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We examine how SMEs choose alternative external finance when their access to formal finance is constrained in an emerging market context. We find that when constraints to formal credit for an SME increase (decrease) over time, the firm's behavior changes accordingly by selectively shifting toward (away from) certain types of informal credit. Specifically, when a firm avoids formal credit because of perceived difficulties in application process, it seeks alternatives from the owner’s family and friends and private money lenders. When the interest rate is perceived to be too high, the firm prefers trade credit and the owner’s family and friends. Trade credit appears to be the most likely substitute of formal finance for firms with bad credit history. Lastly, firms that are denied short-term loans may find emergency funding from private money lenders. Our findings suggest that certain types of informal credit may be more appealing than formal credit in certain cases.

Informal financing choice in SMEs: do the types of formal credit constraints matter?