Liquidity Constraints and Small Firm Performance : Evidence from South Africa's Informal Transit

We analyze the effects of a debt restructuring program that relaxed liquidity constraints — by reducing immediate payments without changing the long-run debt — for financially distressed small firms in South Africa’s minibus industry. We combine novel administrative data on business owners of small informal firms — including their loan performance, driving effort and labor supply, risk-taking behavior, and credit bureau information — with a cut-off rule that generated discontinuity in the program eligibility. We find that one year later small business owners that receive payment reductions (i) have higher repayments and lower defaults on minibus debt; (ii) increase their effort on the job; and (iii) have improved overall financial health. We do not find any evidence of borrowers indulging in misconduct or putting passenger safety at risk, suggesting an improvement in overall welfare for borrowers. These findings run counter to the view that short-run liquidity constraints induce higher borrower effort. We rationalize these findings in the context of a framework where penalties imposed due to late payments in the presence of liquidity constraints lead to future debt overhang, thereby, generating moral hazard in effort. Our findings present payment reduction as a potential low-cost tool that benefits both borrowers and creditors, at least in the short-run