The Role of SMEs in Economic Development: International Experience and Perspective

1. The Role of SMEs in Economic Development: International Experience and Perspective Colombo, October 13, 2014 Dr. P. S. Srinivas, Practice Manager, Asia Trade & Competitiveness Global Practice World Bank Group

2. Developing countries need jobs and growth…….and SMEs are big part of the solutionand SMEs are part of the solution 200 millionpeople are unemployed globally 600 million new jobs needed in next 15 years to absorb new entrants 99.8% of enterprises in developing countries are SMEs 37% of GDP is accounted for by SMEs 80% of all jobs are in SMEs 24% of exports are generated by SMEs

3. Share of Formal Jobs SMEs and jobs • 50% of all formal jobs in developing countries are in small firms ….and SMEs contribute 2/3 • The importance of SMEs for jobs is greater in low income countries (LICs) • SMEs create 86% of new formal jobs , a number that rises to 95% in low income countries • Older SMEs (>10 years) provide almost ¼ of jobs • An extra 60% of jobs are in the informal sector which is mostly micro; but has some small firms that could grow if constraints are solved. Employment Shares across countries by Size and Age* Creation of Formal Jobs Informal Jobs *Source: Small vs. Young Firms Across the World: Contribution to Employment, Job Creation and Growth, World Bank Policy Research Working Paper #5631, April 2011 by M. Ayyagari, A. Demirguc-Kunt and V. Maksimovic; Based on WBG Enterprise Surveys

4. Many different kinds of SMEs…..but all critical to economic development • Informal sector correlated with low productivity, and poverty • Many large firms employ more highly educated professional staff so may not create opportunities across society • For unemployed people, informally employed or underemployed, SMEs represent a key path to prosperity • At the same time, most SMEs face an uneven playing field which stunts their potential to grow Improving the ability of SMEs to become more productive and create more jobs is key to achieving many governments’ objectives of eliminating poverty and reducing inequality

5. The composition of the SME sector changes as country income rises • As country income levels increase: • Informality declines • SME “churn” increases with active entry and exit • SME productivity increases • Large firms grow their share of employment • There are fewer binding constraints to growthdue to improvement in Institutions SME Share of Formal Employment , Informal Sector and Entry Density* (Entry/1000 pop.) * Small vs. Young Firms Across the World: Contribution to Employment, Job Creation and Growth, World Bank Policy Research Working Paper #5631, April 2011 by M. Ayyagari, A. Demirguc-Kunt and V. Maksimovic

6. SMEs are predominantly involved in low-addedactivities across a large selection of industries

7. SMEProductivity • SME labor productivity is low SME Labor Productivity (US$’000) Thailand SME Labor Productivity (US$’000) % Source: Economic Intelligence Center 2012 7

8. Competitive sectors register more high growth firms Competition encourages firms to innovate and renew technologies Rubber Wood Elect. Equipment Communication Equipment Apparel Paper Vehicle Textile Tobacco Office Equipment Petroleum Source: World Bank

9. SMEs vs. Young firms – Focus on promoting entrepreneurship Entrepreneurshipis the creation and growth of new firms. Young firms create more employment and are more productive. Colombia – Young firms create most jobs regardless of size Indonesia – Start up companies are more productive1 relative to incumbents Productivity of startups relative to incumbents Employment created Size of firm Productivity of start-ups surpasses incumbents in year three after onset of firm – no evidence that these are concentrated in specific areas. Age of firm (years) 0-4 5-9 10-14 15+ All Source: Eslava and Haltiwanger (2013); Data Timeframe (1993-2009) Source: Javorcik, Fritani and Iacovone (2012) 1: Total factor productivity

10. Summary…….. rationale for public policy They represent all but 0.2 % of enterprises, account for nearly 80 percent of jobs, but for only 37% of GDP and 24% of exports. 1 Most are in low value added activities, and in services, despite SME policies in almost all countries 2 They are generally less productive than larger companies and most remain small, over time 3 Only a small portion (1 percentile in most Asian countries) grow and account for the bulk of value added and jobs.Most remain small over time 4 5 Rateof informalityishigh. SMEs face different constraints compared to large firms. Suffer more than large firms from weaknesses in the investment climate, lack of access to finance, and lack of leverage with government 6 7 Constraints vary by stages of development of SMEs

11. Typical approach to SME Programs Well intentioned Governments want to remove constraints but in most cases end up “throwing money at the problem” 1 Too many programs, too many implementing agencies, no or inadequate M&E, limited adaptation of programs based on evidence 2 Focus on incentives, tax breaks, subsidies, reserve sectors 3 • Fiscal incentives – reduced tax rates, tax holidays, investment tax credits, VAT exemptions, lower import duties 4 • SME-specific bank branches, SME bank lending targets, interest rate subsidies, credit-guarantee schemes 5 • Input subsidies, typically in agriculture 6 • Effectiveness? Efficiency? Are policies achieving desired results? Can we do better? How?

12. Instead….an alternate approach 1 Take a strategic, comprehensive, demand-driven approach. Be ready to change and adapt. Focus on addressing market imperfections, market failures, and information asymmetries --- help create markets , avoid having “permanent” programs. Reduce fiscal burden caused by ineffective programs 2 SME strategy should be about facilitating entrepreneurship and enabling small firms to grow 3 • Strategy should be evidence-based with a strong built-in M&E component and flexible as realities change and outcomes are evaluated 4 • Only a handful of high impact programs/platforms needed each led by a single agency that would coordinate with others 5

13. Sources of market failures and information asymmetries • Due to their small scale, the cost of working with SMEs can be high. This is a key cause of bank and corporate reluctance to work with SMEs. • Identifying efficient ways of transacting with SMEs is critical to leveling the playing field for SMEs. High Transaction Costs • SMEs are less likely to have transparent information on past performance and current operations, which increases the perception of riskiness • SMEs need solutions that increase transparency, governance and data through partnerships and technology. Lack of Information • SMEs are typically too small to have a high level of specialization in operations or management. Limited innovation. • SMEs need more efficient access to skills, technology and markets that are relevant to the specific needs to their business and their sector. Small Scale Operations • In inefficient markets, banks and corporates have alternative to working with SMEs where there is not a lot of competition so rents can be high • Identifying opportunities and demonstrating success in the SME space can help markets respond better to SME opportunities Inefficient Markets

14. SME Sector Strategy –Life-cycle approach or StagedDevelopment Exit / Expand Stability Growth Start-up Seed Globally, countries are recognizing that SME needs are largely influenced by the stage of development SME Needs SME Needs • Ease of divesture procedures • Ease of M&A regulations and procedures • Talent retention • Cost structure optimization • New product development / product adaptation • Market knowledge SME Needs • Market knowledge • Global & local market access • Marketing and promotion support • Ease of regulation • Talent acquisition 5 SME Needs • Seed funding • Ease of entity registration and related licensing • Product incubation and commercialization support 4 The SME decides on further expansion or exiting business Stages of SME Lifecycle The SME acquires loyal customer base and has stable product base 3 SME Needs • Motivation to start new enterprise 2 The SME embarks on begins entry into new markets and products The SME exists legally 1 SME sector needs change as per the different stages of the development lifecycle The SME is only a thought or idea Time

15. A regulatory regime that provides a level field for SMEs • A stable and fair system for contract enforcement • An educated workforce with access to skills and knowledge • A national innovation system • Reliable and low-cost power and water supply • Well constructed and maintained roads, railways and ports • A modern telecommunications backbone Take an ecosystem approach to SME development strategy Infrastructure • Deep financial systems, financial infrastructure and regulation • A range of savings, credit and insurance products for SMEs • Growth capital for high-growth SMEs Access to Finance Enabling Environment Access to Markets • Efficient and reliable access to good quality inputs • Modern technology & logistics to improve productivity • Efficient access to local, national or international buyers • If even one part of the ecosystem is not working, SMEs will have difficulty increasing productivity and growing

16. Example: The Malaysian SME Masterplan Constraints to Growth

17. New SME Development Framework Globally competitive SMEs across all sectors that enhance wealth creation and contribute to the social well-being Vision SME Development Framework Increase Business Formation Intensify Formalisation Expand Number of High Growth Firms Raise Productivity Goals Innovation & Technology Human Capital Market Access Focus Areas Legal & Regulatory Environment Infrastructure Access to Financing Reliable Database Monitoring & Evaluation Effective Coordination Effective Business Services Institutional Support 5. Vision, Goals and Strategy (B) 17

18. SME development: A shared responsibility SME development through public -private sector partnership • Private Sector • Industry associations, chambers & NGOs to develop SMEs • Large firms to mentor SMEs • Participation in design & implementation of programs • Government • Facilitator • Act as catalyst

19. THANK YOU

20. Without power and hard infrastructure such as roads, railways and ports, SMEs face higher and sometimes insurmountable costs to doing business. Enabling environment and Infrastructure Strengthen operating environments Power & Infrastructure The burden of over-regulation, taxation, crime and corruption falls disproportionately on SMEs who typically do not have the management bandwidth, connections or financial strength that larger entities do. Investment Climate SMEs depend on the education system to prepare workers and management for the needs of the modern economy. SMEs have fewer ways to improve the skill level of their employees. Educated Workforce Efforts to improve the enabling environment need not be targeted at SMEs to have an important impact on SME growth and productivity

21. Access to Finance Link to Jobs Finance: The most common constraint • Finance allows SMEs to growth, invest and become more productive; and it increases firm start-ups, dynamism and innovation. • Financial sector deepening, independent of targeted SME programs, is also strongly and disproportionately correlated with SME growth. • 30% increase in SME finance required in Emerging Markets, up to 300% in Africa and MENA • 70% of SMEs have bank accounts ; 23% have loans • Deeper gaps exist for some products and segments (e.g., leasing, growth capital) • Lack of collateral and skills of entrepreneurs • High transaction costs for banks • Weak credit data and ability to manage risk • Opportunity costs for banks that operate in inefficient markets Increase Required (%) Formal SME Credit Gap 7-8 The Gap 25-30 100-125 13-16 300-360 270-320 Constraint 5-6 9-11 26-32 To reach the goal of full financial inclusion by 2020, new models driven by technology and non-bank FIs are needed

22. Access to Market Market linkages • SMEs operate across agribusiness, manufacturing and service sectors, with services becoming more important as economies grow • SMEs can only grow and create jobs if they have access to inputs and ready buyers for their products and services • Most SMEs operate in corporate value chains or industry clusters; 1/3 of all economic activity globally is associated with the 200 largest transnational corporations • High-growth companies tend to be SMEs that are involved in trade and utilize more modern technologies, making them both more productive and greater contributors to job creation • Market linkages not only enable the transfer of goods and services, but also facilitate the introduction of new skills and technologies, and increased efficiencies to SMEs • Integration into formal markets also help pull high-potential informal SMEs towards greater formalization, and can improve SME access to finance