Absence of a well-developed capital market has been listed as a key obstacle to industrialization in developing countries in the development literature. In this paper, we show that industrial clusters, through specialization and division of labor, can ease the financial constraints of microenterprises even in the absence of a well-functioning capital market. By using data from more than 17,000 microenterprises in four sectors and four regions of Ethiopia, we find that clustering lowers capital entry barrier by reducing the initial investment required to start a business. This effect is found to be significantly larger for microenterprises investing in districts with high capital market inefficiency, indicating the importance of clustering as an organizational response to a credit constrained environment. The findings highlight the importance of cluster-based industrial activities as an alternative method of propagating industrialization when local conditions do not allow easy access to credit.
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