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Role of banks in the development of SMEs in Pakistan

Small & Medium Enterprises (SMEs) are the important components of economic development. This sector can generate increased productivity & new investment. SMEs have the ability to grow the industrial and commercial tax base. Therefore, its value cannot be ignored and it is the yardstick of most of the economic issues like revenue generation, poverty, unemployment and a slow growth rate.

It can generate opportunities for a very heterogeneous group concerning size, age, types of businesses, and the expectations of entrepreneurs. Every sector has its undeniable uniqueness and features in its performance, which in turn, triggers all the economic activities and removes the deregulations from market forces that show no respect for unemployed individuals.

The cost of unemployment has no positive impact on society needs to be analyzed and addressed. To resolve unemployment is not an easy way to handle, but it can be mitigated only if sound policies are formulated that ought to escalate the jobs at the micro-level and ease the difference between the ratio of employment and the labor force availability in the economy.

Nearly, 78% of the non agricultural labor force (industrial employment), the participation of 30% in GDP and 25% to export proceedings and 90% of total enterprises are the key performances of the SMEs in Pakistan. Moreover, more than 53% of SMEs account for wholesale trade, retail trade, restaurants and hotels, which servers the low-income population of the society and works as an incubator for the ailing economy, and is the prosperity engine for a disadvantageous segment of the society.

Despite the above facts, Pakistan is still striving to achieve the status of economic development for numerous reasons including regulatory framework, meager emphasis on Research & Development (R&D) Support, technological barriers, human resource problems, technical assistance and lack of training facilities, market constraints, law & order situation and national economic issues are considered as critical limitations in the development of SMEs.

Besides, other issues include shortages of electricity supply, meager access to the public utility network, acute shortages of water and gas have a significant impact on the SMEs’ growth and its prospects.

Knowingly, the failure in the development of this sector was the initial policies, after the independence, was mainly focused on the large enterprises and continued till the 1980s. This paradigm was considered as the backbone of industrialization strategy. However, later on, the policy rationales and parameters were gradually shifted to the enrichment of SMEs since the late 1990s, but yet the huge amount of chunk is skewed towards large manufacturing sectors.

The role of government specifically federal credit policies pervasively influence the circular flow of the economy and accordingly, they have an impact on private credit and its spending. The borrowing of the government from the banking system for the retirement of loans may hamper or disrupt the private credit markets. The borrowed funds are usually used for running the affairs of the state and subsidize the government-owned enterprises.

So, to understand the significance of Small & Medium Enterprises, perceptibly, different institutions & policies were developed like the Small Medium Enterprises Development Authority (SMEDA) & SME Banks were established in the years 1998 & 2002 respectively. The SME policy 2007 was also introduced. The purpose was to enhance and identify areas for improvement.

Amongst the numerous hurdles, as discussed here in above, the most challenging task for the growth of SME is the access to finance their economic activities.

In the past, various studies like the survey of Gallup Pakistan, accompanied by the World Bank and Government of Pakistan, and SME Survey 2009, conducted by Small and Medium Enterprises Development Authority (SMEDA) & SME Policy 2007 emphasized and endorsed that the failure of utilizing SMEs’ potential is the lack of access to finance to SMEs.

To improve the capitalization and performance ratio of this sector, effective strategies are needed to be exercised by the concerned authorities. Effective strategic management will support you in accomplishing where you want to stand in the future by knowing the market and paying the attention to the factors, say, for instance, social, legal, economic, political, and technological (SLEPT) that greatly influence these small and medium nature of businesses. It will allow the policymakers to control the issues relating to production, distribution, unemployment, growth rate, and financial management. It will support you to assess the strength and weaknesses of the economy at a micro-level and allow you to understand the impact of changes taking place in the business environment by providing relevant information.

It is very crucial to discuss that effectively formulated and implemented policies will always be beneficial for the development of social, economic, and industrial growth. They will increase the gross domestic ratio (GDP) and equal income distribution. The growth of Gross Domestic Product (GDP) can be used as a yardstick for measuring the performance of the economy. Economic growth creates jobs and avoids recessions. So, awareness regarding the importance of this sector has now been given a priority.

Therefore, to get over these problems, it is indispensable to devise such broad policy models that should make the government, financial institutions / DFIs, and the regulator of a banking industry liable for accepting the underlying glitches of SMEs and suggests the solutions that should have implications of industrial & technological revolutions, removing inequality problems, soften the regulatory policies, & aspire the entrepreneurs. It must have the capacity to provide the training programs for building managerial skills, perfect information opportunities, and improving the working environment and provision of credit to entrepreneurs.

The major area of this policy should focus on financial availability and accordingly the policy document be drafted for structuring the efficient credit programs that guarantee the protection of lenders against the risk involved in financing and at the same time should propose and identify the cost and magnitude of borrowing requirements prevailing in the economy and its impact and solutions by supplying credit through extensive and intensive margins. A good credit has the multiplier effect and its ultimate output would be an increase in revenues, employment, taxes, the establishment of new business projects, balancing of demand and supply in the market & poverty alleviation. Simply, put it another way, there will be an acceleration in economic growth. The policy document must have a characteristic of stabilizer, adjusting itself as per the demand and supply factors.

The credit flow is the guarantee of ensuring the continuous circular flow of the economy. The lending to the private sector is usually channeled into two approaches. The first method is an elastic channel famously known as intensive margin, whereby the ratio of loans increases once the interest rate comes down, and second is the credit rationing way, commonly called as extensive margin, it is where loans are not disbursed to individuals at any rate of interest from lenders due to issues of asymmetry information and the creditworthiness, it is where the role of the central bank comes into the forefront in providing the desired credit amount to needy borrowers. Credit to enterprises is the base for operational activity as it enables them to continue the onward activities like production and selling without drawing on equity of the business.

The important factor in advancing a credit is the cost of it known as the interest rate factor. The reduction in rates by following the policy of elastic channel (intensive margins) may cause deposits to outflow from banking industries and would probably be invested in other financial markets such as stock exchanges, where hefty returns are offered. The lessening deposit ratio may create shortages of money supply, and this would resultantly, curtail the credit supply.

The strategy of interest rate cap would also require credit rationing, called extensive margin. In this system, only a few beneficiaries will be able to access the credit and the remaining investors are forced to have high-interest rates than ever before and, thus, the ratio of rationed out in the market is increased. This mechanism of rationing credit and interest rate ceiling is a failure in providing the equal allocation of finance to the most productive economic activities and consequently, it reduces the growth rate productivity factor at a macro level.

If the proper funding is not provided in the economy, the shortage of capital would prevail, and if the credit standards are lax, then it may embolden borrowers to follow the policy of obtaining too much leverage from the banking industry, which they may find difficult to repay the loan at the time of maturity, resultantly, the ratio of bankruptcy is increased and consequently, it translates the increase in the non-performing the loans (NPLs). So, this may generate another round of problems.

In Pakistan, over the past many years, it has been observed that the ratio of private credit against the GDP has been reduced. This failure is mainly due to government policies for borrowing the huge amount of credit from private banks for meeting its needs. During the first quarter of the year 2018, the Government of Pakistan has borrowed short-term financing of PKR. 7 trillion from the banking sector for the retirement of long-term loans, and consequently, this amount has not been channeled to the economic cycle.

During the era of lowest interest rates are charged on extending loans to customers, it would not be rare to say that for banks it is like a dream comes true for earning the risk-free rate of interest on holding government paper without taking any pain or where profit outlook may go bleak while offering loans to the private sector.

For the year ended 2017, the private sector financing was PKR. 5067.04 billion having a slight rise of 16.23%, over the last year of 2016, figures were PKR. 4359.19 billion. Out of total private lending in 2017, the portfolio of SME was only 8.73 percent. This means that financing was massively skewed to large enterprises and remained the top priority over the small businesses.

In the past history, the policy of financial inclusion & other 9 schemes for financing the entrepreneurs and micro businesses have been introduced for the strategic management of these small and medium enterprises as to resolve the issues of financial management, but regrettably the equal importance for directing the funds towards SMEs yet to be observed over the last 10 years approximately. Banks are unwilling to lend them money at a cheaper rate rather they are interested to invest in risk-free government securities, consequently, this hampers the flow to total private financing and thus, SME financing as well.

Besides these factors, banks assume the SME as a risky business on the pretext of undocumented in nature and are highly considered as sensitive to economic fluctuation, therefore, the creditworthiness of the borrower is questioned. Due to information asymmetry, the need for collateral is realized to reduce the business and financial risk. The collateral is taken into the form of primary (usually charge on the cash flow of the business) and secondary (mortgaged of any particular property), must be sufficient in value to work as collateral. It is the pledge of an obligor given to a lender as additional comfort for securing the repayment of interest and the principal amount outstanding. However, issues of adequate collaterals are not uncommon here at the time of seeking an advance from banks. If the loan is given without the sufficient value of collateral, the cost of financing would be excessively high and is charged in the shape of interest rate because of high-risk factor is involved in default on loan. Thus, it increases the debt burden on the cost of doing the business. The securing mechanism also gets complicated when the requirements of complying legal framework come into effect that further consumes the time and the expenses of the borrowers.

To resolve the issue of collateral efficiency, however, in Pakistan, Credit Guarantee Scheme (CGS) has been established jointly with the Regulator of Banking Industry in Pakistan, in conjunction with the Federal Government and Department for International Development (DFID) UK. This form of strategic strategy underscores the provision of formal credit to rural, small and micro-enterprises. It assigns the responsibility of risk-sharing for all types of financial and non-financial institutions, such as leasing companies in agricultural, small enterprises, and micro-enterprising financing as well and in this connection, the State Bank of Pakistan has allocated the credit guarantee limits (CGS) to each participating financial institution (PFI). The unique feature of this policy is the solution of issues pertaining to collateral requirements, one of the important factors of determining the creditworthiness of the borrower. Consequently, through this scheme, the collateral deficient borrowers can have access to finances for their true-ups, however, the selection of the customer is made upon the positive cash flows of the business, based on which capacity for debt servicing is calculated.

Other main constraints are the non-maintenance of proper accounting records, improper budgeting schedules and accounting systems of SMEs, and planning for capacity utilization are some of the reasons due to which financing to SMEs is constrained. Most SMEs are away from the use of the latest applications of information technology, resulting, failure to maintain efficient management information systems (MIS),and a key factor, considered as the heart of every business. MIS is used for a multitude of reasons forsetting goals, review of the employee’s performances, knowing about the strength and weakness of the firm, provides the data relates to the operations, planning, scheduling, and controls, and helps the organization in decision making at various level. Moreover, it can also be used for answering the queries of financial intuitions while applying for loans from banks. And the bank through this can easily understand the company’s overall business processes and its mechanism of operations for making any financial decision.

In the light of the above constraints and respective policies, the lending to the SME sector by commercial banks in Pakistan for the year 2017 is 442.53 billion of the total financing of 5067.04 billion for the private sectors as per the SBP quarterly report showing that the majority of credit is skewed to large enterprises. Out of this total portfolio to SMEs, the working capital financing is approximately 69% and 22% is for fixed investment and the remaining is for trade financing. This report shows that banks are neither contributing much to the fixed asset investment for meeting the long-term needs of the business, nor they are interested to encourage entrepreneurship. Further, financial institutions meagerly support trade-related activities which ultimately have an impact on the foreign exchange of Pakistan.

In fact, a healthy banking system solves the problems of which approach to be used either extensive or intensive credit policy and relies on the progressive economy where the key contribution is dependent upon the SME sector. Therefore, one can say that banking performance and SME are two sides of one coin; if SME does well in the real economy, the banks will automatically do well, and thus, there will be the development of economy such as the generation of employment and improvement in GDP ratio.

If there is a failure in supplying the credit by the banks, non-bank investors will see the market with utmost opportunities and they will exploit it for their conflict of interests and consequently, there will be a surplus of returns in fewer hands. Hence, banks should study and analyze the demands of SMEs for financing considering factors such as the size of the business, age of the borrower, chances of growth, the ratio of profitability against the equity, ownership style, and the industry structure. The business cycle is highly influenced by these variables. The access of funds is directly proportional to the size of the company. The well-diversified SME portfolio will improve the GDP growth, and improving the livelihoods of the individuals by providing them employment opportunities.

To beat the challenges, a much had been toddled in previous policies for inclusion of marginalized individuals, removing disparity of financing and accordingly, strategically management policies like National Financial Inclusion, SME 2007 Policy, Revised Prudential Regulations, Credit Guarantees Schemes & other nine schemes of financing namely to include Scheme of Financing for Renewable Energy Programs, a Facility of Refinance for Updating and Modernization of Small and Medium Enterprises, a Facility for Storing Agricultural Products, Facilities of Long Term Financing (LTFF) and Islamic Facilities for Long Term Financing (I-LTFF), & Low-End Medium Enterprises, Financing for Export Schemes, Refinance working capital Programs and Prime Minister Scheme for Youth Business Loan Scheme. But unfortunately, none has provided optimistic outcomes so far in producing a conducive business environment for entrepreneurs. The basic issues remained the same like complex tax structures, collateral management, financing requirements, and vague procedures for compliance of regulatory standards & inefficient government policies for the retirement of loans through borrowing from the banking sector.

However, another new Policy for Promotion of Small & Medium Enterprises based upon 9 pillars has been introduced in 2017 after the great consultation with different stakeholders and they are: Banks / DFIs, Microfinance Banks, Business Chambers, Trade Associations, Small and Medium Enterprises Development Authority (SMEDA), Multilateral Institutions, SMEs, Federal, and Provincial Government Departments.

The areas of interest in the new policy include improved regulatory framework, increasing the size of SME portfolio through microfinance banks, approaches for reducing the risk parameters, capacity building and awareness creation, the role of non-financial advisory services for small scales businesses through the banking channels, the use of technology for deepening impact of SME banking for its promotion and the simplified taxation rules.

To obtain maximum yield from this small sector, the State Bank of Pakistan is taking painstaking stepson newly-introduced policy besides the previous ones as to get the commercial banks including microfinance banks and Islamic banking industries in board for meeting d targets by arranging the various training programs for specialization in SME financing, enabling them to capture the SME borrowers by introducing a wide range of customized products and services for making a stronger relationship with the borrowers.

The regulator of Pakistan has emphasized Capacity Building and Awareness Creation, where the National Institute of Banking and Finance (NIBAF) and State Bank of Pakistan Banking Services Corporation (SBP BSC) are suggested to commence 100 training programs per year and 150 programs on awareness creation session and through this, the banks will also be advised to make strategic programs and to target around 1000 account holders per city per bank. This targeted plan has to be executed by the quarter ended July to September 2018. The awareness programs will also be initiated via social media, print media, and electronic media as well.

The other pillar of this policy is revolutionizing the technology in SMEs account for 90% of total enterprises in Pakistan. So, digitizing the SMEs means digitizing the major part of the national economy. Using digital technology, SMEs will be able to use the Enterprise Resource Management (ERM) solutions, and the impact of this would be in the reduction of cost of doing the business like marketing expenses, acquisition of online clientele & its retention, etc. But regrettably, Pakistan is yet deprived of profound technology. The dearth of SMEs in using digital tools is keeping them away from the benefits it possesses. It is hence, there is a need to spread awareness and arrange training programs to enhance the productivity of the organization.

State Bank of Pakistan, in this regard, has urged the Banks and Development Finance Institutions (DFIs) to use digital technology for providing financial services to underserved segments of society. For this, SBP has also been working on the National Financial Inclusion Strategy (NFIS), which solely depends upon digitization and branchless banking, whose target will be to provide extraordinary openings to transform financial inclusion in Pakistan by 2020 and the target of escalating the credit to 17%, from existing 8% of total private financing, the number of borrowers has also been increased to 500,000 from the existing position of 174,000. This all must be achieved by 2020.

A much is expected from the recently introduced policy by providing access to finance, creating cordial business environment & appropriate digital platform is indispensable for the entrepreneurs, micro firms, individuals and the investors who in turn increase the productivity, investment, labor market can be a supportive industry for large manufacturing sectors. It has the potential and is a mix of different ingredients and it is a kind of first policy in the history of Pakistan where every pillar is linked to each other via digitization. The major actor in the implementation of the policy pillars is the banking sector. The key implications of this policy document will be improved credit risk strategies, better market intelligence through digitization at a reduced cost & financial inclusion of SMEs, opportunities for entrepreneurs with non-financial advisory services, relaxation in tax structure & favorable regulatory policies.

Once these challenges are tackled, the role of SMEs will further be widened in economic development. Also, the great responsibility lies on the Government of Pakistan to mull the limitations over and provide the fundamental infrastructure, such as sewerage system, better roads, and provision of cheaper electricity without load shedding.

The author, Zuhaib Khokhar is a Lecturer (Management Sciences) at SZABIST
Contact # +92 307 3966507
Email: [email protected]

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