How private debt can plug the credit gap for emerging market SMEs

Private debt could help jumpstart economies where public capital markets have failed.

Large corporations were once considered to be the engine of global development. The industrialists and bankers of the early 20th century were regarded as the beating heart of the economy, bringing growth and prosperity to all levels of society. But as time wore on, this view has become outdated. And while we are still right to recognise the importance of large corporations, nowadays, equal weight is given to the role of SMEs, which serve as vital drivers of employment, innovation and growth in virtually every economy in the world.

Nowhere is this more the case than in emerging markets. Emerging and in particular frontier markets often lack the infrastructure to attract and accommodate large-scale business activity. Yet, unlike big corporations, SMEs can penetrate these underserved markets – often in isolated rural communities and impoverished urban areas – and stimulate much-needed private sector growth. The demand for SMEs to meet this end is reflected in statistics: in emerging markets, SMEs account for more than nine out of ten new jobs, half of all existing jobs and a third of GDP.

Notwithstanding the clear need for SMEs in emerging markets, they face a number of barriers to growth. These range from regulatory and tax constraints, to lack of reliable power, corruption, and political instability. There is, however, one obstacle that is more significant than others: access to finance.

Pressures largely originate from the top-down. Traditional providers such as banks are facing  mounting regulatory and compliance burdens which are crimping their ability to lend. For example, new IFRS accounting standards implemented last year require financial institutions to make higher loss provisions on loans. This translates into an increased ‘cost-of-risk’ resulting in some client segments or parts of the banks’ business becoming less profitable. Banks have accordingly taken a more cautious stance in their loan portfolios, hurting SMEs directly.

The result of this reduced bank appetite is a grand-canyon-sized funding gap. In the latest figures supplied by the World Bank, there are 65 million SMEs in emerging markets that are credit constrained. This puts the potential demand for SME finance at $8.9 trillion. Given the current credit supply is $3.7 trillion, we are left with a financing gap of $5.2 trillion.

Part of the problem is the weak sovereign ratings that weigh down many emerging market economies and the knock-on effect this has on their companies. A mid-sized bank in, say, Georgia, that is looking to tap international capital markets for funding will find that its cost of debt is directly affected by that country’s BB-, or ‘junk’, rating. Its rating can imply a much higher probability of default than is accurate. Banks focused on micro, medium and small enterprise clients tend to achieve superior portfolio diversification and can assert a certain independence from government, public sector contracting and flagship natural resources industries. That well-run bank is being unduly penalised.  This could make it much harder for that bank to access capital markets, in turn restricting its ability to lend to SMEs and entrepreneurs.

While this might not be great for credit-thirsty SMEs, it presents investors with a golden opportunity. Unburdened by the same regulatory and balance sheet issues, this financing gap is being increasingly filled by non-bank financiers with origination, structuring and credit capabilities on par with conventional lenders.

Nimble lenders can also look beyond a country’s sovereign rating and instead focus on a bank or financial institution’s underlying balance sheet strength and market opportunities. Based on this detailed, proprietary analysis, a lender might decide that the bank deserves a higher credit rating, and so is happier to lend to it on this basis.

By differentiating the individual risk profiles of the financial institutions from those of the countries in which they operate, niche lenders are able to deliver investors superior risk-adjusted returns and, in the process, create a meaningful impact to local businesses and livelihoods through financing.

The Georgian case study is not just illustrative. There are plenty more countries like Georgia, with a strong economic outlook and rapidly expanding financial sectors, thanks to a low credit to GDP ratio. They include Georgia, Armenia, Uzbekistan, Indonesia, Cambodia, the Philippines and more.

At a policy level, G20 leaders have repeatedly called for better access to finance for small businesses, and the World Bank Group has set the ambitious goal of universal financial inclusion by 2020. This high-profile governmental and institutional backing, combined with strong GDP growth, and expanding networks of intra-regional trade, means the scope for investing in emerging market SME finance looks as healthy as ever.

Kashama Pascal Nyangombe is manager of the EFA Financial Institutions Debt Fund.