Support for SMEs: lucrative or futile?

Assistance to small and medium enterprises only makes sense if it addresses the key constraints and allows them to grow into larger and more productive enterprises. But what do we really know about the effect of supporting SMEs?

Assistance to small and medium enterprises only makes sense if it addresses the key constraints for SMEs and allows them to grow into larger and more productive enterprises. Many countries and international financial institutions (IFIs) have special programs to support SMEs. But just because everyone is doing it doesn’t necessarily make it “right”. What are some of the pros and cons for SME support, what are some of the challenges, and what do we know about the effect of supporting SMEs?

Some pros and cons

SMEs account for about two thirds of formal employment in developing countries and typically the poorer the countries are, the larger the share of smaller (as well as informal) enterprises.¹ SMEs tend to be particularly affected by a wide variety of constraints, such as access to finance, poor infrastructure and the investment climate, which larger firms can overcome more easily. Small enterprises tend to have faster growth rates than larger ones and contribute more to job growth;² however, they also tend to have higher failure rates. These dynamics illustrate the importance of supporting SMEs, especially for local economies, yet with a keen focus on regular evaluation of which strategies work and which fail to yield results.

Large firms tend to be more productive, offer higher wages, more training and often also better working conditions – and through their value chains provide opportunities for smaller enterprises. Enterprise surveys show that compared to small enterprises, productivity in large enterprises is on average three times higher, wages are twice as high, and about twice as many large firms provide formal training for their employees – and the pattern is even stronger in Sub-Saharan Africa.

Rather than supporting SMEs directly, it may often be better to address the underlying problems. For example, if the problem is a lack of access to finance for SMEs, credit lines for SMEs are one option. Alternatively, support could focus on information asymmetries and the high cost of gathering information about the creditworthiness of smaller enterprises more directly by establishing credit and collateral registries. Movable assets such as inventory, accounts receivable, livestock, equipment, and machinery can serve as collateral for secured lending mechanisms. Registries documenting these transactions are a vital part in governing this mode of finance. Secured transactions reforms have proven to unleash credit potential especially for smaller enterprises. In China, secured transactions law reform led to a significant increase in the size of banks’ SME lending portfolio, by up to 25 percentage points in 2008-2010. About 20 percent of the increased financing went to businesses owned by women.

Similarly, power generators have been shown to significantly improve the performance of SMEs (e.g. including job growth), but they are very expensive and unreliable electricity would better be addressed by investing in more power generation and more efficient transmission and distribution. Such more systemic approaches will benefit all enterprises, but particularly smaller ones, since they are disproportionately affected.

Let the market decide?

We still don’t know enough about SMEs: for example, a lack of clear definitions hampers consistent data gathering,³ making it very difficult to compare performance across countries. Furthermore, we still don’t know very much about how to identify “gazelles”, ex-ante enterprises that are likely to grow fast. Finally, it is often difficult to assess the relative importance of different factors, such as external events, credit, advice, etc.

Clearly allowing SMEs to enter the market easily and to grow into larger – typically more productive – enterprises is essential for economic growth and job creation. In a well-functioning market economy, this happens through constant re-allocation of resources (e.g. financial and labour) to more productive enterprises, and exit of failing or under-performing enterprises. More research is needed to determine which approach to supporting SMEs works best – e.g. directly, through larger enterprises or financial intermediaries, or by improving the enabling environment – and how best to sequence and combine these different approaches. For example, a forthcoming impact evaluation conducted by the Office of Evaluation of the Inter-American Development Bank found that improving access to finance for SMEs clearly resulted in stronger job growth, but that the effects were even stronger when finance was combined with advice.[4] Previous evaluations such as the IEG evaluation Financing MSMEs: An independent evaluation of IFC’s experience with financial intermediaries in frontier countries demonstrated that combining investment with advice was associated with a much higher development outcome success rate (76% vs. 55% where only investments were provided). Advisory services can provide know-how to either financial intermediaries (e.g. helping them set up an SME department with specialized loan officers, improving the assessment of risks or efficiencies) or to micro small and medium enterprises (MSMEs), e.g. helping the latter to develop business plans, access markets or improve operational performance, which in turn lowers the risk for the financial intermediary. This know-how supplements financing, which alone may not be sufficient to help SMEs grow and thrive.

These findings show that the potential of SMEs can only be realized with assistance which addresses the complex constraints preventing enterprises from growing in a comprehensive manner. A combination of advice and investment might be just the right solution to get those constrained gazelles up and running.

Footnotes