Another Approach: Investing in SMEs

This is the first in a three-part series about small- and medium-sized enterprises

The wikipedia picture for the "Small and Medium Enterprise" entry.

In March of 2008, James Surowiecki wrote an article for the New Yorker, titled “What Microloans Miss,” that suggests that the disproportionate amount of attention given to microfinance has steered funding away from other avenues for development.  A year and a half later, the Boston Globe included a piece on two recent studies on microfinance questioning its efficacy,  titled “Small Change.” Both articles revolve around the same central premise: microfinance, while effective at relieving some of the burdens of day-to-day living, does not create jobs.  It is rare that a microbusiness receiving a loan has paid employees.  In other words, microloans allow women to start a business, but more independent businesses do not help to alleviate poverty on a macro (national) scale.  Small- and medium-sized enterprises (SMEs), according to Surowiecki, are the engines of development.  Here he discusses what considers to be the problem of the cult of microfinance:

Both socially and economically, microloans do a lot of good, working what Boudreaux and Cowen call “Micromagic.” But the overselling of their promise has made us neglect the enterprises that could be real engines of macromagic. The cult of the entrepreneur that the microfinance boom has helped foster is understandably appealing. But thinking that everyone is, and should be, an entrepreneur leads us to underrate the virtues of larger businesses and of the income that a steady job can provide. To be sure, for some people the best route out of poverty will be a bank loan. But for most it’s going to be something much simpler: a regular paycheck.

The benefits of increasing support for SMEs in a country are real and quantifiable.  Consolidation into the formal sector provides more people with steady jobs and offers workers better health and wage benefits, disability, pensions, etc.  These businesses help to reduce the size of black markets and generate taxable income.  What’s more, a majority of microentrepreneurs would prefer a steady paycheck with job security to their current situation.  I don’t disagree with the idea that vehicles of mass production – a factory, or a plant, or a farm – create strong upward momentum for poorer people without employment.  But every country has a different profile, and the success of the development approach depends on the different strategies of development.

A graph from the World Business Council for Sustainable Development's report, "Promoting Small and Medium Enterprises for Sustainable Development."

An enlightening graph from the World Business Council on Sustainable Development.

There are several reasons why SMEs may be more difficult to nurture in parts of the developing world.  For one thing, many SMEs are in the manufacturing sector, where success is driven by efficiency and cost-reductions.  These businesses require adequate infrastructure, roads, and access to ports, or at least hubs to which they can transport goods.  They thrive in urban environments, where the population density is high and the labor pool is vast.  Many of the poorest live in rural communities, in small communities far from cities.  Even for business with access to these crucial resources – labor, transportation routes, raw materials – globalization has developed in a such a way that labor-intensive work is almost always outsourced most cost-effectively to China or India.  SMEs are most celebrated in the latter, where they represent 45% of manufacturing output and 40% of the total exports.  These businesses employ at total of 60 million people over ~27 million businesses throughout India.  These statistics are appealing, but are specific to India.  In his article, Surowiecki discusses the issue, and specifically cites India as the model:

Microfinance has led us to focus on lending, but it can be hard for young companies to get big purely on bank loans, which consume cash flow that could be reinvested in the business. Supplying the missing middle will require backers who want to invest in companies rather than just lend to them. There’s been some progress on this front of late; three weeks ago, Google.org, the Soros Economic Development Fund, and the Omidyar Network announced that they are setting up a firm in India that will invest only in small-to-medium businesses.

It is true that these businesses are squeezed, and end up with unfavorable loan terms.  It is not as if some countries that rely on heavily microfinance loans can choose to throw their hat in the global garment manufacturing ring and expect to be competitive.  The same is true for just about any other type of manufacturing.  A toy factory will never be competitive in the global market with a scale manufacturer in China.  On the other hand, SMEs that engage in manufacturing for the domestic market can do very well, if appropriately capitalized.  For example, a furniture-maker in the Philippines that employs 4 people to build one table and four chairs might be able to double his business if given the capital.

Agriculture is a good example of an industry where organization and scale is highly beneficial.  Landowners with large amounts of capital can invest to make the land more productive, in turn paying workers a higher wage and, provided the sector is regulated, can treat them with respect and dignity.  It is probably better for a group of 1,000 people to be working on the same farm, in which the people running the show have the agricultural knowledge and economies of scale to run an efficient operation, than for those same 1,000 people to each operate their own farm.

In this graph, the WBCSD highlights an ironclad causal relationship.

My point is not to dismiss the notion that small- and medium-sized enterprises are good for an economy, or that they are overshadowed in the limited world of development funding – both are the case.  But I do think that the types of SMEs that have been so successful in India (IT outsourcing and manufacturing) may not be feasible or practical in other countries.   The success of the Asian export model to GDP growth might not be replicated elsewhere without new consumer markets, especially after the global financial crisis set back global consumption several years.  In the meantime, microfinance offers hope for individuals if not rapid progress for countries.

It may be difficult for SMEs in some countries tap into the global, or even local, markets.

In response to the article, Ben Moyer, the CEO of Pro Mujer, one of the largest MFIs in Latin America, points out what he considers to be the fallacy in Surowiecki’s logic:

Surowiecki misses an important point of microcredit. The goal is not to make “poor countries richer”; it is to bring desperately poor people out of poverty by helping them to become self-sufficient. At Pro Mujer, our microloans go to the poorest and least educated women in Latin America—most of our clients earn under two dollars a day and many earn less than that. We also give them health-care services and business training so that their businesses have a greater chance of success. When women earn more money, it has a huge multiplier effect, since their income often pays for their own and their children’s health care and education. Perhaps the children of Pro Mujer’s clients who are in school because of their mothers’ business success will one day benefit from the larger investments that Surowiecki is referring to. For now, the impoverished semiliterate and illiterate women receiving microloans won’t benefit from investments in the “missing middle.” Microcredit will continue to offer the best return on investment, because it eradicates poverty one person at a time.

It is important to promote small and medium sized enterprises.   But I think that Surowiecki is wrong to downplay the role of microfinance, however, particularly when many of the very SMEs that need capital started as microbusinesses.   Microfinance serves people that SMEs often do not, cannot, and probably will not, if they do grow in scale and size within a country.

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