationed by the banks (Pham and Talavera 2018).
Additionally, Nguyen et al. (2019) show that firms with bad credit history are more
likely to be rationed from bank loans. We use LATE, a dummy which equals one if
the firm failed to service debt in the last two years and zero otherwise to examine
whether these firms use informal credit to circumvent its intense constraints to for-
mal credit. As Casey and O’Toole (2014) show different behaviors in firms whose
short-term and long-term loan applications are rejected, we also divide DENIED into
two subcategories: (1) firms that are denied short-term loan applications (SDENIED)
and (2) firms that are denied long-term loan applications (LDENIED). See Table 1
for more details on variable definitions.
Moreover, a firm may be discouraged from applying for formal loans because it
perceives the application process as too costly, or interest rate as too high (Kon and
Storey 2003). We use PROCESS and INTEREST to surrogate self-rationing firms.
PROCESS and INTEREST equal one if the firm reported that the reasons it had not
applied for formal loans were “Process [is] too difficult” and “Interest rate [is] too
high,” respectively, and zero otherwise. As previously argued, firms tend to use infor-
mal financing sources if they are constrained from formal credit. It means that b1it in
Equation (1) is expected to be positive.
We consult related literature to add relevant control variables to our model. We
use two main groups of control variables: firm-specific characteristics and owner’s
personal characteristics. Kumar and Rao (2016) show that geographic and sectorial
factors are major determinants of SMEs’ capital structure. We also use year dummies,
industry dummies, and region dummies to control for potential temporal, geograph-
ical, or sectorial idiosyncrasies.
We control for firm-specific characteristics including firm size (LNSALE), prof-
itability (ROA), investment (INV), firm age (LNFIRMAGE), shortage of capital
(SHORTCAP), and business network (NWBUSS). Fhima and Bouabidi (2011) show
that smaller firms are more exposed to credit rationing. Petersen and Rajan (1997)
find that firms with larger size and profitability have larger payables account.
Similarly, Casey and O’Toole (2014) report that the association between financial
constraints and trade credit increases with firm size. Additionally, larger firms
with more growth opportunities and greater investments in current assets obtain
larger trade credit (Casey and O’Toole 2014; Garcıa-Teruel and Martınez-Solano
2010). Younger enterprises in developing countries are more likely to depend on
informal credit, especially loans from friends and relatives due to lack of collateral
and business networks (Akoten, Sawada, and Otsuka 2006; Chavis, Klapper, and
Love 2011).
 JOURNAL OF SMALL BUSINESS & ENTREPRENEURSHIP 7

Table 1. Variable definitions.

Variable Definition
APPLYIN Application for informal loans. Takes the value of 1 if the answer to the question
“Have you borrowed from informal sources since the last survey” is “Yes”, and
0 otherwise.
Use of informal financing sources
TRADE Trade credit. Takes the value of 1 if accounts payable is positive, and 0 otherwise.
F&F Loans from the owner’s family and friends. Takes the value of 1 if the source of the
most important (in value terms) current informal loan is relatives and friends of the
owner, and 0 otherwise.
PRILENDER Private money lender. Takes the value of 1 if the source of the most important (in
value terms) current informal loan is private money lender, and 0 otherwise.
Financial constraints
DENIED Loan applications denied by the banks. Takes the value of 1 if at least one of the
firm’s formal loan applications, both short and long term, has been rejected since
the last survey, and 0 otherwise.
SDENIED Short-term loan applications denied by the banks. Takes the value of 1 if at least one
of the firm’s formal short-term loan applications has been rejected since the last
survey, and 0 otherwise.
LDENIED Long-term loan application denied by the banks. Takes the value of 1 if at least one of
the firm’s formal long-term loan applications has been rejected since the last
survey, and 0 otherwise.
LATE Potential credit rationing due to bad credit history. Takes the value of 1 if the answer
to the question “Did the enterprise ever fail to service its debt on time since the
last survey?” is “Yes”, and 0 otherwise.
PROCESS The application process is too difficult (a self-constraint). Takes the value of 1 if the
answer to the question “Why has the firm not applied for formal loans since [the
last survey]?” is “Process is too difficult”, and 0 otherwise.
INTEREST The interest rate is too high (a self-constraint). Takes the value of 1 if the answer to
the question “Why has the firm not applied for formal loans since the last survey?”
is “Interest rate is too high”, and 0 otherwise.
Controls variables
LNSALE Firm size. Logarithm of sales.
ROA Profitability. Return on assets.
INV Investment. Takes the value of 1 if the firm makes an investment since the last survey,
and 0 otherwise.
LNFIRMAGE Firm age. Logarithm of firm age.
SHORTCAP Shortage of capital. Takes the value of 1 if the firm identifies shortage of capital
/credit as the major constraint to its growth, and 0 otherwise.
NWBUSS Business network. Takes the value of 1 if the firm reports having regular contact with
at least ten people in the same business sector, and 0 otherwise.
EXPER Owner’s experience. Takes the value of 1 if the owner has run an enterprise before the
current firm, or if the entrepreneur is running more than one enterprise, and
0 otherwise.
EDUPR Owner’s education. Takes the value of 1 if the owner finished college/university
education, and 0 otherwise.
AGE Owner’s age. Takes the value of 1 if the owner is 40 years or older, and 0 otherwise.
GENDER Owner’s gender. Takes the value of 1 if the owner is male, and 0 otherwise.
ETHNIC Owner’s ethnics. Takes the value of 1 if the owner belongs to ethnic minority Hoa
people (Chinese origin), and 0 otherwise.

Business network is well researched in the strand of studies about social capital.
Bourdieu (1986) defines social capital as the value of networks, relationships, or
“membership in a group” whose members help each other with the “collectivity-
owned capital.” Firms having higher levels of social capital are more likely to have
access to cheaper sources of informal credit (Akoten, Sawada, and Otsuka 2006).
Pham and Talavera (2018) argue that social capital can relax financial constraints by
helping firms get longer term of loans.
8 H. T. NGUYEN

In addition to firm-specific characteristics, entrepreneur demographics also play an

important role in financing decision making (Tolba, Seoudi, and Fahmy 2014). While
Abor and Biekpe (2006) indicate that female-owned firms employ less debt finance,
Pham and Talavera (2018) document that male entrepreneurs are less likely to obtain
formal credit. Besides, education background of the entrepreneur also affects financ-
ing decisions. Nguyen et al. (2019) find that lower educational levels of managers are
associated with higher debt aversion, stronger perceived financial constraints, and
lower propensity of using formal credit. Akoten, Sawada, and Otsuka (2006) show
that entrepreneurs belonging to the majority ethnic group are more able to access
bank loans.
For the tests using first-differenced approach as in Equation (2), we transform all
variables in Equation (1) into changes between one survey and the previous survey.
The change in the dependent variable (use of informal credit) Y is calculated as fol-
lows.

DðYit Þ ¼ Yit  Yiðt2Þ

Each independent variable is also transformed accordingly.

DðXit Þ ¼ Xit  Xiðt2Þ

Where prefix D(.) indicates change.

Because dependent variables Ys are binomial, change variable D(Y)s are trinomial.
For example, D(APPLYIN) takes the value of 0, 1, –1 when there is no change, an
increase, and a decrease in the tendency to apply for informal loans, respectively.
Therefore, Equation (2) is estimated using ordered logistic regression.

4. Results
4.1. Summary of statistics and univariate analysis
Table 2 presents statistics of main variables. Less than 5% of all firm-years report
having formal loan applications rejected in the previous two years, among which
3.29% are denied short-term loan applications and 2.58% are denied long-term loan
applications2. Obviously, some firms get rejected for both short-term and long-term
loan applications. Moreover, 3.81% of all firm-years report having failed to service
their debt on time. These firms may have their access to credit more constrained
than others.
Intriguingly, 6.92% of all firm-years report self-rationing from formal loans
because they perceive that the application process is too difficult. This is thus a con-
siderable hindrance for SMEs to access finance. About 6.39% of all firm-years report
that the interest rate is too high to borrow from banks. More than half of these
observations are realized in the period 2010–2012. The Vietnamese banking system
was in a bad-debt crisis during this time, and credit rationing was strong.
Almost 54% of all firm-years report applying for informal loans. Note that by the
nature of the data, informal loans do not include trade credit. The percentage of
 JOURNAL OF SMALL BUSINESS & ENTREPRENEURSHIP 9

Table 2. Summary statistics.

Variable Obs. Mean Std. Dev.
DENIED 14,788 0.0473 0.2124
SDENIED 14,788 0.0329 0.1783
LDENIED 14,788 0.0258 0.1584
INTEREST 14,788 0.0639 0.2446
PROCESS 14,788 0.0692 0.2538
LATE 14,788 0.0381 0.1914
APPLYIN 14,788 0.5396 0.4984
TRADE 12,300 0.5697 0.4951
F&F 14,788 0.1131 0.3168
PRILENDER 14,788 0.0515 0.2209
SALES (VND million) 14,788 3226.7 8288.1
ROA 14,788 0.2496 0.3138
INV 14,788 0.5367 0.4987
FIRM AGE (years) 14,754 13.099 10.207
SHORTCAP 14,788 0.3105 0.4627
NWBUSS 14,788 0.2762 0.4471
EXPER 14,788 0.0335 0.1801
EDUPR 14,788 0.2181 0.4130
OWNER AGE (years) 14,787 45.337 10.648
GENDER 14,788 0.6476 0.4777
ETHNIC 14,788 0.0634 0.2437
This table presents number of observations, means, and standard deviations of main variables used in this article.
See Table 1 for variable descriptions.

firm-years that use trade credit, loans from the owner’s family and friends, and loans
from private money lenders are 57%, 11%, and 5%, respectively. These statistics con-
firm the arguments by Petersen and Rajan (1997) and Burkart and Ellingsen (2004)
that trade credit is an important source of capital for SMEs. Private money lenders
seem not so popular in our sample. Private money lenders use high interest rates to
compensate for their risk and are infamous for use of violent physical and mental
attacks on default debtors. In Vietnam, lending at a rate higher than the ceiling inter-
est rate set by the State Bank of Vietnam may be charged with criminal offence3.
Mean firm age is 13 years. Mean sales is VND3227 million (
USD150 thousand –
roughly 250 times and 75 times GDP per capital in 2004 and 2014, respectively).
Mean ROA is 25%, but standard deviation is very high. More than half of all firm-
years carried out investments, while 31% reported a shortage of capital. More than
one fourth of firm-years have regular contacts with at least ten business people in the
same sector.
Regarding the demographics of owners, they are on average 45 years old, 64.76%
are male, 21.81% have a college or university degree, 3.35% have past management
experience or currently manage another firm, and 6.34% are minority ethnic
Hoa people.
Table 3 presents mean of use of informal financing sources conditional on the
types of financial constraints. Row “No” shows the mean for firms without financial
constraints. Row “Yes” shows the mean for firms having financial constraints.
Overall, the values reported in row “Yes” are much higher than those in row “No,”
demonstrating the positive relationship between constraints to formal credit and the
use of informal credit. Noticeably, the firms that have bad credit history (LATE) are
most likely to utilize trade credit, as indicated by the largest and significant difference
(0.312) between the “Yes” and “No” group. Additionally, if firms are self-rationing
10 H. T. NGUYEN

Table 3. Financial constraints and the use of informal credit.

APPLYIN Applied TRADE F&F Loans from PRILENDER Loans
for Trade family from private
informal credit credit and friends money lender
DENIED No 0.531 0.561 0.108 0.048
Bank loan Yes 0.711 0.732 0.214 0.124
applications denied Yes–No 0.180 0.172 0.106 0.0764
(t-stat) (9.37) (8.56) (8.68) (8.96)
SDENIED No 0.533 0.563 0.11 0.048
Bank short-term Yes 0.733 0.743 0.216 0.142
loan Yes–No 0.199 0.180 0.106 0.0936
applications denied (t-stat) (8.7) (7.54) (7.3) (9.21)
LDENIED No 0.535 0.564 0.11 0.05
Bank long-term loan Yes 0.717 0.766 0.215 0.113
applications denied Yes–No 0.182 0.202 0.105 0.063
(t-stat) (7.03) (7.46) (6.38) (5.5)
LATE No 0.531 0.558 0.109 0.049
Potentially credit- Yes 0.751 0.87 0.215 0.105
rationed by bad Yes–No 0.220 0.312 0.106 0.0554
credit history (t-stat) (10.31) (13.46) (7.79) (5.85)
INTEREST No 0.525 0.56 0.106 0.051
Self-rationing due to Yes 0.749 0.713 0.224 0.061
high interest rates Yes–No 0.224 0.153 0.119 0.011
(t-stat) (13.44) (8.54) (11.2) (1.43)
PROCESS No 0.525 0.56 0.1 0.046
Self-rationing due to Yes 0.734 0.695 0.296 0.118
complicated process Yes–No 0.193 0.125 0.178 0.0879
(t-stat) (14.29) (8.69) (20.87) (14.68)
This table presents means of four sources of informal credit conditional on the categories of financial constraints.
See Table 1 for variable descriptions.

because they perceive formal loan application process too difficult (PROCESS), they
borrow more extensively from family and friends as indicated by the greatest and sig-
nificant difference (0.178). Moreover, the firms that are self-rationing from formal
loans due to high borrowing costs (INTEREST) do not seem to borrow more from
private money lenders as the difference (0.0106) is insignificant. Lastly, if the firms
are denied short-term loans, they tend to seek a substitute from private
money lenders.
Figure 1 presents mean changes in financing behavior of firms when there are
changes in the condition of financial constraints it faces from one survey to another
(a gap of two years). Two columns represent changes in the use of respective infor-
mal financing sources given the changes in each type of financial constraints. The
brighter left column represents changes in the use of informal finance when financial
constraint decreases. The darker right column represents changes in the use of infor-
mal finance when financial constraint increases. All the brighter left columns go
below zero, indicating that the use of all types of informal credit decreases when the
constraints to formal credit decrease. All darker right columns rise above zero except
the last one in Panel B, suggesting that the use of most types of informal credit
increases when the constraints to formal credit increase. This again confirms the find-
ings by Casey and O’Toole (2014) that bank finance-constrained firms are likely to
resort to alternative external finance.
Nevertheless, the use of each type of informal credit changes differently according
to the changes in each type of financial constraints, suggesting that each of them is a
 JOURNAL OF SMALL BUSINESS & ENTREPRENEURSHIP 11

Figure 1. Mean changes in the use of informal credit sources when financial constraints change4.
12 H. T. NGUYEN

preferred substitute in a certain context. Specifically, when the constraint to formal

finance is high interest rate, firms use loans from family and friends or trade credit
as substitutes, and not at all use loans from private money lenders (Panel B).
However, if the constraint is burdensome application process, loans from family and
friends are used much more extensively (Panel C). Moreover, when firms have a
stained credit history, they seem less able to access loans from private money lenders
or even loans from family and friends. In this case, they utilize trade credit as the
main substitute for formal credit (Panel D).

4.2. Multivariate analysis

4.2.1. What firms do when their formal loan applications are denied by banks
Table 4 presents selected regressions showing the effects of formal finance constraints
to borrowing behavior of SMEs. In regression (1), consistent with the hypothesis that
SMEs apply for informal credit to circumvent formal credit rationing (Casey and
O’Toole 2014), DENIED has a positive coefficient. In other words, the firms that are
denied formal loans are more likely to apply for informal loans. This relationship is
not only highly statistically significant, but also economically significant, as the aver-
age marginal effect is 10.4%. In other words, if at least one of a firm’s formal loan
applications has been rejected, the probability it seeks informal loans increases
by 10.4%.
The coefficients of control variables are consistent with the literature. Larger
firms, firms with investment and firms with shortage of capital need more exter-
nal funding in general, therefore, apply for more informal loans (Casey and
O’Toole 2014; Garcıa-Teruel and Martınez-Solano 2010; Petersen and Rajan 1997).
Firms with broader networks of trade partners are more able to find informal
credit (Akoten, Sawada, and Otsuka 2006). Older firms are less likely to use infor-
mal loans (Akoten, Sawada, and Otsuka 2006; Chavis, Klapper, and Love 2011).
Older, more educated entrepreneurs tend to refrain from informal loans (Casey
and O’Toole 2014; Nguyen et al. 2019). Other variables do not show statistically
significant effects.
To capture the effects of changes in financial constraints over time on the changes
in the use of informal finance over the same period, we conduct a second test in
regression (2) using first-differenced approach. As the change in firm age, year,
industry, location dummies are almost the same for all firms from one survey to
another, following Wooldridge (2015), we exclude these variables in regression (2).
In agreement with our hypothesis, D(DENIED) exhibits a significant, positive rela-
tionship with D(APPLYIN), indicating that firms apply for informal loans as a
response to the formal credit rationing. This means, on average, a firm increases bor-
rowing from informal finance when financial constraints increase and decreases bor-
rowing from informal finance when financial constraints decrease. Our results
confirm and strengthen the observation that SMEs use informal credit as a substitute
to circumvent formal credit constraints (Casey and O’Toole 2014; Nguyen
et al. 2019).
 JOURNAL OF SMALL BUSINESS & ENTREPRENEURSHIP 13

Table 4. What firms do when their formal loan applications are rejected.
Probit regression (1) Ordered logistic regression (2)
Variables APPLYIN Variable D(APPLYIN)
DENIED 0.315 D(DENIED) 0.135**
(5.50) (2.13)
LNSALE 0.0975 D(LNSALE) 0.211
(10.59) (8.66)
ROA –0.0557 D(ROA) –0.114
(–1.51) (–1.86)
INV 0.470 D(INV) 0.335
(19.08) (9.6)
LNFIRMAGE –0.0508
(–3.33)
SHORTCAP 0.234 D(SHORTCAP) 0.170
(9.17) (5.16)
NWBUSS 0.158 D(NWBUSS) –0.0838
(5.81) (–2.32)
EXPER 0.0779 D(EXPER) –0.00284
(1.19) (–0.03)
EDUPR –0.0947 D(EDUPR) –0.179
(–3.01) (–3.15)
AGE –0.0939 D(AGE) –0.105
(–3.66) (–1.98)
GENDER –0.00244 D(GENDER) –0.0491
(–0.10) (–1.03)
ETHNIC –0.0765 D(ETHNIC) –0.0125
(–1.52) (–0.10)
Constant –1.828 Constant cut1 –1.029
(–19.76) (–24.55)
Year dummies Yes Constant cut2 1.651
Industry dummies Yes (36.62)
Region dummies Yes
Observations 14,754 Observations 9533
This table presents selected P regression results. Column (1) presents coefficients from the probit regression:
APPLYIN ¼ b0 þ b1DENIED þ bxControl
P þE. Column (2) presents coefficients from ordered logistic regression:
D(APPLYIN) ¼ b0 þ b1D(DENIED) þ bxD(Control) þE. See Table 1 for variable descriptions and Section 3.2 for
model specifications. z-statistics in parentheses.
p < .01, p < .05, p < .1.

So far, we have shown that firms borrow more from informal sources of credit to
mitigate the consequence of formal credit constraints. In Table 5, we provide more
insights on the sources of informal credit that firms utilize when they face formal
credit constraints. Based on the availability of data, we identify three sources of infor-
mal credit: trade credit, loans from the owner’s family and friends, and loans from
private money lenders.
We look at the behavior of firms facing different conditions of constraints in regres-
sion (3), (4), (5), and the changes in behavior of a given firm when its condition of
financial constraints changes in regression (6), (7), (8). As expected, the results demon-
strate that firms facing formal credit rationing are more likely to have trade credit, more
likely to borrow from the owner’s family and friends and private money lenders.
Moreover, a firm is more likely to resort to these sources of informal finance when its
formal credit constraints increase, and less when its formal credit constraints decrease.
However, the coefficient of DENIED in regression (8) is not significant, suggesting that
the changes in the use of loans from private money lenders may not be affected by the
changes in financial constraints.
14 H. T. NGUYEN

Table 5. What firms do when their formal loan applications are rejected.
Probit regression (3) (4) (5) Ordered logistic regression (6) (7) (8)
Variables TRADE F&F PRILENDER Variables D(TRADE) D(F&F) D(PRILENDER)
DENIED 0.206 0.191 0.254 D(DENIED) 0.128* 0.198* 0.259
(3.57) (3.16) (3.71) (1.76) (1.67) (1.47)
LNSALE 0.163 –0.0624 0.0449 D(LNSALE) 0.181 –0.0121 0.0947
(16.24) (–5.30) (3.19) (6.59) (–0.39) (2.25)
ROA 0.00483 –0.049 0.00557 D(ROA) 0.0331 –0.108 –0.275
(0.12) (–0.97) (0.09) (0.49) (–1.46) (–2.69)
INV 0.262 0.972 0.638 D(INV) 0.344 0.882 0.507
(10.08) (25.82) (13.68) (8.89) (21.03) (9.04)
LNFIRMAGE –0.0291 –0.0718 –0.0367
(–1.83) (–3.64) (–1.54)
SHORTCAP 0.213 0.244 0.299 D(SHORTCAP) 0.221 0.282 0.293
(8.09) (7.78) (7.73) (5.99) (6.03) (4.48)
NWBUSS 0.150 0.139 0.0487 D(NWBUSS) 0.193 0.148 –0.0286
(5.22) (4.03) (1.13) (4.82) (3.12) (–0.45)
EXPER 0.0288 0.0226 0.0707 D(EXPER) –0.118 –0.0696 0.115
(0.44) (0.29) (0.77) (–1.17) (–0.59) (0.62)
EDUPR –0.0527 –0.0616 –0.0578 D(EDUPR) –0.00885 –0.0374 –0.272
(–1.55) (–1.51) (–1.16) (–0.14) (–0.51) (–2.49)
AGE –0.118 –0.0794 –0.0205 D(AGE) –0.0319 –0.129 –0.0759
(–4.34) (–2.41) (–0.50) (–0.55) (–1.81) (–0.77)
GENDER –0.0437 –0.00423 –0.0534 D(GENDER) –0.0741 –0.0177 –0.0904
(–1.68) (–0.13) (–1.31) (–1.37) (–0.29) (–1.04)
ETHNIC –0.0436 –0.0761 –0.0602 D(ETHNIC) –0.13 0.216 0.109
(–0.81) (–0.92) (–0.49) (–0.88) (1.89) (0.93)
Constant –1.098 –1.751 –2.790 Constant cut 1 –1.021 –1.540 –2.620
(–11.14) (–14.67) (–17.68) (–23.01) (–32.72) (–39.40)
Year dummies Yes Yes Yes Constant cut 2 1.851 3.287 3.697
Industry dummies Yes Yes Yes (37.59) (53.12) (46.07)
Region dummies Yes Yes Yes
Observations 12,268 14,754 14,742 Observations 7631 9533 9533
This table presents selected regression results. Column (3), (4), (5) present
P coefficients from the probit regression.
Use of informal financing sources ¼ b0 þ b1Financial Constraint þ bxControl þE.
Column (6), (7), (8) present coefficients from the ordered logistic regression.P
D(Use of informal financing sources) ¼ b0 þ b1 D(Financial constraints) þ bx D(Control) þe :
Where D(X) denotes changes in variable X from time t – 2 to t. See Table 1 for variable descriptions, Section 3.2 for
model specifications. z-statistics in parentheses.
p < .01, p < .05, p < .1.

In the next part, we replicate the analysis in Tables 4 and 5 for other measures of
financial constraints, including credit rationing by the banks and self-rationing by
the SMEs.

4.2.2. What firms do when they are credit-rationed or self-ration from for-
mal credit
Table 6, Panel A replicates regression (1), (3), (4), and (5), Panel B replicates regres-
sion (2), (6), (7), and (8) but substituting DENIED by other measures of financial
constraints. For visual purpose, only the coefficients of the proxies for different types
of financial constraints are reported. All coefficients in Panel A are positive and sig-
nificant, suggesting that more financially constrained firms use more informal credit.
The magnitudes of coefficients, however, vary substantially. Specifically, LATE exhib-
its the largest effect on the use of trade credit, as evidenced by its coefficient (0.801).
Whereas, PROCESS strongly affects the propensity to use loans from the owner’s fam-
ily and friends and loans from private money lenders.
 JOURNAL OF SMALL BUSINESS & ENTREPRENEURSHIP 15

Table 6. Different types of financial constraints exhibit different effects on the types of informal
finance firms prefer.
Measures of formal credit constraints APPLYIN TRADE F&F PRILENDER
Panel A: Financial constraints and use of informal credit
1. Short-term formal loan application rejected. (SDENIED) 0.331 0.205 0.168 0.312
(4.87) (3.01) (2.35) (4.04)
2. Long-term formal loan application rejected. (LDENIED) 0.321 0.293 0.187 0.193
(4.19) (3.70) (2.36) (2.10)
3. Failed to service the debts from banks. (LATE) 0.562 0.801 0.260 0.237
(8.81) (10.06) (3.88) (3.01)
4. Interest rate is too high. (INTEREST) 0.561 0.423 0.573 0.170
(11.58) (8.31) (11.1) (2.35)
5. Application process is too difficult. (PROCESS) 0.590 0.265 0.710 0.455
(12.63) (5.50) (14.96) (7.81)
Panel B: Changes in financial constraints and changes in the use of informal credit
1. Short-term formal loan application rejected. (SDENIED) 0.146 0.0806 0.219 0.449
(2.08) (0.96) (1.59) (2.20)
2. Long-term formal loan application rejected. (LDENIED) 0.175 0.219 0.231 0.278
(2.10) (2.40) (1.54) (1.27)
3. Failed to service the debts from banks. (LATE) 0.268 0.501 0.213 0.323
(3.79) (6.75) (1.62) (1.88)
4. Interest rate is too high. (INTEREST) 0.624 0.468 0.733 0.00328
(11.74) (7.60) (8.78) (0.03)
5. Application process is too difficult. (PROCESS) 0.419 0.175 0.899 0.736
(7.90) (2.75) (10.18) (6.79)
This table presents selected regression results. Panel A presents coefficient
P b1 from the probit regression.
Use of informal financing sources ¼ b0 þ b1Financial Constraint þ bxControl þE.

Panel B presents coefficient b1 from the ordered logistic regression. P
D(Use of informal financing sources) ¼ b0 þ b1 D(Financial Constraints) þ bx D(Control) þe :
Where D(X) denotes changes in variable X from time t – 2 to t. See Table 1 for variable descriptions, Section 3.2 for
model specifications. z-statistics in parentheses.
p < .01, p < .05, p < .1.

Panel B confirms that when the condition of financial constraints changes, firms
do not change the use of all informal credit types homogeneously, but selectively
depending on the types of constraints they face. Specifically, when denied short-term
loans, firms are most likely to turn to private money lenders, as indicated by the sig-
nificant positive coefficient (0.449). Nevertheless, if they are denied long-term loans,
they do not use loans from private money lenders as a substitute but use trade credit
instead, as indicated by the coefficients in the regressions of PRILENDER and
TRADE. Loans from private money lenders incur high interest rates, thus, can be a
short-term, emergency funding but is not suitable for long-term funding. In Vietnam,
loans from private money lenders are sometimes referred to as “hot loans.” The meta-
phor is that we must not hold hot things for a long time, otherwise our hands
get burned.
When interest rates are higher, firms mostly use trade credit and loans from the
owner’s family and friends as the substitutes for formal loans. When the process to
acquire formal loans gets more difficult, firms are much more likely to use loans
from the owner’s family and friends and private money lenders, and trade credit to a
lesser extent.
When they are potentially constrained by a bad credit history, trade credit is the
most likely substitute. This is consistent with the arguments about the monitoring
advantages of the suppliers and their implicit stake in the customer firms (Burkart
and Ellingsen 2004; Petersen and Rajan 1997). They can find a substitute from private
16 H. T. NGUYEN

money lenders, but the tendency seems weak. There is no evidence that they can find
any help from family and friends.
In sum, these results indicate that SMEs selectively choose specific types of infor-
mal credit to substitute formal credit according to the types of financial constraints
they face.

5. Conclusion
In this article, we extend the literature on the relationship between formal credit con-
straints and alternative financing resources to a developing country setting. We study
formal credit constraints of two types: credit-rationing by banks and self-rationing
due to perceived high interest rate or complicated application process.
Our findings show that SMEs use informal finance as an alternative when they are
constrained to formal finance in the developing country context. Moreover, we find
that they do not use informal finance indiscriminately. Instead, each source of infor-
mal finance is preferred in a certain context of financial constraints. Noticeably, when
interest rates on formal loans are too high, firms embrace cheaper sources of financ-
ing, in particular trade credit and loans from the owner’s family and friends.
Additionally, the firms that have a bad credit history seem less able to acquire loans
from other sources and are more likely to utilize trade credit as an alternative. Lastly,
firms that are denied short-term loans use more loans from private money lenders
but firms that are denied long-term loans use more trade credit.
Our findings suggest that informal creditors may have information advantage over
banks, and informal credit may be more appealing in certain cases. For example, sup-
pliers are willing to grant trade credit to firms with bad credit history because they
have information advantage over banks and private money lenders. Private money
lenders, however, are an important source of emergency funding for the firms that are
denied short-term bank loans. Therefore, policy makers should aim at on the one hand
reducing information asymmetry in the formal credit system, and on the other hand
developing a sound informal credit market. This is not an easy endeavor, as informal
financial market is inherently resistant to regulation. Institutional development such as
better law enforcement may improve parts of the problem, for example, by guarantee-
ing that all parties to an informal financial contract duly perform their obligations, and
when a conflict arises, it is resolved by a court instead of violent gangsters.
We also find that if a firm self-rations from formal finance because it perceives the
loan application process as too difficult, it will seek loans from the owner’s family and
friends and private money lenders, where there is no burdensome procedure. Therefore,
an application process with balance between the qualities of being rigorous and being
borrower-friendly is beneficial for the bank to attract and retain its customers. The paper-
work must certainly be in accordance with the banking industry regulations, thus, the
extent to which the application process can be simplified may be limited. Nevertheless,
the bank can improve the ability of its staff to consult and assist the borrowers through-
out such burdensome process. Moreover, repeated visits in person to the firm by loan
officers can be useful in gathering more information (Degryse and Ongena 2004; Uchida,
Udell, and Yamori 2012). Besides, Nguyen et al. (2019) find that less educated
 JOURNAL OF SMALL BUSINESS & ENTREPRENEURSHIP 17

entrepreneurs are more likely to report administrative difficulties during loan application
process. Improving entrepreneur education, therefore, can be part of the economic and
social policy aiming at improving SMEs’ access to formal credit.
Our data is the “Survey of small and medium scale manufacturing enterprises
(SMEs) in Vietnam” from 2004 to 2014, but our findings may have broader, general
implications. Future research may aim at relating the types of informal finance a firm
uses to its investment and success.

Notes
1. Nominal GDP per capita in Vietnam was roughly USD607 and USD2052 in 2004 and
2014, respectively.
2. Note that in the final dataset, roughly two-third of all firm-years did not apply for formal
loans, thus, the value of DENIED is missing in these observations. Only 4114 firm-years
answered whether they had been denied by the bank, among which 700 (14.5%) reported
being denied. For the purpose of our tests, in which we want to examine the different
financing behavior between firm-years that are denied and other firm-years, including
those who did not apply, we treat these missing values as zero.
3. See “Arrests raise loan sharks higher on social agenda” in Vietnam Investment Review on
12 December 2018, https://www.vir.com.vn/arrests-raise-loan-sharks-higher-on-social-
agenda-64534.html
4. This figure presents mean changes in the use of informal sources conditional on changes
in financial constraints. See Table 1 for variable descriptions.

Acknowledgements
All authors have equal contributions. We would like to thank two anonymous reviewers at the
Journal of Small Business & Entrepreneurship, Michael Troege at ESCP Europe, Nguyen Justin
Hung at Victoria University of Wellington and participants at VICIF 2019, Le Tuan Bach,
Nguyen Thi Hoang Anh, Chu Mai Linh, Nguyen Thi Mai Anh at Foreign Trade University,
HCMC Campus for their valuable comments and suggestions.

Disclosure statement
No potential conflict of interest was reported by the authors.

Funding
Hang Thu Nguyen and Hiep Manh Nguyen received funding from the Corporate Finance and
Investment Research Project of Foreign Trade University of Vietnam.

Notes on contributors
Hang Thu Nguyen is at Foreign Trade University HCMC Campus. The current research inter-
ests are corporate finance and emerging market finance. Email: nguyenthuhang.cs2@ftu.edu.vn.
Thuy Thu Nguyen is at Ministry of Education and Training of Vietnam. The current research
interests are corporate finance and emerging market finance. Email: ntthuy@moet.gov.vn.
18 H. T. NGUYEN

Xuan Le Phuong Dang is at Queensland University of Technology and Foreign Trade

University HCMC Campus. The current research interests are social capital and household
outcomes. Email: phuongxuandangle@gmail.com.
Hiep Manh Nguyen is at ESCP Europe and Foreign Trade University HCMC Campus. The
current research interests are corporate finance and emerging market finance.

ORCID
Hang Thu Nguyen http://orcid.org/0000-0002-2424-5681
Xuan Le Phuong Dang http://orcid.org/0000-0003-3614-6952
Hiep Manh Nguyen http://orcid.org/0000-0003-2327-0196

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