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Creating the right environment for small firms: Small enterprises flourish where the market is relatively free of government regulations: a review of the experience over the past 15 years

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1981
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Keith Marsden

Small enterprises (defined here as firms employing up to 100 workers) account for more than half the industrial employment and contribute a large proportion of total output in the developing world. Their relative importance tends to vary inversely with the level of development, but their contribution remains significant even in the most advanced economies. In Indonesia, for example, 87 per cent and in Colombia 70 per cent of manufacturing employment were provided by small enterprises in 1975. In Japan, their share of employment and of value added was still as high as 53 per cent and 37 per cent in 1965.

Small-scale enterprise could play a more significant role than it does in creating balanced economic and social development of developing countries. Its potential advantages are well known. Small firms tend to use less capital per worker than their larger counterparts. In Mexico, for example, fixed assets per job averaged US$4,700 in small manufacturing firms in 1975, about 25 per cent of the level for large firms. Their labor-intensive character is consistent with the relative abundance of labor and the shortages of capital and foreign exchange characteristic of developing economies (although, as discussed later, wide artificially induced disparities in capital/labor ratios between small and large firms can have negative effects). Small enterprises also have the capability to use capital productively. Data for Colombia, Ghana, and Malaysia, for instance, show significantly higher ratios of value added to fixed assets in small firms than in large.

Perhaps most important, through that elusive characteristic, entrepreneurship, they make use of resources that may otherwise not be drawn into the development process. They generally employ workers with limited formal training, who then learn skills on the job. They are able to mobilize the small savings of proprietors who would not use the banking system but who will invest in their own firms. Experience with small firms in Indonesia shows that firm owners have a surprisingly high propensity to save and to reinvest, even at quite low income levels. They are able to utilize scattered local raw materials (such as straw and clay) that would otherwise be wasted. They are often effective in subcontracting arrangements with larger firms. And they add flexibility to the industrial structure, by engaging in small batch production and made-to-order or other types of “finishing”operations complementary to the activities of large-scale industry.

The disappointing results of small enterprise development programs in many countries show that if such enterprises are to flourish, the right conditions must exist. The failure to create these conditions often goes undocumented because small enterprises are frequently excluded from official statistics. But persistent poverty among those who depend upon small-scale activities for a livelihood provides indirect evidence.

This article examines the experience with small firms over the past 15 years. Briefly, it has been that in most developing countries small-scale enterprises are either left to their own devices and are unable to realize their full potential because of distorted and overregulated markets, or help is extended to them by governments in ways that are often largely ineffective or may even hinder their growth. Significantly, where small-scale enterprises have flourished, it has been in those countries where governments have allowed markets to operate with a considerable degree of freedom. In such an environment, firms in the same line of business compete with each other on a more equal footing. Just as important, in this environment firms in different fields can form complementary, mutually beneficial relationships. Where interdependence between suppliers and customers is allowed to develop freely, many of the supporting services will be provided by small firms and no longer need to be provided by governments.

Inappropriate regulation

It is almost impossible to make valid generalizations about the activities of small enterprises in developing countries, simply because these enterprises are so diverse. They seem to emerge in almost any sector, in any country, in response to unmet needs of the public, where there is ease of entry, an absence of pronounced economies of scale in that line of activity, or a positive advantage in being small.

Yet if they are born easily, their mortality rates are high. To some extent, the failures of small firms are a healthy sign in a dynamic economy: uneconomic enterprises should find it difficult to survive. But in many cases failures, or retarded development, of firms are caused by an unfavorable economic climate. Starved of capital, cold-shouldered by the development finance companies, overlooked in development plans, and, until recently, ignored by most foreign capital aid programs, small-scale firms have had to rely largely on internally generated funds for expansion and modernization. To compound the problem, their profitability and incentive to invest is often undermined by both overt and hidden subsidies to large-scale industry.

Moreover, the numerous regulations that affect markets in developing countries often seem to encourage small firms to develop uneconomic ratios of capital to labor. Small-scale enterprise is typically labor-intensive, and this is usually a desirable characteristic in developing countries. Some countries have even promoted small firms as proxies for government-sponsored programs to provide employment. The low capital intensity is often, however, accentuated by government-induced distortions, with undesirable effects on efficiency and income levels.

In many developing countries the markets for capital, foreign exchange, and labor are affected by numerous types of regulation, subsidy, and taxation. Most small firms have very limited access to foreign exchange and to bank and institutional credit, whereas they can usually draw upon a large reservoir of cheap unemployed or underemployed labor. The result may be capital/labor ratios so low as to result in very low labor productivity in many small firms. Large firms, on the other hand, may be allocated investment funds at negative real interest rates and be provided foreign currency at artificially low exchange rates. This encourages them to be profligate in their use of capital. On the other hand, trade union pressure and labor legislation (which usually cover only the modern sector) may require large firms to pay relatively high wages which, in turn, may induce excessive substitution of capital for labor.

The net effect can be the worst of both worlds—technically backward production methods and depressed incomes in small firms, where the majority of the labor force is employed, and excessive use of capital in the modern sector, which receives the bulk of the investment funds but creates few jobs. A dualistic structure results, inimical to both efficiency and equity.

Inappropriate support

While inappropriate regulation may distort their structure, it is also clear that specific government measures of support to small firms may, unless carefully designed, actually discourage or even prevent their efficient operation. Public support for small enterprises is frequently justified, for example, on the basis that they act as a “breeding ground”for entrepreneurs. This argument needs to be looked at closely, however. Clearly, entrepreneurship is an essential element in economic development: risks must be taken in introducing innovations; businessmen are more likely to take risks, and usually better at gauging them, than public servants. They are able to “think small”and, as “economic lubricants,”to search for, identify, and fill needs likely to be overlooked by the public sector. Moreover, businessmen are more likely to terminate activities which the public will not pay for.

Nevertheless, certain limitations must be recognized if programs to assist small firms are to be appropriately designed. Most fundamentally, entrepreneurs are by definition self-reliant, energetic, and innovative, and do not generally need to be coddled by promotion programs. It has, in any event, proven extremely difficult for the public sector to devise programs that can develop entrepreneurship. Not all—or even most—artisans and petty traders are capable of developing the capacity to innovate by taking the special courses that have sometimes been provided under government auspices.

In general, the skills and aptitudes of most proprietors of small firms are best utilized if concentrated on a narrow range of activities, leaving the more innovative entrepreneurial functions to other organizations such as trading companies or larger firms which then subcontract to smaller ones. As economies develop and their structures change, many independent artisans may, in fact, be absorbed into larger organizations as workers and supervisors. The exceptionally entrepreneurial small businessman will usually survive (and eventually stop being small) if he is left free to operate, subject only to basic ground rules of public safety.

Some shortcomings of three common types of government programs to develop small enterprises are discussed in the following paragraphs.

To overcome the shortage of capital available to small enterprises, many governments earmark resources—both from the budget and from foreign assistance—for loans to small-scale enterprises, usually through one or two specialized and subsidized public institutions and subject to relatively low interest rate ceilings. Often the result is excessive demand for this cheap credit and a need for credit rationing, which often leads to abuse in the allocation process. In some countries, cheap foreign currency loans have encouraged the adoption of imported, capital-intensive technology-Given the relatively high costs and risks of lending to small firms, low interest rate ceilings deter other financial institutions (such as commercial banks), which cannot draw upon subsidized funds, from providing loans to small firms. So the total supply of credit available to small firms tends to contract rather than expand.

Keith Marsden

a British citizen, is a graduate in economics from Cambridge University (United Kingdom). After varied experience in industry, he served as an expert in economic surveys for the United Nations Development Program in Egypt from 1963 to 1965 and as a senior economist in the International Labor Office until 1978. Mr. Marsden now serves as an Operations Adviser in the Bank’s Industrial Development and Finance Department. He is the author of numerous articles and papers on development issues.

A second common measure is to create—often with foreign assistance—a central small-industry institute, to provide services such as technical training, advice and information, management consultancy, legal counselling, common facilities, procurement, product design, quality control, marketing and display, and assistance in obtaining loans from financial institutions. These services are usually supplied either free or at a nominal charge to the recipients.

Experience with such institutions has often been disappointing. There have been numerous obstacles in practice. The heterogeneity of small enterprises has made it impossible to encompass the range of expertise they need in a single institution. Salaries have usually been too low to attract or hold experienced staff. The rapport between staff and client has often been weak, stemming from the civil servant’s traditional distrust of the “free-wheeling”entrepreneur and the businessman’s fear of a government official prying too closely into his affairs.

A third approach has been to introduce selective controls to protect small firms from competition. Such controls are difficult to design well and have sometimes backfired. For example, in some countries licenses for the production of products such as cotton textiles are confined to small firms using traditional handicraft techniques; technological development and adaptation have thus been discouraged, and consumer demand has switched to more competitively priced, or more “modern,”synthetic textiles made in medium-and large-scale industry not subject to controls. Incomes in the protected sectors have consequently declined or remained stagnant. Similarly, attempts to protect the livelihood of taxi and rickshaw operators or small traders by restricting the number of licenses issued have sometimes led—through the corruption of public officials—to these activities being controlled by larger operators or by particular ethnic groups.

How to help small firms

While there are no simple solutions and much remains to be learned about how to create a favorable environment for small enterprise, several countries, with assistance from the World Bank during the last five years, have employed a more market-oriented approach to fostering them. It is too early to evaluate the results, but the response so far has been encouraging.

Essentially, the approach entails measures: (1) to reduce subsidies and policy preferences which favor large industry and discriminate against small; (2) to enhance the availability and efficient utilization of inputs commonly needed by small firms; and (3) to increase the range of marketing opportunities. Fundamental to the market-oriented approach is the view that small enterprises will thrive, if they are economically efficient, without a plethora of special subsidies and government interventions. Broad programs designed to provide equal incentives and access to scarce resources for all firms, irrespective of size, are likely to be more beneficial in the long run than special programs tailored exclusively for small-scale enterprises, which, as seen, can often yield perverse results.

A well-designed program is likely to include many of the following components:

  • Credit. The availability of credit to small firms can often be increased by removing—or at least raising—interest rate ceilings and permitting a “spread”that makes it worthwhile for banks to lend to small businesses; or by increasing the number and range of intermediaries allocating foreign exchange for investment. A refinancing facility can be useful, as can credit guarantee schemes (with costs passed on to borrowers) and training of local bank staff in simplified project appraisal and supervision methods.

  • Imported raw materials. Reform of trade regimes may be necessary to remove abuses of the import licensing system. It is not uncommon, for instance, for middlemen to find their way on to the allocation lists and then resell their supplies at black market prices to small firms that desperately need imported inputs to survive in business but lack influence over the licensing authorities. Freer access to foreign sources and lower levels of protection for domestic alternatives would be desirable.

  • Labor. The objective here is to increase labor skills and mobility by supplementing on-the-job training and by reducing labor market rigidities (particularly those affecting wages) which prevent the free flow of workers. Useful advice and assistance in training can often best be provided by the suppliers and customers of small firms, but governmental vocational training programs can also be adapted to small-scale enterprise needs and circumstances (through such media as mobile demonstration units and night schools).

  • Technology and equipment. Changing policies that have the effect of subsidizing imported machinery would stimulate domestic engineering industries and machine shops, which are potentially important in helping small-scale enterprises improve their equipment.

  • Building and utilities. “Industrial estates”are valuable to small enterprises but generally are subsidized and sometimes are built above the necessary standards. Removing the subsidies, levying charges adequate to recover costs and thereby permitting wider replication, and adopting appropriate, more modest standards are likely to produce economic rewards in the long run. “Sites and services”programs for small enterprises, under which they build to their own specifications, also are useful.

  • Advisory services. Advisory services are needed but should be charged for on a full-cost basis so that the providing agencies—or preferably consulting firms—have ready evidence, from the market, of their utility. Public technical assistance institutions are more likely to be useful and responsive if they are specialized than if they seek to cover all areas of need. Also, their utility is more likely to be assured if their intended beneficiaries are adequately represented on their governing bodies.

  • Markets. The demand for small-enterprise products and services would be increased by eliminating “unfair”competition in the form of subsidies given to large-scale industry. Often barriers to the trading companies which market the products of small firms exist and should be removed. Export markets can be tapped more fully by ensuring that small firms as well as large benefit from import duty rebates or exemptions on imported materials and components that are incorporated into exported products. Governments can also directly enlarge the markets for small firms by subcontracting maintenance and repair services that public agencies might otherwise perform themselves.

This list is not, of course, exhaustive. The best overall tonic for small business is likely to be an economic climate combining minimum regulation with maximum openness. It is relevant, for instance, that small-scale enterprises have contributed substantially to economic and social development in Korea and Taiwan, which have relatively un-distorted markets, though they are not completely free of biases against small firms (including credit rationing). Their success is reflected not so much in the expansion of output from, and employment within, the small-enterprise category itself but in the fact that many small enterprises had the vigor and opportunity to grow into medium- and large-scale enterprises.

Thus employment in factories with 100 or more workers expanded twelvefold in Korea between 1958 and 1975. A large proportion of this expansion came from small firms that became larger ones; at the same time total employment in the remaining small firms doubled. Real wages rose by over 10 per cent per annum in Korea between 1970 and 1978, and workers in small and large firms benefited.

Recent World Bank projects in Bangladesh, Nepal, and Sri Lanka also illustrate some elements of a market-oriented approach to the development of small firms.

Consultants provided by the Bank have advised on industrial policy reform, including rationalizing incentives to small firms in Nepal and the reform of tariffs and export incentives in Sri Lanka. Participation agreements between a refinancing agency within the National Development Bank of Sri Lanka and five credit institutions (four commercial banks and one development finance company) allow larger interest-rate spreads to encourage institutions to lend to small enterprise and to provide training for their staff in the appraisal and supervision of these subloans.

The services of private traders and large exporters are being harnessed on behalf of cottage industry and artisan producers by means of “performance contracts”and cooperation agreements with the Trade Promotion Center in Nepal and the Export Promotion Bureau in Bangladesh and by the establishment of Lanka Handloom Private Export Limited in Sri Lanka. The services provided include raw material supplies, product design, quality control, training, and export sales.

Subcontracting is being facilitated both in Bangladesh and in Sri Lanka by the establishment of subcontracting exchanges that supply large firms with information on the production capabilities of small enterprises. And development institutions promoting small firms are being strengthened by greater subsectoral specialization, by making salaries more competitive, by introducing performance-related incentives for advisory staff, and by directly involving private sector associations in the management of these institutions. Examples include the Rubber Products Testing and Product Development Center in Sri Lanka and the Tanning and Finishing Facility in Bangladesh.

In conclusion, the best environment for small firms is a relatively free market that provides equal incentive and opportunity for all enterprises. Development programs focused specifically on small enterprises can also be useful provided they reinforce and supplement private sector initiatives, rather than replace them. But the primary need in most countries is simply to remove the biases and obstacles to small enterprise that are implicit in existing incentive and regulatory systems. F&D

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Related reading

    Samuel P.S.HoSmall-scale Enterprise in Korea and Taiwan,World Bank Staff Working PaperNo. 384 (April1980).

    KeithMarsdenProgressive Technologies for Developing Countries,International Labour Review (May1970) and (abridged) inGerald M.MeierLeading Issues in Economic Development (New York, Oxford University Press1976).

    KeithMarsdenThe Role of Small-scale Industry in Development: Opportunities and Constraints,paper prepared for the Colloquium on New Concepts and Technologies in Third World UrbanizationUniversity of California at Los Angeles1974.

    Philip A.NeckeditorSmall Enterprise Development: Policies and Programs (Geneva, International Labor Office1977).

    John M.PageJr.Small Enterprises in African Development: A Survey,World Bank Staff Working PaperNo. 363 (October1979).

    William F.Steel and YasuokiTakagiThe Intermediate Sector, Unemployment, and the Employment-Output Conflict: A Multi-Sector Model,World Bank Staff Working PaperNo. 301 (October1978).

    World BankEmployment and Development of Small Enterprises: Sector Policy Paper (Washington, DC, World BankFebruary1978).

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