Getting small firms to make big strides

Densil A. Williams, Contributor 

If small firms are to fulfil their mandate as creators of jobs and wealth for the masses, Government, as well as multilateral institutions, and stronger private-sector institutions, must adopt a coherent set of policies, including managerial training and creative ways to provide collateral for loans. These will ensure increased lending to small firms while reducing risks to the banks.

Both academic and practitioners' literature is replete with empirical evidence which suggests that raising financing is one of the most pervasive problems faced by micro, small, and medium-size enterprises - MSMEs (for ease of reference, small firms will be used to refer to MSMEs) in almost all geographical locations. This is especially so in small cash-strapped economies like Jamaica, where capital is generally scarce. The growth and survival of these firms depend significantly on their ability to raise financing to meet their working-capital needs, buy capital equipment and improve production capabilities, among other things.

Academic studies have shown that failure rate among small firms is very high, averaging about 90 per cent, although it varies significantly across sectors. Securing financing is strongly related to the sector in which a firm is established. While this is generally true, the situation in Jamaica shows that financing problems affects all sectors. Why do small firms find it so difficult to access financing, and what can be done to reverse the situation?

THE IMPORTANCE OF FINANCING SMALL FIRMS

It is an indisputable fact that small firms play a significant role in the economic life of any country. They contribute to economic output as measured by their share in gross domestic product (GDP), provide employment opportunities, help in the development of local communities because of their close links with the local economy, and are generally credited with being innovative.

These benefits are true for economies everywhere. For example, the Planning Institute of Jamaica (PIOJ) suggests the small-firm sector contributes more than 33 per cent to employment each year, and in 2009 the actual figure was 36 per cent. A similar contribution is reported for the US economy. Contribution to economic output is also high. The US small-business association reported that small firms contribute more than 50 per cent to GDP. In Jamaica, the figure is about 32 per cent. These contributions are by no means insignificant, hence, policymakers, both in the private and public sectors of the economy, must find creative ways to help these firms overcome their most pressing challenge, that is, raising financing for their operations. A call for the financing of small enterprises is, therefore, most urgent and relevant.

Financing for small firms is an emotive issue in many economies. In most developing economies, especially those with weak economic structures and high levels of poverty, credit to small firms is used as a social safety net and anti-poverty initiative. Where small firms are generally owned by poor households, public financing of these enterprises is normally seen as empowering the owners. For example, in Jamaica, a poor, low-growth developing economy, a significant portion of the small firms in the economy are classified as 'own accounts', namely, businesses operated by single individuals without any employees. Government credit to these enterprises usually flow based on social needs rather than economic rationale and in some cases poses a moral hazard. Because funds are provided by the Government, borrowers are not always inclined to repay in a timely manner and, in some cases, they do not repay at all. Government subsidies are, therefore, an unprofitable and unsustainable way to finance small enterprises.

Offering credit through market-based schemes is the best way to ensure greater sustainability and efficiency in financing small enterprises. In an insightful paper titled 'Strategy of Financing Small and Medium Enterprises in a New Economic Environment', Thomas Timberg noted that: "Market-based credit schemes are not only able to sustain access to banking services, but also function as a catalyst in developing the self-reliance and entrepreneurship of small-scale entrepreneurs." Timberg argued that subsidised credit is unprofitable for banks and, moreover, their amount is limited given the heavy dependence on government budget. If small firms are to get the desired financing to help them improve their international competitiveness, it is clear that the private market has to play a stronger role in financing these enterprises. This is especially true for economies such as Jamaica's, where government budget deficit is high and the fiscal space to provide subsidised credit is limited.

ASSESSING SMALL FIRMS' FINANCING OPTIONS IN CASH-STRAPPED ECONOMIES: THE CASE OF JAMAICA

The Jamaican economy has witnessed a long period of macroeconomic instability and anaemic economic growth, largely caused by irresponsible and profligate fiscal management. The Government's appetite for credit forces the price of credit upwards (interest rate on loans) and, therefore, prevents private capital from investing in productive activities such as those in which small firms are engaged. In the jargon, this is called 'crowding out'. It is no surprise, therefore, that a significant portion of small firms do not borrow from the private market.

My own research which investigates the financing of small, family-owned businesses in Jamaica found that less than one per cent of firms took a bank loan for business start-up. The research also found that the major source of financing for start-up activities came from owners' personal savings. Borrowing from family members was also another option. Other sources such as government grants, credit cards, overdraft on current accounts etc. accounted for a sizeable portion of the source of financing to start-up operations among small firms.

While small firms shy away from borrowing for start-up operations, interestingly, when they are expanding, most firms actually borrow from commercial banks (almost 50 per cent as against zero in the start-up phase). It appears that once businesses become mature and understand the market, their institutional capacity becomes stronger and, as such, they are more confident to borrow from the private market.

Loans to the small-business sector are channelled through the Government or the private market. The Government has wholesalers such as the Micro Investment Development Agency (MIDA), Development Bank of Jamaica (DBJ) and Development Options which provide loans to the sector. In 2009, the amount of loans disbursed through wholesalers was more than J$1.6 billion (50 per cent above the amount disbursed in 2008). Retail lending, which is mainly done through the private market, also increased in 2009.

The three major institutions (National Commercial Bank - NCB, Jamaica National - JN, and Bank of Nova Scotia - BNS) which lend to the small-firm sector had more than J$9.5 billion in loanable funds among them in 2009. Between the wholesale and retail markets, loanable funds for the small-firm sector in 2009 stood at more than J$11 billion. This is close to one per cent of the country's GDP. These funds are generally provided at concessionary rates to the small-firm sector. Besides these concessionary loans, other loans are available which are not specifically designed for the small-firm sector.

With almost one per cent of the country's GDP dedicated to providing special financial assistance to the small-firm sector, why is financing still a major problem for this sector? Small firms' unwillingness to borrow for start-up suggests that the problems in the small-firm sector are more serious than what the data suggest.

My own research showed that only a small percentage of entrepreneurs opted for loans from the private market to start up their enterprises and that even fewer were successful in accessing the loans applied for. This suggests that the small firms are not 'bank-ready'. Accessing loans on the private market requires borrowers to adhere to strict conditions, including proper record-keeping, proof of ability to repay the loan (i.e. having good collateral), and good corporate governance, among other things.

By and large, small firms in Jamaica lack these prerequisites. Their operations are normally informal and they suffer from constraints such as low managerial capabilities, poor production facilities and inadequate marketing capabilities. These inadequacies increase the risk for banks which lend to small firms. Simply put, small firms need to be better prepared if they want to access capital for business start-up and growth.

STRATEGIES FOR IMPROVING BANKABILITY

If small firms are to fulfil their mandate as creators of jobs and wealth for the masses, merely providing credit is not a sufficient condition to help them achieve these goals. Technical assistance is critical in order to help them to improve their bankability. Government, multilateral institutions and, stronger private-sector institutions should play a role in this regard. A few things can be done to improve bankability:

1. Government and multilateral institutions should provide special training programmes to address deficiencies in managerial capabilities, entrepreneurship thinking, marketing capabilities and production capabilities. These programmes do not have to be organic. Lessons from countries with successful credit programmes such as Indonesia can be adapted in the Jamaican context.

2. Private institutions need to find creative ways to serve the small-business sector. Providing concessionary loans is not sufficient. Special institutional arrangements must be established to serve the credit needs of these enterprises. Similar to the Indonesian case, community ties can be used as a form of social collateral for lending. For this to work, however, there must be simple and clear procedures coordinated with the right technical assistance. This is the only way social collateral is going to be successful.

3. Unused government assets can be used to collateralise loans for small firms. Setting up a national collateral agency with clear rules and supervision will help more small firms access credit in a timely manner. The moral-hazard problem once Government is involved will have to be guarded against.

CONCLUSION

Most small firms in Jamaica are not ready for sophisticated forms of investment capital such as venture-capital funding, angel investments or even private equity such as trading on the Junior Stock Exchange. The major sources for capital, therefore, remain the wholesale and retail markets financed by government and private banks. To access these funds, small firms will require a lot of training to improve their bankability. Without targeted technical assistance, lending to the sector will always be low and financing will always be a problem. Technical assistance will help to alleviate the risks to banks and also help to solve the moral-hazard problems in the wholesale market.

The strategies proposed above are ways to reduce the risks to banks and ensure that increased lending is driven by commercial market forces, not government. Government lending is less efficient than private capital. What small firms in Jamaica, and anywhere else for that matter, need in order to improve their competitiveness is efficient credit, not merely credit.

Densil A. Williams is senior lecturer in international business and head the Department of Management Studies at UWI, Mona. Email feedback to columns@gleanerjm.com.