FINANCING SMALL SCALE INDUSTRY


FINANCING SMALL SCALE INDUSTRY

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Introduction

The contributions which small enterprises make to the economic development process have been well documented.1/ Small-scale enterprises (SSEs) generate more direct jobs per dollar of investment than do large enterprises. They serve as a training ground for developing technical and entrepreneurial skills and by virtue of their greater use of indigenous technological capabilities, they promote local inter-sectoral linkages (particularly with agriculture) and contribute to the dynamism and competitiveness of the economy.

1/Notably Hoselitz, 1959; Staley and Morse, 1966; World Bank, 1978a, 1978b.

Rural SSEs have an added significance in that they provide an appreciable and growing share of the employment and incomes of the rural population, particularly the poorer section of this population – the landless.2/ Rural SSEs help in stabilising rural incomes normally subject to seasonal production cycles and by providing non-farm goods and services to the rural population, they contribute to increases in agricultural output and general improvements in living standards in rural areas.

2/The World Bank (1978b) estimates that for developing countries taken as a whole rural non-farm activities account for roughly one-third of the rural labour force. Ho (1986) suggests that with rural being defined to include rural towns and if part-time employment is also included some 35-65% of the rural labour force is involved in rural non-farm activities. Ho also indicates a strong inverse relationship between farm size and non-farm activities underscoring the importance of SSE development for the poorer members of the rural population.

One way of transporting wood – very costly in terms of time

Within the broad group of rural SSEs, forest-based small-scale enterprises (FB-SSEs) are of major importance in many developing countries – an importance reflected in the number of FB-SSEs, in their contribution to employment and in their relative accessibility to the poor and to women.3/

3/FAO (1985) reports that in a survey of six developing countries, FB-SSEs represented between 13% and 37% of all SSEs and contributed between 13% and 35% of total SSE employment. It appears that the share of women in the total SSE labour force is frequently understated in official statistics and that the percentage of females in SSE labour force averaged around 37% in five of the six countries surveyed.

This significance of SSEs has been recognised by most developing country governments and many have introduced special support programmes. A large number of these programmes have concentrated on the provision of small industry credit, frequently associated with technical advice. It is important to recognise, however, that credit is no panacea for raising the incomes and productivity of low income populations. The poor performance of so many agricultural credit programmes in various parts of the developing world is ample testimony to the ineffectiveness of credit without the existence (or, at least, simultaneous provision) of the other factors required to stimulate agricultural production.

The same argument is valid for manufacturing enterprises, small or large. Simply making credit available will not result in a significant investment if the other factors necessary to encourage this investment are absent. Such factors include markets at remunerative prices, adequate infrastructure, availability of raw materials and other resources at competitive prices and the existence (and knowledge) of relevant technical and organisation systems of production. When these factors are present at the appropriate levels, however, credit can serve as a powerful catalyst in hastening the rate of growth of manufacturing investment. Properly applied, credit can also be used, along with other measures such as appropriate pricing policy, to encourage a particular pattern of investment activity deemed desirable under prevailing economic and social circumstances.

This paper seeks to examine the ways that credit can be made more available to the rural SSEs. The underlying premise of the analysis presented is that credit availability is a function of the operational efficiency of the rural financial market and that traditional approaches to the problem have been unsuccessful because they have failed to take into account the diversity of the interactions occurring in this market.

The definitional context

Small-Scale Enterprises

The two most commonly used measures for defining enterprise size are the level of fixed capital investment and the number of employees. Different countries use different cut-off points for these criteria and what may be considered small in one country may de deemed medium or even large in another.4/ In fact, a high degree of arbitrariness exists. For the purposes of this paper, enterprises considered as small-scale are those employing under 50 persons. No specific reference is made to fixed capital investment as it is felt that the wide diversity which exists with respect to this aspect makes it difficult to come up with a generally accepted cut-off point. In any event, the importance of the employment generation effect of SSEs would seem to justify concentration on the number of persons as a measure of size. Also, in practice, the majority of small-scale rural manufacturing enterprises employ less than five persons and have fixed assets of under US$50,000.5/

4/See for instance Vasiliades (1985) Annex II. The size of the country itself, its stage of development and the policy objectives of the government are factors which would influence the criteria.5/Frequently referred to as “cottage” industries.

Most small manufacturing enterprises operate in an environment that exhibits characteristics which potentially, at least, constrain their survival and growth prospects. These include limited access to credit and other forms of institutional support, marketing constraints and raw material procurement problems, frequently exacerbated by the internal problems of a small production base and technical and organisational inefficiencies.

In a sense, these characteristics are probably more important than reference to fixed capital investment and number of employees in the context of identifying SSEs, for they help to focus attention on the type of assistance that should be provided if they are to fulfill their potential in the development process.

The Rural-Urban Distinction

A certain degree of arbitrariness also exists in deciding on a dividing line for the rural/urban distinction given the existence of “what is in fact a continuous spectrum of situations” (World Bank, 1978b). In the UN classification, towns of up to 20,000 inhabitants are considered rural. This paper thus defines rural to include:

(a) the obviously rural areas including farm households and rural villages; and(b) rural towns as defined in the UN classification.

One advantage of incorporating rural towns into the definition relates to the fact that a large proportion of the economic activities of these towns are closely linked to the rural economy. SSEs located in rural towns are involved mainly in the processing of agricultural and other rural products (e.g. forest products) or in the provision of non-farm goods and services to the rural population. Rural towns thus serve as marketing and service centres for the rural economy (Sinha, 1983).

Agricultural and industrial policy and rural SSEs

The intimate relationship between agriculture and rural non-farm activities, by virtue of strong backward and forward production linkages and by the consumption demands of farm households, indicates that the vitality of the agricultural sector will, to a large extent, determine the attractiveness of rural manufacturing investment (Ho, 1986). Governmental policies toward agriculture will thus have a pervasive influence on rural SSE development.

Similarly, a country’s industrial development policy will largely determine the extent to which rural SSEs are provided with adequate incentives. In many developing countries measures used to promote industrial development have tended to discriminate against SSEs such that the major beneficiaries of industrial incentives are the larger, often urban-based enterprises.

The development of rural SSEs is thus contingent on the extent to which the macroeconomic context is favourable for such development. In situations where this context is not conducive, the demand for support services such as credit will be severely restricted (World Bank, 1977). Even in the absence of specific support services, much can be done to promote rural SSE development by such things as adoption of appropriate pricing policy for agricultural products and developing agricultural programmes that reach a large share of the low-income farmers “who are more likely to generate demand for rural non-agricultural goods and services” (Ho, 1986).

Financial requirements of rural SSEs

The financial requirements of any enterprise, small or large, can be under two broad headings – fixed capital and working capital. Fixed capital refers to investment in assets such as land, buildings and equipment, the economic lives of which extend for the medium to long term.

Working capital, on the other hand, consists mainly of cash, inventories of raw materials, work-in progress and finished goods, and accounts receivable. Working capital can thus be thought of as representing the funds required to operate the enterprise over the production period. Implicit in this definition is the notion that working capital funds are ‘self-liquidating’ over the short-term – a period approximating the enterprise’s production cycle – whereas funds invested in fixed capital are only recovered from cash-flow surpluses over the medium to long term.

The relative importance of these financial requirements depends on a number of factors, the most important being the size of the enterprise, the industry group in which it operates and the nature of the technology employed. While there are significant differences between countries, regions and sectors, in general, small enterprises tend to have lower relative requirements for fixed as against working capital because of the high degree of labour intensity (or, conversely, the low capital intensity) exhibited.

 , show quite high labour/capital ratios. Of significance in this context is the predominance of household enterprises in the rural areas.6/ This has two major implications as far as financial requirements are concerned:

6/ Anderson (1982), quoting a number of sources, indicates that around three-quarters of the household manufacturing in India is rural, with somewhat higher percentages for East and West Africa, roughly one-half for the Philippines and Colombia and two-fifths for Korea.

(a) most rural household manufacturing enterprises are part-time activities and the available funds are subject to the competing demands of the farm, the non-farm enterprise and household consumption. Poor returns from farming in a particular period could reduce the availability of funds to the non-farm enterprise. Similarly, unusually high household expenditures could affect both the farm and non-farm operations. Thus, whereas the cash working capital requirements for the household SSE may be relatively low – compared to the enterprise operated off the farm – the competing demands for household resources may still result in working capital shortages with effects on the SSE’s operations. Figure 1: The rural SSE Continuum

(b) When the household enterprise attempts to expand its operations and move out of the household the whole financial complexion of the unit changes. Investment in buildings (or fixed overheads if premises are rented), equipment and other items of fixed capital becomes important. Most of the labour has to be hired (as compared to the high input of unpaid family labour in the household enterprise) and the working capital requirements increases significantly. Also, the SSE becomes the only, or at least the major, source of family income.

Again, while generalisations are difficult given the diversity of SSE activity in developing countries, there is an indication that forest-based enterprises would tend to have a higher working capital demand than other types of rural SSEs. This stems from the relationship between working capital demand and the lengths of the production and marketing periods. The longer the length of these periods the greater the working capital demand and the nature of the forest-based processing enterprise, in terms of both the production process and the products, is such as to suggest relatively high values for these parameters.7/

7/ Kilby et al (1984). These writers indicated, for example, that in a survey of small-scale industries in Sierra Leone, carpentry had the highest average inventory/annual sales ratio of all the industry groups analysed. They also suggested that from preliminary analysis of data collected in Jamaica and Honduras similar inferences could be drawn.

Rural SSE Diversity

From the perspective of finance, there exists a continuum of SSE types ranging from the informal household enterprise at one extreme to the relatively modern workshop or factory-type SSE operating outside the household, at the other. The financial characteristics and requirements of the different enterprises along this continuum may vary considerably and a recognition of these differences is critical if SSEs are to be adequately serviced.

Three criteria may be used to make the distinction between SSEs:

(a) the source of finance as between institutional vs. non-institutional or informal credit;
(b) the relative importance of fixed vs. working capital in the capital structure; and
(c) the relative importance of savings as a source of finance.

The significance of the relationships implied by these criteria is illustrated in the schematic shown as Figure 1. At the level of the informal SSE, the major source of finance is in the form of savings and when external finance is sought it is normally from the informal or non-institutional credit suppliers. At this level also, the greatest requirement is for working capital. As one moves up the continuum, the relative importance of savings decreases, the proportion of institutional to non-institutional credit increases and so does the proportion of fixed to working capital.

If SSEs are to improve their contribution8/ to the economic development process the proportion of enterprises in the ‘modern’ category (i.e. the upper right-hand corner of the diagram) must be increased. In one sense this notion defines the problem of financing SSEs, for whereas the enterprises at either extreme may be reasonably well serviced, it is the intermediary-type enterprises that have the greatest potential and present the greatest challenge.

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