Effect of access to finance and investment climate on the performance of small and medium enterprises (SMEs) in India

Small and medium-sized enterprises (SMEs) are crucial for economic development and achieving developmental goals in developing economies. However, they face challenges related to access to finance and the investment climate. This study investigates how access to finance and the investment climate affect SME performance, using data from the World Bank Enterprise Survey (2022) covering 6,383 SMEs in India. The study uses four performance indicators: employment growth, annual sales growth, capacity utilization, and labour productivity growth. The two-stage least squares (2SLS) method is applied to address potential endogeneity, and post-estimation tests such as the Cragg-Donald F-statistic, the Sargan test, and the Basmann test are used to assess the validity of the instrument. The study’s major findings suggest that access to formal working capital finance positively affects firm performance, whereas access to formal fixed-asset finance negatively affects it. Additionally, mixed evidence is found regarding the effect of access to informal finance on firm performance. The effect of investment climate variables, particularly informal competition, negatively impacts firm performance, while the impact of other variables remains inconclusive. Moreover, it is observed that firm performance decreases with firm size. The study’s findings introduce nuanced insights into formal finance and informal competition, providing an in-depth look at how these unique factors shape SME growth in developing economies. Therefore, to support SMEs in India, policies should aim to improve access to working capital through flexible and affordable financing options, and measures should be taken to reduce informal competition.