It’s not just the economy, stupid

Inclusive Economy01 Oct 2014Caroline Reeg, Markus Loewe

A “good business environment” has been cited over and over as a decisive factor for SME development. Yet upgrading a micro enterprise to a small or medium-sized business requires a lot more than that, argue Caroline Reeg and Markus Loewe.

Most low- and middle-income countries (LMICs) have a lot of micro enterprises but only a few large and medium-size enterprises. This phenomenon is often labelled the ‘missing middle’ and constitutes a problem because medium-size companies can be seen as the backbone of an economy: They create higher quality wage employment, drive innovation and economic diversification and may contribute to future exports.

The question is thus why the gap exists – and how it can be filled. There are two ways to tackle the missing middle: the immediate launch of medium-size companies by direct investment – and the growth of micro or small enterprises (MSEs) into the medium-size segment.

A popular strategy to tackle the missing middle is therefore to promote MSEs by providing micro credits, improving business registration processes and upgrading infrastructure. It is based on the assumption that a considerable number of MSEs would develop and grow if only the framework conditions of doing business were more favourable.

However, in many cases business reality has not met expectations. Across LMICs, only very few MSEs have actually become medium in size – even where governments have substantially improved the business environment. Egypt, for example, was labelled a top reformer by three consecutive Doing Business reports between 2008 and 2010, yet the number of medium-sized companies in the country remained very small.

The reason is that MSE growth depends as much on internal factors as on the business environment. Many MSEs produce the same products with the same methods, with the effect that markets are crowded and competition is high. Single companies can therefore only grow if they innovate and become distinct from the rest. A garments producer in a satellite town of Cairo, for example, started as a tailor in his father’s clothes shop and now, 15 years later, has more than 500 employees despite manifold bureaucratic challenges. This is because he has understood what kinds of clothes Egyptians not only want but can also afford. Hence, innovation requires more than good framework conditions: The entrepreneur must be creative, ambitious, clever, well informed. She or he must understand that it is important to have access to good market information, to invest in new products and production processes and to keep talented workers in the company even if this requires paying higher wages.

A recent study by the German Development Institute (DIE) on the factors of MSE upgrading in Egypt, India and the Philippines has found that entrepreneurs with these characteristics are able to grow even if the framework conditions are not at all ideal. Some MSE owners can compensate for lengthy administrative procedures, deficits in the rule of law, lack of skilled workers and deficits in the access to formal credit by the fact that they have enjoyed quality education, work experience in their economic sector and exposure to international trends, ideas and relevant business networks. Also, in making risky investments they benefited from the financial and moral support of friends and relatives.

In order to mobilize more upgrading of MSEs, development policies must use a larger set of instruments. There is no question that many countries have to continue and intensify their efforts in improving the business environment. As argued in arecent contribution by Tara Sabre Collier infrastructure investments and regulatory reforms are necessary to spur economic dynamism. Clarifying laws and streamlining procedures may further reduce the perceived costs and insecurities of micro and small entrepreneurs when interacting with bureaucracies, particularly on tax and labour issues.

However, to enable MSEs to make use of an improved business environment, policies must also address the potential of MSE owners themselves. This requires a much more systemic approach: First, a fundamental reform of the education system, which must provide labour-market entrants with the ability to analyse, be creative, be critical and work in teams. In some countries, that requires comprehensive reform of the whole school system where students memorize what teachers have told them rather than analyse and discuss topics. Second, improved vocational training systems should provide entrepreneurs with a better skilled workforce. Third, information campaigns that are geared towards improving the financial literacy of entrepreneurs and their ability to draft business plans. And fourth, support of linkage-building as well as cooperation between SMEs and large enterprises across industries. In some countries, a lot could already be achieved in this regard by judicial reforms; one reason why companies are reluctant to cooperate is that contract enforcement is extremely difficult in these countries.