Small and Medium Enterprises play an important role in the economic growth of a country. The SME sector is labour intensive and is generally based on indigenous raw material. But the sector faces multifarious problems. The major problem faced by the SME sector is access to capital. A small or medium business can meet its financing needs through a combination of debt, primarily bank loans, and cash investment. It is important for a modern business to keep its cost of capital low in the scheme of its overall economics.
The banking system is averse to lending to SME’s due to a risk-averse approach that does not adequately weigh in the talent in an enterprise or viability of the business idea or an entrepreneur’s individual credit history. A nascent business is denied credit, while business history and value of immovable collateral, aided by unfair influence, are prime lending factors; they favour the mightier capitalists over cash-strapped but capable entrepreneurs. In effect this often leads to misallocation of credit, in turn creating deadweight losses and opportunity costs apart from violating the idea of equal opportunity.
In Pakistan an estimated eight million SME’s are currently eligible for credit, while only 0.5 million of them (6 percent) have any credit facility. As a result, despite the SBP’s policies’ having struggled to assist SME financing since 2002, the bank credit to SME’s is only 7-8 percent of a banks’ total lending portfolio to the private sector against SBP’s target of 20 percent, which is the standard in emerging markets. The meagre nature of credit by international standards is further explained by the fact that the total share of bank credit in the economy in terms of “credit to GDP ratio” is 16 in Pakistan (2011-2015), compared to 52 in India and 122 in Singapore. Data suggests that even that paltry SME financing is disproportionately channelled to medium rather than small enterprises.
The obvious inference from these statistics is that the overall environment for private credit is unfavourable and that, too, goes to medium and large enterprises. The banks in the country are not effectively performing their core function, i.e. channelling depositors’ savings into loans for creditworthy businesses and individuals. Despite extracting a widely known boon from the disproportionate banking spreads-the differential between the borrowing and lending rates-Pakistani banks are unwilling to support the very economy that feeds them.
The Musharraf government created a SME Bank in 2004 but the bank has been unable to come into proper operation due to meagre financial assets, technical capacity, and small loan amounts (about Rs. 0.8 million on average). During the same period a USAID-supported technical assistance project was launched involving the National Bank of Pakistan (NBP) but did not go far in addressing the problem. Then came the economic slump and macroeconomic indicators fell; a situation that persisted from 2008 to 2013. Nothing significant has happened since then, except the SBP’s Credit Guarantee Scheme for micro and small businesses, which has not moved the banking sector yet. It is also true that, on the demand side, a large number of eligible SME’s stay away from bank credit due to their mistrust of the banks’ intrusive disclosure requirements, complicated paperwork, long processing times that often transcend the time of need, and religious beliefs about loan interest. But overall the demand for bank credit on reasonable terms is solid.
While SME’s find securing bank loans hard enough, private investments are not easy to raise either. In the advanced economies there are very well functioning private equity and venture capital firms, making both private investment and technical advice available to promising businesses. That organized mechanism of private investment is totally missing in Pakistan. Although the regulatory framework for private equity and venture capital was first introduced by the Securities and Exchange Commission of Pakistan (SECP) in 1995 and has been revised thrice in 2001, 2008, and most recently in 2015, the industry is yet to make its mark in any significant manner. As of now there is virtually no private equity firm in operation signaling a lack of confidence of investors in regulatory practices and the overall business environment. It is well known in finance literature that investors—both local and foreign—take a lead from the bank lending in deciding to invest apart from the financial space that the credit provides in structuring business finance. The aforementioned low share of Pakistan’s bank credit in the economy partially explains the reluctance of investors to invest.
A viable way to mitigate SMEs’ finance problem would be to form a business partnership which is an excellent mechanism to raise or enhance early and mid-stage capital, distribute failure risk, and add to management capacity when right partnerships are forged. However, there are peculiar inhibiting factors that discourage such alliances in Pakistan, which mostly lead to business failures when forged. The foremost barrier is a high risk of business failure creating a stressful environment in the business operations and cash flows. The other is prohibitive business dispute costs which stems from the absence of viable dispute resolution mechanisms. The third is the lack of an entrepreneurial culture that could promote partnerships through taking risk and entrusting resources.
Many rich people, particularly in rural areas, view business as a way to show off wealth and cultivate power and prestige rather than as a value creation tool. The partnerships are therefore discouraged by economic, legal and cultural barriers. In view of this situation, entrepreneurs are left with very limited financing options to start a business; primarily through personal and family and friends’ savings. While this funding is often enough as early stage capital, in most cases the capital doesn’t take the businesses far as the growth capital is more challenging to raise.
Consequently, either the business has to settle with limited growth, or close altogether when additional investment or business growth is crucial to survival beyond the early stage.