How does low access to finance affect innovation?

A major new study highlights the barriers to innovation that face firms from across Europe

Georgios_Efthyvoulou_100There is ample evidence in the economics literature that achieving sustained long-term productivity and economic growth is intrinsically linked to investment in research and development (R&D) and innovation activity (i.e. through the introduction of new or significantly improved goods and services). However, due to the uncertainty associated with predicting the output of an innovation project and the lack of information about the time needed to bring an innovation project onto the market, innovation investment is considered to be particularly sensitive to financial constraints.

In a recently published study in ‘The Manchester School’ journal Priit Vahter and I examine how a firm’s innovation performance is affected by financial constraints; that is, low access to external sources of finance (bank loans and other forms of debt) and internal sources of finance (retained earnings or new equity).  We explored the relationship between financial constraints and innovation performance using Community Innovation Survey data from a large sample of 40,000 innovative firms in 11 Western and Eastern European countries, and examined whether the resulting effects vary between and within the broad sectors of production and services.

Our results show that innovative firms facing financial constraints have a 15-20% lower probability to be in the group of the most successful innovators. We found this effect to be mostly driven by limited availability of internal funds, rather than limited access to external sources of funding.  This is consistent with the fact that innovation projects tend to be financed by retained profits or equity, and thus the lack of funds from such internal sources is a more binding constraint.

The results also show that a firm’s responsiveness to financial constraints differs between the production and services sectors, and also by a firm’s export status. Specifically, we found that: (i) innovative firms in production industries are significantly more sensitive to financial constraints than those in services industries; (ii) within sectors, financial constraints are particularly detrimental for innovative firms with no exporting activities.

The differential impact of financial constraints between the two broad sectors can be explained by sectoral differences in the type, combination and intensity of use of innovation inputs. Specifically, the success of innovative products in service sector firms relies more on inputs that are less dependent on the availability of funds – such as collaboration with clients and suppliers, and external sources of information like universities and research institutions – and less on R&D investment which is highly susceptible to financial constraints. On the other hand, the stronger effects of financial barriers for non-exporting firms may reflect the relatively lower productivity and financial performance of these firms, which weakens their ability to overcome the sunk costs of innovation investments. In addition, not having access to international financial markets can strengthen the impact of external financial constraints (e.g. access to bank borrowing), due to lower assurances to lenders that these firms will be able to service their debt obligations.

This finding emphasizes the role of financial constraints as one of the principal driving forces behind low innovation performance for a significant proportion of firms. Thus, implementing policies aimed at enhancing access to external finance can have a strong positive impact on encouraging innovation activities, especially for firms with limited internal funds and those that do not engage in exporting activities. Other policy initiatives – such as strengthening investor protection, offering R&D tax incentives and providing funding support for innovation-related collaboration between firms and technological institutions – can also be particularly beneficial.

Furthermore, the higher responsiveness to financial constraints in production industries (such as manufacturing; mining and quarrying; electricity, gas and water supply; and construction), compared to services industries, can explain the productivity differences between the two sectors and be seen as one of the factors that cause different responses to financial crises. Indeed, as previous research has highlighted, episodes of financial turmoil have a more pronounced negative impact on the labour productivity of production industries. Hence, further investigation into the mechanisms of how financial crises affect firm-level and sectoral-level innovation performance is a fruitful avenue for future research.

According to Felix Brandes, the glory time for manufacturing as the steering engine for Europe’s economy and provider of massive employment is over, and the structural change towards services is likely to continue over coming decades. Our research shows that if the adverse effects of financial constraints on innovation performance can be alleviated then this could have a substantial impact on slowing down the relative decline of manufacturing in Europe – which is a key policy goal for EU policymakers.