| Abstract: |
SMEs are key to development, as they provide livelihoods and jobs for the
majority of people in LMICs. Yet, their development is often hampered by
constrained access to finance. SMEs mostly depend on bank loans for external
finance. However, these have been insufficient to overcome SMEs' financing
constraints, especially in LMICs, such that it seems pertinent to explore
other financing sources. The World Bank and OECD have repeatedly pointed to
capital markets (e.g. Thompson et al., 2018; World Bank, 2020a). Hence, this
policy brief explores the role of capital markets for SME finance in LMICs.
Numerous challenges, both on the supply and demand sides, impede SMEs'
involvement with capital markets. SMEs struggle with the costs of issuing
securities, reporting and corporate governance requirements and, in the case
of equity, with concerns about dilution of ownership. Investors on the demand
side are discouraged by imperfect information and limited exit options.
Consequently, SMEs hardly use equity or market-based debt, especially in
LMICs. However, capital markets can have an indirect positive effect on SME
finance: Several financial instruments (e.g. securitisation, equity capital
for banks) exploit the respective comparative advantages of banks
(information-related activities) and markets (liquidity), and create
interactions with benefit flows from markets to banks and vice versa, which
result in their complementarity and co-evolution. Specifically, capital market
development is associated with increases in bank lending, in particular to
smaller and riskier firms (Sommer, 2024; Song & Thakor, 2010). Yet, this is
not necessarily the first-best option to mitigate SMEs' financing constraints,
since it often takes decade-long reforms to create suitable conditions for
capital markets. This has the following implications for policymaking:
Policymakers need to tailor their decisions to the most promising ways of
fostering SME finance to local contexts. While SME promotion may involve
capital market development in some middle-income countries, this is still way
off for many LMICs, as it may take strenuous institutional and structural
reforms over a prolonged period to create an environment for thriving capital
markets. Policymakers should foster non-traditional instruments to provide
SMEs with direct access to capital market financing. Receivables and lending
platforms are especially promising for LMICs and can be promoted through
specialised regulatory frameworks, information and capacity-building, as well
as co-investments and tax incentives. Policymakers should scale up policies to
improve SMEs' access to loans; this serves both as an immediate response to
SMEs' financing constraints and as a complement to policies to ensure that
banks' increased lending activities (spillovers from capital market
development) can (also) be channelled towards SMEs. Depending on
country-specific bottlenecks, this may include addressing well-known problems
in SME lending through the establishment of credit bureaus and registries as
well as moveable asset registries; strengthening contract enforcement and
insolvency laws; and implementing a regulatory framework conducive to
digitalisation. |