Beyond Microfinance: Getting Capital to Small and Medium Enterprises to Fuel Faster Development

Small and medium-sized enterprises (SMEs), typically employing between 10 and 250 workers, form the backbone of modern economies and can be crucial engines of development through their role as seedbeds of innovation. In much of the developing world, though, SMEs are under-represented, stifled by perverse regulatory climates and poor access to inputs. A critical missing ingredient is often capital.

Tinier firms-micro-enterprises-frequently get more attention, as donors seek to help the very poor: the recent Nobel Peace Prize awarded to Muhammad Yunus of the Grameen Bank visibly demonstrates the emphasis given to this approach. But the type of support inherent to microfinance lending is generally ill-adapted to serving their slightly larger, and arguably more dynamic, cousins, the SMEs.

New options are emerging for meeting SMEs’ financial needs, including commercial banks moving “down-market,” micro-credit institutions moving “up,” and creative application of venture capital investing ideas.

Governments can help by removing artificial policy and regulatory obstacles to SME lending-importantly, policies that promote greater competition within the financial sector as a whole are generally likely to be especially good news for smaller borrowers like SMEs. External actors can help too-for example by promoting development of credit information systems and reform of collateral regulations. They can also usefully play a selective pump-priming role; for example, they can partially guarantee commercial lenders’ moves into SME lending.

Private investors-sometimes with collaboration from and in partnership with the public sector-have a key role, too. For example, in the case of firms facing high-risk, high-return scenarios, home-grown “angel investors” can step in.

Donor support for traditional microfinance models has helped provide basic financial services to millions of poor people. But in order to help build dynamic competitive economies in developing countries, the time has come to pay greater attention to the potential of small and medium-sized commercial firms to promote economic growth.

Policy Brief #159

Why Care about Small and Medium Firms?

Small and medium-sized firms matter-everywhere.

Advanced economies are paying new attention to small and medium enterprises (SMEs). One reason is their sheer quantitative importance. The OECD reports that SMEs account for more than 95 percent of manufacturing enterprises and an even higher share of many service industries in OECD countries; in most OECD countries, SMEs generate two-thirds of private sector employment and are the principal creator of new jobs. Additional interest in SMEs has been sparked by dynamic firms like Microsoft, which developed from tiny start-ups.

What are SMEs? Analysts use varying definitions of SMEs. Many advanced countries define SMEs as firms employing between 10 and 250 workers (or, in some countries, 500). SMEs are generally viewed as occupying the middle of the firm size distribution — larger (and typically more formalized) than “micro-enterprises,” which are usually informal units employing at most a handful of people. In many small and less-developed countries, it should be noted, firms employing 250 or 500 people could well be among the larger firms in the country.

Not every SME is a budding Microsoft. A three-way typology is useful:

  • (i) A large proportion of SMEs are relatively stable in their technology, market, and scale. Many are in retail or service sectors. A significant number are at best static and at worst heading for failure;

    (ii) Other SMEs are technically advanced specialists filling crucial product or service niches within complex modern economies. Examples come from the German mittelstand and technically savvy sub-contractors in Japan and northern Italy;

    (iii) U.S.-style “start-ups” are potentially the most dynamic but often the riskiest SMEs. Many seek to commercialize new technology coming straight from the research sector.

The “start-up” phenomenon has highlighted the contribution of flexible equity financing to innovation. Professional venture capitalists, who manage pools of risk capital, famously helped build Silicon Valley. More recently, many have ratcheted up the minimum size of their deals. The resulting gap for early-stage funding is increasingly being filled by angel investors, affluent individuals who back nascent entrepreneurs with their own money and intensive mentoring, in return for equity stakes.

SMEs in developing countries face a harder time.

The SME picture in developing countries varies greatly. Some more dynamic emerging market economies, notably in East Asia, present thriving SME sectors, including significant numbers of skill-intensive subcontractors. Many more developing countries, though, suffer from a “missing middle”. They typically have very large numbers of informal micro-enterprises. They may also have a handful of larger firms-possibly ventures created by foreign investment (in large-scale activities like mining, for example), or family-controlled conglomerates built up over generations. But there are typically few SMEs in-between.

The World Bank estimates that SMEs contribute an average 51.5 percent of GDP in high income countries-but only 15.6 percent in low income countries. By contrast, the “informal” micro-enterprise sector accounts for an average 47.2 percent of GDP in low income countries, but just 13 percent in high income countries.

Does it matter whether SMEs in developing countries thrive? Yes. In contrast to healthy SMEs, most micro-enterprises show very low productivity, with little capacity to master improved technology or grow beyond the smallest scale. In developing countries with a “missing middle,” competition is often squelched by dominant conglomerates.

The organic growth of small firms in developing countries may be held back by numerous obstacles, including government red tape and corruption, as well as infrastructure deficiencies, and difficulties in accessing technology, skills, or markets (surveys like the World Bank’s annual Doing Business series have helped to highlight inter-country differences in the regulatory climate for aspiring entrepreneurs, and the hurdles that perverse government regulations can create for enterprise development). Regulatory reform may be a critical priority at national level, and technical assistance a crucial need for aspiring entrepreneurs. But finance also ranks high among their concerns.

In the World Bank’s “World Business Environment Survey” (WBES) of more than 10,000 firms in 80 countries, SMEs worldwide on average named financing constraints as the second most severe obstacle to their growth, while large firms on average placed finance only fourth. Firms in Central and Eastern Europe, the former Soviet Union, and Africa were most likely to cite finance as their most severe constraint, followed by those in South Asia and Latin America. World Bank researchers Beck, Demirguc-Kunt, and Maksimovic concur that SMEs are far more likely than larger firms to be held back by financial constraints.

Empirically, World Bank researchers find a positive correlation between the size of a country’s SME sector and the rate of economic growth. This does not necessarily prove causation runs from SMEs to growth. More plausibly, policies that are good for SMEs are generally good for growth, too. Among these policies, the promotion of vibrant, competitive financial systems has proven to be especially important.

Challenges to Financial Systems

How well countries’ financial systems provide SMEs with access to finance depends on a range of factors, from the overall financial sector framework to the ingenuity of individual intermediaries.

Policymakers need to get financial sector incentives right-competition is fundamental.

Rajan and Zingales argue convincingly that, when misguided government policies stifle financial sector competition, banks feel little pressure to seek new customers and broaden financial access. By contrast, financial intermediaries exposed to vigorous competition are motivated to pursue non-traditional customers, including SMEs. Empirical studies confirm, for example, that when foreign banks are allowed to enter previously closed national markets, financial access improves for smaller clients. Eliminating barriers to competition in the provision of financial services in general may be the single most important task for governments and regulators in helping small firms.

Financial intermediaries face particularly challenging environments.

Every financial intermediary must overcome certain basic challenges to remain viable. First and foremost remains managing the risks raised by asymmetric information:

  • Adverse selection: How can lenders screen out high risk borrowers in advance?
  • Moral hazard: How can lenders protect their repayment prospects once borrowers have the money in their hands?

Lenders in many developing countries must handle these challenges in the face of special obstacles: weak accounting standards, limited third-party credit information services, and restrictions on the use of physical collateral.

Very likely the most important longer-term contribution that development partners can make will be to address the underlying weaknesses in financial infrastructure-e.g., by helping countries establish credit bureaus and reform collateral laws.

The second major challenge for intermediaries is to keep costs low (and revenues sufficiently high). Cost management is especially challenging when average loan size is small, since transaction costs do not automatically fall as loan size declines. Successful micro-finance institutions (MFIs) employ creative procedures to hold down their costs, while setting interest rates at cost-covering levels.

Finally, each intermediary must mobilize a continuing supply of funds. Banks can pursue increased deposits; they may also sell securities. Some non-bank MFIs are licensed to take deposits, others are not. Many MFIs have relied at least in part on external funding-often from non-commercial sources such as public sector aid or philanthropies.