Assessing the Impact of Financing on SMEs' Innovation in China

This paper investigates the effects of formal and informal financing on the innovation-generating activities of small- and medium-scale enterprises (SMEs) in China. While formal finance mainly includes loans from banks, informal finance includes loans obtained outside the banking system—loans based on personal relationships, loans from online loan providers, and other informal institutions. Our assessment of SMEs' innovation encompasses both the input and output of innovative activities as well as their involvement in the One Belt One Road (OBOR) initiatives. Substantial empirical evidence suggests that formal and informal finance propel SMEs to innovate. These findings are robust to alternative measures of innovation and formal and informal finance. To address endogeneity concerns related to formal financing, we utilize two instrumental variables: firms' capacity to provide collateral and governmental support in securing bank loans. Additionally, we demonstrate that increased investment in research and development (R&D) serves as a pathway through which financing influences and enhances SMEs' innovation pursuits.