strategy

Enhancing access of small- and medium-sized enterprises to finance

Context:
In almost all countries, including industrialized countries, financing is deemed as the major constraining factor for the development and expansion of small and medium-sized enterprises (SMEs). Consequently, governments generally view financial support as the major component of promotion policies in favour of SMEs. The promotion of SMEs in developing countries often finds justification in considerations related to poverty alleviation and employment-generation. Micro-enterprises are believed to increase employment of the poor in the informal sector and SMEs are, in general, labour-intensive. However, a policy in support of long-term dynamic development of the small-scale industrial sector should go beyond these considerations and be integrated into the overall industrial strategy of a country, if the basic objective is to help improve the efficiency of SMEs and make them healthy and viable. In the context of increasing openness and wider exposure of developing economies to international competition, the role that the small-scale industrial sector is expected to perform needs to be clearly understood and its promotion designed in line with the overall national policy environment.

Such questions as how financial mechanisms could be improved or what cost-efficient schemes could be implemented in order to encourage lending to SMEs could thus best be addressed once there is a clear picture of the role played by SMEs in an integrated development strategy. This role can differ from one country to another. Some countries (for example, Japan and the Republic of Korea) at the beginning of their industrialization process had based their strategy on the development of large industrial conglomerates. However, the role of SMEs as sub-contractors or as producers of specialized products, or even as competitors with large enterprises was subsequently recognized and particular attention was donated to this aspect. Other countries, in contrast, started their industrialization process on the strength of SMEs (which could be regrouped in a cooperative structure). These subsequently expanded and became large industrial complexes (as was the case in Taiwan Province of China). It is important to note that the distribution of finance and credit is a determinant in the shaping of these industrial strategies. Between these two extremes, however, there are other successful models of industrial development that have relied on the constitution of both large enterprises and SMEs.

Large-scale production derives its efficiency from such factors as economies of scale and improved business and production organization through the possibilities of interlocking interest in various plants and firms. In these circumstances, what then explains the strength of SMEs ? A number of factors may be cited:

(a) Large industry has easier access to cheap capital while small industry has easier access to cheap labour; these respective advantages might keep the cost-scale in balance for both types;
(b) Sometimes manufacturers prefer to start a new line of products on small scale to minimize risks:
(c) Small-scale production is advantageous where the material to work on is not uniform, where the processes are not amenable to quick replication and where the products are not standardized;
(d) Market imperfections, owing to consumer preferences or transport costs, limit the size of the market and the scope for large-scale production;
(e) Long-term structural changes in product markets, reinforced by innovations in information technology result in increasing segmentation of markets, shifts towards flexible production systems which imply the scaling down of plants and which alter the relative importance of economies of scale, thus significantly strengthening the role of small-scale producers in the overall production system.

(f) Large enterprises can rely on subcontracting networks with SMEs to increase overall efficiency in the whole production chain, especially as industrial competition now emphasizes non-price factors, product differentiation and creation of new products. Japanese large corporations have traditionally established such business relations with smaller enterprises supplying specialized components; other countries, such as Republic of Korea, have likewise favoured subcontracting relations on a large scale.

Alongside a "modern" small-scale industrial sector, in many developing countries micro-enterprises of the informal sector play an important role in short-term poverty alleviation and the containment of unemployment. It is often believed that this sector produces for the poor and needs much technological upgrading in order to be integrated into the formal industrial sector.

Although the role of SMEs in the development process is increasingly recognized, it is less clear why special measures should be taken to promote SMEs. In the case of micro-enterprises in the poor informal sector, the rationale for special support is obviously based on socio-economic and income redistribution considerations. It is less clear why small firms in the "modern" industrial sector deserve special promotion measures. Employment generation is not a sufficient argument: maintaining inefficient small firms to protect employment will create stagnation and retard development of the economy as a whole. The rationale for promotion of SMEs might perhaps also be based on arguments related to "infant-industry" protection and market imperfections and failures. The first argument would explain the protection and assistance of SMEs to help build up their competitiveness until they reach a self-sustaining growth level. The second argument lends support to special measures to correct market imperfections and failures (especially in capital markets), in order to reduce any bias against small-scale industry.

The heterogeneity of SMEs might complicate the design and implementation of support policies, in particular in the financing area. All types of SMEs might not respond in the same way to a set of financial support measures. It is, therefore, important to have in mind some kind of functional classification of SMEs which could be relevant for promotion policies. Furthermore, it should be noted that the small-scale industry is an easy-entry sector (barriers to entry are low, owing to low start-up capital requirements). It can therefore be prone to overcrowding (and excess capacity) a tendency that might be accentuated by support measures, thus, nullifying the impact of assistance.

Surveys of SMEs in developing countries have highlighted the problem of financing as the major obstacle for their development and expansion. SMEs have generally limited access to sources of finance, especially finance from formal financial institutions. There are myriad reasons for this:

(a) Lending to small enterprises is perceived as risky because of the uncertainties faced by these enterprises (high failure rate and high susceptibility to market changes and economic fluctuations);
(b) The administrative costs of lending to small enterprises are high, and the size of loans is too small to cover these costs. (The transaction costs must include the risk element and potential losses);
(c) There is an institutional bias toward lending to the larger corporate sector, because of links in directorships, joint ownerships and other joint financial dealings between banks and large enterprises;
(d) The administrative formalities, time and paper work involved in obtaining credits from banks often deter SMEs from approaching banks. Moreover, small enterprises are often unable, or unwilling, to present full accounting and other documentation called for by banks;
(e) Small borrowers are unable to provide the collateral and security demanded by lending institutions.

These difficulties are compounded in countries where the financial systems are weak and capital markets nonexistent. Moreover, problems are exacerbated when tapping sources of long-term finance, as commercial banks provide mostly short-term loans while specialized institutions which provide long-term finance are scarce. SMEs, consequently, have to rely primarily on the proprietors' own resources and retained earnings to finance their operations. Money-lenders and curb financial markets often provide bridging finance, but at a substantial cost. In these circumstances, what mechanisms and policies should be implemented to enhance SMEs' access to finance from financial institutions ? In countries where the informal sector plays an important role, is it necessary to increase the linkages between the formal and informal sectors so as to improve the supply of finance to SMEs ?

The primary source of initial capital for SMEs is the proprietors own savings and that of relatives or close friends; for expansion, reinvested earnings are the main source of funds. This finding seems to be generally applicable in most developing countries. A study of financing of SMEs in Latin America has shown that SMEs in this region exhibit low debt-equity ratios (equity is understood here as proprietors' own resources In Mexico, for example, this ratio amounted in 1993 to 0,27 for small manufacturing firms, against an average level of 0.66 in the manufacturing sector. It is also reported" that self-finance as a percentage of fixed capital amounted to 80 per cent in Mexico, 92 per cent in Brazil, 65 per cent in Bolivia, 84 per cent in Colombia. Self-finance also funded 87 per cent of the working capital of SMEs in Mexico, and 97 per cent in Brazil. The second major source of finance comes from relatives and friends. In Africa, a similar pattern has been noted.
Claim:
Adequate access to finance is critical for the development and expansion of SMEs. However, the supply of credits from the formal financial sector is scarce, given the reluctance to lend to SMEs because of the perceived high risks. Informal finance is available, but on very small scale and at high cost. In these circumstances, governments can play a useful role in reducing the risks and costs of lending, by providing credit guarantees or insurance, making available to banks refinancing facilities or imposing reasonable lending quota limits. Governments, through provision of low-cost funds, can also help set up specialized financial institutions to provide long-term finance to SMEs or retail loans to micro-enterprises.

However, as government resources are limited, their cost-efficient use would require that the assistance provided to SMEs be well integrated into the overall industrial policy of the country, aiming at assuring the viability of SMEs and strengthening their development. In this respect, governments needs to have clear ideas about target groups and their specific need, as well as encouraging backward and forward linkages between enterprises. The usefulness of schemes which link savings with credit supply could be further explored, especially as SMEs have amply demonstrated their capacity to save through the financing of their enterprises by their own resources.

As the economy grows and the financial system is deepened, made more diversified and competitive, SMEs' access to finance will also become easier and there will be less government involvement in enhancing this access. Efforts to develop a viable domestic financial system could yield great benefits for the small business sector in particular.

Broader:
Improving access
Values:
Shortness
Subjects:
Finance
Business enterprises
Type Classification:
E: Emanations of other strategies