MSMEs and finance as a binding constraint

Small, medium and microenterprise sector (MSMEs) is of immense importance especially for emerging markets like Pakistan, contributing more than 50% to the GDP of the country and employing around 72% of the nation’s industrial labour force.

Even though the sector faces constraints in terms of inadequate access to infrastructure, absence of business-friendly regulatory framework amongst others, the primary constraint identified is the lack of availability of finance to fund such organizations’ survival and expansion. Such phenomena is not only common in Pakistan but has also been observed in most developing countries across the globe.

Access to finance remains one of the key primary constraints hindering the growth of MSMEs in emerging markets, and not allowing them to participate in international markets via global value chains. The case is rampant especially in case of Central Asia Regional Cooperation (CAREC) countries which include Azerbaijan, Georgia, Kazakhstan, Kyrgyzstan, Mongolia, Tajikistan, Turkmenistan, Uzbekistan, Afghanistan, Pakistan, and China.

Difficulties in such firms' access to finance has significantly contributed to the resultant low exports and falling competitiveness. Other than low provision of domestic credit to private sector firms and a high real interest rate, many of the MSMEs firms face challenges having access to the much-needed finance to grow and expand their capacities.

Relative to most of its peers such as India, Bangladesh and Vietnam, Pakistan’s MSME’s export dependency on external finance has remained close to constant over the years, whereas peers’ dependency on it has increased, implying that owing to low orders, Pakistani firms have not undertaken much expansion relative to the peers, which have become more interconnected with the global financial system and require external finance to produce and deliver high-quality exports.

The implication can be corroborated by analyzing the World Bank firm-level survey, in which exporters cited reported up to 92% of the finance required being internally funded as compared to the 72% in South Asia, implying that Pakistani exporters are not taking advantage of widely available external finance for business expansion.

Since MSMEs play a vital role in exports of the country, it can be inferred that internal finance to be much more common for small-sized firms relative to medium and large corporations. Furthermore, when having access to finance, the need to provide collateral for Pakistani firms is 1.25 times in the South Asian average, which will be even higher than small-size firms.

Moreover, most of the country's exporter firms rely on non-traditional finances and internal savings. Only 2.50% of the companies are financed through formal banking channels relative to 15.30% of the South Asian and 17.60% World average, respectively. The figure for MSMEs can be expected to be extremely high.

Lack of finance does not only serve as major hindrance to growth of MSMEs but also affect ancillary industries as well such as suppliers of raw-materials and other complementary inputs, as when cash-flow cycle is affected, complete business-cycle is halted, which can be extremely detrimental to the short-term survival of MSMEs. Such firms not only have to bear the cost of working capital, but also must pay for participation in global value chain operations.

Mostly, such firms cannot afford insurance premiums and therefore, must bear the brunt of the cost should any damage to the goods occur. In emerging markets such as Pakistan, inadequate infrastructure coupled with a weak regulatory framework to impose copyrights infringements induces an extremely high probability of the goods produced by a particular MSMEs to be damaged or copied, respectively, thus, increasing the potential cost to be incurred solely by the MSMEs themselves.

Even MSMEs, which do get access to finance, face stringent conditions in the case of high interest rates, stringent condition to provide collateral and preference for timely interest payments, which further puts a strain on the working capital requirements of such firms. According to a study by ADB “Leveraging SME Finance Through Value Chains in CAREC landlocked Countries”, edited by Peter J. Morgan and Naoyuki Yoshino(Peter & Naoyuki), such a phenomenon was widely observed in the CAREC countries, especially former Soviet states, where public sector still dominates much of the economic activity and the private sector is at its nascency.

Restricted and inadequate access to finance to MSMEs also result in such firms investing much less capital in acquiring technology to become more competitive at the national and global stage. Consequently, such firms find it extremely difficult to break the constraints for entering the global high-value markets.

To make the matters worse, such countries are negatively impacted by the external demand and supply shocks such as the recent COVID-19.

The pandemic, which started in late 2019, caused major disruptions in global supply chains as well as reduced the global demand for products being manufactured by MSMEs.

A study conducted by the CAREC Institute, 'Impact of COVID-19 on Micro, Small, and Medium-sized Enterprises (MSME) in Selected CAREC Countries' found that from Kazakhstan to Uzbekistan, small businesses were the ones most affected by the policy of nation-wide lockdowns.

Since, as part of lockdown strategy, countries also curb public transport systems, the local outreach of MSMEs was negatively affected, causing many of them in need of raising additional finance, which also became extremely difficult to limitations placed by the financial institutions to protect their own liquidity and cash-reserves.

Similar situation was observed in CAREC countries, including Pakistan. Despite the challenges faced by such firms, in general, most of the MSMEs did not receive any external or governmental support during the pandemic. Some of the largest of MSMEs, however, did receive support in terms of tax relief and soft loans (CAREC Institute, July 2021)

Access to finance in CAREC countries, including Pakistan, has proven to be the fundamental binding constraint when it comes to expansion and sustainable growth of such firms.

Since economies of most of the CAREC countries is driven by public sector, the state can play a pivotal role in addressing the constraint and taking relevant measures, which will allow MSMEs, -which form approximately between 45 to 50% of the GDP of such countries-to grow, sustain and expand into international markets and reap the benefits of higher returns.

In addition, increased profitability, technology and skill transfer are other primary advantages such firms will experience. Therefore, equipping the whole economy with the benefits of participating in international markets through global value chains.

To achieve that, however, the governments can offer soft loans, micro-insurance, training of owners and managers, providing financial literacy amongst others. Other measures that CAREC governments can undertake is to reform regulatory financial framework and introduce non-traditional means of finance such as Islamic-banking and delve into novel financial instruments. Novel instruments are necessary as few entities are willing to take responsibility to share the risk of failure with MSMEs.

One of the fundamental reasons for that is that the risk is extremely high and only the government or state-backed financial institution posses the ability to share it. In doing so, the government will be addressing one of the key concerns of MSMEs, and thus, allowing them to take risk and be as innovative as possible. Furthermore, to complement financial access, the government can fund special programs in collaboration with foreign institutions on entrepreneurial training, encouraging networking amongst the MSMEs and introduce productive yet cost-effective information technology systems. Such a cross-country coordination in sharing skillset and pooling of resources together can result in firms making a joint funding pool to undertake collaborative investment projects, which will benefit all.

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