Daily Times

The regulatory authorities generally lack capacity, resources, and, sadly, the integrity, to perform their important functions. The draconian powers vested in them encourage corrupt practices, leading to harassment and exploitation of businesses. The laws and policies are problematic in the first place. For example price control policies envisage same prices across an entire city while ignoring the cost differentials arising from variable transportation and real estate costs across different locations. While addressing the market failures, both the law and the enforcement agencies ignore the underlying causes and instead deal with the symptoms.

In many cases the root cause is a government failure rather than the market’s. For instance, in case of the supply chains of perishables, it is often impossible to transport fresh produce like milk, without the addition of chemical preservatives in order to avoid the exorbitant costs of cold chain management and still meet the price control limits. The government should avoid direct price controls and instead focus on enforcing antitrust (competition) laws. The government should also review the relevant laws and make offences compliant with the demands of justice by digging deeper into the real causes of problems. The punishments should be proportionate to violations and should be awarded only after transparent due process. To check the corruption among regulators appropriate anti-corruption measures should be taken.

The other major problem faced by the SME sector is access to capital. A small or medium business can meet its financing needs through a combination of debt, primarily bank loans, and cash investment (business equity). It is important for a modern business to keep its cost of capital low in the scheme of its overall economics. Pakistani entrepreneurs have no comfort in either of the modes of financing.

They favour the mightier capitalists over cash-strapped but capable entrepreneurs. In effect this often leads to misallocation of credit, in turn creating deadweight losses and opportunity costs apart from hurting the ideal of equal opportunity

The banking system is averse to lending to SME’s, due to a pedantic risk-averse approach that does not adequately weigh in the talent in an enterprise or viability of the business idea or an entrepreneur’s individual credit history. The green-field project, as a nascent business is often dubbed, is plainly declined credit, while business history and value of immovable collateral, aided by unfair influence, are prime lending factors; they favour the mightier capitalists over cash-strapped but capable entrepreneurs. In effect this often leads to misallocation of credit, in turn creating deadweight losses and opportunity costs apart from hurting the ideal of equal opportunity.

In Pakistan an estimated 8 million SME’s are currently eligible for credit while only 0.5 million of them (6 percent) have any credit facility. As a result, despite the SBP’s policies’ having struggled to assist SME financing since 2002, the bank credit to SME’s is only 7-8 percent of banks’ total lending portfolio to private sector against SBP’s target of 20 percent, which is the standard in emerging markets. The meager nature of credit by international standards is further explained by the fact that the total share of bank credit in the economy in terms of ‘credit to GDP ratio’ is 16 in Pakistan (2011-2015), compared to 52 in India and 122 in Singapore. Data suggests that even that paltry SME financing is disproportionately channelled to medium rather than small enterprises. The obvious inference from these statistics is that the overall environment for private credit is unfavourable and that too goes to medium and large enterprises. The banks in the country are not effectively performing their core function, i.e. channelling depositors’ savings into loans for creditworthy businesses and individuals. Despite extracting a widely known boon from the disproportionate banking spreads-the differential between the borrowing and lending rates-Pakistani banks are unwilling to support the very economy that feeds them.

The Musharraf government did create a SME Bank in 200,4 but the bank has been unable to come into proper operation due to meager financial assets, technical capacity, and small loan amounts (about Rs. 0.8 million on average). During the same period an USAID-supported technical assistance project was launched involving National Bank of Pakistan (NBP) but did not go far in addressing the problem. Then came the economic slump and macroeconomic indicators fell; a situation that persisted from 2008 to 2013, shunning SME growth further. Nothing significant has happened since then except SBP’s Credit Guarantee Scheme for micro and small businesses, which has not moved the banking sector yet.

It is also true that, on the demand side, a large number of eligible SME’s stay away from bank credit due to their mistrust of banks’ intrusive disclosure requirements, complicated paperwork, long processing times that often transcend the time of need, and religious beliefs about loan interest. But overall the demand for bank credit on reasonable terms is solid.

While SME’s find securing bank loans hard enough, private investments are not easy to raise either. In the advanced economies there are very well functioning private equity and venture capital firms, making both private investment and technical advice available to the promising businesses. That organized mechanism of private investment is totally missing in Pakistan. Although the regulatory framework for private equity and venture capital was first introduced by the Securities and Exchange Commission of Pakistan (SECP) in 1995 and has been revised thrice in 2001, 2008, and most recently in 2015, the industry is yet to make its mark in any significant manner. As of now there is virtually no private equity firm in operation signaling a lack of confidence of investors in regulatory practices and the overall business environment. It is well known in finance literature that investors—both local and foreign—take a lead from the bank lending in deciding to invest apart from the financial space that the credit provides in structuring business finance. The aforementioned low share of Pakistan’s bank credit in the economy partially explains the reluctance of investors to invest.

A viable way to mitigate the business finance problem would be to form a business partnership which is an excellent mechanism to raise or enhance early and mid-stage capital, distribute failure risk, and add to management capacity when right partnerships are forged. However, there are peculiar inhibiting factors that discourage such alliances in Pakistan, which mostly lead to business failures when forged. The foremost barrier is a high risk of business failure creating a stressful environment in the business operations and cash flows. The other is prohibitive business dispute cost which stems from the absence of viable dispute resolution mechanisms. The third is the lack of an entrepreneurial culture that could promote partnerships through taking risk and entrusting resources.

Many rich people particularly in rural areas view business as a way to show off wealth and cultivate power and prestige rather than as a value creation tool. The partnerships are therefore discouraged by economic, legal and cultural barriers.

In view of this situation, entrepreneurs are left with very limited financing options to start a business; primarily through personal and family and friends’ savings. While this funding is often enough as early stage capital, in most cases the capital doesn’t take the businesses far as the growth capital is more challenging to raise. Consequently, either the business has to settle with limited growth, or close altogether when additional investment or business growth is crucial to survival beyond early stage.

Continued

The writer is a graduate of MIT based in Islamabad. He is an experienced entrepreneur with previous service in public sector. The above is part of a series of related articles. He can be contacted at tasadduq69@hotmail.com

Published in Daily Times, October 3^rd 2018.