what is stopping the sme sector?

Despite the huge contribution from SMEs to the country’s economy, the full potential of this sector is yet to be met. Part of the solution may lie in the banking sector’s approach to it.

Nepal’s private sector continues to be plagued by various factors such as poor infrastructure (particularly in transportation and energy sectors), inadequate labor skills and continuous labor unrest, unstable and inefficient credit markets and an impending political instability.

Despite all these hurdles, Small and Medium Enterprises (SMEs) have played a significant role in creating self employment opportunities, mobilizing and using local resources, and raising the income level of the rural populace. After Nepal shifted its economic policy from a protectionist regime to an open market regime, the proliferation of banks and financial Institutions played a major role in providing access to finance by catering to the entire range of business segments, from big corporate businesses to small micro entrepreneurs in the rural areas of Nepal.

SMEs can play the role of being the “engine of growth” in our country, both in terms of employment generation and improving production. This is vindicated by a recent IFC study that suggests there is a $2.5 billion untapped market for SME lending in Nepal. Currently, about 111000 small and medium enterprises are operating in Nepal, providing employment to 1.75 million people and accounting for 21.7 percent of the country’s GDP. However, 25 percent of these businesses do not have formal banking relations with financial institutions. This sector presents an opportunity to the nation to harness local competitive advantages for achieving economic growth.

Even during the great European financial crisis of 2008-2011 when the world was busy analyzing the reasons and trying to strike a balance between profligacy and austerity, Germany was one country that came out largely unscathed from the economic crisis mainly due to the contributions made by Mittelstand, small and medium sized enterprises that still continue to employ 70 percent of the country’s workforce and contribute 50 percent of its GDP. Mittelstand companies are privately owned and operate mainly in small, rural communities and have made a significant contribution to making Germany the world’s second largest exporter.

Despite immense opportunities in the country’s SME sector, it is still challenged by lots of constraints in resource mobilization. SMEs in Nepal still employ traditional management practice; they have low capital base, outdated and inefficient production process, technology, and poor information and knowledge about business opportunities and marketing. Moreover, by giving utmost priority to the safety of loans, banks and financial institutions tend to give preference to lending funds to category “A” corporate borrowers over SMEs who do not have sufficient wherewithal to provide securities to the banks. Current lending practices coupled with rapid fluctuations in the interest rate market has inflated the perception of risk in the SME sector so banks and financial institutions seek higher returns in their investments in SMEs. This then increases the cost of starting up new businesses.

Nevertheless, the need of the hour is for financial institutions to come out of their comfort zones and start increasing access to finance by scaling up their lending to SMEs in a profitable manner without compromising on loan quality. They also need to take prudent steps to reduce transaction costs and mitigate risks by employing efficient and effective lending processes.
Here are some ways that can reduce overall banking costs for SMEs:

Financing Model: Traditionally, banks and financial institutions have relied on conventional collateral based lending approaches which have made it difficult for SMEs to provide sufficient collateral in order to get financing. This coupled with the SME market which is highly characterized by deficient information has led to SME finance gap resulting in an increase in the overall banking costs for SMEs. So banks and financial institutions need to be forward looking and perhaps start to implement a viability based financing modes which aims to provide appropriate financing tailored to the cash flows of the SME. In our context, implementing this model comes with an obstacle of getting the information required to assess the viability of a business, nevertheless, with the help of improved technology and information sharing, this approach could become significantly faster, cost-effective and attractive to SMEs.

Effective management of business lending: This pertains to the use of technology to quantify the information related to borrowers through standardized credit scoring techniques as well as centralizing business banking operations which will significantly reduce processing costs, helping in minimizing costs for the SME. Computer based assessments may also be more accurate and fairer than relying on personal judgments.

Institutional Support: Despite possessing the capacity to sustain national economic growth as well as create new entrepreneurs, the Nepali SME sector suffers from inadequate business advisory services to enhance their competitiveness. To counter this, the time is ripe for the government to come up with a separate Export Import Bank (EXIM) that, in co-ordination with banks and financial institutions, will work to provide the required business leads, assistance in generating export business, capacity building and information dissemination, and financial advisory services such as loan syndication to SMEs. This will help banks and financial institutions scale up SME lending as well as minimize costs.

Most importantly, with the introduction of stringent new banking requirements such as BASEL III that asks banks to raise capital requirements and reduce leverage in the financial system, banks will find it difficult to extend credit in the long run. To counter this problem, in the future, the Government of Nepal, has to initiate the formation of a specific SME bond market platform for the creation of cheaper and alternative sources of financing.

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