Credits to Small Businesses and Microenterprises

Par Marc Labie

Introduction

Credits to small businesses and microenterprises have become a fashionable topic in development economics. With the benefit of hindsight, this is perfectly understandable as it fits in with the trend of the eighties to give more importance to microeconomic choices of economic agents (Toye-1993).

No universal definition of the microenterprise has been adopted yet. Before we start our analysis, we will provide a tentative definition. Small and microenterprises are generally more labour than capital intensive and have high relative production costs (because raw materials are purchased in small quantities). They lack technical experience in production, accounting, administration and stock control (due to low levels of qualification). Most of the time they are unregistered (or partially registered) and family-based.

This review has two main objectives: first to determine the reasons for an interest in small and microenterprises and second, to present the views of different international institutions involved in programmes to supply credits to these enterprises. We will focus on the World Bank, the OECD and two NGOs, namely SOS-Faim (from Belgium) and RAFAD (from Switzerland).

Why focus on credits to small businesses and microenterprises?

Supplying credits to small and microenterprises is important for two reasons. The first one has to do with the idea of market imperfection and it is, without any doubt, the reason favoured by the World Bank and the OECD. The second reason is more general and is related to the belief that small businesses have important functions (mainly social ones) which justify their role in the economic structure. This reason is favoured by the ONGs. There is no strict opposition between the two.

Market imperfections

Most small enterprises start their existence without any institutional help. The entrepreneur usually obtains the small amount of finance he needs from his own savings or from his family. However, small enterprises then find it difficult to grow without the possibility to borrow additional capital from lending institutions (Levitsky, p.1). The difficulty stems from the fact that, in developing countries, the banking system causes "imperfections in financial markets that constrain small borrowers access to credit" (Webster,vii). The reasons are (Levitsky; OECD; Waterfield):

1. Banks are biased in favour of lending to large enterprises.
2. Lending to small and microenterprises is considered to be risky.
3. The administrative costs of lending to small enterprises are high and can sometimes reduce the profitability of such loans to (almost) zero.
4. Small and microenterprises are often unable (or unwilling) to give precise information about themselves.
5. Small and microenterprises can rarely provide securities or collateral's for their loans.

When formal financial markets cannot fulfil the needs of small and microenterprises, informal markets will do so, but usually at usurious rates which jeopardize the survival of small businesses (Human Development Report, p. 44)

Role and functions of microenterprises

It is said that microenterprises should be supported because they fulfil many priorities of development economics. They favour the development of the private sector, the promotion of women and the implementation of community development by private initiative; and they reduce poverty and contribute to a fairer income distribution, (OECD, p. 7). They also increase employment as small and microenterprises are usually more labour intensive. This view is shared by many economists and international institutions (Human Development Report, p 43 or the OECD, p. 13). However, not everyone agrees with this view. A study made in India by DHAR and Lydall in 1961 shows that capital intensity is not lower in smaller firms when the products manufactured are compared (Gillis, p. 685). Even disregarding the employment issue, the social and economic importance of small and microenterprises in the development process cannot be denied.

The size of the problem

The so-called informal sector to which pertain most of the enterprises we are talking about, is indeed very important.

In Africa, two jobs out of three are already linked to the informal sector and there are estimates that it will cover 93% of all new urban jobs created in the nineties (OECD, p. 73). For five countries in Latin America the estimates are as follows: In Bolivia 55% of the labour force belongs to the informal sector; Chile has some 450.000 microenterprises; Colombia counts more than 1.500.000 urban microenterprises; In Ecuador, 850.000 workers are employed in the informal sector, half of them in just two towns, Guayaquil and Quito; and finally, in Peru, 42% of the population of Lima belongs to the informal sector (RAFAD, p. 13).

Considering these numbers, it seems hard to qualify the informal sector as "marginal" and to dismiss its problem of obtaining credit as an "imperfection of financial markets".

The solution to the problem: three approaches

1. The World Bank

World Bank activity in the field is based on two financial tools: Credit Guarantee Schemes (CGS), initially designed for small and medium enterprises, but more and more used for microenterprises as well; and Lending Programmes. Unfortunately, the information form the World Bank is still mainly related to small and medium enterprises (SME, but in the future, more information on microenterprise programmes should become available as the Bank has created a structure called the CGAP (Consultative Group to Assist the Poorest).The information presented below focuses on small enterprises.

The Credit Guarantee Schemes

"Credit guarantee schemes are set up with the purpose of covering some portion of the losses incurred when borrowers default on loans. The purpose of such schemes is to encourage financial institutions, and in particular commercial banks, to lend to small businesses with viable projects and good prospects of success but which are unable to provide adequate collateral or which do not have a suitable record of financial transactions to prove that they are creditworthy" (Levitsky, p. 1).

According to a survey conducted by Levitsky and Prasad on the topic of CGS in 27 developed and developing countries, three conditions are required for a CGS to be successful: (Levitsky; Webster, p. 39)

• Commercial banks have to take part in these programmes.
• Each request for a guarantee has to be studied by an independent institution.
• The guarantee part should not exceed 70 or 80 percent.

Credit Guarantee Schemes have also been criticized. Banks may develop a tendency to transfer any risky businesses to a CGS. Those who receive guarantees are often borrowers who would have obtained loans under normal conditions anyway (Levitsky, p. 3).

The lending programmes

In 1991, Leila Webster studied 33 completed lending programmes for small and medium enterprises conducted by the World Bank between 1973 and 1989. The conditions for success were: (Webster, p.ix)

• Commitment to project goals, stable political environment and strong demand for the services provided by the project.
• Thorough appraisal of the financial and technical assistance used.
• Enlistment of qualified individuals in the government or in the institutions that provide the financial and technical assistance.
• Project design matching local demands.

Two other aspects were covered by this study: credit delivery systems and interest rate issues.

Credit Delivery Systems

"World Bank loans that support SME credit operations normally are channelled through either a single financial institution, which onlends the funds to small and medium enterprises; or an apex entity, which channels funds to multiple retail-level financial intermediaries with the retailers assuming the credit risk" (Webster, p.21). It seems that the apex credit delivery systems turned out to be more effective in reaching small borrowers and in achieving higher repayment rates. This conclusions is of interest at a time where other international financial institutions like the European Investment Bank (EIB) are starting to use apex systems for their own deliveries to small businesses in developing countries.

Interest Rate Issues

"The Bank has argued consistently that final interest rates charged to subborrowers under SME lines of credits should be positive and market-determined" (Webster, p.39). Mainly for political reasons, it is not always the case and many countries are more willing to use subsidized interest rates. Of the 33 credit line projects studied, 19 had commercial or close to commercial rate and 14 had subsidized interest rate (Webster, p.39). Interestingly an analysis of projects with high repayment rates indicated little relationship between the repayment of subloans and the type of rates used.

2. The O.E.C.D.

In a publication issued in 1993, the OECD proposes guidelines for future aid to microenterprises on the basis of previous experiences. Flexibility should be the key element; no general framework, procedures or requirements should be imposed in the way to implement actions in favour of small businesses.

Three levels of actions are suggested: (at the general level of the economy; at local level; at credit level)

Action at the general level of the economy

At this level, the OECD countries have agreed to six actions (OECD, p.16)

• Actions favouring economic reforms in order to strengthen the market mechanisms and to create new investment opportunities.
• Actions favouring agriculture to compensate for what is called "the urban bias".
• Actions favouring national savings.
• Actions promoting institutional reforms in order to improve factors markets (particularly labour and credit markets).
• Actions supporting infrastructures projects (roads, harbours, electricity networks,....).
• Investment in human resources by promoting basic management knowledge for men and women.

Action at local level

According to the OECD, donors should: (OECD, p.17-18)

• Favour the development of local associations of microentrepreneur.
• Imagine aid programmes which respect the cultural habits of the populations.
• Imagine aid programmes that fit the needs of local development organizations.
• Promote relationship between small and microenterprises associations of developing and industrialized countries.
• Develop actions in cooperation with local NGOs.

Action at credit level

At this level the OECD countries agree on the following: (OECD, p.19)

• No highly subsidized programmes should be kept going for ever.
• The credits and savings procedures inspired by the practice of the informal markets are the ones which have the highest chance of succeeding.
• Interest rates should always be positive for the final borrower and linked to market rates.
• There should be a strong reliance on people and group dynamics (motivated by the perspective of getting new loans) more than on a close study of potential guarantees and collateral's.

3. The NGOs

It is important to review the various experiences of NGOs with supplying credits to small businesses and microenterprises as they appear as major actors in this field. To tackle the subject, we present the conclusions of a meeting which took place in Quito in October 1992. About 20 Latin American associations supplying credit to microenterprises attended the meeting which was organized by two NGOs from the North, RAFAD from Switzerland and SOS Faim from Belgium.

The associations involved fit in one of the following categories (RAFAD, p. 16-18): popular organization; support organization; credits and savings cooperative; private bank; local investment company specialized in risk capital.

Two elements were identified as particularly critical for microenterprises in Latin America:

1. The lack of equity capital (RAFAD, p. 58). This is preoccupying because it limits not only financial independence but also the risk which the people involved in microenterprises are willing to carry themselves. It is therefore a very significant signal for formal banks.

This view is challenged by Cortes, Berry and Ishaq (Cortes, f.i. p. 153) who, on the basis of a study of the situation in Colombia, identify working capital as being most relevant.

2. The complexity of banking procedures. Banking procedures do not fit the needs of microproducers. There are insufficiencies with regard to guarantees, low rates and flexible credits (so that the microenterprises could use the credit line when needed).

As a conclusion it can be said that, even if there are some differences between institutions (e.g. the OECD and the World Bank do not share the same views on informal credit procedures), there are common points which seem to be essential:

• Tools that increase flexibility and facilitate access to credits should be favoured.
• Local savings should be encouraged in parallel with the credit programme in order to achieve a certain degree of autonomy in the long run.
• Reliance on local groups has to be increased.
• Interest rates management should keep interest rates close enough to market rates to avoid a definite break between the microenterprises and the formal banking system.

These are only starting points. Hopefully, further research in this field will help us to develop the appropriate tools for credit programmes to small businesses and microenterprises.

REFERENCES

[1] Banque Mondiale Actualités, Vol. XIV, no 31, 31 août 1995

[2] Cortes M.- Berry A. - Ishaq A., Success in Small and Medium-Scale Enterprises, the Evidence from Colombia, The World Bank, Oxford University Press, 1987

[3] Gillis M. - Perkins D.H. - Roemer M. - Snodgrass D.R., Economics of Development, 2nd edition, W.W. Norton & Company, New York, 1987

[4] Levitsky J. - Prasad R.N., Credit Guarantee Schemes for Small and Medium Enterprises, World Bank Technical Paper 58 (Industry and Finance Series), Washington, 1990

[5] Little I.M.D. - Mazumdar D. - Page J.M., Small Manufacturing Enterprises, a Comparative Study of India and Other Economies, The World Bank, Oxford University Press, 1987

[6] OCDE, Les orientations nouvelles de l'aide en faveur des micro-entreprises, OCDE publications, Paris, 1993

[7] RAFAD - SOS Faim, Le financement alternatif, le cas des micro-entreprises et des associations de producteurs des pays andins; Edition Action pour le DÇveloppement, Bruxelles, 1993

[8] Toye J., Dilemmas of Development, 2nd edition, Blackwell Publishers, Oxford, 1993

[9] United Nations, Human Development Report (French version), Oxford University Press (Economica), 1993

[10] Waterfield Ch., Designing for Financial Viability of Microenterprise Programs, GEMINI (Growth and Equity through Microenterprise Investment and Institutions), A.I.D., USA, 1993

[11] Webster L., World Bank Lending for Small and Medium Enterprises, Fifteen Years of Experience, World Bank Discussion Paper 113, Washington, 1991.

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