Development economists are obsessed with SMEs. And for good reason: employment in SMEs – defined as enterprises with up to 250 employees – constitutes over 60 percent of total employment in manufacturing in many countries. A large SME sector is also a characteristic of rapidly growing economies (although researchers are more skeptical of the claim that “SMEs are the engine of growth”). Also, few disagree that SMEs face greater constraints to their growth than large firms. Not only does access to finance rank high among these constraints, but it also has a proportionally greater impact on SME growth.
Constraints
All these facts suggest SMEs deserve policymakers’ attention, but there are many questions about the efficacy of pro-SME policies in different areas. In reviewing research findings, I’ve grouped these areas roughly under four headings: institution building, financial development, interim solutions, and directed government interventions.
Institution Building
First, findings emphasize the importance of strengthening the underlying institutions and investment climate for all firms, instead of focusing on and subsidizing SMEs. In other words, splitting big firms into small firms or subsidizing small firms will not lead to faster growth, unless more fundamental reforms are undertaken to address the underlying reasons for the inability of firms to fulfill their growth potential. Information asymmetries are an important reason why small firms with potentially profitable growth opportunities find it difficult to access finance. These are likely to be overcome through the development of credit bureaus and better information sharing.
And it is not only firm growth that is hampered by weaknesses in investment climate – the entry of new firms also takes a hit. Indeed, bureaucratic entry regulations manage both to impede entry and also negatively affect the growth and size of incumbent firms. Similarly, individuals are more likely to become entrepreneurs and they are more likely to reinvest their profits if the institutional environment is favorable.
Financial Development
Second, both firm-level and industry-level studies suggest that small firms do relatively better compared to large firms in countries with better-developed financial institutions. With financial development, small firms grow faster since their financing constraints are relaxed to a greater extent. Furthermore, industrial sectors that naturally should have a disproportionately large number of small firms also grow faster with greater financial development, suggesting that it is the small firms that benefit the most.
The lack of well-functioning financial markets is compounded by underdeveloped legal systems, which make it very difficult for firms to grow to their optimal size since outside investors cannot trust that they will not be taken advantage of. This tends to limit firm size. This is important for SME-promotion strategies since if it is optimal for firms to stay small in countries with underdeveloped institutions, simply subsidizing SMEs may be at best ineffective, but at worst, counterproductive.
A contestable financial system makes it more likely that banks go downstream and seek out new ways to serve the smaller firms. Foreign banks have generally played an important role in facilitating this process, whereas public banks have been less useful in the past. Furthermore, contrary to conventional wisdom, it is not only the smaller, niche banks that serve the SMEs. Large banks – both domestic and foreign – also pursue SME business aggressively, including extending loans to the smallest businesses through the use of hard information-based technologies as well as relationship lending.
Interim Solutions
Third, although improving institutions and the investment climate is probably the most effective way of relaxing the growth constraints SMEs face, institution building is a long term process. In the interim, embracing innovative lending technologies and promoting competition may provide market-friendly solutions to the problem. Technologies such as factoring are particularly promising in the interim since they rely on institutions to a lesser extent. However, other technologies such as credit-scoring and leasing can also be useful for relaxing the financing constraints of SMEs, and their use would improve with the development of institutions over time. These technologies will be adopted more rapidly in contestable financial systems open to foreign entry.
Directed Government Interventions
What about direct government interventions in improving access to finance for SMEs? Unfortunately the scope for these tend to be more limited than often believed. In general, experience with direct and directed lending programs have not been successful. More recently, the direct intervention mechanism of choice for SME lending has been the government-backed partial credit guarantee programs. Although more than half of all countries around the world have some form of credit guarantee scheme, rigorous evaluation of these schemes is still rare. Available evidence suggests these programs can be more costly in budgetary terms than expected, and their performance can be improved by careful design. Nevertheless, in the absence of thorough evaluations, the net effect in terms of cost-benefit terms remains unclear.
So we need much more analysis, case studies, innovative thinking to level the playing field for SMEs. Focusing on building institutions that are important for SMEs’ access, continuing the search for financial tools that can circumvent institutional deficiencies, and experimentation with different approaches hold promise.
Tuesday, March 16, 2010
Can Informal Finance Substitute for Formal Finance?
A couple of years ago, at a meeting of World Bank financial sector experts, one of the Vice Presidents at the time challenged me by saying, “You always talk about the importance of the financial sector for development, and emphasize we need to prioritize financial sector reforms, but just look at China. It is doing very well without a well functioning financial system.”
This struck a chord. I had also recently seen an academic paper making more or less the same point, that China is one of the fastest-growing economies in the world despite weaknesses in its formal banking system. Of course there is a large literature on finance which shows that development of formal financial institutions is associated with faster growth and better resource allocation. It has also long been recognized that informal financial systems play a complementary role in developing countries, typically consisting of small, unsecured, short-term loans restricted to rural areas, agricultural contracts, households, individuals, or small entrepreneurial ventures.
There is even a direct parallel in developed countries called angel finance, where high-net-worth individuals—“angel investors”—provide initial funding to young firms with modest capital needs until they are able to receive more formal venture capital financing. But informal finance substituting for formal finance? Conventional wisdom has always been that this is not likely since informal monitoring and enforcement mechanisms are generally ill equipped for scaling up and meeting the needs of the higher end of the market.
But more and more frequently, China was being brought up as an example to support the contention that the reform of formal financial systems is a low priority. The fast growth of Chinese private sector firms was seen as evidence that what supports China’s growth is alternative financing and governance mechanisms. Some even thought this was enough to ignore financial systems and move straight on to other development priorities in designing reform programs. We had to do more research to understand better…
My co-authors Max, Meghana and I started doing this by using the World Bank’s detailed, firm-level enterprise survey data on 2,400 Chinese firms. We wanted to investigate which of two views is consistent with the operation of the informal financial sector in China:
1. Is the informal financial sector associated with high growth and profit reinvestment, and does it serve as a substitute for the formal financial system?
2. Or does the informal sector primarily serve the lower end of the market?
We find that in China the use of bank financing by private firms is comparable to that in other developing countries, but the breakdown of nonbank financing sources shows greater differences (see table below). Unlike firms in other countries, Chinese firms in our sample do rely on a large informal sector and alternative financing channels, which could well be the large underground lending in China.
Financing
Nevertheless we see that it is financing from formal bank sources that is positively associated with firm growth and reinvestment. Contrary to earlier findings, fund-raising from informal channels is not associated with faster firm growth. Interestingly, while we find that the majority of firms that receive bank loans grow faster as a result, there is a subpopulation of firms that do not. These are the firms that report it was government’s help that allowed them to obtain the bank loan in the first place. These firms do not show faster growth, higher reinvestment, or greater productivity, unlike firms getting bank loans without government help. Of course these results do not make China an exception to the growth and finance literature. Far from it, they are also very consistent with previous work showing the disadvantages of government owned banks.
Overall, the conclusion is quite clear: even in fast-growing economies like China where the formal financial system serves only a small part of the private sector because of a poorly developed financial and legal system, external finance from the formal financial system is associated with faster growth and higher profit reinvestment rates for the firms that receive it. We find no evidence that alternative financing channels are associated with higher growth. So reputation- and relationship-based informal financing and governance mechanisms are likely to play a limited role in supporting the growth of private sector firms and unlikely to substitute for formal mechanisms. These results underline – once again – not only the importance of formal finance in the development process, but the urgency in carrying out financial sector reforms where financial systems are poorly developed.
This struck a chord. I had also recently seen an academic paper making more or less the same point, that China is one of the fastest-growing economies in the world despite weaknesses in its formal banking system. Of course there is a large literature on finance which shows that development of formal financial institutions is associated with faster growth and better resource allocation. It has also long been recognized that informal financial systems play a complementary role in developing countries, typically consisting of small, unsecured, short-term loans restricted to rural areas, agricultural contracts, households, individuals, or small entrepreneurial ventures.
There is even a direct parallel in developed countries called angel finance, where high-net-worth individuals—“angel investors”—provide initial funding to young firms with modest capital needs until they are able to receive more formal venture capital financing. But informal finance substituting for formal finance? Conventional wisdom has always been that this is not likely since informal monitoring and enforcement mechanisms are generally ill equipped for scaling up and meeting the needs of the higher end of the market.
But more and more frequently, China was being brought up as an example to support the contention that the reform of formal financial systems is a low priority. The fast growth of Chinese private sector firms was seen as evidence that what supports China’s growth is alternative financing and governance mechanisms. Some even thought this was enough to ignore financial systems and move straight on to other development priorities in designing reform programs. We had to do more research to understand better…
My co-authors Max, Meghana and I started doing this by using the World Bank’s detailed, firm-level enterprise survey data on 2,400 Chinese firms. We wanted to investigate which of two views is consistent with the operation of the informal financial sector in China:
1. Is the informal financial sector associated with high growth and profit reinvestment, and does it serve as a substitute for the formal financial system?
2. Or does the informal sector primarily serve the lower end of the market?
We find that in China the use of bank financing by private firms is comparable to that in other developing countries, but the breakdown of nonbank financing sources shows greater differences (see table below). Unlike firms in other countries, Chinese firms in our sample do rely on a large informal sector and alternative financing channels, which could well be the large underground lending in China.
Financing
Nevertheless we see that it is financing from formal bank sources that is positively associated with firm growth and reinvestment. Contrary to earlier findings, fund-raising from informal channels is not associated with faster firm growth. Interestingly, while we find that the majority of firms that receive bank loans grow faster as a result, there is a subpopulation of firms that do not. These are the firms that report it was government’s help that allowed them to obtain the bank loan in the first place. These firms do not show faster growth, higher reinvestment, or greater productivity, unlike firms getting bank loans without government help. Of course these results do not make China an exception to the growth and finance literature. Far from it, they are also very consistent with previous work showing the disadvantages of government owned banks.
Overall, the conclusion is quite clear: even in fast-growing economies like China where the formal financial system serves only a small part of the private sector because of a poorly developed financial and legal system, external finance from the formal financial system is associated with faster growth and higher profit reinvestment rates for the firms that receive it. We find no evidence that alternative financing channels are associated with higher growth. So reputation- and relationship-based informal financing and governance mechanisms are likely to play a limited role in supporting the growth of private sector firms and unlikely to substitute for formal mechanisms. These results underline – once again – not only the importance of formal finance in the development process, but the urgency in carrying out financial sector reforms where financial systems are poorly developed.
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