How Valuable are Informal Relationships between Firms?

Abstract

It has been suggested that informal relationships between firms can effectively substitute for market mechanisms in certain situations. When such mechanisms are weak or non-existent, this would indeed be very desirable. Using a unique dataset combining survey responses with panel data of business activities by a sample of small and medium enterprises in India, the present paper investigates the benefits of informal inter-firm relationships and finds that they are weak at best. The types of benefits considered include contract enforcement, informal credit sales, and improvement in corporate performance, including profitability and growth. The root of the problem, we find, is that informal relationships are generally ineffective in enforcing relational contracts. Though such relationships seem to offer certain advantages, such as more credit sales to other firms, attributable to more information being available about each other, those advantages are limited. Conceivably, a weak court system in India fails to complement relational contracting, and exacerbates the problem. We also find that relationship-based credit has adverse cost implications and affects firm profitability. Interestingly, the costs are more favorable at relatively high levels of dependence on relationship-based credit, indicating that the suppliers prefer “locked-in” customers when the non-legal sanctions as well as the court system are ineffective. Our results are robust to a host of alternative specifications and tests. We conclude that the case for accessible and reliable legal and market institutions remains strong. Our findings are relevant for many other countries where relationship-based commerce is common and creditor protection is poor in practice.