Can Low Returns to Capital Explain Low Formal Credit Use?: Evidence from Ecuador

One potential explanation for low formal credit use is that poor entrepreneurs generate returns to capital below borrowing costs and cannot afford the loans. I test this using a new, nationally representative data from Ecuador, focusing on entrepreneurs that say credit constraints are a major problem. I estimate returns to capital and find monthly returns between 3.5% and 21%, well above prevailing interest rates. Despite this, one third of the finance constrained sample expresses no demand for a hypothetical loan. I estimate the determinants of demand for this loan, focusing on the role profitability may play. I find that measures of profitability are positively and significantly associated with demand, and that perceptions of profitability are among the strongest determinants. Meanwhile, assets, employees, duration, formality and past credit use have no predictive power. This suggests that some microentrepreneurs cannot afford prevailing interest rates and rationally eschew formal credit as a result.