Many discussions on economic development today center on supporting the development of small and medium enterprises. This is understandable, since small business constitutes a very significant share of economic activity in developed and successful transitioning economies. “Think small” is a message relayed by many development experts as microcrediting is gaining momentum in Latin America, Asia, and Africa. Here is one story about the success of a microlending program in Africa.
For example, a $40 loan was extended to a woman who sold pastries off a tray on Kisangani’s streets. The $40, accompanied with a little business counsel and encouragement, let her expand the variety of her offerings and buy her product more prudently and at lower cost. Over the next few weeks, during which the loan officer touched base with her every few days both for continued counsel and to collect regular payments on the loan, her bottom line improved. At the end of the 16-week cycle, her loan was totally repaid—with 16 percent interest—and she was ready for a new and slightly larger loan to propel her to a new level in her little business.
Tiny and insignificant in the global scheme of things? Of course. Except that during his nine months in Kisangani, Peter Brinkerhoff and his little team of newly trained loan officers oversaw the closing of more than 800 such loans, with a total face value of about $50,000. Strict guidelines are in place to monitor repayment procedures, and the 95 percent rate of timely return would make many U.S. banks envious. Best of all, the original $50,000 is not used up, but is constantly available in its entirety for new rounds of equally prudent lending.
It is true that in many developing countries entrepreneurs lack access to capital and providing them with capital seems like a natural solution – but the problems may be more profound than that. Why can’t many small business owners in developing economies gain access to domestic capital? (note, that in many cases these microlending programs are run with donor money, although in some cases there are very successful programs run by domestic banks – a story on one of such programs in Latin America is forthcoming in CIPE’s Feature Service).
One reason is that many small entrepreneurs often operate in the informal sector (which in some countries constitutes more than 50% of all economic activity). Being in the informal sector these entrepreneurs “don’t exist” – of course they operate and they may act as suppliers and customers of legally registered companies – but they are not officially registered and do not pay taxes. This means that they can’t just go to a bank and ask for a loan, just as they can’t go to the government and use some of the public services that the government may provide to small business owners. They can, however, become an easy prey for corrupt government officials. For more information on the informal sector you can visit the website of the Institute for Liberty and Democracy, run by one of the pioneers of informal sector work Hernando de Soto.
What Hernando de Soto showed back in the 1980s was the people are driven into the informal sector by inefficient business regulations. Since then, his theories and approaches to combating informality have become mainstream, and one of the projects that highlights the link between informality and bad regulations best these days is World Bank’s annual Doing Business survey. What the database shows is that countries’ ability to develop a viable private sector-led economy is hampered by bad regulations. If entrepreneurs need to pay 100% or more of a country’s average income and spend weeks filling out dozens of applications to register a business or if they can’t be sure that a government will protect their property – negative incentives of becoming part of a formal economy begin to outweigh the positive ones.
I don’t want to discount the importance of microloans – business ideas and hard work ethic can only take you so far if you are not able to get the money to run and operate a business, as small as it can be. At the same time, microcredits do not address the underlying reality of doing business in developing countries. If the overall business environment is not improved – whether entrepreneurs get the money or not, the reality is that they still have to deal with poor regulations. So, to be truly successful, microloan programs should be combined with initiatives that improve the overall environment for doing business – they can’t be implemented at the expense of those initiatives.