22967 WORLD BANK OPERATIONS EVALUATION DEPARTMENT AUTUMN 1998 NUMBER 173 Support for Smaller Enterprises T HE BANK HAS OFTEN SUPPORTED SMALL AND medium-size enterprises (SMEs) to encourage employment of lower-paid wage earners and to diversify and broaden the base of an economy. The strategy for smaller enterprises has generally been to ease the scarcity of term finance by providing funds and improving the banking system's ability to lend to them. Thought to be labor-intensive, especially outside the major urban centers, small firms would create jobs at a low cost, which would improve the distribu- tion of income and alleviate poverty. All wonderful outcomes. But such outcomes are rare. Smaller enterprises can be less labor-intensive and less efficient than larger firms. Access to finance is a problem. And the Bank's financial sector policy, with Operational Directive 8.30 in 1992, reduced lending to SMEs. The presumption of the directive was: it is better to let commercial banks decide their clients than to restrict the size of firms receiving Bank funds. In the past year, the directive was revised, * Support for small and medium-size in part to allow a more flexible consider- enterprises in the Philippines shows ation of the Bank's approach to the finan- that SMEs can be effective in creat- cial sector. Here we explore that presump- ing jobs, but they are unlikely to re- tion for support to the Philippines, Ecua- duce poverty, boost exports, or shift dor, and Sri Lanka. Our analysis repre- the location of industries, which sents the first time that detailed empirical were all stated objectives of Bank findings of the results on the ground were support. adduced for Bank SME support. Did the * In Sri Lanka, too, SMEs were a good circumstances of some economies make it vehicle for creating jobs-especially desirable to channel funds to smaller en- important in an economy undergo- terprises? Did the mechanisms of support ing restructuring. Direct support to result in funds getting to needy beneficia- Sri Lankan SMEs has gone a long ries? Or should Bank support have left it way toward improving the pruden- to the banking sector to identify and tial soundness of the banking system assume the risks of lending decisions? (as it also did in the Philippines). 2 World Bank Operations Evaluation Department * In Ecuador, however, support for SMEs used the FIGURE 1: Much Lower Arrears wrong instrument: long-term credit at fixed interest rates. The results: fewer jobs, little financial devel- 9 opment, and only slightly better access to credit. ° .E 7 Philippines-reasonable success 6 Between 1976 and 1992 the Bank provided the Philip- pines with $180 million to finance SMEs through four 4 consecutive lines of credit, with the Asian Development ° Bank contributing $100 million to the fourth. All four > 2 were retailed as subloans to eligible SMEs, financing 1 1 about 2,600 subprojects and generating 64,000 jobs. 1989 1990 1991 1992 1993 1994 1995 (The average subproject was almost $70,000, with an All Loans - IGLF Loans average maturity of more than five years.) S..- BSP and ADB data. Bank support for SMEs in the Philippines may have resulted in more jobs, but these did not benefit the very credits. The Asian Development Bank (ADB) provided poor. No gain in productivity was noted over firms that parallel financing of $45 million for the last two did not receive Bank credit. Nor was any increase re- projects and, in June 1997, approved a third project for corded in these firms' exports. In short, support to $55 million. As with the loans to the Philippines and to SMEs in the Philippines resulted in more "middle class" Ecuador, these were accompanied by economic and sec- jobs, but these were not as productive as those provided tor work, policy dialogue, and policy-based lending de- by larger firms. signed to affect the environment for smaller firms. Intermediaries supported subprojects with high eco- The strategy in Sri Lanka had three major objectives. nomic and financial returns. For 170 subprojects, the First, engage the government in a dialogue about the effi- rate of return on assets was 12 percent. cacy of economic policies for trade, and the appropriate Firms also exploited the fluctuations in interest roles of the public and private sectors. Second, work with rates from quarter to quarter, by prepaying their loans the government to restructure the financial sector from one when rates were high and obtaining loans when rates that serviced a centrally planned industrial economy, favor- were low, revealing that firms had both adequate li- ing large enterprises, into one that responded to the needs quidity and access to the banking system. of entrepreneurs. Third, generate jobs, so that Sri Lanka's World Bank-assisted Philippine SMEs have greater unemployment problem could be addressed cost-effectively. indebtedness than similar firms in other parts of the The credits and the attention given to the policy world. These firms had little difficulty in tapping credit distortions that impeded the financial sector helped by the mid-1990s. Moreover, because the repayment develop a more diversified, private sector-oriented record of SMEs is considerably better than that of larger economy. They also helped generate a more effective firms (see figure 1), SMEs pose a reduced credit risk to financial infrastructure and a significant number of the commercial banking sector. Budget costs were low lower-paying jobs. Employment at assisted firms and did not expose the government to risks; instead, the increased by more than 8 percent a year-more than projects helped reduce the government's risk exposure. three times as fast as general employment growth. This Also, the allocational effects of the directed credit translates into about 22 additional employees per firm, channels do not appear to be large. Technical efficiency and the value added of their employees was almost 20 is slightly lower at SMEs than at larger firms, so the re- percent higher than employees elsewhere, where strictions on credit use can result in some misallocation employment increased by less than 6 percent a year. of resources. In addition, the technical assistance pro- Assisted firms also increased their labor intensity at vided directly to SMEs had no significant impact- a greater rate than other firms. Unlike the situation in more the result of program scale and structure than many other countries, credit was directed to firms that content-so when the better portfolio performance and were truly credit-constrained, lifting a major impedi- diversification of the banking sector are considered, the ment to productive investments. Moreover, access to forgone technical efficiency is a small price to pay for a credit, both for assisted firms and others, improved sub- relatively effective jobs program. stantially as financial liberalization took root, and Sri Lanka became an important manufacturing producer Sri Lanka-creating jobs among low-income countries. Between 1979 and 1991 the Bank provided Sri Lanka On the positive side, assisted firms employed more with $110 million in financing for SMEs through four lower-wage workers. Most of the smallest firms became Precis 3 larger, graduating faster than their counterparts in other measures, it appears that SMEs in Sri Lanka now have countries. Beneficiaries were diffused outside the heavy as much access to credit as do the SMEs in developed industrial concentration in the capital. economies. While the state commercial banks continue On the negative side, 40 percent of assisted firms to suffer from overstaffing and government interference, (which produced largely for domestic markets rather their progress in institutional performance indicators than for export) went out of business within eight years has been substantial. of borrowing. (Similar exit rates are observed in other Fewer policy impediments. Sri Lankan firms now developed and developing countries.) The high failure have more access to finance, particularly long-term fi- rates did not result in significant losses to the lending in- nance, than they did 10 years ago. And the financial in- stitutions, but they indicate that the employment effects frastructure to underwrite, monitor, and fund profitable of Bank support are overstated. investments has unquestionably been established. The fi- One important reason for SME credits to Sri Lanka nancial environment has improved significantly, and it is was to accelerate the creation of a financial system that likely that the Bank's policy dialogue contributed much would provide information on the performance of pri- to this advance. vate firms. When such a system of intermediation ex- ists, entrepreneurs can mobilize resources more easily, Ecuador-a record of failure as well as garner rewards for undertaking high-return Beginning in 1980 the Bank lent $140 million for four investments. Until such a system is established, finan- projects to finance lines of credit for more than 16,000 cial institutions will have fewer incentives to invest in small enterprises. The first two (in 1980 and 1982) fo- the capacity needed to provide this service, which re- cused on creating an apex institution and establishing tards financial development. interest rate spreads attractive to commercial banks. A How did the credits affect the profits and outreach new government in 1984 embraced the shift to a more of intermediaries? Bank support contributed to an ex- market-oriented development strategy, and with the ini- pansion of funding for the most promising activities- tiation of financial sector adjustment lending, the third and to a general deepening of the financial system. In- loan, in 1986, incorporated financial sector policy con- terest rates became market-determined, varying with the ditionality. The fourth project, approved in 1990 (dur- riskiness of borrowers. An effective repayment system ing a period of stabilization and adjustment), intro- was also established under the credits, with recoveries duced adjustable interest rates for subprojects. The aim ultimately at commercial rates. Most intermediaries im- was to reach market-determined commercial bank proved their financial positions. The second-tier devel- rates. Positive real interest rates were finally achieved opment finance institution in the program was priva- (see figure 2) in the 1990s. tized, and the intermediaries expanded their own lend- Project results. The first three projects fell short on ing to SMEs and microenterprises. Indeed, by some all three criteria for development effectiveness: rel- evance, efficacy, and efficiency. They were not sustain- FIGURE 2: Positive Real Interest Rates able, they were very costly for the government, and they Achieved Only in the 1990s, Ecuador probably had regressive distributional effects. By pro- vidng deeply subsidized credits to borrowers, rather 60 than access to credit, the projects substituted govern- SSE I SSE II SSE III SSE IV ment transfers for borrower finance. 40 Simply put, the provision of long-term credit at fixed interest rates was the wrong instrument. And 20 i/\ even though FOPINAR, the apex institution, was con- sidered one of the most effective institutions support- ' o- ing SMEs, it had little or no ability to mobilize domes- tic resources. Providing funds to small firms in a -20 \\ ; \\ / 't,sS deeply distorted financial system contributed to further I @ \\ / distortion. -40 Employment grew faster in larger firms than in _60 \i?smaller ones that were the targets for Bank credit. Thus, 0 -60 V credit was restricted to firms least likely to generate jobs. The high failure rate among the beneficiary firms-only a 1980 1983 1986 1992 1996 third of those receiving credit in the early 1980s sur- Real Deposit Rate Real Lending Rate vived-means that even the limited benefits of the pro- Quarterly, 1980-96 gram in job creation diminished sharply over time. It 4 World Bank Operations Evaluation Department should be noted that entrepreneurs received such large Three lessons subsidies from the Bank's lines of credit and generated so SMEs can create more jobs-but don't always live up to little employment, that it was they, and not their employ- other expectations. Under the right circumstances, support ees, who received most of the income the projects gener- to SMEs can be effective in creating jobs, as was the case ated. Firms that borrowed under the World Bank lines of in Sri Lanka and the Philippines. Policy reforms could im- credit increased their value added faster than those with- prove performance. But support for SMEs is not likely to out Bank credit. But the costs of the subsidies to beneficia- have much effect on directly reducing poverty or increas- ries almost certainly canceled-and may have exceeded- ing exports. Nor should it be thought of as a way to shift the gains in value added. the location of industry. Given the negative interest rates during much of the If banks are to learn more about SMEs, and thus to 1980s and early 1990s (as low as minus 50 percent), reduce risk, financial products have to be more flex- along with the legislated above-market wages, it is not ible. SMEs confront higher real borrowing costs be- surprising that the small firms receiving Bank-supported cause they are seen as bigger risks-or simply have credit tended to be overcapitalized-and less labor-in- higher transaction costs-and are priced accordingly. tensive than other firms. Moreover, very small firms ap- One way to reduce some of these costs would be to es- pear to be less efficient than larger ones-using more tablish basic banking links, such as bank accounts or capital and labor to produce the same output. short-term credit. These links can be seen as building Some diversification and decentralization. Credit to blocks toward a more complex banking relationship, small enterprises has become both more diversified and such as that implied by long-term loans. more decentralized (subsidiary objectives of the projects). Good institutions cannot overcome a weak policy More than half of the credit in recent years was targeted environment. It is essential to have a coherent strategy to the country's smaller industries and provinces. But it is for removing distortions in the economy-for getting questionable whether these are relevant objectives for the prices right-before undertaking financial sector Bank support. A considerable amount of Bank work has lending. The highly distorted economic environment in shown that providing locational incentives to firms is Ecuador during most of the implementation period- usually expensive and ineffective. particularly the highly negative real interest rates, along By the end of the projects, Ecuador's financial sys- with regulated wages and a heavily protected industrial tem had liberalized and started to grow, but it remains sector-meant that the loans could not have the desired much shallower than those of most other Latin Ameri- impact of greater employment. By continuing to pro- can countries. Continuing macroeconomic turbulence vide deeply subsidized credits to borrowers, rather than has caused real interest rates to rise above 30 percent. access to credit, the projects merely substituted govern- Thus, all borrowers (not just small-scale borrowers) face ment transfers for borrower finance. Reforming the fi- expensive financing. Although most firms do have access nancial sector or relying on sustainable microfinance in- to some credit, access to medium- and long-term credit stitutions would have been a better way to provide sup- (more than one year) is rare outside the Bank's projects. port for small-scale entrepreneurs unable to get credit. PrAris, Review or Report: "World Bank Support for Small and Medium Please address comments and inquiries to the Editor-in-Chief, Industries in the Philippines: An Impact Evaluation," by Robert Elizabeth Campbell-Pag6, tel: 1-202/458-5365, Buckley and Edgard Rodriguez, Report No. 18041, June 1998; fax: 1-202/522-3125, e-mail: ecampbellpage@worldbank.org "World Bank Support for Small Scale Industries in Ecuador: An Please address publication requests and inquiries to OED, Impact Evaluation," by Alice Galenson, Robert Buckley, and tel: 1-202/458-4497, fax: 1-202/522-3200, Edgard Rodriguez, Report No. 17953, June 1998; and "World e-mail: eline@worldbank.org Bank Support for Small and Medium Industries in Sri Lanka: An Impact Evaluation," by Robert Buckley, Edgard Rodriguez and This and other OED publications can be found on the Internet, Dipak Mazumdar, Report No. 16790, June 1997. 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OED Study Series Evaluation and Development: The Institutional Dimension (1998) 1997 Annual Review of Development Effectiveness (1998) India: The Dairy Revolution (1998) The World Bank's Experience with Post-Conflict Reconstruction (1998) Financial Sector Reform: A Review of World Bank Assistance (1998) Rebuilding the Mozambique Economy: Assessment of a Development Partnership (1998) Mainstreaming Gender in World Bank Lending: An Update (1997) Agricultural Extension and Research: Achievements and Problems in National Systems (1997) Fiscal Management in Adjustment Lending (1997) Reforming Agriculture: The World Bank Goes to Market (1997) Paddy Irrigation and Water Management in Southeast Asia (1997) Poland Country Assistance Review: Partnership in a Transition Economy (1997) 1995 Evaluation Results (1997) Zambia Country Assistance Review: Turning an Economy Around (1997) The Aga Khan Support Program: A Third Evaluation (1996) Lending for Electric Power in Sub-Saharan Africa (1996) Industrial Restructuring: World Bank Experience, Future Challenges (1996) Social Dimensions of Adjustment: World Bank Experience, 1980-93 (1996) 1994 Evaluation Results (1996) Ghana Country Assistance Review: A Review of Development Effectiveness (1995) Evaluation and Development: Proceedings of the 1994 World Bank Conference (1995) Developing Industrial Technology: Lessons for Policy and Practice (1995) The World Bank and Irrigation (1995) 1993 Evaluation Results (1995) Structural and Sectoral Adjustment: World Bank Experience, 1980-82 (1995) Gender Issues in World Bank Lending (1995) The World Bank's Role in Human Resource Development in Sub-Saharan Africa: Education, Training, and Technical Assistance (1994) 1992 Evaluation Results (1994) New Lessons from Old Projects: The Workings on Rural Development in Northeast Brazil (1993, contains summaries in French, Portuguese, and Spanish) World Bank Approaches to the Environment in Brazil (1993, contains summaries in French, Portuguese, and Spanish) Rapid Appraisal Methods (1993) Trade Policy Reforms Under Adjustment Programs (1992) World Bank Support for Industrialization in Korea, India, and Indonesia (1992) Population and the World Bank: Implications from Eight Case Studies (1992) The Aga Khan Rural Support Program in Pakistan: Second Interim Evaluation (1990) Book sales available from: The World Bank PO Box 960 Herndon, VA 20172-0960 USA Fax: (703) 661-1501 Tel: (703) 661-1580 Internet: http://www.worldbank.org From the World Bank homepage, select publications. 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E-mail address: ecampbellpage@worldbank.org QUANTITY TITLE PRtCIS # PLEASE PRINT CLEARLY Name_ _ _ _ __ _ Address City State Postal Codeo Country Telephone OED Precis Issued in 1998 NUMBER 153 Grassroots Organizations for Resource Management in the Philippines 154 Sustaining Rural Water Systems: The Case of Mali 155 Two Projects in One: Lessons from Jamaica 156 Best Practices in Urban Development: Learning from Brazil 157 Reducing Flood Hazards and Traffic Congestion in Tunisia 158 Agriculture in Hungary 159 Transport in Thailand: Lessons for Institutional Development 160 Feeder Roads in Brazil 161 C6te D'Ivoire: Devaluation's Benefits 162 Kenya's Geothermal Development Program 163 1997 Annual Review of Development Effectiveness (ARDE) 164 Rebuilding the Mozambique Economy 165 A Borrower's View of the World Bank 166 Financial Sector Reform 167 Philippines: From Crisis to Opportunity 168 India's Dairy Revolution 169 Post-Conflict Reconstruction (PCR) 170 PCR: Bosnia & Herzegovinia 171 PCR: Uganda 172 PCR: El Salvador