Why SME Lending? A Reminder

Remembering to look up

I went to a new part of town over the last couple of days for a conference. And because it was new, I noticed myself monitoring Google Maps pretty regularly to make sure I was going in the right direction. It made me think that I don’t look at the big picture enough in other parts of my life. For example, I have now been moving around the SME spending space for a while, and I thought this was a good time to look up and take note of the bigger picture. More philosophically, the bigger picture then serves as reminder of why we do the work that we do.

Five guiding questions

Five big questions come to mind that might serve as a guide.

• One is meta: why care about small businesses at all?
• A second is: if there are good reasons to care, why do we focus on credit so much?
• Then, if credit makes sense to focus on, we get to a third question: how much credit do SMEs need? In other words, what is the demand for credit?
• And, if we’re talking demand, the natural follow up is what does the supply landscape look like?
• Finally, you can zoom in to where supply and demand meet: in the form of some product or another. Question 5 then is what do those products look like?

I’ll plan to tackle the questions over the next several weeks. So I’ll start with the first one today.

Question 1: Why do we care about small businesses anyway?

What do we mean by small?

Well, it might help to start with some clarity on what small businesses are. Because what you can think of as small varies depending on where you are, the definition is typically set at the national level as a function of one of three variables: the maximum number of employees, the maximum amount of sales, or the maximum loan size roughly in that order of prevalence. See Table 2 in World Bank 2011.

In India, where I am, the definition is a bit more complicated. There is a distinction between manufacturing and trading businesses. And then, based on how much investment they make in their business, they are classified as micro, small, or medium. The thresholds are 25 lakh (USD35k), 5cr (USD 750k), and 10 cr (USD 1.5m) for manufacturing businesses. And 10 lakh (USD15k), 2 cr (USD 300 k), 5 cr (USD 750k) for trading businesses (see the chart below).

We’re basically talking about the range of businesses from about 15k in investment in the smallest part of the range to about a hundred times bigger at the largest 1.5m. India figures and image from KPMG 2017.

Why we care? Jobs and Growth

When you read reports on small businesses like the ones I cite above, you come across phrases like “backbone of the economy” (see the foreward of the KPMG report). And in this one from the IFC on MSME Financing Gap, the rationale is made pretty clear right in the first sentence of the forward:

At the International Finance Corporation, we pay special attention to small businesses because they are the engines of job creation and economic growth. Nine out of ten new jobs worldwide are created by small businesses, and we need nearly 3,3 million jobs every month in emerging markets by 2030 to absorb the growing workforce.

So we care about SMEs because they drive the economy. And because they are a source of employment. Let me start with employment and come back to the question of economic growth in a moment in a moment because as we’ll see the evidence on that is not clear.

Indian small businesses are not employing anywhere near 50% of the labor force. More like 10-15%

On the employment question though, this World Bank paper from 2017 cites another work: “Ayyagari,Demirgüç-Kunt and Maksimovic (2014) find that SMEs in the formal sector account for 50% of employees in developing countries.”

I’m not sure how useful that is for India where the bulk (90%+) of the sector is informal. The KPMG report cites a 2006 government study (The All India Census of MSME) which showed that some 360 lakh or 36 million Indians were employed by SMEs in 2006 and that this number would grow to over 50m by now. This seems low to me. But, in this ILO brief, the total Indian workforce was 473m in 2011 with Agriculture still about 50% and Manufacturing at a little over 10%. So maybe small businesses really are employing only a little over a ten percent of the labor force in India?

Small businesses as a driver of growth is murkier and depends on other factors …

The same paper (World Bank 2017) suggests that the relationship with growth is less clear. In fact, it’s not even directly growth but rather ‘recovery from recessions in developing countries.’ One study cited in the paper didn’t find any relationship between the proportional size of the SME sector to growth or poverty alleviation. Another shows that there is a positive relationship, but only in developed countries but not developing ones. A third that bigger firms are actually better drivers of growth (because they are typically run by more skilled entrepreneurs, can leverage economies of scale, can afford to fund innovation and offer more stable jobs to employees).

So what’s the deal?

Question 2: Why then do we care about financial inclusion for small businesses?

It seems that whether SMEs can grow and contribute to economic growth depends on whether they have access to finance…

If there is good access to finance, SMEs prosper and can grow to be larger firms which are even better. In fact, a large number of SMEs is probably a good sign that there are inefficiencies in the system that prevent companies from getting bigger.

This World Bank Working Paper from 2006 studied 10,000 firms across 80 countries. It finds that of all the factors that are generally described as being constraints for the growth of small businesses, access to finance is the most robust amongst “inadequate security, enforcement of property rights, poor provision of infrastructure, inefficient regulation and taxation, and broader governance features such as corruption and macroeconomic stability.” I should add though that this same study finds that political stability and crime also matter for firm growth along with access to finance, just that this study finds a more robust relationship for finance. Other factors affect firm growth operating through these three main factors.

But why is access to financial services so important for individuals and firms?

A flagship report by the IFC and World Bank on Financial Inclusion from 2014 has a good synthesis of why financial inclusion matters from a theoretical perspective. One reason is that a lack of financial inclusion persists inequalities and traps people in poverty. If you don’t have the money already (you’re poor in other words) you’re stuck because you can’t invest in the education you need to become more productive (earn more) and you can’t pursue entrepreneurial ideas which again could lead to higher productivity (p15). There are other problems aside from these which are basically about getting credit. Without access to basic financial services, it’s hard to save up for the future (or retirement) and it’s hard to protect yourself from risk from health or death without insurance.

And empirical evidence seems to bear this out. Having access to savings accounts leads to higher “savings, womens empowerment, productive investment, consumption, investment in productive health, productivity and income” (p41). The evidence supporting credit is also pretty strong. Insurance is more complicated but seems to lead toward better investments and higher productivity (p42). Credit does indeed help households smooth consumption and pursue entrepreneurship. And lack of credit constraints economic growth pretty much more than anything else (p43) as I also said the section above.

A long parenthetical caution here: credit is not unambiguously positive. Micro-credit was meant to unleash the entrepreneurship and economic potential trapped at the bottom of the pyramid for lack of credit. More than a decade on from the rapid expansion of micro-credit across the world, what we see is that micro-credit has been helpful for consumption smoothing and risk management, but has little or no impact on entrepreneurship and investment. And at the macroeconomic level, it looks like micro-credit is mostly redistributive and potentially reduces financial stability. Giving credit to high risk borrowers without a proper institutional framework can lead to disaster (think the housing crisis in the US in 2008 or the micro-credit crisis in Andhra Pradesh in 2010). In short, credit is very important but it has to be done right.

Summing up

In summary: we care about small businesses because it is the primary source of employment in most countries, and economic prosperity for an economy overall is then tied to the success of small businesses. And the main thing that propels or inhibits the success of small businesses is access to financial services.

Ok so that’s a long answer to questions 1 and 2. Now, if credit makes sense to focus on, how much credit do SMEs need? In other words, what is the demand for credit? And what is the supply? And if there is a gap, why is that? I’ll turn to these questions next.