Smart finance to induce growth and reduce poverty (01)

Can access to finance be a driver of the economy? I have developed a paper - 10 pages long - in which I have tried to answer this question. Given the limited space of this blog, I will just share with you the main conclusions. Of course, your comments and conributions are welcome. Thanks!

There is a general consensus that access to finance is one of the major impediments to SME development in transition and developing countries, particularly for export led businesses. In recent studies, SMEs identify financing, especially medium to long-term finance[1], as their topmost obstacle to growth and investment[2].

Evidence suggests that the challenge for improving SME’s access to finance lies in understanding the market and its needs. In most developing and transition countries, rural farm and non-farm activities and urban informal businesses constitute 90 % of wealth creation. Recent empirical studies show that SMEs and informal enterprises account for over 60% of GDP and over 70% of total employment in low-income countries. The study also indicates that the relative importance of SMEs and the informal sector (shadow economy) are inversely associated with economic development. In low-income countries, especially in the least developed economies, the contribution of SMEs to employment and GDP is less than that of the informal sector, where the great majority of the poorest of the poor make a subsistence level of living. Up to 80% of people in developing countries derive their incomes from the informal sector. Thus, the need for good financial mechanisms to support wealth creation and financial services in this sector is crucial.

Smart finance is a holistic (integrated, sector-focused) approach associating technical assistance (TA) with lending activities. It is based on the current best practice which brings TA and access to business information into the mainstream of financial services in order to mitigate operational risks and ensure investment sustainability.

A smart finance will lead to increase income and make markets work for the poor through improved access to demand driven financial services coupled with appropriate business development services. It represents the view that to be sustainable, access to finance for SME can no longer be dissociated with BDS or technical assistance. Access to finance is all about managing risk and making the business of the beneficiary profitable. Smart finance requires the followings:

o Understanding the market and copying strategies for borrowers, particularly the poor rural household (household practice of diversifying activities as coping and risk management strategy)
o Think in terms of market segment having specific needs to be addressed (the opposite of treating the market as a homogeneous entity).
o Address the risk that are inherent to their activity and be specifically responsive to the vulnerable groups (gender, rights based and equity issues).
o The provision of BDS services to support the lending activities and to address the barriers which are synonyms of additional cost and lack of compatibility. The right technical assistance and advisory capacity are crucial.
o Address information asymmetry issues by supporting access to business information services.
o Integrating the suppliers which remain the main source of funding, particularly for agricultural producers (both exporters and producers for local markets)
o The development of new financial instruments based on best practice ( what works, what does not work) and focusing on better understanding of the demand. Distinguish short term needs (social and safety net, working capital) from long term needs (investment, equity and seed capital). The loan guarantee schemes implying cost and risk sharing mechanisms seem to produce very encouraging results. Support broader donors partnerships based on capacity and distinctive advantages and expertise and risk sharing based on capacity.

A viable access to finance strategy should inevitably support this framework along specific cluster, particularly on export led supply chains.

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[1] Beck, T. A. Demirguc-Kunt and V. Maksimovic (2005), Financial and legal constraints to firm growth: does size matter.? Journal of Finance, Vol 60, No 1, pp137-177
[2] Ayyagari, Meghana., Thorsten Beck, Asli Demirgüc-Kunt (2003), “Small and Medium Enterprises Across the Globe”, World Bank Policy Research Working Paper 3127, August, Washington D.C.

Next, I will publish the policy recommendations. Thanks for your comments.