Finance and Small and Medium Enterprise Development

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Finance and Small and Medium-Sized Enterprise Development

Paul Cook and Fred Nixson

1. INTRODUCTION

Interest in the role of small and medium-sized enter pr ises (SMEs) in the development process continues to be in the foref r ont of policy debates in

developing countr ies. The advantages claimed for SMEs ar e various, including: the encouragement of entrepr eneurship; the greater likelihood that SMEs will

utilise labour intensive technologies and thus have an immediate im pact on em ployment generation; they can usually be established rapidlyand put into

operation to produce quick returns; SME development can encourage the process of both inter- and intra-regional decentr alisation; and, they may well become a countervailing f orce against the economic power of larger enterprises. More generally the development of SMEs is seen as accelerating the

achievement of wider economic and socio-economic objectives, including pover ty alleviation.

Staley and Morse (1965, p.318) identif y a ‘developmental appr oach’ to SME promotion which has as its objective the creation of ‘economically viable

enter pr ises which can stand on their own f eet without perpetual subsidy and can make a positive contribution to the growth of real income and theref ore to

better living levels’. This approach em phasises the im portance of ef f iciency innew SMEs. Small producers must be encouraged to adopt new methods,

move into new lines of production and in the longer-run, wher ever feasible, they should be encouraged to become medium- or even lar ge-scale producers.

More r ecent concerns associated with the growth and ef f iciency of smaller enterprises have also become prominent (Mazumdar, 1997). Using the case of

Northern Italy, Piore and Sabel (1984) have argued that small enterpr ises are more ef f icient because they have adopted a f lexible specialisation approach.

Corr espondingly, there has been growing inter est in whether this model has or can be replicated in developing countries (Schmitz, 1989; Pederson, 1994;

Schmitz and Musyck, 1994; Schmitz, 1995).

The role of f inance has been viewed as a critical element f or the development of small and medium-sized enterprises. Previous studies have highlighted thelimited access to f inancial resources available to smaller enterprises com pared to larger or ganisations and the consequences f or their growth and

development (Levy, 1993). Ty pically, smaller enterprises f ace higher tr ansactions costs than larger enterprises in obtaining credit (Saito and Villanueva,

1981). Insuf ficient f unding has been made available to f inance wor king capital (Peel and Wilson, 1996). Poor management and accounting practices have

ham pered the ability of smaller enterprises to r aise f inance. Inf or mation asymmetries associated with lending to small scale borr owers have restricted the

f low of finance to smaller enter prises. In spite of these claims however , some studies show a large num ber ofsmall enterprises f ail because of non-f inancial

reasons (Liedholm, MacPherson and Chuta, 1994).

The purpose of this paper is to discuss the f ocus of previous studies on the relation between f inance and small and medium-sized enterprise development

and to identify some of the gaps in our knowledge. While a considerable amount is known about the char acteristics and behaviour of small and medium-

sized enterprises, this knowledge continues to be im perf ect and a large num ber of questions remain unanswered in relation to f inance and small enterpr ise

development. This paper discusses some of the issues raised by previous research and points to newer areas that can f ruitf ully be resear ched.

Section two provides some general char acteristics of pr evious research on small enterprise development and indicates the main areas of em phasis. The third section reviews some of the issues that emerge f rom the literatur e that has attem pted to assess the im pact of policy r ef orm, particular ly f inancial sector

ref or ms on small and medium-sized enterprises. Interesting issues are raised by the eff ects of ref or ms on both the demand and su pply off inance. The f ourth

section discusses issues r elated to the theoretical treatment of the r elation between f inance and small and medium-sized enterpr ise development. An attem pt

is made in the concluding section to identif y the kinds of testable hypotheses that emerge f rom the body of theory and to discuss their im plications in the

context of low income countries. The Appendix discusses the proposals f or the directions of the curr ent r esearch programme and provides an outline of

proposed f ieldwork activities f or the next year .

2. STYLISED FEATURES OF CURRENT RESEARCH

SME Research in Industrialised Countries

There are a num ber ofdistinctive f eatures concerning the nature of economic research on small and medium-sized enterprises. First, the bulk of research has

predominantly been under taken in the context of US and UK f ir ms and has sometimes entailed com parisons with other Eur opean economies (Storey,

1995). As such, the theoretical wor k has assumed an institutional setting and made assum ptions about the policy environment that is relevant to theseeconomies. Second, much of the theoretical wor k on enterprises has r elated to larger f irms, and in the context of smaller f ir ms, research ef f ort has tended to

f ocus on the larger smaller enter prises. Third, research has been divided between those examining the macro environment within which small and medium-

sized f irms operate and those directed towards the inter nal workings of enterprises.

With respect to the macr oeconomic envir onment the work has involved: assessing the im portance of aggr egate demand and the r ole of macroeconomic

policies f or small enterprise development; the role played by the var ious f ormal sector and inf ormal sector lending institutions that provide credit f or the small

scale sector , and the im portance of pr omotional policies in ter ms of pr oviding manager ial, technical and marketing inf ormation to small enter prises. With

respect to internal f actors, attention has concentr ated on the choice of investment; em ployment; f irm level per f ormance and productivity; capital structure

and the owner ship and incentive structur es f or management.

Four th, ther e has been less work directly related to small and medium-sized enterprises in low income countr ies. It is also the case that the major propor tion

of this work has been em pirical rather than theor etical and it is reasonable to conclude that relatively little is known about the behaviour of entrepr eneurs in

low income countries relative to those operating in higher income countries.

SME Research in Low Income Countries

The liter atur e on low income countr ies f ollows the same divide between studies that are concer ned with external and internal f actors that af f ect small and

medium-sized enterprise development. In terms of external f actors, much of the earlier literatur e in the 1970s was concerned with the biases established

against smaller enter prises through trade and industrial policies pur sued in low income countr ies and with the design of appropr iate support institutions that



would com pensate f or these so-called policy-induced biases. Policies of economic liberalisation were intr oduced later, partly with the aim of reducing the

bias in f avour of larger enterprises. The 1980s also witnessed a greater concern f or the im por tance of r ecognising the need f or and integrating policies at the

macr o, meso and micro level towar ds the development of smaller enter pr ises in low income countries (Stewart, 1990).

Ear lier work on the internal wor kings of small and medium-sized enter prises was mainly concerned with the size of small f ir ms and providing ex planations f or

their growth. Staley and Morse (1965) examined the stages small f irms pass thr ough as an economy gr ows. They postulated several r easons why small f irms

in low income countries initially grow rapidly bef ore their share in total industrial activity begins to decline. Rapid growth of small f irms could be explained

wher e: demand was rising as rural incomes were growing and wher e inf rastructure costs still f avoured small f ir ms locating near f ragmented markets;

subcontracting and local assem bly was common, as f or exam ple in varieties of machine-shop activities and wher e smaller f irms produced a range of

dif f erentiated and innovative pr oducts serving small total markets. But as Ander son (1982) pointed out these propositions had not been quantitatively tested

by the early 1980s.

Ear lier researchers were also pr eoccu pied with investigating the extent to which small f irms f orm the f oundation for larger f irm growth. As Ander son (1982)

reported, the body of that r esearch claimed that,

‘f irms pr actically always begin as ver y small entities, with low amounts of capital drawn f rom the savings of

the owner or borr owings f rom f riends and relatives; initial levels of em ployment are low, typically less than

a dozen, though the f igure varies with the nature of the business; the social and occupational backgrounds

of the owners varies greatly; and the f irms that expand into medium or large scale activities do so

continually or in steps. Expansion can be very f ast f or some f irms, though the growth rates appear as

broadly distributed as their f inal sizes’ (p.923).

Anderson (1982, p.926) concluded that the available em pirical evidence suggested that a signif icant part of the gr owth of lar ge scale enterprises was r ooted

in the expansion of once small f irms through the size distribution.

In low income countries wor k dir ected towards the internal wor kings of enterprises has been ham pered by the lack of basic data on the management and

characteristics of smaller f ir ms. Considerable eff ort has been expended on attem pting to gather consistent and measurable inf ormation about small f irms.

Industrial censuses in a lar ge range of low income countries have not been under taken annually; they have concentrated on larger enterprises; they have only

infrequently surveyed small enterprises and have of ten been pu blished with long delays. As a consequence, usef ul time series data f or smaller enterprises

f rom of f icial sources are lar gely absent.

This has had im plications f or research ef f orts into small enterpr ises in low income countries in three im por tant ways. First, a considerable amount of time has

been spent on gathering baseline inf ormation on small f irms. This has involved identif ying universes and constructing sam ples; devising methods to deal with

delinquent retur ns and editing the r esults in a consistent manner. Second, inf ormation collected tends to be more qualitative than quantitative because of the

poor record keeping and lack of cross ref er encing sources through f ormal channels that can be used to conf irm the reliability of surveyed data. This tends to

limit their use in statistical analysis. Third, surveys are more of ten conducted on an ad hoc basis at a point in time. Few com par e dif f er ent points in time and f ewer still have attem pted to use the same database f or f ollow-u p wor k. As a result time ser ies work on the small scale sector is relatively scarce. The

preoccu pation with gather ing baseline data and the restricted natur e of the data that have eventually been collected has resulted in a preponderance of

studies that have attem pted to describe and r eport on the character istics and f eatures of the small scale sector r ather than test theoretical propositions about

relationships and the expected behaviour of the small f ir m sector. This is not to suggest that theor ising and testing of theories is com pletely absent in relation

to work on small enter prises in low income countries, but in com parison with work in industr ialised countries or in relation to resear ch on the behaviour of

larger f oreign-owned enterprises in low income countries, it is quantitatively much less evident.

In contrast to the earlier wor k, a distinctive f eature of the curr ent spate of em pirical work undertaken in low income countries r ests with its concentration on

attem pting to identif y the constraints f acing the development of the small scale sector (Levy, 1993). Most sur veys have sought to capture the r ange of

f actor s that inhibit the growth and development of small firms. A lar ge pr oportion of this inf ormation has been collected f rom smaller f irms thr ough

questionnair es asking owners and managers to give their views on either the kind of constr aint they f ace, whether it be related to such f actors as access to

f inance, poor managerial skills and lack of training opportunities and the high cost of inputs, or on the severity of the constraints, of ten r anking them on an

ordinal scale. Few studies have concentrated on a particular constraint, so that f inance has most of ten been identif ied as a inhibiting f actor as part of a lar ger investigation into a wider range of variables. The results in terms of the signif icance of f inancing acting as a constraint to development ar e mixed and it is

dif f icult to draw f irm conclusions about the su bject. Interpretation is com plicated because of the qualitative nature of the surveys and to the f act that enquiries

have almost exclusively been dir ected at f irms that exist rather than f ollowing the histories of those that have eventually f ailed.

In summary, it cannot be denied that a considerable amount is known about the behaviour of smaller f irms in a range of areas r elating to gr owth, ef f iciency,

management, investment and em ployment. A smaller propor tion of this work is theoretical in nature. The vast majority of studies, particularly those r elating

to low income countries, ar e em pirical, and in general sur veys have been used to generate basic inf ormation on smaller enterprises where of f icial

enumer ation is lacking. The dilemma f acing researchers is how to maximise the use of existing surveys and f orgo the need f or newer enquir ies which may

waste r esources and time by duplicating or replicating existing sources of infor mation. What seems clear is that, in the past, there has been a too distinct

separation between theoretical work that advances hypotheses about the small scale sector and em pir ical work that has not clear ly sought to test hy potheses

but instead has been involved with describing the characteristics of small enterprises. In par t, this can best be ex plained by the preoccupation with gather ing

original data that in some way has crowded out initiatives to apply the data to test theor ies. Alternatively, it may sim ply ref lect data inadequacies once they

had been collected. Whatever the reasons, it is appar ent that wor k in relation to low income countr ies, where these data pr oblems most evidently exist, has

lacked the f ormalised hypothesis, data collection and testing approaches widely adopted in other br anches of industrial studies.

3. IMPACT OF POLICY REFORM

In the 1990s greater attention has been given to assessing the im pact of economic ref orms on smaller enter pr ises introduced as part of World Bank

structural adjustment programmes (Cook, 1996). Overall views concerning the likely im pact of these ref orms on small enterprise development have varied.



Whereas some claim structural adjustment has brought consider able benef its to small scale enterprises, others stress wide r anging constraints have f requently

prevented such ef f ects f rom reaching small scale enterprises. Em pirical evidence in support of these claims is br ief ly examined in this section in relation to the

array of economic and f inancial ref or ms that have been im plemented in low income countries during the past decade and a half .

The evidence reviewed is f ound in a growing but relatively small num ber of studies that directly attem pt to measure the im pact ofeconomic liberalisation and

structural adjustment on the small scale industr ial sector (Liedholm, 1990; Koppel, 1991; Steel and Webster , 1992; Boeh-Ocansey, 1994; Dawson, 1993,

1994; Steel, 1993, 1994; Vachani, 1994; Zake, 1994; Helmsing and Kolstee, 1993; World Bank, 1995). Further evidence can be extracted f rom a larger

num ber ofstudies which concentrate more specif ically on constr aints to small scale enterprise development. Dir ect causal links ar e, however, dif f icult to f ind

owing to the paucity of time series data that can be used to measure the im pact ofstructural adjustment on small scale enterprise development and to the

limitations of evaluation methodologies.

Studies broadly f all into three categories: those attem pting to deter mine the im pact of measur es designed to work through the market mechanism, such as

interest and exchange rate policy; those that attem pt to assess the overall im pact of policy measures on small scale development, which generally include an

array of market and non-market initiatives; and, those that review the policy environment. The f ormer set of studies tends to r ely on economic data drawn

f rom of f icial statistics such as supplied by the monetary authorities and census bureau f or establishment level data. Studies based on dir ect surveys, as a rule,

tend to focus on whether or not the f actors previously identified as constraining the development of small scale enter prises have been eased or removed.

Finally, policy studies are generally broader in f ocus, reviewing the existing policy f ramework and providing prescriptions, of ten based upon what has

appeared to work elsewhere. This brief review concentrates on the f irst category of studies that have attem pted to evaluate the ef f orts of specif ic policy

packages.

Agricultural Price Liberalisation

Agricultural pr ice liberalisation is ex pected to contr ibute to raising f ar m incomes in situations where government-controlled prices previously led to low

f ar mer remuneration. It is argued that policies that kept agricultural prices at the f ar m gate at a low level provided little incentive f or f armers to ex pand their

output. In com bination with unf avour able exchange rates, this had the ef f ect of stif ling agr icultur al-based ex port pr oduction. Price liberalisation and thelessening of controls over price setting and procurement are expected to im prove r ural incomes and lead to an increase in demand f or non-agricultural

products. It is likely that a signif icant pr opor tion of these goods and ser vices will be provided by smaller enterprises (Elkan, 1993).

In assessing the ef f ects of agricultural price liberalisation on the small scale sector, the im pact ofdevaluation in increasing the cost of agricultural inputs is

of ten lef t out of the equation. Studies show that such increases in the cost of im ported machinery and f ertilisers f requently of f set any advantage achieved

thr ough price liberalisation. Increased costs have prohibited the use of f er tiliser by some Gam bian and Nigerian farmer s r esulting in decreased pr oduction

levels and reduced f arm incomes. Fertiliser costs in Nigeria rose 700 per cent between 1983 and 1990, increasing the cost of f ood production, increasing

prices and r educing rural incomes (Dawson, 1994). As Liedholm (1990) shows, studies in Af rica, including those f rom Sierr a Leone and Nigeria, have

shown a strong link between local income and both demand f or small scale enterprise products and enter prise size. Dawson’s study is no exception. The

reduction in incomes has meant that many could no longer purchase new goods, but instead relied on repair s to existing commodities. The f all in demand for

small scale enterprise products which f ollowed was associated with a move within the small scale enter prise sector f rom production towards activities in the

service sector, particularly in response to the increased demand f or r epairs. Concerns with both access to inputs, tools and machinery and with markets and

demand are also shown to be signif icant in Botswana, Lesotho, Malawi and Zim babwe (Mead, 1994).

In an attem pt to reduce par astatal def icits, structural adjustment policies in Zim babwe have also lead to f alling real producer pr ices since the end of the

1980s. Closur e of rural-depots and f ood security stock sell-outs have contributed to the pr oblem (Pederson, 1994). Low agricultural prices, com bined with

incr easing consumer prices attr ibuted to devaluation and drought, have led to contracting low income and rur al consumer mar kets.

More positive r esults f rom agricultural liberalisation come f r om Ghana and Tanzania. In these countries the num bers ofagricultural r etail and processing f irms

have increased considerably f ollowing price liber alisation and the r emoval of parastatal monopolies. In Tanzania, where controls had previously been

somewhat stricter, the benef its were particular ly evident. The presence of small-traders throughout the country has lead to increased ef f iciency in mar keting

produce and in turn to r educed crop wastage, previously caused by inef f icient state co-oper ative staf f’s inability to collect and purchase cr ops when

necessary. Where the National Milling Corporation in Tanzania previously dominated grain milling, deregulation has lead to a rapid incr ease in the num ber of

small scale milling enterprises (Dawson, 1994).

Import Liberalisation and Devaluation

Removal of trade bar riers, reduction in im port tarif f s and the r emoval of quotas and other im por t restrictions such as licensing ar e expected to im pr ove the

com petitiveness of local enter prises. It is anticipated that im port liber alisation will incr ease access to im ported raw materials and intermediate goods

em bodying new technology that will benef it smaller enterprises. A more open policy towards direct f oreign investment will encourage greater use of su b-

contracting arrangements involving smaller f irms and provide learning oppor tunities for locally em ployed workers to become local entrepr eneurs (World

Investment Repor t, 1994). It is also anticipated that liberalisation will enable small enter prises to acquir e new skills that will assist in the process of im proving

indigenous technological capacity. Im port liberalisation is also ex pected to contribute to the com petitiveness of local enterprises through the consequences of

the direct ef f ect of im port com petition and through stimulating new enter prise entry into the market as im ported inputs previously unavailable lead to lower

costs. The adjustment of over valued exchange rates is likely to im pr ove prospects f or developing the export potential of local labour intensive activities. It is

expected that the price-increasing ef f ects of devaluation will not have a major im pact f or small enter prises since im ported in puts ar e not im portant elements

in their cost structures.

Trade liberalisation and cur rency devaluation measures have had mixed results. As Dawson (1994) highlights, increases in im port costs ofraw materials and

in puts in Nigeria have averaged 515 per cent between the late 1980s and early 1990s. This has resulted in a shift in demand f rom im por ted pr oducts togood-quality locally pr oduced goods in the middle and upper range of the market. Small-scale enterprises able to produce high quality pr oducts have been

able to ex pand in response to increased demand. Of Dawson’s sam ple, 16 per cent of those in Lagos and 26 per cent in Zaria benef ited f rom increased

prof itability, f ollowing tr ade liberalisation measures.

Likewise, the Ghanaian exchange rate which depreciated f r om 2.75 cedis to the US dollar in 1983 to 1075 cedis in 1994, r esulted in prohibitive im port

costs that led, as they have in Niger ia, to the opening u p of specialist niches (Steel and Webster, 1992; Boeh-Ocansey, 1995). Those producing non-



traditional items, in direct com petition with im ported products such as f reezer s, water coolers and dr ums, were f ound to be particularly successf ul. An

incr ease has also been noted in the num ber ofenterprises producing low-cost im port substitutes f or items such as pottery, paint and sim ple agricultural

machinery. Those concentrating on innovative pr ocessing of raw materials and recycled pr oducts also appear to have benef ited.

Similar evidence is revealed in Dawson’s questionnaire survey of 672 small f irms in Suame, Ghana and f rom a 1991 study of small-scale entrepr eneurs in

Tanzania (Dawson, 1993). Devaluations of the Ghanaian cedi between 1983 and 1988, and of the Tanzanian shilling between March 1984 and June 1992,

allowed small-scale enterpr ises to com pete with, and in some cases displace, im ported goods. Ghana’s small-scale industries have been particularly

successful in com peting with products such as machine and tool parts, specialised nuts and bolts and bulky f ood-processing equipment. Increased access to

im por ts and new com ponents has also allowed small-scale industries to diversify product lines, increase output and im prove quality. This has been

particularly benef icial f or those producing f or donors and large f irms who pay high prices f or quality products, f or exam ple saw-millingequipment pr oducer s,

animal f eed-mills and f ood-pr ocessing enter prises producing f or large f irms and donors in Ghana. Evidence of similar benef its being derived f rom increased access to better quality im por ts has also been recorded by Kessous and Lessard (1993) in Mali.

There appears to be dir ect evidence that small enterprises are better able than larger enterprises to adapt to changes in the post trade liber alisation per iod.

In the case of Senegal, the im pact of trade-liberalisationon large-scale over -protected industries was severe. In contrast, small-scale industries adapted

product lines to meet new market niches (Steel, 1993). Successf ul new product lines, including oil presses and ex pellers, water pum ps and storage tanks

and drill presses, have also been adopted in Tanzania (Bagachwa, 1993). Similarly, through skill and institutional development, small-scale textile producers

in Sri Lanka incr eased quality and became more ex port-orientated in response to the trade liber alisation programme which commenced in 1977 (Steel,

1993). Zim babwe has also opted to phase their trade liberalisation process, with initial f ocus concentrating on capital goods and intermediate in puts to allow

f or adjustment in consumer industr ies, although in this case the im plications for small-scale pr oducer s are less clear.

Despite the success stories however, a signif icant num ber ofstudies indicate that the majority of small scale enterprises lack the capacity to meet standards

requir ed within these niche markets (Dawson, 1994). Instead for them benef its gained through the removal of barriers which previously restricted access to

im por ts have been of f set by the rising and prohibitive cost of im ports, cr eated by currency devaluations. While several fir ms in Dawson’s (1993) Tanzanian

study contracted as a result of incr easing im port costs, other s were f orced to cease operation. More than 50 per cent of Dawson’s (1994) Nigerian sam ple

reported a r educed use of im ports f ollowing liberalisation. Since the price of tools and equipment in Zaria increased by 1075 per cent, f ew have pur chased

im por ted power dr iven machinery since 1986. Costs of r eplacement par ts also became pr ohibitive. As a result, 25 per cent of the Zaria sam ple experienced

a decrease in the use of operating equipment and a down-gr ading of technological capacity amongst small-scale enterprises.

The move away f rom mor e technological-intensive pr oduction towar ds a labour-intensive operation may also result, in part, f rom vastlyreduced real wages

and increasing interest rates. Steel and Webster (1992) identif ied similar results in their Ghanaian study, wher e increased labour absor ption was revealed

when 62 per cent of the enter prises sur veyed in their study recorded increases in em ployment and only 39 per cent reported increases in production. The

World Bank (1995) f urther conf irmed this in their studies of Ghana, Mali and Senegal.

Increasing costs of im ported raw materials have also led to increased com petition for , and costs of , local raw materials and recycled products in Nigeria

(Dawson, 1994). Wher eas previously small-scale enterprises had little com petition f or recycled materials such as rubber, metals and plastics, as im port

costs rose large-scale enter pr ises recognised the benef its to be gained f rom recycling existing materials. As a consequence, prices f or these items went up as

demand increased. The prices f or scrap aluminium have increased by 500 per cent, steel by 1000 per cent and plastic by 700 per cent between 1986 and 1993. Likewise, as new export commodities such as tim ber, leather and scrap metal are encour aged, the su pply f or the local market is adversely af f ected.

Evidence exists of lower quality goods and increased prices f or goods catering to the local mar ket. The devaluation of the nair a, while the sur rounding

countries’ currencies remained overvalued, has led to f urther supply problems as materials are smuggled out of the country.

Steel and Webster (1992) also reported that f ollowing price liberalisation the high cost of local raw materials, including agricultural goods, was proving to be

prohibitive f or smaller enter pr ises em ploying between 10-29 em ployees in Ghana. Larger enterpr ises were able to substitute local su pplies f or im ported

in puts.

Small-scale enterprises were also expected to benef it f r om the elimination of im port controls and the foreign exchange auction f or all im ports, im plemented

as part of the trade policy r ef orm programme in Zam bia in 1985. However, administrative requirements, such as the owning of a commer cial bank account,

f requently prevented small-scale enter prises f rom taking advantage of the increased access to f oreign exchange and im por ts.

In some cases, trade liberalisation appear s to have led to increased com petition f rom im ports which local producers have been unable to match. This has

been the situation r egarding the im portation of mass-pr oduced, low-cost, high-quality products against which locally produced, labour-intensive productshave had dif f iculty in com peting. Steel and Webster’s (1992) study f ound im port com petition was signif icant f or 12 per cent of the enter prises. Moreover, in

specif ic sector s, im por t com petition was seen to be more signif icant, with 21 per cent of metal producers (predominantly in agricultural machiner y) and 29

per cent of soap and cosmetics producers viewing im ports as a major sour ce of com petition. Other studies of the ex perience of structural adjustment in

Ghana have cited the signif icance of increased im port com petition (Boeh-Ocansey, 1995). Af ter trade liberalisation, Singaporean vegetable oil and Dutch

soyabean oil were f ound to be or superior quality and cheaper than locally-produced brands; likewise im ported alcoholic drinks were cheaper than a

traditional unref ined local beverage. The increasing cost and decreasing quality of local traditional industrial and micr o-enterprise products, the dum ping of

cheap manuf actured goods and the im por tation of second-hand goods f urther exacer bated the pr oblem.

Trends in Tanzania were similar, with im ported second-hand clothing, plastic sandals and soap having a par ticular ly adverse im pact on local producers

(Dawson, 1993). In Tanzania local standard nuts and bolts have almost entirely been displaced by im ports (Dawson, 1993). Further supporting evidence

comes f rom the Ghana study by Osei et al (1993) where, of the 1365 small-enterpr ises studied, 34 per cent of those who have contr acted since 1983 cited

incr eased im ports as the cause.

Ex port pr omotion policies have also had a limited im pact on small-scale enterprises as few have the capacity to produce suf f icient quantity or quality f or

expor t and lack the necessary contacts and ability to develop this capacity. Only two per cent of enterprises in the Osei et al (1993) study in Ghana wer e

engaged in export production. Likewise, Pedersen’s (1994) study in Zim babwe f ound that, while a signif icant small-scale clothing sector existed, twenty f ive

large-scale f irms accounted f or most ex ports. In turn, the lack of expor t earnings constr ains the purchase of im ported inputs. Over all, the im pact of trade

liberalisation in Zim babwe appears to have had a predominantly negative ef f ect on small-scale enter prises, with a smaller market resulting f rom increasing

f ood prices and devaluation (Pederson, 1994).



Industrial Policy Reforms

Industrial policy ref or ms which f acilitate the access of small-scale enterprises to production and markets previously monopolised by lar ge-scale enterprises,

are intended to pr omote com petition and im pr ove ef f iciency. Similarly, the privatisation and ‘br eak-u p’ options of large-scale public enterprises are also

seen to of f er increased scope f or small-scale enterprise production. The removal of subsidies, protection and long-term su pport to parastatals is seen to

assist this process. It is also anticipated that links between large- scale and small-scale enterprises will be encouraged, particularly where large-scale direct

f oreign investment increases the use of subcontracting arr angements with small-scale enterpr ises. In turn, these are expected to increase skills tr aining, and

encourage technological im provement and increased production.

Evidence su pporting some of these pr edictions is given in the World Bank (1994) study of small and medium-scale enter pr ises in East Asia. It shows that

enter pr ises in middle income developing economies, such as Singapore, Republic of Korea and Taiwan, have benef ited f rom industrial sector ref or ms. Inthis case, it is apparent that a relatively developed market, skilled workf orces, technology-intensive pr oduction and pu blic and pr ivate su pport mechanisms

have assisted small enterprises in capturing niche markets and undertaking sub-contracting arrangements. In contr ast, countries such as Malaysia, Thailand

and, in particular , Indonesia, which have been relatively constrained by less developed markets, less-skilled wor kers and inadequate government suppor t,

have had less success in developing their small and medium-enterprise sectors. The lack of absorptive capacity amongst small-scale enterpr ises is seen as

the largest constraint to their development. Factors such as a lack of management, technological skills, basic technology and insuf f icient f inance are seen to

be signif icant, particularly wher e multinational f irms ar e able to of f er considerable benef its to small-scale su b-contractors who are able to of f er technology-

intensive quality products.

Studies f r om Af r ica highlight similar mixed results. The study by Osei et al (1993), focused predominantly on enterprises at the smaller end of the small-

scale sector in Ghana, shows evidence of only limited use of linkages between small and lar ge-scale enter pr ises. Only 15 per cent of small enterprises

surveyed pr oduced f or lar ge-scale enterprises. Similarly, linkages between small-scale enterprises were f ound in only 18 per cent of cases. In contrast,

Dawson’s (1993) com parative study of Ghana and Tanzania showed that small-scale enter prises in Ghana showed a greater capacity f or technological and

quality im provements and f or developing benef icial links with lar ge-scale enter prises in the gr owth sectors than those in the less sophisticated sector in

Tanzania. Access to equipment f rom government auctions f ollowing the break-up of large-scale state enter pr ises in Ghana, together with the movement of

retr enched skilled government staf f to the small-scale sector, assisted this process. The clustering of f irms in urban areas in Ghana allowed these more

sophisticated f irms to enhance the collective ef f iciency of the sector as a whole thr ough the development of f urther linkages between these and other small-

scale f irms.

The development of external linkages has proven more diff icult f or bothcountries. In Ghana, Boeh-Ocansey (1995) shows that ten year s of structur al

adjustment have done little to entice f oreign investment. Between 1990-1992 FDI inf lows amounted to US$19 million per annum. com par ed with US$68

million in l970 alone. Further more, f inance f or the privatisation of state-owned enterprises has accounted f or much of the f oreign investment inf lows in the

earlier part of the 1990s. Moreover, near ly half of the approved investment por tf olios at the Ghana Investment Centre targeted low-technology, natural-

resource based products, indicating, as Boeh-Ocansey highlights, a lack of conf idence in high-quality production.

It is apparent that small-scale enterprises cannot always take advantage of the newly-created open markets and subcontracting arrangements. Poorly

developed market inf rastructur es put small-scale enterprises at a com petitive disadvantage com pared to larger enter pr ises (Vachani, 1994). Ver tical

integration within large-scale enterprises provides opportunities to lower transaction costs. Lar ge wor kf orces, together with access to cr edit and savings f or technological and skill development, permit skill specialisation in both technological production and support services. A greater capacity also exists f or

developing the necessary contacts with overseas su pplier s and marketing agents and gives larger enterpr ises more clout in contract negotiations. In contrast,

small-scale enter pr ises are f r equently reliant on the market f or support in areas such as accountancy, legal, marketing and transport services and, when

institutional development is weak, suf f er f rom high transaction costs. Moreover, most small enterprises lack human r esource skills f or product innovation and

f or sourcing and negotiating overseas contracts.

High transaction costs f or registration and licensing ar e also f ound to constrain small-scale enterprise operations. High transaction costs related to

government procedures are seen to be par ticular ly pr oblematic in Bangladesh, Nepal and to a lesser extent in the Philippines (Meier and Pilgrim, 1994).

Com plicated time-consuming bur eaucratic procedures, a lack of infor mation regarding processes and the extra pr ocessing payments f requently required, all

adversely af f ect small-scale enter prises relative to larger enter prises which, due to economies of scale and specialist staf f , are able to absorb these costs

more easily.

There is also evidence that ‘administrative discretion’ in the allocation of pu blic procurement contracts disadvantages small-scale enterprises. In many cases

pu blic procurement is no longer limited to public su ppliers, but is open to com petitive tender s f rom the open market. In theory, small-scale enterprises

should be able to benef it f rom government contracts; however pu blic procurement in Bangladesh continues to be dominated by nepotism and in Nepal extr a

payments are required to secure contracts. This puts small-scale enterprises at a further disadvantage (Meier and Pilgr im, 1994).

Finally, the political and social envir onment has also been seen to be im portant in deter mining the success of small-scale enterprises (Steel, 1994). Indeed, a

positive image of prof it-seeking in private business in Taiwan Province of China may have contributed signif icantly to small-scale enterpr ise success (World

Bank, 1994). Conversely, small-scale enterprises in Malawi and Zim babwe have been adversely af f ected by shortages and the high cost of r aw mater ials

which r esult f rom government policies that channel commodities to lar ge-scale enterprises (Mead, 1994).

Pubic Sector Reform

Under str uctural adjustment, governments have intr oduced pu blic sector ref orms which have f ocused on the need to increase tradable production, while

reducing government ex penditur e in the non-tr adable sectors. Policies have therefore concentrated on su pport f or inf rastructure, industry and export

production while f unding to social services has of ten been severely cut. While such cuts are not seen to have a direct im pact on production, their indirectef f ect on small-scale enter prise production is ver y evident. For exam ple, public sector r ef orms, conducted as part of structural adjustment packages, have

led to signif icant levels of retrenchment, f or exam ple in Ghana, wher e more than f our thousand teachers lef t the education system as a result of adjustment

(Cor nia et al, 1987). Moreover , Dawson (1993) shows that around 100,000 wor kers, a f if th of r egistered salary wor kers, were made redundant between

1983 and 1989. Levels of retrenchment of this order can adversely aff ect small-scale industr ies in a num ber ofways. First, many of those leaving pu blic

sector em ployment in Ghana have set u p small-scale enterpr ises owing to a lack of alternative em ployment options available. Osei et al (1993) f ound that

twenty per cent of new enterpr ises established af ter str uctural adjustment were set u p by retrenched workers. While this may be recorded in small-scale



enter pr ise statistics as sector growth, it is more likely to ref lect the need f or small-scale enterprises to act as a labour sponge when aggregate demand is

decreasing. With increasing num ber s of enter prises com peting in a contr acting market in Ghana, a high mortality rate of SMEs has been observed,

particularly in branches where barriers to entry are low. Some sectors, such as engineering, appear to be protected against excessive com petition because

high skill levels raise entry bar rier s. Similar ef f ects of com petition on small enterprises are beginning to be seen in Tanzania (Dawson, 1993).

Second, cuts in education and training and the introduction or increase in education f ees, conducted as part of public sector ref or ms, im pede skills

development to the detriment of those enterprises wishing to progr ess beyond the most basic level of production. For exam ple, low levels of trained human

resources have been observed to result in low productivity levels and an inability to adapt to changing market demands in Ghana (Boeh-Ocansey, 1995).

Third, the retrenchment of government staf f has also had a marked ef fect on demand f or small-scale enterprise goods. Dawson (1994) notes that the

retr enchment of a thir d of salar ied workers in Nigeria led to a signif icant r eduction in urban purchasing power and, in turn, in decreased demand f or new products. Similar evidence is provided f rom Tanzania and Ghana (Dawson, 1993). Likewise, Pedersen (1994) em phasises the im pact of r etrenchment on

markets in r ural areas and small towns in Zim babwe where a lar ge proportion of income comes f rom public sector em ployment.

Financial Se ctor Liberalisation

Financial liberalisation is expected to result in the reallocation of domestic credit towards smaller enter prises, and the substitution of more ex pensive f orms of

credit f or cheaper ones. Moreover, while nominal and r eal interest r ises are anticipated, real r etur ns are expected to outweigh this bur den. It is also argued

that the process of transf erring f rom an administr ative process of credit allocation to a market based mechanism will not only im prove the access to credit

f or smaller local enterpr ises, but will also lower the transactions costs associated with borr owing. Further, in cases where highly su bsidised export credit

schemes exist f or larger enterprises, f inancial liberalisation can be expected to remove this bias.

Questions have been raised in the developing country context over these predictions. Taylor (1988) argues that f inancial liberalisation will not result in more

f unds f or borrowing being available. As interest rates rise f unds available will be diverted out of the inf ormal sector to the f or mal sector. An increased share

of borrowing will take place in the f ormal f inancial sector but the total available f unds between the two sector s will remain unchanged. The net r esult in amacr o sense means there will be no new borrowing and this contradicts the McKinnon-Shaw hypothesis that argues that f inancial liberalisation, by

incr easing interest rates, leads to higher savings, investment and growth. Unf ortunately, the desir ed ef f ects have not always materialised in the way that policy

prescriptions envisaged. As Steel (1994) highlights, high transactions costs and r isks associated with small loans, a lack of collateral and an historical

orientation towards lar ger enterprises, continue to restrict small scale enterprise access to f ormal credit.

The case of Ghana shows that despite f inancial sector ref or m, the str engthening of banking capabilities and the introduction of numerous f inancial

instruments, such as the stock exchange, a venture capital com pany and business assistance f unds, access to institutional credit f or working capital and

equipment continued to be a major constraint to small enter pr ise development (Steel and Webster , 1992). Even where demand f or small scale enterpr ise

products appear ed strong, a lack of credit meant that many small enterprises did not have the capacity to r espond and expand production. Interest rates of

30 per cent or mor e, high transactions costs and an administration and culture unf riendly to small scale enterprises contributed to the pr oblem (Boeh-

Ocansey, 1995). The Ghana study by Osei et al (1993) cites similar evidence; 95 per cent of the respondents depended solely on personal resources and

loans f r om r elatives and f riends. Dawson’s (1993) work in Ghana and Tanzania also conf irms these f indings; of the 672 small scale enterprises in the Ghana

study only two had received a bank loan and in Tanzania the f or mal banking system was seen to be out of r each f or almost all small enter prises. The World Bank reported that around 90 per cent of small enterprises sur veyed indicated that access to credit was a major constraint to new investment (World Bank,

1994).

Kariuki’s (1995) study of bank credit access in Kenya illustrates this point further. A survey of 89 small and medium-scale f ir ms in manuf acturing and

service industr ies, com bined with secondary inf ormation f rom commercial banks, f ound that f rom 1985 to 1990 the aver age real volume of credit f or the

sam ple fir ms f ell, except f or the year 1986 which showed a marginal increase of 1.5 per cent. Several deter rents to utilising f ormal credit wer e identif ied.

Small scale borrower s were f ound to be f aced with higher nominal interest rates at higher inf lation rates in the latter half of the 1980s. Moreover, the explicit

transactions costs of borrowing were f ound to be high in r elation to interest costs.

The cases of Bangladesh, Nepal and the Philippines appear to support these claims (Meier and Pilgr im, 1994). Despite specif ic progr ammes aimed at small

scale enterprises, only between 12 per cent and 33 per cent of those sur veyed were f ound to have access to for mal cr edit and, of those, the major ity were

f rom the larger end of the sector. Again, f actors such as the relatively high cost of processing small loans, the need f or high collateral and bureaucratic

procedures were seen to restrict lending to small scale enterprises. The taxation policies which were also examined were f ound to have little im pact on small

scale enterprises, particular lyas many of those surveyed were f ound not to be paying taxes.

Similar evidence r egarding the lack of im portance given by small scale enter prises to tax policies is also f ound in Southern Af r ica, including Niger, Botswana,

Swaziland, Lesotho, Malawi, and Zim babwe (Mead, 1994). Studies f or these locations f ound little concern f or government regulations, except f rom those

enter pr ises concentr ated in targeted locations and specif ic sectors such as f ood processing. Instead the greatest concern f or the majority of those surveyed

was the lack of access to working capital, credit and f inance.

4. THEORETICAL PERSPECTIVES

Most of the theoretical wor k on small f ir m f inance and the behaviour of institutions that lend to small scale enter prises has beenundertaken on the industr ial

countries, particularly the US and the UK (Chittenden, Hall and Huchinson, 1996). A lar ge proportion of this work has tended to concentrate on f ir ms that,

in ter ms of size, lie towar ds the upper end of the spectrum, where the range of ownership and f inancing options becomes wider.

In gener al, two areas of research have become prominent. First, ther e are studies that have attem pted to examine the im plications of dif f erent f inancial

structures f ound in dif f erent sized f ir ms. In part, these ar e based on survey work which has attem pted to catalogue the range of f inance sources available tosmaller fir ms and to examine their im plications f or growth and investment. In f irms where f orms of equity have been em ployed, this wor k has been extended

to incorporate an investigation into a num ber of distributional issues concerning income f lows to owners and managers and inside and outside shareholders

(Myers, 1998). Much of this analysis has been set within the f r amework of a pr incipal-agent approach. The conditions under which each r espective inter est

operates are examined with ref erence to the internal incentive systems that emerge in f irms and to the external f actor s, such as the macr oeconomic policy

envir onment and the development of legal systems that of f er potential pr otection to outside investor s in f ir ms (La Porter, Lopez-de-Silanes, Shleif er and



Vishny, 1998).

Second, there has been a concentration of theoretically based studies examining the behaviour of var ious lending institutions, as suppliers of f inance to small

and medium-sized enterpr ises. Typically, f or small enter pr ises, these have involved models of lending behaviour based in an agency f ramework. Central to

the hy potheses that have emerged f rom this body of r esearch is the notion that inf ormation asymmetr ies lead to su b-optimal f lows of f inance available to

smaller fir ms com pared to larger f irms. Im perf ect information can lead to restricted f lows of f inance whether the problem lies within the f ir m, thr ough poor

record management or in banks, through the relatively high costs associated with gather ing inf ormation on smaller f irms (Binks, Ennew and Reed, 1992).

There is considerable debate over whether or not banks in low income countries have a com parative advantage in lending to smaller f ir ms precisely because

they may possess an accumulated knowledge concerning the riskiness of investing that places them in a position to make optimal rather than sub-optimal

decisions over lending to smaller enterpr ises. Building relationships with banks increases the infor mation f low between lender and borrower (Ber ger and

Udell, 1995).

The em phasis on the relative lack of theoretical work ought not to im ply that the stock of knowledge gained about f inance and smaller enterprises through

em pirical work is not valuable. Considerable insights have been gleaned f rom a wide range of em pirical investigations (Hall, 1992; Kaplan and Zingales,

1995; Cosh and Hughes, 1996). In terms of work in the UK some general conclusions have emer ged and ar e summarised in Table 1 below. On the right

hand side of the Table, the likely situation in low income countries is presented in order to enable a com parison to be made.

Small Firms in the UK Small Firms in Low Income Countries

small f irms have a high reliance on shor t term f inancing

through the banking sector

a low proportion of their assets are f inanced by

shareholder s so debt to equity ratios are relatively highcom pared to larger f irms

f ixed assets are relatively unim portant in the balance

sheets of smaller f irms

trade credit and trade debt are relatively im por tant

in recent years, leasing and hire pur chase and venture

capital have become more im por tant

small f irms have higher transactions costs than larger

f irms

smaller f irms have greater inf ormation im perf ections than

larger f irms

smaller f irms have poor business planning lack of

interf irm cooperation between small f irms weakens

relations with f inancial institutions

small f ir ms rely on f ormal and inf ormal sectors f or short

term f inance

f amily and f r iends contribute a high pr oportion towards

f inancing small f irms’ assetsunestablished

unestablished

relatively less im portant

conf irmed

conf irmed

more signif icant in developing countries particular lywith

respect to f inancial accounting and management

networks shown to be im portant but little resear ch on

relations with f inancial institutions

The general conclusions shown in the lef t hand column in Table 1 are drawn primarily f r om work in the UK, and have either been derived f r om hy potheses

that have been subjected to em pirical testing or they have resulted f rom direct observation and measurement, and theories have been developed to explain

them. Most of this kind of analysis continues to be undertaken in the context of the industrialised countries which raises a num ber of issues concer ning its

relevance and applicability to the low income country case. Nevertheless, it is usef ul to review some of the theor etical perspectives that have been

developed, principally in an industrialised context, to explain aspects of f inancial behaviour among small f irms and to examine their im plications f or low

income countr ies.

In Table 2 an attem pt is made to select a num ber ofappr oaches relating to small enterprise finance and examine these elements that may contribute to the

development of research in low income countr ies. Column 1 provides a summary of each theoretical per spective while columns 2-5 respectively outline the

im plications for the f inancing and capital structure of small f ir ms, the im plications f or their gr owth, the hypotheses that can be tested and f inally the f actors

that need to be considered when applying the appr oaches to low income countries. The approaches summarised in Table 2 incor porate r esults f rom

em pirically based studies (Bates, 1971); lif e cycle models (Weston and Brigham, 1981); pecking order approaches (Myers, 1984); pr incipal agent models

(Jensen and Meckling, 1976); transaction cost hypotheses and models of f inancial sector refor m.

Table 2

Approaches Financial Structure Implications for Growth

of Firms

Testable Hypothes es Low Income Country

Implications

Em pirical based studies on

financial structur e between

large and small f irms

small f irms more self-

f inancingrely on shorter ter m

bank credit

less likely issue

shares

f irms maximise short run

variables

f inancing gap (no long

term f inance) inhibits growth

f irms maximise f inance

from short term sources

how growth changes with

dif f er ent f orms of f inance

im por tance of working

capital in LIC

capital market

underdeveloped entry to capital market/

stock costly

insider dealing

avoid entry to avoid tax

disclosure



Lif e cycle appr oach to

ex plain f inancial structure

small f irms initially use

owner s resources

f irm survival over

time widens f inancial

sources

rapid growth reduces

liquidity as rely on

short term f inance

f ailure to gain entr y to

equity markets results

in f inancial gap

linear type

progression in

f inancial sources

growth dependent on

obtaining wider

sources of f inance

(which is costly)

failure to gain access

leads to growth slow

down as rely on

internal sources of

finance

f irms r elying on internal

sour ces of f inance f ail to

gr ow over time

higher success rate with

fir ms diversif ying sources of

finance

limited r ange of f inancing

options (venture capital,

f actor ing, trade credit etc)

high f ailure rate among

small f irms in LICs due to

non-f inancial f actors

Approaches Financial Structure Implications for Growth

of Firms

Testable Hypothes es Low Income Country

Implications

Pecking order suggests f irms

financing needs are

hierar chical

use internal sources

then debt

then equity (outside)

ref lects r elative costof sources of finance

owner reluctance to

widen finance because lose

control of fir m

stock market access

costly

if use inter nal f unds

initially, then ex pect f irms

with lower prof its to go f or

external f unds

high profits gives more

inter nal retained ear nings so borr ow less in the short

term

older f ir ms ar e more

liquid so use less external

funds

small f irms only have

access to short term

bor rowing

low liquidity among small

f irms results in under-

investmentgrowth f irms will increase

need f or external f unds if

present use short term cr edit

reduces liquidity. Access to

long term f unds raised

liquidity

(1) Agency theor y

Firms (A) and Banks (P)

high tr ansaction costs

in getting external

f unds

inf ormation problems

cannot access r isk

banks need signals

f r om small f irm

owner s to assess risk

banks want to r educerisk of lending to

smaller f irms

inf ormation problems lead

to moral hazard and adver se

selection

star t-u p f irms are

learning, are less likely to

hide inf ormation and

ther ef ore are attractive to

banks, get short ter m

f inance f or gr owth

incr ease incentives to

agents to act in pr incipal’s

interest to increase lending

conditional contracts to

ensur e repayment facilitates

lending

f irms use collator al to

solve agency problems

small f irms rely on shor t

term credit because of

agency problems

mor al hazard im plies f irms

move to high risk, high

return investments if rates

inter est rise

assumes owners of small

fir ms have mor e inf ormation

than banks

banks reduce risk by

raising interest rates

com petition in banking

lower s interest rate,

small f irms have low

f ixed assets so

dif f icult to induce

longer term lending

by of f ering collatoral

small f irms have poor

record keeping

banks in LICs better

knowledge on f irmsurvival, business

planning so able

assess risk/

overcome agency

problems



banks need to

monitor agent, pass

on costs of

monitoring through

lending

banks follow cautious

lending policy will

ration credit or

charge higher interestrates

collatoral, restr ictive

conditional clauses in

lending

banks with im per f ect

inf ormation less likely use

price mechanism to allocate

their loan f unds leads to

adver se selection, highest

return projects missed

banks in LICs better

vehicle f or

overcoming

inf ormation problems

than equity markets

small f irms willing to

pay more f or cr edit

not given option if

rationing system

operates

monitoring costshigher in LICs

com petition/

regulation banks

suspect

(2) Agency theor y

insider (A)/outsider (P)

inside management

have better

inf ormation than

outside shareholders

insiders derive private

benef its f rom

investment so use

internal f unds, not

want outsiders

gaining control

larger small f irms

wher e macro

environment/legal

protection good,

outsiders have better

inf ormation and

power

higher growth f irms where

legal protection is high have

mor e investment. Outsider s

accept lower dividends in

knowledge that insider s not

misbehavelow growth f irms where

legal protection is high have

low investment since

outsiders take higher share

in dividends

if dividends a

su bstitute f or legal

protection then

insider s go to externalcapital market f or

funds to invest

do other f orms of

ownership lead to dif f erent

investment/ dividend policies

ie cooperatives/

par tnerships

common law systemsof f er better protection to

investors than those based

on civil law

if legal/regulatory

system weak,

outsider shar eholders

not able to demand

high dividends, yield

to insider s power and

are only shor t term

equity investors

entry to external

f unds market requires

credibility on part of

insiders ie pay

dividends

some LICs legally

stipulate payment of

dividends

market f or selling shares

limited in LICs

distinction betweeninsiders and outsiders less

clear



Transactions costs

inter -f irm transactions costs

ar e high f or small f ir ms.

Buyers and manuf acturers

of f set high transactions costs

by dealing in high volumes

limits opportunities

for small f ir ms

investment in

inf rastructure will help

lower transactions

costs

weak inf rastructur e

leads to higher

tr ansactions costs

argued high

tr ansactions costs

need to be su bsidised

in LICs ie tointroduce new

f inancing f or m eg

venture capital

Financial market

im per f ections (K, L)

lowers cost of capital

and f avours labour

lower wages f avour

smaller f irms

higher ef f iciency of

larger f irms means

high wages

capital market and labour

mar ket distortions im pede

growth

capital market

distor tions result in

small f irms with a

smaller proportion of

net value added

small scale sector likely to

be smaller than it would be

if no f actor market

distor tions

capital intensity

would be higher in

small f irms if no

distortions in capital

market

when f actor market

distortions then lower

pr oductivity of

smaller f irms willresult in higher

pr oportion of

em ployment in total

even though

pr oportion value

added is lower

com pared to larger

f irms

f actor market

distortions greater in

LICs

existing studies on

ef f ects of

liberalisation givemixed r esults

argued high

tr ansactions costs

The pr incipal-agent model r elating to lending behaviour can be taken to illustrate the kind of issues f aced when applying models of this ty pe to low incomecountries. As developed, the application of principal-agent theory argues that banks have less perf ect inf ormation on smaller f ir ms than larger f irms (costs of

gathering this inf ormation are higher ) and, as a consequence, lending to smaller f irms is riskier. The observed outcome f rom this analysis is less lending to

small f irms r elative to larger ones. In turn, lending institutions are likely to demand higher risk premiums.

In the developing country context, however, it may be argued that banks have better infor mation to assess the r iskiness of an investment than the small f irm

itself . This is because they ar e continually lending to small f irms over extended periods of time and have acquired suf f icient insights to be able to make

sensible and sound judgements over lending decisions. Banks may have more experience about a small ventur e’s survival prospects than it has inf ormation

on larger f irms, since the latter may be in a better position to conceal and manipulate inf ormation to their own advantages. Measuring the extent of

information asymmetries is intrinsically dif f icult. Nevertheless, the low income case may challenge the applicability of principal-agent analysis in terms of the

conventional f orms established in an industrialised country context, and lead to new insights in which lending institutions, rather than being seen as villains, are

acting in the interests of small f irm development.

Similarly, the macro and legal environments are assumed to provide im portant conditioning f actors on the behaviour of borrowers, lenders and investors in

some of the theories outlined in Table 3. In a low income context this may be even more r elevant in the sense that a stable macroeconomic environment and

a strong legal system provides signif icantly higher levels of protection f or potential lenders and investors. Alternatively, this may be of little consequence f or

smaller fir ms whose source of f unding comes predominantly f rom f amily and f riends.

Sim ply examining the way in which the demand or supply of f inance changes in response to policy changes may not be enough to indicate what kinds of

enter pr ises will survive and contribute to economic gr owth. A usef ul per spective may be adopted by attem pting to im plant f inancial elements into an



approach adopted by Dawson (1993) in an earlier study of Ghana and Tanzania. In this study an attem pt was made to identif y a set of char acteristics

em bodied in small enter prises which were either f avoured or disf avoured by the adjustment process. Table 3 repr oduced below indicates the im portance of

technical and technological f actor s in determining the way in which small enterprises are likely to respond to structural adjustment. The relatively more

technologically sophisticated enterprises appear to have been more able to upgrade their products and services to a level wher e they have been able to

develop linkages with the f aster growing sectors of the economy and overcome scale constraints by f inding new so-called niche markets mor e suited to their

economies of f lexibilityand ser ving an im port-substitution f unction.

Table 3 Enterprise Characteristics Favoured and Penalised by Structural

Adjustment Programmes

Characteristics Favoured Characteristics Penalised

- Low im port dependence - High im port dependence

- Development of linkages with gr owth

sectors of the economy

- Few linkages - demand mostly f rom low-

income groups

- Signif icant technological enhancement - Little technological enhancement

- High bar riers to entry - Low barriers to entry

- Innovation - Cut-throat com petition

- Serving an im port-substitution f unction

Sour ce: Dawson (1993)

In contrast, enterprises that were technologically weaker tended to remain dependent on low income groups f or their main mar kets, whose purchasing

power may have been declining under adjustment.

What this ty pe ofanalysis and the com parison between Ghana and Tanzania clear ly pointed out, however, was not the im portance of the cross-countr y

dif f erences in the response to adjustment processes but var iations between dif f erent types of enter prises within the countries. As pointed out above, some

enter pr ises were better able to r espond to the changes created in the policy environment than other s. In this r espect the cr eation of an environment f avouring

small scale enterprise development may not be suf f icient to ex plain why some enterprises im prove their perf ormance and other f ail. The response of small

scale enterprises to structur al adjustment ref or ms is more likely to be related to a wide range of f actors, including internal enterprise characteristics, the level

of development of the economies’ inf r astr ucture and the institutional and political f ramework that reinf orces the sector’s development.

5. CONCLUSIONS

At this stage at least f our strands of r esearch can be indicated that com bine theoretical and em pirical per spectives.

(1) Research is needed on the f orms of f inance used by small and medium-sized enter prises and made available by lending institutions and

investors. In par ticular , a clear picture is required of the f inancing dif f erences between f irms of dif f erent sizes and the dif f erences in f inancing in

r elation to types of owner ship str uctures. Cross country and regional diff erences may also exist in these respects.

(2) Research is required into the relation between dif f er ent f inancial f orms and f irm level perf ormance. Existing research on small size and

per f ormance has not isolated the im portance of dif f er ent f orms of f inance. Methods should be devised to examine the relationship between

dif f erent f inancial structures of f irms and a range of perf ormance measures (including out put, productivity, em ployment, and survival rates).

(3) Research is required r elating to the behaviour of small and medium-sized f irms with dif ferent f orms of finance. We need to predict how

dif f erent f or ms of f inance will af f ect the allocation of prof its between income (dividend f lows), investment and consum ption and their ef f ect on

other f orms of expenditure r elating to innovation, marketing and human resour ce development through training. In particular, the links need to

be made between dif f erent f orms of f inance and the im pact of small f irm development on poverty alleviation.

(4) Research is required on the supply side of finance, involving for mal and inf or mal sector lending institutions and savers, and the

macroeconomic environment, including economic policies, promotional policies and the role played by private, inter national and non-

gover nmental or ganisations.

A f inal point needs to be made. Smallness of f actory or plant size is not in and of itself a virtue. The development of SMEs must be a coherent part of a

development progr amme aimed at the achievement of explicit socio-economic objectives which vary both overtime and between countries. Appropriate and

ef f ective policy packages f or SME development will similar ly var y and it cannot be assumed that there will exist a standard policy package. The conditions

under which SMEs can r ealise their em ployment and growth potential have to be identified and the links with poverty alleviation and other development

objectives clearly established.



As Br yce (1965, p.77) warned:

Properly def ined and r ealistically appr oached, the small-industry f ield is

im portant and can contr ibute much to the whole process of industrialisation.

If conf used by sentimentalism and approached emotionally with little regard

f or the costs and benef its involved, small industry development can easily

become a missionary movement which accom plishes little but which diver ts

scarce resources of development funds and people away f rom other

activities which, in most situations, could produce more industrial gr owth.

(Bryce, 1965, p.77)

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Finance and Small and Medium Enterprise Development

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