2. Understanding micro, small and medium enterprises.

This section profiles Chilean SMEs and provides the basis for analysis of the government programs and incentives discussed in subsequent sections. The profile is based on survey statistics, census data and studies and ends with a short discussion of efficiency and productivity, including implications for direct and indirect exports for SMEs.

To highlight business trends, this discussion uses various levels of analysis and terms. The terms "micro business," "small enterprise" and "medium enterprise" reflect the national definitions explained in Table 2.1 below. The term "broadly defined SMEs" includes micro, small and medium enterprises--but not the self-employed or subsistence micro businesses. This definitional convention allows the discussion to emphasize certain trends detected in the analysis. For instance, a discussion of employment trends should recognize the dominant role of micro businesses in the creation of lower skilled jobs. However, a discussion of export promotion policy should focus on SMEs. National surveys permit this kind of disaggregation and allow for more powerful conclusions.

Chilean SMEs, like those in other countries, have special features and feel the effects of regulations and risk factors quite differently from micro or large firms. Generally speaking, SMEs are family businesses and their management falls directly on the owners (often untrained). SMEs differ from large firms in their effectiveness at strategic planning, but they may also pursue goals that differ from profit maximization, such as market survival, maintaining their jobs and sources of income, or keeping up the family business tradition. Thus, the owner's outlook (a generational and cultural factor) is especially important in deciding what determines a firm's development and growth.

As a result, SMEs should be treated as economic agents with unique characteristics, rather than merely "smaller-sized large firms." Of particular relevance in the comparison between SMEs and large firms are factors that significantly affect their unit costs, interest rates and transaction and logistics costs--all significantly higher for SMEs. This suggests that selective policy interventions could prove instrumental in improving SME productivity. To maximize their impact, these interventions should be aimed at fostering linkages, promoting innovation, advancing training, improving technology and developing new forms of work organization, among other aspects of business development.

Although the number of small and medium enterprises has grown, their share in the economy has fallen. This decline is not the result of structural changes in the Chilean economy. The SME and formally registered micro businesses (not including self-employment or subsistence level firms) account for 77 percent of employment by the private sector and 99 percent of total number of firms. However, SMEs and formally registered micro businesses only generate 23 percent of sales and have an extremely limited direct participation in the dynamic Chilean export sector.

A PROFILE OF SMALL AND MEDIUM ENTERPRISES (SMES)

CLASSIFICATION

Chile's unique classification system makes international performance comparisons difficult. To classify firms by size, Chile uses the unidad de fomento (UF), which is a precise measure based on an indexed unit of account used to express prices and limit the effects of inflation in budget allocations and contracts. Based on the Chilean definitions, many firms labeled as "micro businesses" would be considered small enterprises in other economies. This explains the apparently low number of SMEs in the data presented in this section. (12)

SECTORAL DISTRIBUTION

The tables below show the distribution of firms by size and sector and the contribution of SMEs to employment and sales. The crucial importance of broadly defined SMEs to the Chilean economy is illustrated by their share in the number of the country's firms (99 percent) and of national employment (77 percent). Although they predominate in certain sectors, broadly defined SMEs are found in a large number of economic activities. Around 58 percent concentrate in commerce and services; 11 percent are in agriculture; 11.5 percent are in transportation; and only 6.5 percent are in industrial activities. (13)

The sectoral distribution of SMEs follows the regional patterns. SMEs have the greatest market share in services (38 percent), agriculture (35 percent), construction (31 percent) and trade (24 percent). SMEs concentrate sales in four sectors: trade (35 percent), finances, technical and professionals services (16 percent), industry (12 percent) and agriculture (9 percent). These sectors represent 76 percent of SME sales. SMEs are found in sectors with low barriers of entry, low capital requirements, a strong regional presence and less "sophisticated" markets (less stringent quality or packaging requirements). (14)

Contribution to National Economy

SALES

The importance of SMEs in the national economy has been small and declining. Figures 2.1 and 2.2 show annual sales growth rates by size between 1994 and 2000. Figure 2.1 shows the annual sales growth rates for the periods 1997-95, 1995-96, 1996-97, 1997-98, and 1999-2000. Figure 2.2 compares the growth rates for the six-year period 1994 to 2000. As large firms have increased their dominance, SME sales have fallen. Micro and SME sales fell from around 27 percent of total sales in 1994 to just over 23 percent in 2000. In addition, the relative weight of large firms increased during the 1990's in terms of absolute sales, sales per worker and sales per company. (15)

SMEs may be less vibrant than micro businesses or large firms during economic growth spurts and appear more vulnerable to shocks. In 1996, the SME growth rate lagged micros and large firms during a period of economic growth. Moreover, during the 1999 recession, SMEs sales fell by 5.7 percent, a bigger decline than that suffered by micros and large firms. The greater operational flexibility of micros and their reliance on commerce and trade seem to cushion these firms during economic downturns.

[FIGURE 2.1 OMITTED]

ACCESS TO CREDIT

Limited access to credit can be a critical constraint, since it can limit sales, investment, expansion, the adoption of technology and worker training. On the one hand, compared to large companies, SMEs have more difficulty gaining access to bank financing. On the other hand, SMEs' indebtedness relative to sales is greater than that of the large companies--and the conditions of their loans are more costly. The principal problem to gaining access to financing is usually the lack of guarantees. In addition, there is little access to other sources of financing, besides credit. That some SMEs have access to financing and others do not means that the conclusions and policy implications are complex. (16)

EXPORTS

In addition, SMEs are becoming marginal direct exporters. They export a very small and declining amount of products--at least directly. The table below reveals that SME participation in total export value declined from an already meager US$ 781 million in 1994, to US$ 716 million in 2000, representing just 3.94 percent of total export value. In addition, in 2000 only 0.53 percent of total SMEs and micros exported directly (3,423 firms out of a universe of 640,480 SMEs and micros). (17)

FIRM SIZE, REGULATION AND SURVIVAL

The size of a firm has an impact on its use of inputs, regulations, and productivity of capital. The differences among firms affect SMEs' prospects for growth and development. In one study, for example, labor productivity for larger firms was between two and four times higher than that of smaller firms--when firm size was measured by either number of workers or gross production value. SMEs require a much higher proportion of working capital as a percentage of sales than larger firms, affecting unit costs and productivity. The figures below show some indicators for Chile. All point to the SMEs' disadvantages relative to larger firms. However, a closer look at the business environment and the causes or drivers behind those differences is essential in evaluating the case for intervention, at least on efficiency grounds. (18)

Firm entry and exit rates and growth trends for SMEs are similar to large firms; and there appear to be no significant differences in growth trends and levels of growth. However, large companies have a lower risk of closing Sector concentration and the availability of machinery suppliers also affect risk of closing. Other factors linked to a higher risk of failure include the firm's debt and productivity, the availability of financial services, the growth of market, and the debt of the sector. (19)

The proportion of firms that grow, shrink or exit the market shows a great deal of dynamism. The sectors with the highest entry rates have the highest exit rates. They also have a large number of SMEs. The entry and exit trends of Chilean SMEs appear to be similar to those in OECD countries. However, exit rates for medium and large firms appear high by OECD standards, and the likelihood of a small firm in Chile growing into a medium firm appears low. The exception is agriculture, which has a low rate of entry and a low exit rate. SMEs in Japan and the United States have similar trends. (20)

Company survival rates are positively related to company size (see Table 2.7). A company's risk of closing declines with its size, the concentration of the sector, and the availability of machinery suppliers. It increases with the firm's debt, productivity, the availability of financial services, the growth of markets, and the debt of the sector. Not surprisingly, with low entrance barriers and little documentation required for bankruptcy, micro businesses have a high exit rate. It seems that they also mature into small firms at a fairly high rate--but this could be based on the definitional distinctions between micro and small firms. (21)

EFFICIENCY

Efficiency is the key to growth and jobs creation. The technical efficiency of SMEs is central to the debate about the role of small-scale industries in economic development. SMEs are unlikely to be important sources of growth and employment generation if they are relatively inefficient, with limited ability to compete, survive and grow into larger firms. The evidence is not conclusive, but there are broad tendencies. SMEs are, on average, less efficient than larger firms, due to increasing returns to scale. The average efficiency of smaller firms is below the production possibility frontier, controlling for scale effects.

Batra and Tan suggest, however, that, while SMEs are less efficient on average than their larger counterparts, significant numbers of highly efficient SMEs are more productive than many large firms. There are also notable sectoral differences. The objective of reducing the differences is often at the heart of policies for assisting and targeting SMEs. However, because SMEs are heterogeneous, simple comparisons of the efficiencies of different sized firms can be very misleading. For policy makers, the latter is the more important finding. (23)

Highly efficient firms, both large and small, have several technological, work force, and organizational characteristics that less-efficient SMEs can, in principle, emulate. Efficient firms have better access to new technology through know-how, licensing agreements, integration into the supply chain, joint ventures with foreign partners, and export contacts with foreign buyers and suppliers. They have a more educated work force, and are more likely to provide formal structured training to their workers. The work organization of more efficient firms is characterized by greater automation and quality control in production, and by human resource management and compensation practices that emphasize job stability, productivity and skill acquisition. The wide dissemination and adoption of these best practices can have productivity-enhancing benefits to less efficient firms, SMEs in particular.

The major problem that affects SME growth is isolation--more than size, access to finance or business development services (BDS). Business linkages, such as marketing, managerial, technical, financial and design linkages are primary determinants of learning innovation and productivity, whether the linkages are to large firms or other SMEs. However, by most accounts, Chilean firms work in isolation and lack well-developed networks. In one survey, only 5.1 percent of business owners considered ties with other organizations (firms and institutions) are important, while 58.6 percent and 36.3 percent operate in, high and medium levels of isolation, respectively. Compared to other SMEs in other countries, Chilean SMEs show limited integration along the supply chain and even less success in exporting. Even among successful SME exporters, only about 30 percent of the firms have formal cooperation agreements with other firms. (24)

Knowledge constraints differ greatly between successful SMEs (which grow and export consistently) and failing and barely surviving SMEs. For the successful SMEs, the constraint is high-quality high-intensity marketing and managerial and technical knowledge, which are often available through global export-oriented value chains. That might argue for a public policy role to facilitate connecting these firms into the global private networks of knowledge.

To remain competitive and, as a result, to improve export potential, the private sector must produce high quality outputs while lowering production costs and improving business productivity. This increased orientation to quality and to international markets has led to greater differences between large firms and most SMEs, due to the lags in SME efficiency and productivity. Large firms and some medium firms demonstrate a high level of dynamism and technology adoption. They have diversified sources of funds, and they are able to obtain timely information on a range of investment and trade opportunities. However, the dynamism and innovation of some of the large Chilean firms, such as in the mining and agro industry sectors have not generated significant spillovers to other firms. Most SMEs appear to be isolated from the supply chain, do not invest in innovation, face knowledge constraints and have had limited access to financial and technical resources and market information.

Therefore, they have not been able to take advantage of market opportunities, including opening in international markets. These factors have limited their productivity, integration and growth. (25)

Given the characteristics of SMEs and the constraints they face, the Chilean Government has promoted linkages among SMEs and between SMEs and large firms. The Government also encourages SMEs to raise their productivity and competitivenes by adopting new technologies and innovative processes s. In addition, the Government has supported vulnerable, yet commercially viable SMEs during economic downturns. This approach has opened open the door to identifying market or coordination failures and, when they exist, justify government intervention to address them.

Further, policy makers have a role to play in assisting SMEs on grounds of knowledge and coordination failures. While markets in developing economies are generally well functioning, there is evidence that factors such as poor information, high labor turnover, and imperfect capital markets pose important constraints on training for many employers, especially SMEs. Many of the same constraints are pertinent to other employer decisions tied intimately to training, such as investments in new technology, use of quality control methods, and adoption of high performance work practices. The resulting low levels of efficiency limit the contribution that SMEs can make to overall economic growth and to employment generation.