Scaling up small firms' access to finance in developing economies: evidence from Tanzania.

Introduction

Unlike entrepreneurship, which is essentially a subjective concept, small firms are commonly defined in terms of turnover or numbers of employees (Deakins, 1999). The criterion of the number of workers is the most widely used, because of its apparent simplicity and that data on the other criteria are generally lacking. Small firms in the context of this paper refer to all businesses that employ less than 50 employees.

In most developing economies small firms face a wide variety of constraints throughout their life cycle. These constraints limit their productivity and growth. Out of the several problems affecting their growth, difficulties on accessing external finance is arguably central. So far there is a consensus view from theoretical investigation supported by numerous empirical studies that small businesses as opposed to large firms face specific constraints in raising external finance (Berger et al., 1998). (1) Small firms in Tanzania, according to a recent study, view access to finance as the most constraining factor to their development (Satta, 2003). (2)

Much has been written on why the suppliers of finance are reluctant to provide finance to small firms. Common constraints that face small firms in raising finance include the small nature of their operations which makes their needs small, and the administration of small loans is costly and unattractive to established suppliers of finance. Lack of adequate collateral, unfamiliarity with complicated procedures for raising finance from formal suppliers (banks), high risks and transaction costs brought about by information asymmetry, difficulties in enforcing contracts, and lack of appropriate instruments to manage the risk involved also form part of the constraints (Steel and Webster, 1992; Aryeetey et al., 1997; Cook and Nixson, 2000; Van Oyen and Levitsky, 1999). In some cases the problem is aggravated by supervisory and capital adequacy requirements that restrict banks from extending uncollateralised loans to small firms (Wright, 2000).

This paper evaluates three Tanzanian small firms' financing schemes in terms of scale and outreach, and sustainability. This evaluation aims at determining their replicability as a strategy of scaling up small firms' access to formal finance. The three schemes are the Rural Based Community Bank approach by Kilimanjaro Co-operative Bank (KCB); Akiba Commercial Bank's (ACB) scheme, whose financing approach targets one economic activity at a time with an expectation of applying the acquired experience to another activity; and the CRDB Bank-Microfinance Institution's (MFIs) linkage scheme. KCB's scheme focuses on rural small firms in the Kilimanjaro region (northern Tanzania). ACB's focus is currently on urban small firms. CRDB bank's linkage with MFIs aims at financing both urban and rural small firms in the country. Using this approach, CRDB bank avails the needed funds by lending wholesale to participating MFIs, which in turn extend the much needed finance to small firms.

The remainder of the paper is organised as follows. The next section reviews the literature on the link between financial systems, economic development and small firms' growth. This is followed by a discussion of the methodological approach to the schemes' analysis. This section also highlights the lack of a universally accepted assessment methodology. Section four presents the study results. The paper concludes with a discussion of policy implications and an integrated approach for scaling up small firms' financing.

Literature Review

The development of a financial system has, to a large extent, been viewed as a critical path for economic development. The widespread desire to see an effectively functioning financial system is warranted by its clear causal link to growth, macroeconomic stability, and poverty reduction (Brownbridge and Kirkpatrick, 1999: 3; World Bank, 2001). Financial development appears to contribute to long-term average economic growth, poverty reduction and stabilisation of economic activity and incomes. So far an entire strand of research has emerged documenting the critical importance of an efficient financial system. Akinboade (2000: 941) notes that the theoretical underpinnings of this relationship have been traced back to Schumpeter (1934). Similarly, Goldsmith (1955), Cameron (1967, 1972) and Patrick (1966) provide some of the early works which link the importance of finance and the process of industrialisation. The argument since then has been that the organisation of the financial system is crucial to economic development. Furthermore, the financial system, according to Gibson and Tsakalotos (1994: 581), can both actively help to promote growth and, if poorly developed, help to stifle it.

In their empirical study, King and Levine (1993a, 1993b), using a selection of financial development indicators, found that there is a strong correlation between financial development and economic growth. In Rajan and Zingales' (1998) view, financial development is important in the creation of new firms in an economy, and a strong financial system is a necessary ingredient for enterprise development and growth as it represents the sum total of all intermediary institutions, which offer financial services to the business community and the population at large. Overall, there is now little doubt that the financial sector in general plays an important role in fostering the economic development of a country.

While the study recognises the development of small firms as a valuable tool for broader economic and social development, it is equally important to acknowledge that this sector has a number of special needs (White, 1999). So far there is a general consensus that growth in small businesses is a complex process, and that this process is neither linearly continuous nor does it depend upon a limited number of factors (Deakins, 1999). Although there has been considerable research effort to identify small businesses' growth factors, Bridge et al. (1998) note that in practice there are many factors that interact and influence enterprise growth, and that they doubt whether it is possible to isolate individual factors. Indeed, Gibb and Davies (1990) in their study, argue that most of the research work in this area "fails" to provide convincing evidence of the determinants of small businesses' growth as a basis for informing policy makers. Storey (1994) similarly, in his review of a number of empirical studies that examine which characteristics are related to growth, finds no conclusive evidence that permits the development of a profile or model of the growth performance of the enterprise. What appears to be the consensus among most scholars is that enterprise growth or its absence can be attributed to a wide variety of factors.

Despite the absence of a comprehensive theory to explain which small firms will grow or how they grow, various explanatory approaches are used (Bridge et al., 1998). While various studies recognise, for example, the importance of availability of financial and other resources, managers and management skills that can adapt to and cope with a changing environment and the potential to develop staff and exploit new opportunities are equally important (Deakins, 1999).

While finance is not the only factor that promotes the growth or creation of enterprises, it is viewed to be vital, for without it creativity, drive and innovation cannot be transformed into material actions (Levitsky, 1989; Kessous and Lessard, 1993). Several studies for example, cite lack of finance as one of the major barriers to enterprise development, particularly at the small-scale level (Satta, 2003; Cook and Nixson, 2000; Van Oyen and Levitsky, 1999; Berger et al., 1998; Parker et al., 1995; Keasey and Watson, 1994; Levy, 1993; Koch, 1990). The absence of funding leaves small firms caught up in a vicious cycle of low investment, low incomes, low profits and savings for reinvestment. By failing to secure finance, small firms certainly miss opportunities for business growth. Lacking access to formal financial services means small firms must provide this financing themselves through their own savings, the help of relatives, business profits, or money lenders whose loans are normally costly.

Financial support to small firms, therefore, is important for turning these enterprises into efficient units. By providing small firms with access to financial services, suppliers of these services help entrepreneurs to improve productivity and management skills, create jobs, smoothen income flows and consumption costs, enlarge and diversify their businesses, and increase their income and other benefits such as health care and education (Khandker, 1998). This support has a strong impact on their size, organisation, and ambitions, and hence positive economic, social and political results that help to reduce unemployment, increase household income, and strengthen democratic institutions (Carval, 1989: 202). Modest interventions in capital supply, with a minimum of associated assistance or supervision, therefore is likely to achieve remarkable results. Clearly understanding the role of finance in enterprise development is critical for policy formulation. Given the relative importance of financial services for small firms and the emerging evidence that potential and existing small firms face difficulties in accessing credit, this study using Tanzanian data focuses on identifying policy interventions that could scale up small firms access to finance in developing economies.

Study Methodology

One of the major problems currently hindering the assessment of small businesses' financing schemes is the absence of a universally accepted methodology (Reille et al., 2002; Meyer, 2002). Most existing assessment methodologies lack standardised indicators and definitions leading to a multitude of performance indicators (see Table 1). Eight assessment methodologies, for example, use more than 170 different indicators to evaluate small businesses' financing schemes. (3) These methodologies are CAMEL, PEARLS, GIRAFE, Micro Rate, M-CRIL, CGAP, Paxton and Cuevas, and von Pischke. Consequently, widely agreed definitions and indicators exist for very few indicators. However, despite the dominance of individual assessment methodologies, recent literature indicates that some initiatives are underway to develop standardised indicators and definitions (Von Stauffernberg, 2002).

This section briefly examines the methodologies that were employed in assessing the three small firms' financing schemes. The study used two methodologies (outreach and sustainability levels) in assessing the small firms' financing schemes. Although the two assessment methodologies do not provide a full assessment of the economic impact of small firms' financing schemes' operations, they serve as quantifiable proxies on the extent to which a scheme has achieved its objectives (Yaron et al., 1997). The underlying argument is that if both outreach and sustainability have been enhanced then intervention is judged to have a beneficial impact as it is deemed to have widened the financial market in a sustainable way (Hulme, 2000). Hallberg (2000) also argues that when clients are willing to pay the full cost of services, sustainability is a proxy for impact. Such impacts potentially extend the choices of small firms looking for finance and this extension is likely to lead to improved enterprise performance and household economic security.

The scale of outreach and sustainability indicators are normally compared with country averages. Given the lack of country averages in Tanzania, we use Africa averages as proxy averages to compare with the schemes' indicators. These averages are adapted from Paxton's (2002) study, which compares the performance of eighteen Latin American and African financial institutions (Table 2). Finally we determine the depth of outreach by computing the Depth of Outreach Index (DOI). If this index is positive, a scheme is considered to have deepened small firms' access to finance. With the exception of one scheme that became operational in 2001 (CRDB bank-MFIs linkage scheme), the analysis covers four years (1998-2001). (4) The two assessment methodologies that were employed in this study are discussed below.

Scale and Depth of Outreach

In measuring institutional outreach, it is important to distinguish between the extent (breadth/scale) and depth of outreach. The former accounts for the absolute number of enterprises (or relative market penetration) reached by the scheme. The latter indicates how deep in the pool of the underserved the scheme reached. Generally, however, the term outreach often alludes to the Depth of Outreach measure.

Several indicators have been used to measure the depth of outreach. Typically, loan size has been in use as a proxy for depth of outreach. However, loan size according to Paxton and Cuevas (1998) is considered to be an imperfect measure of depth of outreach since it may not reflect the degree of isolation from formal finance. In an effort to address the isolation, they proposed an alternative measure. Using Von Pischke's (1991) description of a frontier between formal and informal sectors where those outside the frontier do not have regular access to formal financial services, Paxton and Cuevas (1998) derived the Depth of Outreach Index (DOI) as a measure of depth of outreach. This computation uses readily available variables relating to clients who have traditionally been excluded from formal finance. In a recently published study, Woller (2000) uses an average loan size to GNP per capita as an alternative measure to depth of outreach.

Given the lack of a general consensus on what is the best measure for depth of outreach, both indicators are used (Average loan size to GNP per capita and the DOI) to assess the schemes' levels of deepening small firms' access to credit. The following four categories of the underserved small firms are used to compute the DOI.

Microenterprises

Formal financial intermediaries experience relatively high transaction costs when dealing with the smallest of small businesses. This is due to the small size of each transaction as well as the involved high degree of risk due to information asymmetry and lack of collateral by most of them.

Small Firms Owned by Women

Several studies indicate that women entrepreneurs in developing countries are excluded from formal financial services for a variety of reasons, the most significant one being cultural bias. In these countries, women-owned small businesses and their petty trade appear not to have sufficient scale to interest formal financial intermediaries (Hopkins et al., 1994).

Rural Small Businesses

Due to high transaction costs and high risk associated with serving a largely dispersed population and rural enterprise activities, formal financial intermediaries avoid rural areas.

The Uneducated Entrepreneurs

Entrepreneurs who cannot read and write face an obvious obstacle to obtaining financial services since lending operations by financial intermediaries involve paperwork.

The above demographic factors are used to define and measure DOI. This measure sums the difference between the institutional outreach averages and country averages. However, given lack of country averages for Tanzania, we use Africa averages as proxies to compute DOI (Paxton, 2002). The DOI sums the differences between the institutional outreach averages (i) and proxy Africa averages (s) for (N) categories of small businesses excluded from formal finance (e). A positive DOI indicates that a scheme has deepened outreach levels of small firms excluded from the formal finance frontier.

DOI = [n.summation over (n-1)] (ei - es) (1)

When the four variables are incorporated into the above formula, it can be written as:

DOI = (ri - rs) + (ini - ins) + (wei - wes) + (uni - uns) (2)

The degree to which financial institutions reach the smallest of small firms, rural entrepreneurs, women entrepreneurs, and uneducated entrepreneurs is therefore analysed by calculating the DOI. Three of the variables (Urban entrepreneurs, male entrepreneurs, and literate entrepreneurs) are percentages calculated on a 0 to 1 scale. Instead of using GNP per capita, we use GNI (Gross National Income) per capita (recently introduced by the World Bank to replace the GNP per capita) for the income level and then we normalise it to one (World Bank, 2003). (5)

Schemes' Sustainability

While it is useful to examine to what extent enterprise financing schemes reach beyond the traditional financial frontier, it is equally important to assess their ability to reach large numbers of small businesses with financial services in the long run. This ability is a function of schemes financial viability. Khandker (1998) broadly describes sustainability of a scheme to include financial, economic and institutional viability, and its ability to promote economic viability among small firms' borrowers.

Sustainability is also dependent on a number of other factors. A sustainable scheme, for example, operates in such a way that the difference between the cost of making a loan and the cost of funds plus administrative and default costs is equal to or less than the price (that is the interest rate) it charges borrowers. A scheme's sustainability is also dependent on the resources raised, repayment rate on loans, and on institutional performance. Savings mobilisation similarly is an integral part of a sustainable financial institution because it reduces dependence on outside sources.

A number of indicators are used to examine a financial institution's sustainability. Perhaps one of the most comprehensive indicators of sustainability is the Subsidy Dependence Index (SDI) (Yaron, 1992; Paxton, 2002). This index measures by what percentage interest rates charged to clients would have to be increased, hypothetically in order to cover program costs and eliminate subsidies. SDI is obtained as follows:

SDI = m*E + A* (m-c) + K - P/LP*I (3)

Where:

m = opportunity cost of funds A = average debt K = grants and discounts on expenses LP = loan portfolio outstanding E = average equity c = interest rate of debt P = accounting profit i = interest on loan portfolio

OR

SDI = S/lp*i (4)

Where:

S = total annual subsidies received lp = loan portfolio outstanding i = interest on loan portfolio

Other indicators of sustainability include operational self-sufficiency, which indicates whether or not enough revenue has been earned to cover the scheme's direct costs excluding the adjusted cost of capital but including any actual financing, and financial self-sufficiency, which indicates whether or not enough revenue has been earned to cover both direct costs, including financing costs, provisions for loan losses, operating expenses, and indirect costs, including the adjusted cost of capital.

A Subsidy Dependence Index of zero means that an enterprise financing scheme has achieved financial self-sufficiency without dependence on external subsidies. This achievement is normally reflected on adequate lending rates, high rates of loan collection, savings mobilisation and control of administrative costs. Active savings mobilisation according to Ledgerwood (1999) helps to ensure a continuous source of funds for the financial institution. Specifically, increase overtime in total value of voluntary savings to loan portfolio indicates the extent to which the financial institution is dependent on savings from clients and not subsidies. This is also reflected in an improvement of self-sufficiency indicators.

To facilitate the analysis, a questionnaire was used to capture the relevant data. The analysis of the collected data began by an adjustment of the obtained financial statements for inflation in order to restate the financial results, which in turn gives a more accurate reflection of the full financial position. These adjustments were particularly important in determining the true financial viability (sustainability) of the banks implementing the financing schemes. Specifically, inflation affects the non-financial assets and an organisation's equity. Most liabilities are not affected because they are repaid in a devalued currency (which is usually factored into the interest rate set by the creditor).

To adjust for inflation, two accounts were considered. These involved revaluation of non-financial assets and the cost of inflation on real value of equity. Non-financial assets include fixed assets such as land, buildings, and equipment. Fixed assets, particularly land and buildings, are assumed to increase with inflation. However, their increase is not usually recorded in the conventional financial statements. As a result, their true value may be understated. To adjust non-financial assets, the nominal value relative to the amount of inflation was increased. To make this adjustment, an entry as revenue (credit) on the income statement and a corresponding increase in fixed assets (debit) on the balance sheet were recorded. (6)

Results and Discussion

Table 3 provides a summary of the three schemes' assessments. These findings demonstrate that the KCB scheme offers the strongest policy option for scaling up small firms' access to formal finance. Replication of this scheme in other parts of the country is not only expected to have an immediate impact on small firms' access to credit but could also contribute towards increased access to financial services by the majority rural population.

The performance of the other two schemes signalled strong potential for improving small firms' access to finance in the long run. Despite CRDB-MFIs scheme being at an infancy stage at the time of this study, the few indicators used to evaluate this scheme were found to be better than Africa averages. Using the average loan size to GNI per capita as a measure of the scheme's depth of outreach, CRDB's performance was found to be better than the Africa average. In addition, CRDB's SDI indicated that the scheme is providing financial services to small firms sustainably. The only exceptions were on the scheme's scale of outreach and DOI. These exceptions, however, can partly be explained by the infancy state of the scheme. Given time, the scheme is likely to be a useful policy option for improving small firms' access to finance.

With the exception of scale of outreach and the DOI indicators, the ACB scheme seems to be achieving its objectives as it scored better than the Africa average. This is evidenced by the scheme's average loan size to GNI per capita as a measure the scheme's depth of outreach. The scheme's negative DOI was partly a result of the scheme's focus on urban small firms. If any realistic conclusion is to be drawn on this scheme, its objectives have to be taken into account. Overall, the study results indicate that ACB's scheme has the potential in the long run for scaling up small firms' access to finance. This assertion is further supported by the computed sustainability indicators, which indicate that the scheme was self-sufficient without dependence on external subsidies. These indicators also show that the scheme was providing financial services sustainably.

[FIGURE 1 OMITTED]

Integrated Approach for Scaling Up Small Firms' Access to Finance

Based on findings from this study, three policy options emerge and are used to develop the integrated approach as a strategy for scaling up small firms' access to finance (Figure 1, see previous page). Of the three policy options, replication of the rural-based community bank scheme by Kilimanjaro Cooperative Bank demonstrates the possibility of having an immediate impact on scaling up small firms' outreach levels. Given the performance of this scheme, this policy option appears to address not only rural small firms but also the broader problem of rural population exclusion from accessing reliable financial services in developing countries. Furthermore, the involvement of local communities through their economic associations appears to provide this scheme with a solid base in terms of the business clientele. This policy option is particularly relevant in Regions/Provinces in Tanzania and indeed in other developing economies where there is a strong presence of economic activities involving rural dwellers.

The other two policy options (based on Akiba Commercial Bank and CRDB Bank schemes) so far have exhibited the potential for improving small firms' financing in the long run. The performance of these schemes as indicated earlier seems to be consistent with recent literature that in the long run young financing schemes are likely to mature and operate efficiently. Consequently, these two schemes form part of the developed approach to scaling up the access of small firms to finance.

Conclusion

This paper evaluated three financing schemes run by three banks in Tanzania to determine the extent to which they have deepened small firms' access to finance. While acknowledging the lack of a world-wide accepted assessment methodology, the study employed two of the widely used methodologies. Findings from the analysis of the three financing schemes led to several policy implications for the development of small firms in Tanzania and other developing countries. One of the emerging policy implications is the need for a new approach to policy interventions in these countries. While acknowledging that currently the issue is no longer on whether there should be policy interventions in financial systems, the key challenge to policy makers remains to be what the nature and approach of these interventions should be. This paper attempts to provide one approach to such interventions. Although the developed approach purely relates to the Tanzanian environment, it provides relevant clues to other developing economies that experience similar small-firm financing difficulties. Given the combined effect from the three distinct financing approaches, the policy options developed by this paper provide policy makers in developing economies with an opportunity to address small firms' financing difficulties from different angles.

Contact Information

For further information on this article, contact

Tadeo Andrew Satta, Centre for Advanced Studies in Corporate Governance, Entrepreneurship and Finance in Africa, Leeds University Business School and Institute of Finance Management, Dar es Salaam, Tanzania

Telephone: [phone]/Fax: [phone] E-mail: [e-mail]

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(1.) Small firms and small businesses terms are interchangeably used in this paper.

(2.) In a recent study in Tanzania, a survey of 136 small firms found that 63% of them consider difficulties in accessing finance from financial institutions as the major constraint to their development.

(3.) Ibid.

(4.) Out of the three schemes under evaluation, one scheme (CRDB-MFIs linkage), although established in 1999, became operational in 2001 with the 2 previous years being spent mostly on capacity building.

(5.) Gross National Income (GNI-formerly gross national product or GNP) according to the World Bank (2003), is the broadest measure of national income, which measures total value added from domestic and foreign sources claimed by residents. GNI comprises gross domestic product (GDP) plus net receipts of primary income from foreign sources. Data are converted from national currency to current US dollars using the World Bank Atlas method. This involves using a three-year average of exchange rates to smooth the effects of transitory exchange rate fluctuations.

(6.) The credit entry in the income statement is not recorded as operating income because it is not derived from normal business operations.

Tadeo Andrew Satta, Centre for Advanced Studies in Corporate Governance, Entrepreneurship and Finance in Africa, Leeds University Business School and Institute of Finance Management, Dar es Salaam, Tanzania

Table 1. A Summary of the Used Assessment Indicators and
Their Originating Methodologies

Assessment        Assessment Indicators   Origin of the Used
Methodology       Used by the Study       Methodologies

Scale and Depth   Number of clients       CGAP(1997) and Yaron
of Outreach                                 et al. (1997)
                  Average Loan Size       Woller (2000)
                    per GNI capita
                  Depth of Outreach       Paxton and Cuevas
                    Index (DOI)             (1998)

Sustainability    Financial Self          GIRAFE
                    Sufficiency
                  Operational Self        GIRAFE
                    Sufficiency
                  Subsidy Dependence      Yaron, Benjamin and
                    Index (SDI)             Piprek (1997)

Source: Compiled by Author.

Table 2. Africa Averages: Scale, Depth of
Outreach, and Sustainability Indicators

Indicator                      Average

Number of Clients              37,357
Average Loan Size (US $)          194
Subsidy Dependence Index          425
Operational self sufficiency     0.71
Financial Self Sufficiency       0.51

Source: Paxton (2002).

Table 3. Results from the Analysis of the Three Financing
Schemes (1998-2001 Averages)

Variable             Indicator   KCB Scheme   ACB Scheme

Outreach               Scale       19,430       14,360
                     Loan Size   539 (US$)     863 US$
                        DOI         0.17        -1.82
                        SDI          0           0.5
Sustainability (d)
                        FSS         0.72         0.59
                        OSS         0.98         0.73
                      Arrears       0.4          0.065

                                 CRDB-MFIs   Africa
Variable             Indicator    Scheme     Averages

Outreach               Scale      12,000      37,357
                     Loan Size   239 (US$)   194 US$
                        DOI        -0.37       > 0
                        SDI          0        < 4.25
Sustainability (d)
                        FSS         --         0.51
                        OSS         --         0.71
                      Arrears      0.02      <0.091%

Source: Annual Reports and Survey Data.