“Policymakers in developing countries are very interested in helping the SME sector and the World Bank is often involved in designing SME strategies,” says Asli Demirgüç-Kunt, Senior Research Manager (Finance) at the World Bank, “Our research takes a much-needed look at the effect of SMEs on development, their growth constraints, and policies to overcome these constraints—areas inadequately researched until now.”

Improve the overall business environment for all firms

The Bank’s latest research emphasizes the importance of strengthening the overall business environment for all firms, instead of focusing on and subsidizing SMEs. In fact, there is no robust evidence that SMEs by themselves matter for growth or poverty alleviation.

“Splitting big firms into small firms or subsidizing small firms will not lead to faster growth,” says Senior Financial Economist Thorsten Beck. “More fundamental reforms must first be instituted to tackle the underlying reasons why firms do not fulfill their growth potential.”

These reforms should lead to a better business environment that promotes competition, protection of private property rights, and a sound contract environment. All of these are proven to boost economic growth, says Beck.   

 SMEs need better access to finance to overcome obstacles to growth

SMEs face greater growth obstacles than larger firms, and limited access to finance is an important one of these. Further, compared to large firms, small firms are also more constrained by these obstacles.
 

 
This graph shows the effect of financing, legal and corruption
obstacles on firm growth and is based on a regression of firm growth
on the respective growth obstacle, interacted with dummy variables
for small, medium-size and large firms, and controlling for other
firm and country characteristics. 
Source: Beck, Demirgüç-Kunt and Maksimovic (2005). 

“Inability to access finance may be one of the reasons why we do not see a robust correlation between SME prevalence and economic growth,” says Demirgüç-Kunt. 

“It appears that financial constraints are particularly preventing small firms from reaching their growth potential.”   

Improving institutions is certainly the best way to level the playing field so that all deserving firms—including small ones—will be able to access finance, she concludes.  

Well-developed financial institutions help small firms the most

Recent research also finds that financial development helps small firms the most.  Both firm-level and industry-level studies suggest that small firms do relatively better compared to large firms in countries with better-developed financial institutions.

With financial development, small firms grow faster since their financing constraints are relaxed to a greater extent.  Further, industrial sectors that should naturally have a disproportionately large number of small firms also grow faster with financial development, suggesting that it is the small firms that benefit the most.

The lack of well-functioning financial markets and underdeveloped legal systems makes it very difficult for firms to grow to their optimal size since outside investors cannot prevent expropriation by corporate insiders. 

“This is important for SME-promotion strategies,” says Beck. “If it is optimal for firms to stay small in countries with underdeveloped institutions, simply subsidizing SMEs may be at best ineffective—and at worst, counterproductive.”

A weak business environment hampers firm entry

It is not only firm growth that is hampered by weaknesses in business environment, but also entry.  Bureaucratic entry regulations impede entry but perhaps more importantly, they also negatively affect the growth and size of incumbent firms. 

However, other regulations such as those that enhance the enforcement of intellectual property rights or those that lead to a better developed financial sector are beneficial in that they lead to greater entry.

Similarly, firm incorporation decisions and entrepreneurship are also affected by the business environment.  In fact, research shows that a poor business environment may actually lead to a larger SME sector, because restrictions and market imperfections dampen competition and slow firm growth, further shedding light on why a large SME sector is unlikely to be associated with faster growth.

A comparison of Italy and U.K. illustrates this effect. In Italy, where entry costs are 20 percent of GNP as opposed to 1.4 percent of GNP in U.K., there are many small firms yet slower growth.

The problem in Italy is that the SME sector has many old and inefficient firms compared to its UK counterpart. Indeed, firms start out larger in Italy, but grow more slowly so that firms in the U.K. are about twice as large by age ten. 

Italy vs. UK
Firm Size at Entry and Over Time

This graph shows the average value added for firms at entry and over time in Italy and the U.K.
Source: Klapper, Rajan and Laeven (forthcoming).

Businesses are also more likely to incorporate in countries with better-developed financial sectors and efficient legal systems. Similarly, individuals are more likely to become entrepreneurs and they are more likely to reinvest their profits if the institutional environment is favorable.

Innovative lending technologies can help in the short term

Although developing institutions and building a more enabling business environment are key to improving firm entry and performance, and particularly that of smaller firms, institution building is a long term process, fraught with many challenges.

In the interim, innovative lending technologies hold promise. These can provide market-friendly ways of relaxing the constraints of the SMEs. Some technologies, such as factoring are particularly promising in the interim, since they rely on institutions to a lesser extent. However, others such as credit-scoring and leasing can also be useful for relaxing the financing constraints of SMEs and their use would improve with development of institutions over time.  

“Foreign institutions have an important role to play in facilitating the adoption of these technologies, whereas public banks have been less useful in the past,” says Demirgüç-Kunt.

Researchers

Thorsten Beck  is a Senior Financial Economist in the Finance Team of the Development Research Group of the World Bank. He has published articles about the impact of financial development and structure on economic growth, the determinants of financial development, and the link between international trade and financial development. His recent research has focused on the effects of bank concentration and competitiveness, access to financial services, and the impediments to growth that SMEs face. His country experience, both in operational and research work, includes Bangladesh, Bolivia, Brazil, Cameroon, Guinea, Kenya, Madagascar, Mozambique, Russia, Rwanda and Uganda. He holds a Ph.D. in economics from the University of Virginia and a M.A. degree from the University of Tubingen in Germany. He also studied at the University of Kansas and the Universidad de Costa Rica.

Asli Demirgüç-Kunt holds the joint appointment of Senior Research Manager in Finance, in the World Bank's Development Economics Research Group, and Senior Adviser, Operations and Policy Department in the Bank's Financial Sector Vice Presidency. After joining the Bank in 1989 as a Young Economist, she has been in different parts of the Bank, working on external finance and domestic financial sector issues. Her research interests include how financial development contributes to economic growth and poverty reduction; and how best to improve the stability, efficiency and reach of the financial systems around the world. She has published widely in academic journals. Prior to coming to the Bank, she was an Economist at the Federal Reserve Bank of Cleveland. She holds a Ph.D. and M.A. in economics from the Ohio State University.

References
Ayyagari, Meghana, Beck, Thorsten, and Demirgüç-Kunt, Asli. 2006. Small and Medium Enterprises Across the Globe, Small Business Economics, forthcoming.

Beck, Thorsten, Demirgüç-Kunt, Asli, 2006. Small and Medium-Size Enterprises:
Access to Finance as a Growth Constraint, Journal of Banking and Finance, forthcoming.

Beck, Thorsten, Demirgüç-Kunt, Asli, Laeven, Luc and Maksimovic, Vojislav. 2006. The Determinants of Financing Obstacles, Journal of International Money and Finance, forthcoming.

Beck, Thorsten, Demirgüç-Kunt, Asli and Maksimovic, Vojislav. 2006. Financing Patterns Around the World: Are Small Firms Different?, World Bank Mimeo.

Beck, Thorsten, Demirgüç-Kunt, Asli and Levine, Ross. 2005.  SMEs, Growth, and Poverty: Cross-Country Evidence, Journal of Economic Growth 10,197-227.

Beck, Thorsten, Demirgüç-Kunt, Asli and Maksimovic, Vojislav. 2005. Financial and Legal Constraints to Firm Growth: Does Firm Size Matter? Journal of Finance 60, 137- 177.

Beck, Thorsten, Demirgüç-Kunt, Asli and Maksimovic, Vojislav. 2005. Financial and Legal Institutions and Firm Size, Journal of Banking and Finance, forthcoming.

Beck, Thorsten, Demirgüç-Kunt, Asli, Laeven, Luc and Levine, Ross. 2006. Finance, Firm Size and Growth, World Bank mimeo.

Berger, Allen and Udell, Greg. 2006. A More Complete Conceptual Framework for SME Financing, Journal of Banking and Finance, forthcoming.

Biggs, Tyler and Sha, Manju Kedia. 2006. African SMEs, Networks, and Manufacturing Performance, Journal of Banking and Finance, forthcoming.

Cull, Robert, Lance, Davis, Lamoreaux, Naomi, and Rosenthal, Jean-Laurent. 2006. Historical Financing of SMEs, Journal of Banking and Finance, forthcoming.

Demirgüç-Kunt, Asli, Love, Inessa and Maksimovic, Vojislav. 2006. Business Environment and the Incorporation Decision, Journal of Banking and Finance, forthcoming.

Djankov, Simeon, Miguel, Edward, Qian, Yingyi, Roland, Gerard and Zhuravskaya, Ekaterina. 2004. Who are Russia’s Entrepreneurs?, World Bank mimeo.

Klapper, Leora. 2006. The Role of Reverse Factoring in Supplier Financing of Small and Medium Sized Enterprises, Journal of Banking and Finance, forthcoming.

Klapper, Leora, Laeven, Leora and Rajan, Raghuram, 2006, Barriers to Entrepreneurship, Journal of Financial Economics, forthcoming.