Introduction

The issue of whether the shift towards market-based credit policy has helped in directing credit to technically more efficient firms have been investigated in numerous studies. Do financial resources flow to more efficient firms after the removal of administrative controls in the financial market? Other things being equal, do more efficient firms receive more debt after liberalization that affect their capital structure? Is a higher proportion of investment carried out by firms that are more efficient, that is, firms with higher productivity?

This chapter investigates whether financial reform in Indonesia has indeed redirected credit towards more efficient firms, as suggested in financial repression literature. Firm-level efficiency is an interesting tool to compare market-based and government-directed allocation of credit. To explore this issue, an attempt is made to incorporate different measures of efficiency in explaining the distribution of credit and investment, before and after the reform. In particular, taking into account market structure issues, this chapter will explore a physical measure of efficiency derived from different specifications of frontier production functions. Whether a firm's technical efficiency plays a role in the allocation of credit, and whether its role changes before and after liberalization will be tested. It will also investigate whether there are specific characteristics of firms that can be identified as being potentially related to efficiency. The performance of measures of efficiency derived from the production function will also be compared with less structured measures of efficiency.

Literature Overview and the Measurement of Efficiency

How is efficiency measured? There are various concepts of efficiency available in the economic literature. The focus here will be on firm-specific technical efficiency, defined as how close a firm is to the production possibility frontier, given its quantity of capital and labour.

Farrell (1957) develops a method of measuring efficiency and characterizes the ways in which a production unit can be technically and allocatively inefficient.