Innovation Financing in Developing Economies

While finance is a critical input to the innovative process, it is often difficult to obtain, particularly in developing economies with less well-developed financial markets. As innovation is a central driver of growth, it is therefore important for policymakers to understand how different sources of financing may affect innovation. Extant literature emphasizes the relative importance of internal versus debt financing for innovative activity for firms in developed economies, yet the effect on innovation inclusive of other sources of external finance that may be particularly important in the developing context (such as informal financing) remain relatively unknown. This paper investigates the relationship between firms’ external capital sourcing and innovative activity in a large sample of developing economy enterprises. Contrary to the established literature that focuses largely on the impact of internal financing, we argue that external financing plays a central role in financing innovative activity in developing economies, particularly for more difficult to fund innovative activity. Results using instrumental variables estimation across a wide set of economies and a series of robustness checks for endogeneity indicate that a one standard deviation increase in external financing leads to a 28 percent increase in the probability of firm innovation, a magnitude far exceeding prior estimates of the relationship between external financing and innovation in the developed context. We also find that equity financing is a more salient driver of innovative activity for firms, even though most developing economies are bank-centered. These effects are larger for less tangible innovative processes and for firms facing greater a priori obstacles to innovation such as smaller and younger firms, and those with informal organizational structures. Altogether, these results imply that the provision of government incentives to private investors (including family and friends) for equity investment in innovative activity may be an effective development policy tool.