Is there econometric evidence that liberalization has succeeded in relaxing financial constraints faced by individual establishments? This chapter investigates the issue by estimating a simple form of the investment function for the panel of individual establishments.

Introduction

Our basic theoretical view is that Indonesian manufacturing establishments increase their capital stock through investment in response to potential profitearning opportunities. Desired investment can be financed in a number of ways, the two most important being borrowing from the credit market and retention of cash flow (internal finance). If capital markets are perfect and taxes are absent, firms will be indifferent between various sources of funds. They will finance their investment at a constant marginal cost that is closely related to the risk-free market interest rate, and they will invest until the latter is equated with the expected marginal return to investment. In such a world, only the constant marginal cost of funds and rate of return to investment are important for the investment decision and the former should be closely related to the risk-free market interest rate.

However, even in perfect markets there will be constraints to borrowing because of asymmetric information, monitoring costs, and other factors, which make fixed-interest-rate lenders willing to lend a higher proportion of the costs of proposed investments only at increasing interest in order to compensate for the increased risk. The premium charged will depend on the value of the firm's assets that can be used as collateral. This is referred to in the literature as agency costs. Therefore, a negative association is expected between increasing divergence between average and marginal interest rates for individual borrower firms as the degree of financial leverage increases.

If markets are segmented so that some classes of firms have limited access to borrowing, they will be forced to rely on internally generated funds and may have to forego some desired investment because of financial constraints.