Financing of small and medium enterprises in asia:credit rationing, adverse selection, and information asymmetry

Nội dung text: Financing of small and medium enterprises in asia:credit rationing, adverse selection, and information asymmetry

1. FINANCING OF SMALL AND MEDIUM ENTERPRISES IN ASIA:CREDIT RATIONING, ADVERSE SELECTION, AND INFORMATION ASYMMETRY Hervộ B. Boismery - University of La Reunion (France) Tran Kieu Trang - Vietnam Commercial University Abstract The purpose of this paper is to explore the causes of financing difficulties of small and medium-sized enterprises in the Asian context. Recent literature suggests that lack of capital is the most severe constraint for SMEs’ survival and growth Financing remains a critical constraint for several reasons. Information asymmetry between banks and SMEs retards the loans applications and underdeveloped equity markets deny SMEs future growth opportunities. It results a structural “credit rationing” that impairs a socially balanced development. Enabling policymakers to assist SMEs in their search for financing will stimulate the economic growth and contribute significantly to the alleviation of poverty. Keywords: Asian Countries, SME Lending, Financial Development, Information Asymmetry, Adverse Selection, Credit Rationing, Firm Behavior. The Law of Supply and Demand is not in fact a law, nor should it be viewed as an assumption needed for competitive analysis. It is rather a result generated by the underlying assumptions that prices have neither sorting nor incentive effects. The usual result of economic theorizing that prices clear markets is model specific and is not a general property of markets. Unemployment and credit rationing are not phantasms. Joseph E. Stiglitz and Andrew Weiss (1981) – ‘Credit Rationing in Markets with Imperfect Information’ The American Economic Review, Vol. 71, No. 3. 1- Introduction Although the various regions of the world differ significantly in their socio-economic characteristics, the fundamental financing difficulties that the small and medium-sized enterprises ( SMEs) face around the world are often similar (Boocock and Wahab- 2001). The ability of SMEs to develop, grow, sustain and strengthen themselves is heavily determined by their capacity to access and manage finance. Unfortunately, SMEs, including micro- enterprises and start-ups, in the developing countries of East and South Asia, consistently cite lack of access to finance as a serious obstacle to their development and the necessity of effective governmental interventions have been suggested (ESCAP-2009). SME financing refers to a range of mechanisms to provide additional funds for development of SMEs. There are several noteworthy aspects of SME financing. The ability to increase capital relatively quickly in response to SMEs growth is a key feature, especially with venture capital in high-tech sectors. Another salient characteristic of SME financing is complementarity, as it augments existing traditional sources of financing in many contexts. Effective finance is also sustainable in the sense that the funding of successful SMEs begets more capital for future SMEs, thereby creating a virtuous cycle. 15
2. This paper deals with a pressing empirical and policy issue that has affected developing Asia since its take-off and especially since the global financial crisis. Why do small and medium-sized enterprises not borrow more from commercial banks, which dominate financial systems in the region? The motivation for studying SME finance and firm characteristics related to financial access stems for their important contribution to economic development in Asia and the unfolding implications of the financial access on the growth. SMEs, seen as the backbone of production, employment and poverty reduction in East Asian economies, have returned to the spotlight due to the role they play in the continuing expansion of trade globalization across the region and in the recovery of the world economy following the 2007- 2009 crisis. Recent literature suggests that lack of capital is the most severe constraint for SME survival and growth. Enabling policymakers to assist SMEs in their search for financing will boost economic growth and sustainable development. This paper begins with a brief description of SMEs’ definitions and types. It continues with an examination of the current situation of SME financing in the Asian region and the financing needs of SMEs in different growth stages. It appears that financing is a critical constraint for SMEs for several reasons. Many SME owners do not manage working capital effectively. Moreover, information asymmetry between banks and SMEs retards the loan application and approval process, and underdeveloped equity markets deny SMEs future growth opportunities. In accordance with Stiglitz and Weiss (1981) and Storey (1994), the SMES are penalized by factors that are related with the rationing credit, as the high fixed cost of information research and the variety in credit conditions (interest rate, terms and other conditions like collaterals or mortgage requirements). Nevertheless, policymakers can ameliorate conditions by serving as facilitators and communicators. It is hoped that some policy prescriptions will enhance the growth and survival prospects of SMES, thereby decreasing their high ‘mortality rate’ and creating more employment, innovation and economic growth. 2- Significant Data and Descriptive Analysis Definitions of what constitutes an SME in East and South Asia vary quite widely from country to country and even within single countries, depending on the business sector concerned, such as agriculture, natural resources, manufacturing services, and retailing (ESCAP-2009). For this reason, international comparisons are often difficult, despite the universal socio-economic dimension of the phenomenon. 2.1- A Difficult Concept: Definitions and Typologies of SMEs There is no universal criterion of an SME, but the three main parameters that have been generally applied to define SMEs are the number of employees, the turnover of business and the capital investments. Table 1 summarizes the definitions of SMEs among selected East and South Asian countries and multilateral organizations. Both the number of employees and the size of investment are mainly used for such national definitions, while some countries also set separate definitions among different SME segments, such as manufacturing and services. Developing countries in East and South Asia typically define SMEs, including micro- enterprises belonging to the informal sector, as commercial entities with < 100 300 employees (Asian Association of Management Organizations AAMO-2007). As we can check it, in Viet Nam, the criterion of definition remains extensive and does not seem− 16
3. accurate, considering an employment 300 employees and a capital VND 10 billion (450,000 $US). The definition in each national context≤ facilitates the targeting of policy ≤interventions in a specific group of enterprises, such as the provision of technical assistance, fiscal and financial concessions, and other incentives. It also makes the physical identification of SMEs on the micro level possible, encouraging better articulation of the problems and prospects of the sector. It indicates that the more precise the definition is, the more effective is the efficiency of SME policies. Table 1- Definitions of SMEs in East and South Asia and by Multilateral Organizations Country Category of Criteria and country’s official definition Measure enterprises China Manufacturing Small <300 employees; turnover< 20 Million yuan Employment and turnover Medium 300-1000 employees; turnover 20-40 Million yuan India Manufacturing Micro Rs 2.5 Million Small Rs 50 Million Manufacturing enterprises defined in Medium ≤Rs 100 Million terms of investment and equipment. -Services ≤ Micro ≤Rs 1 Million Small 20 Rs 20 Million Medium ≤50 Million ≤ ≤ Indonesia SME <100 employees Employment Malaysia Manufacturing Employment or annual sales return Micro <5 employees or <RM 250,000 Small 5-50 employees or RM 250,000-10 Million Medium 51-150 employees or RM 10-25 Million Services (including ICT) Micro <5 employees or RM 200,000 Small 5-19 employees or RM 200,000 -1 Million Medium 20-50 employees or RM 10-25 Million Thailand Manufacturing and services Employment and capital Small <50 employees or capital 50 Million Baht Medium 51-200 employees or capital 51-200 Million Baht ≤ Vietnam SME 300 employees; capital VND 10 billion Employment and capital United SME ≤200 employees ≤ Employment Nations (UNDP ≤ World Bank SME 300 employees; turnover US$ 15 million; Employment, turn over and assets Assets US$ 15 million ≤ ≤ ≤ Sources – Abe, M.; Troilo, M.; Batsaikhan, O. (2015) –op.cit. Table 2 offers various categories for the SMEs’ typology influencing their foundation, survival and growth. The table specifically explains the category-based system where several indicators of business could be considered for SME development policies. This system might be used to assist policymaking for taxation, capital requirements, and market orientation/access. Each SME unit should fall in a particular grid based on the categories explained below, which in turn provides policymakers guidance and flexibility while drafting 17
4. policies. For example, appropriate measures may help the company, which is innovative but is domestic market oriented, to enter into foreign markets. Table 2 – Categories for SME typology Topic Category 1 Category 2 Category 3 (if applicable) Stage of economic Low income Middle income High income development $1,025 or less $1,006 to $12,475 $12,476 or more e.g. Lao PDR or e.g. Thailand or e.g. Japan or Korea Cambodia Vietnam Market orientation Born global Domestic Domestic or gradual Pace of innovation global Incremental Use of technology Incremental and Isolated radical Corporate life stage Mature (5+years) Nascent (<2 years) Increasingly connected Young (2-5 years) Source- Abe, M.; Troilo, M. and Batsaikhan, O. (2015): op.cit. 2.2- SMEs: Socio-Economic Dimension and Realities Table 3 provides statistics on the contribution of SMEs to employment, gross domestic product and exports in several Asian countries including China. We can observe that SMEs contribute much to employment, to economic activity but less to trade, China excepted. - As a share of employment, SMEs contribute the most in Indonesia (97.2%), followed by China (80%), Thailand (78%) and Vietnam (77%). - SMEs contribute more than 50 % of GDP in China and Indonesia, and around 30-40 % in Malaysia, Thailand, Philippines and Vietnam. - The share of SMEs’ participation in exports (direct and indirect) ranges from 60 % for China, 29.5 % for Thailand, and more or less 20 % for Malaysia, Philippines and Vietnam. Table 3 – SME: Contribution to total employment, to GDP and to total exports. Countries Employment GDP Exports Countries Employment GDP Exports China 79.8 % 59.8 % 60.0 % Vietnam 77.0 % 40.0 % 20.0 % Malaysia 58.9 % 31.9 % 19.2 % India 40.2 % 17.4 % 40.3 % Thailand 77.9 % 38.7 % 29.5 % Sri Lanka 35.3 % 52.3 % 20.1 % Philippines 61.0 % 35.7 % 20.0 % Bangladesh 40.4 % 22.5 % 11.3 % Indonesia 97.2 % 57.8 % 15.8 % Korea 87.5 % 49.4 % 30.9 % Source – Various statistical agencies (ASEAN SME data; Business in Asia; PRC Ministry of Industry and Information technology; UNESCAP; Xin Hua Agency. Nevertheless, research on the contribution of SMEs to export participation is scarce and sometimes contentious (Wignaraja-2013). More importantly, overall, SMEs appear to make a less-than-expected contribution to international trade relative to their size of employment contributions and to domestic economies (see Harvie et al.- 2010, for the case of ASEAN). It is possible that the average SME is smaller than the threshold size required to gain sufficient economies of scale for competing in export markets. Export participation may be undermined 18
5. by the shortage of access to credit that would help overcome the fixed costs of entering market. The lack of export participation of SMEs may also be due to multiple market failures in relation to SME development and local entrepreneurship. In the Vietnamese context, as we can see in the Table 4, micro, small and medium-sized enterprises (M-SMEs) represent almost 98 % of the total corporate effective in Vietnam, twenty-five years after the beginning of the Doi Moi Policy. The M-SMEs employ almost 47 % of the workforce, affirming as the most dynamic protagonist of the development process in sectors as essential as trade, services, construction and manufacturing, contributing decisively to the diversification and growth of the productive activities. Table 4 – Vietnam: M-SME Landscape (M-SME = micro, small and medium-sized enterprises) 2007 2012 2007 2012 M-SMEs (number) 143,622 333,835 M-SMEs employees (people) 2,835,808 5,129,980 M-SMEs to total (%) 96.3 % 97.7 % M-SMEs employees to total 39.2 % 46.8 % Total enterprises 149,069 341,601 (%) By sector (% to M- (100.0 %) (100.0 %) By sector (% to M-SME (100.0 %) (100.0 %) SMEs) 16.0 % 11.0 % employees 2.6 % 1.8 % Primary industry (*) 41.5 % 39.8 % Primary industry (*) 19.9 % 21.8 % Trade 16.1 % 20.5 % Trade 9.6 % 13.0 % Service 14.0 % 13.8 % Service 21.1 % 23.6 % Construction 18.6 % 15.7 % Construction 39.2 % 31.8 % Manufacturing 8.3 % 9.0 % Manufacturing 7.6 % 7.9 % Others Others (*) Primary industry includes agriculture, forestry and fisheries. Source –General Statistical Office and Asian Development Bank. 3- Exploring Selected Policy and Access to Finance It is hard to portray the overall business environment for SMEs in Southeast Asian economies and disentangle the different effects on firms. One practical method is to use available data on enterprise perceptions to examine the supportive nature of the policy regime facing SMEs in their quest to participate in production activities. 3.1- Perceived Major Obstacles and Access to Finance Table 5 lists the main obstacles to conducting business in five ASEAN economies identified by the SMEs using information from the World Bank’s Enterprise Surveys. These are grouped under three headings: incentive framework, supply-side factors and others. With those data, it is possible to highlight SMEs’ views of major obstacles facing them for all ASEAN economies and for individual economies. Table 5- Perceived major of severe obstacles to conducting business, SME firms (% of SME firms). 19
6. All Malaysia Thailand Philippines Indonesia Vietnam countries Incentives Tax rates 31.9 31.1 54.8 42.9 14.3 16.5 Tax administration 26.7 24.0 49.6 34.2 13.3 12.4 Customs and trade regulations 20.0 20.1 41.0 18.0 12.5 8.7 Political instability 34.7 28.8 84.0 28.9 29.5 2.3 /economic uncertainty Supply side Transport 23.8 11.3 33.6 26.5 23.2 24.2 Electricity 29.6 17.9 42.4 30.6 30.0 26.7 Access to finance/credit 34.6 22.1 44.3 28.5 38.6 39.4 Inadequately-educated force 28.0 24.1 60.2 16.8 15.4 23.7 Access to land 16.0 11.1 11.7 9.6 19.2 28.3 Others Crime, theft, disorder 24.5 25.3 53.7 16.5 21.4 5.8 Corruption 30.1 20.6 59.7 37.4 23.4 9.5 Practices of competitors in 38.9 20.7 55.9 44.5 35.3 35.3 informal sector Source – Wignaraja, G.: Can SMEs participate in global production networks, in Elms, D. and Low, P. (ed.), Global Value Chains in a Changing World, World Trade Organization. Geneva The leading obstacle facing SMEs in all ASEAN economies fails under the heading of other and relates to the practices of competitors in the informal sector. Cited by 38.9 per cent of all SMEs in ASEAN economies, such practices refer to a variety of negative activities including smuggling of goods and inputs, price fixing and other anti-competitive practices. Nevertheless, access to finance follows closely as the second most important in ASEAN economies. This issue seems least severe in Malaysia (22.1 percent) and most severe in Indonesia (38.6 per cent) and clearly crucial in Viet Nam (39.4 per cent). Both the high cost of borrowing and the availability of financing from commercial banks fall under these heading inter-country differences. Moreover, access to finance partly reflects the influence of monetary policies and the development of capital markets. A lack of financing is deterrent to some firms investing in new equipment, technologies and marketing methods which are needed to participate in production networks. Figure 1 explains that time gap between receivables and payables, which is difficult for SME to avoid, requires additional funds for operations. This time gap between cash inflows and outflows is the main reason for SME failure in Asia (Abe, Troilo andBatsaikan – 2015) Figure 1 Costumer Receivables Sales Payment Time Gap Payment to Procurement Payables Supliers Operating funds needed 3.2- SME Credit Gap across Asia Evidence suggests that the financial gap of SMEs is large internationally. Based on statistics of the International Finance Corporation (IFC-2011), 17 million firms (60 % of 20
7. SME worldwide) report that their financial needs are unmet, with more than half of these in Asia. The total global financial gap of SMEs is estimated at $1.5-$1.8 trillion. As Table 6 shows, the total credit gap and the average credit gap per enterprise are sizable in developing Asia. Table 6 – SME Credit Gap in Developing Asia Countries Total Credit Average Countries Total Credit Average Gap (US$ Credit Gap Gap (US$ Credit Gap Billion) per Enterprise billion) per Enterprise (US$) (US$) Singapore 7.1 856,000 Lao PDR 0.2 13,000 Brunei 7.2 736,000 Hong Kong 10.2 733,000 Malaysia 8.1 127,000 Korea 28.5 503,000 Thailand 11.8 126,000 PR of China 62.7 44,000 Philippines 2.3 59,000 Sri Lanka 0.1 54,000 Cambodia 0.4 50,000 India 3.4 56,000 Vietnam 4.3 42,000 Pakistan 2.9 51,000 Indonesia 11.9 29,000 Bangladesh 1.8 17,000 Note- ‘Credit Gap’ is the difference between formal credit provided to SMEs and total estimated potential need based on Mc Kinsey & Co. estimates. Source – International Finance Corporation (IFC): Enterprise Finance Gap Database (2011). The financial difficulty is most widespread in Asia, where 70% of SMEs struggle to access finance. The IFC has estimated that for China and South East Asia the total financial gap is approximately $100 billion, an average of $400,000 per SME (Stein et al.- 2013). Nevertheless, we can observe that in Vietnam the average credit gap reached a median value, comparable to the Chinese situation. 3.3 – SMEs and Finance for Investment Projects To assess how SMEs’ demand for financial access is underserved in developing Asia, it is also imperative to account for supply-side factors that affect SME financing. The relationship between SMEs and lenders depends on the products and services available from the lenders, e.g. domestic and foreign commercial banks. Table 7- Sources of Finance for Investment Projects of SMEs in Asia (% by source) Countries Financed Financed by Financed by Financed by internally banks supplier credit equity or stock sales PR China 80.6 10.6 3.4 5.4 Malaysia 39.8 37.9 5.3 17.0 Thailand 29.7 53.1 3.4 13.8 India 59.8 31.9 4.2 4.1 Lao PDR 79.8 11.2 5.0 4.0 Sri Lanka 50.9 44.0 2.2 2.9 Pakistan 91.4 6.6 0.6 1.4 Philippines 75.6 11.1 8.3 5.0 Viet Nam 78.9 11.9 2.1 7.1 Bangladesh 76.6 13.1 3.1 7.2 Cambodia 75.6 17.2 7.0 0.2 Myanmar 94.2 2.3 1.2 2.3 Note- SME is defined as firms with less than 100 employees. Source- Wignaraja, G. (2015): SMEs Internationalization and Finance in Asia- Asian Development Bank. 21
8. In a recent study, Wignaraja and Jinjarak (2015) examine the relationship between firm characteristics and SMEs’ finance in China and Southeast Asian economies (Indonesia, Malaysia, Philippines, Thailand, and Vietnam). Using recent micro data on over 8000 firms, key findings from their study include: - SMEs typically resort more to internal sources rather than external to finance their activity. - As we can check, in Vietnam, almost 80 % of investment projects are financed internally. - SMEs, which borrow from banks, undergo financial audits and tend to be more steady and exporting. - Personal assets of SME owners tend to matter more as collateral for SME borrowing from banks. 4- SME Financing: Findings from Academic Literature Empirical research strongly backs the notion that access to finance plays a critical role in entrepreneurship. According to a 2009Asian Development Survey of SMEs in 13 countries, obtaining capital is the top constraint for firm formation and growth (ADB-2009). For instance, Chittithaworn et al. surveyed SMEs in Thailand and find that financing is among the top factors constraining entrepreneurs and their enterprises in the country, along with SMEs characteristics, customer and market, the way of doing business and external environment. In Vietnam, Rand (2007) conducted an analysis on SME credit data collected in 2000 and 2001, and estimated that 14-25 per cent of all SMEs in the country face credit constraints. It would increase their debt exposure by 40-115 per cent if the borrowing requirements were relaxed. Interestingly, Rand also finds that non-family-owned enterprises are more likely to be credit constrained than similar family-owned enterprises. The author suggests that this finding is perhaps an indication that policy should be shifted from family-owned enterprises to limited liability companies and private corporations. Otherwise, in a recent book, Lờ Quan (2015) confirms the severity of the financial handicaps faced by the Vietnamese SMEs, the main cause, according to this author, explaining their high rate of ‘mortality’ and bankruptcy. If a country lacks SME financing programs or only provides inadequate ones, then SMEs often approach informal sources for their financing needs. An important study by Tanaka and Molnar (2008) in China find that informal lenders tend to focus on the borrower’s current operations, particularly the seize of receivables, while formal lenders such as banking institutions, largely focus on past performance. This suggests that there is an active market for receivable factoring in China that can be a source of finance for a constrained SME (Tanaka and Molnar-2008). In addition to informal financing sources, companies can also tap trade credit with their suppliers. Mc Millan and Woodruff (1999) examine trade credit in Viet Nam and find that the fewer the suppliers that a firm has the more likely it is to receive a trade credit. To be specific, when a SME has multiple suppliers that it can do with, the extended credit is on average 0.15 per cent less. They also find that the longevity of the supplier relationship has a positive impact on trade credit. After two years of doing business together, the credit is on average 0.14% per cent higher than when the relation first started. Interestingly, the effect gradually diminishes with time. The idea of long-term business relationship can also be extended to banking and lending institutions. Baas and Schrooten (2006) enhance this understanding with a theoretical analysis of relationship lending using a Bertrand competition framework and model where they find that lending institutions primarily rely on accounting information when making financing 22
9. decisions. Their theoretical model suggests that better information management practices in SME would not only improve their access to credit, but would do so with more favorable terms. SMEs have weaker accounting systems and East and South East Asian developing countries have weaker accounting standards (ESCAP-2012). Thus, governments in developing countries could start with information management education and regulations in their attempts to spur growth of SMEs. From the bank’s perspective, the scarcity of loanable funds, especially in East and South Asian developing countries, means there is less incentive to seek out the profitable SMEs when larger and more qualified clients are available. Formal financial institutions often face higher transaction costs when dealing with the rather fragmented SME sector. The poor accounting system, insufficient collateral due to limited fixed investment, and lack of risk management skills related to SME banking contributed to significant non- performing loan problems in the past which demonstrated an inconsistency between commercial banks loans and SMEs, and discouraged banks from further lending to SMEs (Abe, Troilo and Batsaikhan – 2015). Overall, several studies across Asia confirm crucial necessity of improving the access to credit for the SMEs. In China, for instance, Ayyagari et al. (2010) find that ‘firms with bank financing grow faster than similar firms’. In indonsesia, Wengel and Rodriguez (2006) observe that firms with more access and use of credit export get a higher share of their output. In Malaysia and the Philippines, Harvie et al. (2011) suggest that there is a gap between what firms intend to borrow and the amount of credit available to them and that this gap appears to be more sizable for smaller firms. In Thailand, it has been found that having better financial information raises firm performance among SMEs. In Vietnam, SMEs involved in production networks ‘have more opportunities to obtain trade credits and other financial resources’ (Nguyen and Rachmachandran – 2006). More importantly, according to Jinjarak,Mutuc and Wignaraja (2015), SMEs can potentially gain more scale economies (via firm size) by participating in the export markets, potentially induced by higher competition and necessary production upgrading. Their recent study, across a wide variety of empirical tests, suggests that SMEs participating in the export markets tend to have more access to credit and that bank borrowing matters for export participation. Moreover, firm size seems to be the most critical for export participation and access to credit. Specifically, larger firms tend to export more of their output, while having access to more external credit relative to SMEs 5- Adverse selection and information asymmetry The major obstacle to the effective operation of credit is the asymmetric information between lenders and borrowers. Asymmetric information will lead to adverse selection and moral hazard problems. Thus, with the increase of credit risk and the failure of interest rate tools, credit-rationing phenomenon appears because financial institutions aim to increase profitability and reduce risk in the framework of fragmented markets (Stiglitz and Weiss – 1981). 5.1- Fragmented Credit Markets: Consequences In most of the developing countries, is prevailing a situation of socio-economic dualism with a structural fragmentation of the credit markets affecting deeply the SMEs. Compared with large firms, SMEs lack of valuable mortgages, and suffer serious asymmetric information problems. 23
10. Figure 2 – Borrowers, Lenders and Market. Market Lenders Borrowers Banks SMEs Individuals Microcredit Information Asymmetry Especially SME Market The information asymmetry has received a great deal of attention in the literature on credit markets in developing and transitional countries. We suppose here a high degree of heterogeneity among the enterprises. While lenders might have a good idea about the average characteristics of the pool of potential borrowers, they may not have complete information concerning the characteristics of any particular borrower. This may lead to problems of adverse selection, and by establishing a model, it will be helpful to reveal the inherent logic of financing difficulties for Asian SMEs in the different credit market. Suppose that there are several capital suppliers and capital demanders in the credit market. To promote a project, with expected profits, fund-demanders must get a loan of dollars from fund-suppliers and the interest rate of the loan is , which is smaller than ( > ). If the moneylender refuses to 𝜋𝜋provide the enterprise demander with loans, the expectedΦ profits of both the protagonists are zero. If the banks accept to lend𝑖𝑖 funds to the enterprise𝜋𝜋 borrower,𝜋𝜋 𝑖𝑖 moneylenders and enterprises settle a principal-agent relationship. Nevertheless, this relationship is influenced by a situation of asymmetric information. In this context, the enterprises are facing a hazard moral situation, with no refunds risks. If borrowers refund the moneylenders, enterprises can get ( ) expected profits, while the expected profits of banks are ( ) . However, when the borrowers are unable to refund on time, enterprises will have (1 + ∗) expected profits, while𝜋𝜋 − the𝑖𝑖 Φ expected profits of the moneylenders are in fact a loss of ( 𝑖𝑖 ).∗Φ In this context, we can define a simple payoff matrix in terms of game theory. 𝜋𝜋 Φ − Φ Table 8 – Payoff matrix for moneylenders and borrowers Banks provide loans Banks refuse to lend Enterprises’ Borrowers: ( ) ; Moneylenders: Nil repayment (∗ ) Enterprises’ default Borrowers: (1 +𝜋𝜋 − )𝑖𝑖∗ Φ; Moneylenders: - Nil 𝑖𝑖 ∗ Φ In their lending policy, banks take in account𝜋𝜋 Φ the situation of Φthe enterprises and the risk they are facing. Let us suppose the probability of repayment is expressed by ( , ) and then the probability of repayment avoiding is expressed by 1 - ( , ). 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐷𝐷 𝐺𝐺 - D will be equal to 1 if the enterprise is important, and equal𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 to𝐷𝐷 0 𝐺𝐺if it is a SME. Indeed, the SMEs are often unable to offer sufficient mortgage, significant collateral or complete information. It means that commonly the probability for large enterprises to repay their loans on time is considered like higher, which implies: (1, ) > (0, ) 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐺𝐺 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐺𝐺 24
11. - The independent variable G is a valuation of the level of financial development. An efficient banking system has the ability of getting efficient information, which implies limiting and sharing the risks. Hence, it is able to overcome the information asymmetries for both borrower and lender. - As a consequence of a banking system more efficient, the probability for loans repayments becomes more and more important and tends to 1, which implies that > 0 , and lim (Prob)= 1 with + . 𝛿𝛿𝛿𝛿𝛿𝛿𝛿𝛿𝛿𝛿 Banks𝛿𝛿 𝛿𝛿will offer loans only if their expected𝐺𝐺 → profits∞ are greater or equal to zero, which means: 1 ( , ) [1 ( , )] 0 ( , ) . or 1+ Or else, banks will not lend∗ ∗ funds to the enterprises. From𝑖𝑖 Φ 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 those 𝐷𝐷expressions,𝐺𝐺 − Φ we− 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 can guess𝐷𝐷 𝐺𝐺 that≥ large𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 firms are𝐷𝐷 𝐺𝐺 able≥ to 𝑖𝑖get funds from the financial institutions because they offer more important probabilities of repayment, including valid mortgages and significant collaterals. Obviously, the scale of SMEs restricts their borrowing capacity. Moral hazard and adverse selection, as a consequence of asymmetric information, explain the SMEs’ financing weakness and their difficulties to access credit. Nevertheless, a financial development could enhance the efficiency of the banking system and decrease significantly the risk of asymmetric information at the expense of SMEs. However, a financial development too slow could cause the probability of returning loans to become lower and lower, while the risk of providing enterprises could become more and more important. 5.2 - Heterogeneity among Potential Borrowers and Credit Rationing There is commonly a great deal of heterogeneity among potential borrowers in any country. While lenders might have a good idea about the average characteristics of the pool of potential borrowers, they may not have complete information concerning the characteristics of any particular borrower. This may imply a worse adverse selection. Suppose that there are two types of potential borrowers indexed by [1,2]. Borrowers type 2 are considered like presenting a higher risk than borrowers type 1,because they are mainly SMEs with limited mortgage or collateral. The expected return 𝑡𝑡of∈ the lender is ( ). We assume that lenders, as a consequence of the financial policy, have access to a risk-free capital market with a return of . -Define (1) as the highest interest rate at which type𝐸𝐸Π 1𝑖𝑖 borrowers are willing to borrow. So (1) is implicitly∗ defined by the equation [ ( )]. (2) is defined analogously, with𝜌𝜌 (1)∗ 0. For > (2), we have ( )= 0. ∗ 𝑖𝑖 ∗ ∗ 𝑖𝑖 𝑖𝑖 ≤ 𝑖𝑖 𝐸𝐸Π 𝑖𝑖 𝑖𝑖 𝑖𝑖 𝐸𝐸Π 𝑖𝑖 25
12. Figure 3 ( ) (2) 𝐸𝐸 Π 𝑖𝑖 (1) 𝜌𝜌 (1) 2 (2) (1)∗ Credit demand function from borrowers∗ (both types 1 and 2 apply). 𝑖𝑖(2) Credit demand function from𝑖𝑖̂𝑖𝑖 𝑖𝑖 borrowers type 2 (only risky types apply). Lenders cannot distinguish between borrowers of different types. Therefore, the competitive equilibrium with adverse selection is defined as an interest rate 2 such as ( 2) = . There is no interest rate i for which (i)> .In other words, an interest rate i is an equilibrium interest rate if lenders do not lose money on average at , and if𝑖𝑖 there is no𝐸𝐸 otherΠ 𝑖𝑖 interest𝜌𝜌 rate at which lenders would avoid losing𝐸𝐸Π money.𝜌𝜌 We can settle that, in a competitive equilibrium, a loan𝑖𝑖̂ market may be characterized by credit rationing, according to the following steps: - Mechanism: the interest a bank charges may itself affect the riskiness of a pool of loans by either: a) sorting potential borrowers, by an adverse selection – b) affecting the actions of borrowers, by a moral hazard. - Information asymmetry: borrowers have different probabilities of repayment but banks cannot identify “good” borrowers from “bad”. Hence, process is acting as a screening device. - The price mechanism may not clear the loan market if interest rates go above 2, since the bank would be attracting worse risk. Hence, the bank’s best strategy is to ration credit whenever demand pushes interest above this level corresponding to a risk𝑖𝑖 -free position with a return . - Credit rationing: given loan applicants that appear equal, some receive a loan and some do not even when𝜌𝜌 they offer to pay a higher interest rate. Indeed, the segment ( 2- 2 ) represents a highly speculative and risky fund-demand and often an usurary segment∗ of informal finance. 𝑖𝑖 𝑖𝑖 In this context, some individuals unable to get a loan under one supply schedule at any interest rate would get a loan under a larger schedule, by a mortgage or collateral requirement. But, higher collateral or mortgage means firms can only finance projects with higher risks, like for instance speculative real estate projects. Hence, higher collateral requirements attract riskier borrowers and result in an aggravated adverse selection. Of course, the SMEs, unable to satisfy collateral requirements, are victims of this credit rationing and adverse selection, which explains the severity of the credit gaps they are commonly suffering. Within this situation of exclusion and in the absence of Microfinance institutions, the only pssibility of credit for microenterprises remains the ‘informal finance’, i.e. the usurers, with exobitant interest rates, until a level of (2). ∗ 𝑖𝑖 26
13. 6- Results and Implications for Policy Makers Policy makers need to ensure that the the existing overall business climate is conducive for people to engage in entrepreneurial activities with adequate and timely assistance. We can summarize some advices suggested by several studies ordered by the World Bank. Some agencies have pointed out that in developing countries there has been a growing financial gap between commercial debt financing and microfinance (IFC-2010). While the traditional term loans have focused on financing large firms or SMEs with relatively healthy performance and sufficient financial records, microfinance targets the poor, low-income groups, and informal sector with small size of loans as well as high interest rates, as a consequence of an adverse selection. Between those target groups by commercial banks and microfinance institutions, small and microenterprises have difficulty in raising funds from commercial banks because they have inadequate collateral and financial records, while they are not satisfied with microfinance loans due to its small size and high interest rates (see Figure 4 ). Figure 4 – Missing middle, financial gap in SME financing Commercial debt Microfinance financing Missing middle Medium and large Poor low-income enterprises Informal sector Financial gap To narrow the gap, policymakers may consider some options. First, microfinance as it has has been growing rapidly in the Asian region may expand its operations to target small businesses, providing large loans with discounted interest rates. Second, commercial banks may wish to extend their financial services to those small protagonists, perhaps in cooperation with public agencies and a governmental support. Third, governments could lauch and further develop various direct financial assistances to them. Moreover, inadequate or insufficient information is one of the main obstacles hampering finance in SMEs. With information asymmetry, banks cannot be sure of the creditworthiness of SMEs and potential equity investors may forego the equity offerings of SMEs unless otherwise policymakers do implement expensive safeguards. SMEs, however, usually lack the financial and administrative skills to provide this information, or may even lack the basic knowledge about what kind of information should be prepared. Policy intervention can be essential to address this issue. Policymakers not only need to educate SMEs about related regulations, standards and practices but they must also strive to streamline them. There is a careful balancing action policymakers must consider between the needs of creditors/investors to feel secure and informed, and the ability of SMEs to meet these needs. Regulating policies are needed to promote transparent lending terms and conditions of financial institutions. We summarize the key issues and suggestions for strengthening bank-SME relationships, suggesting a four-tier national financial system, in accordance with the Asian Association of Management Organizations (2007). This system aims to establish the significance and the importance of restructuring the institutional network of the financial sector into a simplified framework for clear division of labor, so that its reach and institutional coordination are 27
14. further improved. Besides having the Apex Bank (or agency) for SMEs, micro-financing institutions (MFIs)’s role in this framework also assumes greater importance. They should be given national recognition and legal status in the country’s financial system so they are able to serve an increasing number of micro-enterprises. Figure 5 Apex SME Bank National DFIs, Commercial banks, Import-Export Banks Venture Capital, Support institutions Regional DFIs, Regional Banks Microfinance Institutions MFIs Source – AAMO (2007) This four-tier national financial system is described as follows in the Figure 4. -First tier: an Apex Bank or agency for SMEs at the top oversees policy prescriptions, credit guarantees schemes, new financing schemes and programs, Business Development Services (BDS) and training, and the flow of credit and equity to the sector. Above all, the apex bank should argument financial resources for all the concerned players and give them institutional support from time to time. -Second-tier: national financial institutions, commercial banks, specialized Development Finance Institutions (DFIs) such export-import banks, credit guarantee agencies, credit information providers, credit registries, venture capitalist associations/networks and national chambers of commerce and industry, should play the role of credit providers or facilitators to the organized sector of SMEs. In addition, corporate bond markets (and stock markets in some cases) also fall in this category for open market borrowings and share offerings. -Third-tier: subnational development financial institutions, regional banks, BDS providers, and local chambers of commerce and industry have a manageable specified region or a command area for serving the specific sector. -Four-tier: at the base of the pyramid, MFIs cover the unorganized micro-enterprises, informal economy and self-help groups through the provision of microcredit. MFIs have been placed at the base of the system because it has to cover the biggest segment and largest number of enterprises and individual entrepreneurs in the field. Moreover, it is imperative to neutralize the usurers whose pervert effects persist, particularly in rural and suburban areas.The MFIs system is experienced and best suited to keep close contact with clients and to ensure full recovery of loans. They are also equipped to give non-financial support to entrepreneurs. 7- Conclusion South East Asian developing countries have a large number of microenterprises and some large firms, but far fewer small and medium enterprises. The SME gap is called the ‘missing middle’. Repeatedly, access to finance is held up as the major problem. Firms in this segment consistently rate access to finance as the top barrier to growth (Beck- 2007). However, paradoxically, the evidence clearly shows that returns to capital are high in this segment 28
15. (Banerjee and Duflo-2008; McKenzie and Woodruff-2015 ). SMEs are not missing because they would not be profitable but rather finance is not reaching them in an effective way. Microfinance may reach microenterprises, but such firms often do not graduate to formal employment-generating SMEs. The microcredit model falls short when larger and riskier investments are needed and cash flow are not immediate. Similarly for banks, the transaction costs are so high that only the highest-potential investments can be considered. As the SME segment represents a larger number of smaller loans, it is only viable if transaction costs in screening applicants are low. Financing remains a major constraint for SME survival and growth in East and South East Asia as in other parts of the world. Maximizing working capital, developing capital markets, strengthening the bank-SME relationship, lowering information asymmetries would provide the greatest benefit. In all cases, policymakers wil have to consider the existing level of economic development, to enact these suggestions in a viable manner. Imperfections of the credit market can have a dramatic impact on the labour market. Only few rich individuals with wealth and important collateralhave access to credit. They can borrow to finance businesses, earn a high return and remain rich. The large number of poor individuals cannot borrow and they all supply labour, driving down the wage. They remain poor, and the low wages further increase the returns, and thus the future wealth of the rich entrepreneurs. In conclusion, we can name Joaquim Winborg (1997), when he writes: ‘ the dream of transforming an idea into a company, without access to the external financing, will not be more than a dream’. Finally, it appears clearly that policy makers will need to pay closer attention to issues related to small firms, particularly those concerning enterprise growth, credit policy, taxation and financial regulation. Those findings raise several intriguing policy questions with respect to SMEs. - How important are small and medium-sized firms to developing Asia ? - What are the barriers that prevent SMEs from ‘graduating’ to larger sizes, from becoming midsize enterprises and for overcoming the ‘missing middle’. - Given that export participation among SMEs is associated with having external credit, should credit policy toward firms be broad-based or targeted toward specific firms or sectors ? - What complementary policies are needed to promote SME participation in export markets ? - In light of the evidence that many firms have unmet or largely unserved credit needs, what roles should central banks play in regulating financial institutions for financial inclusion? Financing remains a critical constraint for SMEs for several reasons. Many SMEs owners do not manage working capital effectively, information asymmetry between banks and SMEs retards the loan applications and approval process, and underdeveloped equity markets deny SMEs future growth opportunities. Policymakers can ameliorate conditions by serving as facilitators and communicators. It is hoped and expected that new policy prescriptions in South East Asia will enhance the growth and survival prospects of SMEs, thereby creating more employment, innovation, economic growth, and poverty alleviation. References -Abe, Masato; Troilo, Michael & Batsaikhan, Orgil (2015) - Financing Small and Medium Enterprises in Asia and the Pacific, Journal of Enrepreneurship and Public Policy, vol. 4, No 1, pp 2-32. 29
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