Enhancing Formal and Informal Entrepreneurship in Developing Countries

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Businesses in developing countries follow a different evolution than new businesses in developed countries. Even formal businesses in developing countries have to deal with numerous challenges: poor infrastructure, high interest rates or limited access to loans, a weak service sector, high legal costs, and a small local market. These conditions, all related to the transaction costs concept of the New Institutional Economics, affect the competitiveness of emerging business. The informal sector faces these factors as well as additional challenges.

Developing countries have a larger number of informal businesses than developed countries. In the majority of these countries, more than one third of small businesses face at least one of the following situations: they do not pay revenue taxes or sales taxes, do not have a legal payroll, or are located in facilities that are not legally registered.

Given these relatively challenging environments and high levels of informality, why are entrepreneurship and small business growing in developing countries? How can we think about policies to reduce transaction costs and foster entrepreneurship given that entrepreneurship is the most effective way to reduce poverty and generate wealth?

Informal businesses and microfinance

When researchers discovered the scale and the unmet potential of informal entrepreneurship in poor countries, they started to look for policies that help reduce transaction costs. The initial focus was on property rights in real estate. Several studies measured the “dead capital” held by entrepreneurs in unregistered land and hypothesized that if their land was formally registered and recognized by the state, they could use it as collateral to access loans.

This approach generated a very positive wave of reforms to physically register property. Nevertheless, property reforms had limited impact on access to credit. Meanwhile, several non-governmental organizations (NGOs) in developing countries of Asia and South America began a new approach based on microfinance.

At the beginning, microfinance was conceived only as a way to help poor people overcome their dayto- day needs. NGOs started making loans at high interest rates to their beneficiaries and discovered that a commercial relationship had advantages over a donor–recipient relationship. Commercial loans proved better at sustaining business development in an informal, emerging business environment. Little by little, something that started out as a not-for-profit activity became a business in itself. Subsequently the model was adopted by regional banks and finally by private banks. Countries like Peru (number one in microfinance according to the World Bank) count now more than $8 billion in microfinance loans (average of $500 each). Hundreds of thousands of entrepreneurs starting from a very poor financial situation have succeeded in their ventures relying on microfinance.

How did commercial loans become a powerful tool to enhance entrepreneurship in the informal sector without any collateral? The microfinance institutions developed new techniques, unknown in the developed world, to evaluate credit based on positive cash flow and the reputation of their clients. In this way, the spontaneous order of the market generated a more efficient solution than a top-down government-driven solution. This does not mean that land property rights are unimportant. The larger point is that cash flow in an informal property right structure is more important for small loans than “dead capital” without a viable business plan. However, in the long term, entrepreneurs will gain access to cheaper loans if they are able to provide a properly registered land guarantee.

Last but not least, we must point out that in countries like Peru, microfinance received critical support from the Bank Regulation Agency, when it modified its regulations to incorporate the microfinance cash flow-driven logic and reduce the weight of collateral for loan evaluations.

Formal businesses and entrepreneurship promotion

In Latin America we find both the informal entrepreneurs and the “modern entrepreneurs,” who tend to start as formal as possible. The modern entrepreneurs normally have similar features:

  • They start with their own friends-and-family equity.
  • It takes them several years to have access to banks loans.
  • They have on average a better education and contacts in the wealthiest part of the population.
  • They have the alternative of formal employment. In fact, most start their business in parallel to a formal job and only go for full-time entrepreneurship once the venture is ongoing and profitable.

Given these facts and our knowledge of entrepreneurship promotion in developed countries, we can find ways to enhance “modern entrepreneurship” in developing countries:

  • Angel investors networks are a good way to help modern entrepreneurs who are looking for equity and do not have friends and family with money. These networks can evolve into small and medium-sized enterprise (SME) investment banking. Venture capital funds also help dynamic SMEs to grow.
  • Financial techniques like factoring (credit against receivables) can be a highly effective solution for financing modern entrepreneurship. All kinds of systems for reducing creditors’ risk have been tested in Europe and the United States. Government financial institutions in developing countries could benefit from technical assistance on these solutions to reduce the gap in access to credit.
  • Creating networks between large companies and emerging entrepreneurs should be part of any public policy to enhance entrepreneurship. Trust and contacts are crucial for achieving success in business.
  • Corporate entrepreneurship is relatively new but is now included in several programs looking to enhance innovation within corporate structures.

Some organizations in developing countries, like CORFO in Chile, have been very successful in implementing these kinds of programs. The best programs are focused and incorporate a competitive process for selecting beneficiaries.

Conclusion: from informal to “modern” business

Informal businesses must grow based on new markets and microfinance until they reach a level where the costs of formality become lower than the costs of informality. During the informal phase of their evolution, businesses can pay high interest rates for microfinance (given their high cost of credit evaluation) because they are sufficiently profitable. They normally are creating markets at the “bottom of the pyramid.” Nevertheless, when markets are consolidated, competition reduces profitability and informality becomes impossible. At that moment, it is worth becoming formal.

The process of formalization takes time, but it comes with economic development. Microfinance will remain important for a while in countries like Peru. Some day, however, microfinance institutions will create more equity-based financial products to maintain their presence in new financial markets, and traditional microfinance will be reduced to marginal markets.

Daniel Cordova is President of Instiuto Invertir.

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