Small and Medium Enterprises – What Works? What Doesn’t?

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.

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.

Further reading (cited in hyperlinks above):

1. Ayyagari, Meghana, Thorsten Beck, and Asli Demirgüç-Kunt. 2007. “Small and Medium Enterprises across the Globe.” Small Business Economics 29: 415-434.
2. Beck, Thorsten, Asli Demirguc-Kunt, and Ross Levine. 2005. “SMEs, Growth, and Poverty: Cross-Country Evidence.” Journal of Economic Growth 10(3, September), 197 227.
3. Beck, Thorsten, Aslı Demirgüç-Kunt, and Vojislav Maksimovic. 2005. “Financial and Legal Constraints to Firm Growth: Does Firm Size Matter?” Journal of Finance 60(1, February): 137-177.
4. Beck, Thorsten, Aslı Demirgüç-Kunt, Luc Laeven, and Vojislav Maksimovic. 2006. “The Determinants of Financing Obstacles.” Journal of International Money and Finance 25(6, October): 932-952.
5. Beck, Thorsten, Aslı Demirgüç-Kunt, and Vojislav Maksimovic. 2008. “Financing Patterns around the World: Are Small Firms Different?” Journal of Financial Economics, Vol 89, No. 3, September 2008.
6. Beck, Thorsten, Asli Demirguc-Kunt, Luc Laeven, and Ross Levine. 2008. “Finance, Firm Size, and Growth.” Journal of Money, Credit and Banking, Vol 40, No. 7
7. Beck, Thorsten, Aslı Demirgüç-Kunt, and Vojislav Maksimovic. 2006. “The Influence of Financial and Legal Institutions and Firm Size.” Journal of Banking and Finance 30(11, November): 2995-3015.
8. Klapper, Leora, Luc Laeven, and Raghuram Rajan. 2006. “Entry Regulation as a Barrier to Entrepreneurship.” Journal of Financial Economics 82(3): 591-629.
9. Klapper, Leora. 2006. “The Role of “Reverse Factoring” in Supplier Financing of Small and Medium Sized Enterprises.” Journal of Banking and Finance 30(11, November): 3111-3130.
10. Berger, Allen N. and Gregory F. Udell. 2006. “A More Complete Conceptual Framework for SME Finance.” Journal of Banking and Finance 30(11, November): 2945-2966.
11. Beck, T., Demirguc-Kunt, A., and Martinez Peria, M.S., 2009. Bank Financing for SMEs: Evidence Across Countries and Bank-Ownership Types. World Bank. Mimeo.
12. De la Torre, A., Martinez Peria, M.S., and Schmukler, S., 2010. “Bank Involvement with SMEs: Beyond Relationship Lending.” Journal of Banking and Finance, Forthcoming.