Making capital accessible to small and medium enterprises in the developing world
On October 22, GMF hosted Pierre Jacquet, Chief Economist of the French Development Agency (AFD) and a panel discussion with Director of Capital Studies at the Milken Institute Dr. Glenn Yago, COO of Microfinance International Corporation (MFIC) Kai Schmitz, and GMF Program Officer Jonathan White, that examined the approaches challenges of making capital more accessible to Small and Medium Enterprises (SME) in the developing world. The event coincided with the launching of the joint GMF/Milken report Transatlantic Innovations in Affordable Capital for SMEs : Prospects for Market-Based Development Finance, co-authored by Dr. Yago, Mr. White and Daniela Roveda, a Senior Researcher of the Milken Institute.
In recent years, development agencies have changed their task from transferring money from one government to another to providing catalytic solutions and creating markets. Mr. Jacquet described this "revolution" in development as the implementation of new practices and policies that leverage partnerships with donors, international financial institutions (IFI), foundations, nongovernmental organizations (NGO), local governments, and other actors. Development is not just about "resources" and must involve new forms of collaboration. However, many obstacles still hinder private sector development in the developing world, such as poor infrastructure, weak business environments, corruption, gender discrimination, a lack of training, poor standards and management, and limited access to capital. To avoid fads and falling into the trap of "one dominant idea," as has been the case in the past, we must consider multiple and interconnected perspectives. He described this new way of thinking about development as getting beyond the "Cartesian mind."
AFD is the main operator for French bilateral aid with two primary functions: a development bank that gives concessional loans and a distributor of grants. The goals of AFD include poverty reduction, economic growth, and supporting global public goods. Furthermore, it is a bilateral agency that is particularly interested in making finance and markets work for the poor. In the poorest countries around 80% of the economy is informal, so development agencies must adapt to reach the informal economy. These firms have few incentives to pursue formal capital or adopt formal accounting and business practices. The "formalization" of small enterprises by lowering costs and barriers to capital and through training will help foster private sector development.
In Vietnam, AFD is supporting SME development by supporting the improvement of the legal and regulatory environment and simplifying financial documents. AFD tries to find solutions based on the reality on the ground. In the area of finance, it is deepening its work in the microfinance sector, reaching SMEs through innovative schemes and strengthening direct support to local banks and financial markets. Examples of these strategies include risk-sharing guarantee funds, increasing access to equity, and helping develop local currency instruments. Mr. Jacquet emphasized that the financial instruments available to developed nations must be made available in and adapted to the volatility of the developing world. Examples such as counter-cyclical loans for cotton are a way to deal with potential debt problems. Developed countries also need to focus on responsible lending and covering risk for the poorest.
Importantly, official development assistance (ODA) consists of concessionsal loans and grants, but not guarantees and these other kinds of financial instruments being used. Public discussions tend to focus on ODA and that drives policy-making. Accordingly, the growth of these financial innovations is limited as a result. ODA needs to be modernized to reflect these new forms of assistance by moving beyond traditional resources. We need to "explode these constraints" on alternative approaches to development.
During the panel discussion with Dr. Yago, Mr. White and Mr. Schmitz, findings and experiences inSME development were discussed in greater detail. In line with Mr. Jacquet's belief that "countries are largely unhinged because they are un-hedged," Dr. Yago emphasized the need to re-invent non-sovereign tools in fragile states to help cover risk. Corporate finance innovations over the past thirty years have created numerous financial innovations, lowering risk premiums, and creating scalable economies. Yet, these events have left emerging markets largely untouched. There needs to be a "democratization of capital" in these countries to allow entrepreneurs to thrive and a middle class grow. There are foreign policy implications from helping small enterprises gain access to capital.
Through his research, Dr. Yago has found that a driver for growth in developed countries is ownership. Around 66 percent of national income growth in advanced economies is from SMEs while the number is only 18 percent for developing countries. While the introduction of microfinance has revolutionized development finance, MFIs have only penetrated 9 percent of the market. Dr. Yago went on to say that this is a "transfer payment conception substitute rather than the creation of pools of capital."
This "missing middle" must be bridged by not only upstream innovations from the microfinance level and downstream financing from banks, but also from new approaches by new organizations, both nonprofit and for-profit, including direct investors, remittance facilitators, and service and information providers who are reshaping the way we think about SME finance. Like AFD, companies and organizations such as Agora Partnerships, Root Capital, Microfinance International Corporation, and Small Enterprise Assistance Funds (SEAF) offer credit and capacity building to ensure sustainable growth. Whether it's providing direct investment to grassroots companies, channeling remittances into entrepreneurial activities, or providing services and technology to generate credit information or helping with strategic planning, these innovators seek to align interests of the SMEs with their investors to help achieve profitable rates of return. This project was about highlighting such innovators both in the U.S. and Europe and areas of possible collaboration.
Mr. Kai Schmitz, who is helping U.S.-based Latin American immigrants channel remittances to their home countries for enterprise development, stressed that there is a difference between microfinance institutions and SMEs. There are limits to what microfinance can do and their impact on growth is not fully validated by the data. He said, "there are so many things that SMEs need that MFIs cannot do." While microfinance institutions (MFI) usually provide credit under $5,000, they are hard-pressed to lend to SMEs that usually look for more than $10,000. Similarly, small and informal companies with no exit mechanism make it difficult for bigger banks to invest at that level. There is a danger to trying encouraging these banks to service SMEs when they choose not to do so on their own and when they are not prepared or capable of doing so. Mr. Schmitz believes the crucial factor is helping SMEs build tools to enable them to efficiently absorb capital and training.
In the discussion that followed, various participants from different sectors including governmental, private sector, nonprofit and multilateral agencies sought to address the future goals for SME financing. Most agreed on the need for greater collaboration. Many also argued that donors and banks in Sub-Saharan Africa should create more transparent SME programs which show the results of their loans (to track and monitor them). Some expressed caution about the kind of support donors give to local banks due to limited transparency and moral hazard problems with encouraging local banks to development products and services for SMEs. Others stressed the need to focus on infrastructure building and regional markets that help foster more robust supply chains for enterprises to take advantage of. Looking forward, panelists encouraged a cross-sector dialogue in order to evaluate the progress and the challenges that lay ahead.