The importance of SMEs in growing inclusive growth in Africa

The importance of SMEs in growing inclusive growth in Africa

Inclusive economic growth is growth that leads to job creation, causing a ripple effect on the purchasing power of the majority of the populace. The private sector, and in particular small and medium enterprises (SMEs), are the drivers of an economy. SMEs are also the largest providers of direct employment and inclusive growth can be achieved through promotion of policies that would drive their development.

According to the Central Bank of Nigeria, 96% of Nigerian businesses are SMEs (US = 53%, EU = 65%). Inclusive growth can be achieved by positioning these SMEs to take advantage of the opportunities in the economy.

Financial services is crucial to SMEs

According to the Small Business Administration of the USA, two of the top 10 reasons why SMEs fail are lack of capital, and poor credit management. It is no different in Nigeria and the rest of Africa. While there are several aggregators/sources of capital including Private Equity (PE) funds, development finance institutions (DFIs) and insurance companies in Africa, the key players in the financial services industry that are optimally positioned to serve SMEs and therefore drive inclusive growth are banks and micro-lenders.

Government macro-economic policies impact SME financing

Lenders operate within the wider macro-economic environment, and government policies regarding inflation and infrastructure are crucial to keeping the cost of funding down. When inflation drives up the cost of funding and ultimately lending costs, it in turn drives up the cost of production, making SMEs less competitive.

Standardisation of physical address systems is another area where African governments can make a meaningful contribution to SME growth. Inconsistent address systems make it difficult for SMEs to establish formal relationships and credit histories with suppliers, customers and transient clients.

What can banks do?

At the credit application and processing stage, banks need to invest in systems that allow more efficient and tailored risk profiling. Such a system rewards diligent entrepreneurs with lower lending rates and greater access to capital.

Post-disbursement, the establishment of dedicated advisory/support teams can help minimise credit risk and improve credit management by educating and advising SMEs on day-to-day financial management, record-keeping and corporate governance. The incremental cost of this will be easily offset by increased patronage and lower default rates.

Banks also need to create systems for long-term funding by innovating longer tenured liability products. In Nigeria this sort of long-term funding would help the growth of the manufacturing and agriculture sectors, which are better positioned to create more jobs.

Tapping into private equity

SMEs can now look to a wider range of funding sources including private equity, DFIs and diaspora remittances.

PE is critical to developing SMEs. PE institutions are a source of capital that remains largely untapped in Nigeria. They offer a number of secondary benefits that cannot be easily quantified.

PE institutions provide a diversified mix of capital, debt, equity, preferential shares, etc. They also provide capital over every stage of an SME’s growth: from start up to expansion.

PE institutions are good at spotting investment opportunities – risk capital goes where it will work best. They help individual companies fulfil their potential, and the macro effect is to drive efficiency and growth across the entire economy. Their high level of commitment means they offer significant operational support to SMEs (in order to protect their investment).

Furthermore, PE institutions help instil an accounting discipline, something that is often absent from a one-person start up, or even an established family firm. They help to spot talent within an organisation and can provide access to a bigger human capital pool and to training opportunities. They are also able to attract talent, a function that SMEs find challenging as they simply don’t have the resources or skills to find suitable staff.

On an operational level, PE institutions provide the discipline for SMEs to base their operations on the best environmental, social and governance principles. They also use their networks to help SMEs grow and expand outside of their local environment: via acquisitions or via additional capital for expansion. PE institutions are instrumental in launching SMEs into a higher orbit of operations. PE institutions are normally not involved longer than seven years, and at the end of their involvement will help the SME with its IPO, when it becomes a listed company.

DFIs

Development finance institutions (DFIs) are another category of investor that can help power SMEs. Examples of DFIs include organisations such as the International Finance Corporation, the CDC (UK’s Development Finance Institution), and the FMO (the Dutch development bank). Traditionally DFIs will fund SMEs indirectly, by lending to PE institutions, who do the investing.

But there is a trend starting whereby DFIs invest directly in SMEs. At present DFIs limit their loans to between 3 and 5 years, but African economies will greatly benefit from more long-term arrangements.

Diaspora remittances and unclaimed dividends

It is estimated that expatriate Nigerians remit approximately US$21 billion per annum. This is more than three-quarters of the national budget. This inflow can be aggregated to SMEs with the right framework such as through the active promotion of the Nigerian ASeM – the specialised board of the Nigeria Stock Exchange (NSE) for emerging business with high growth potential. There could be tax breaks on dividend income earned on diaspora remittances that are directly invested in certain SME categories.

Further, there is an estimated 45 billion naira worth of dividends in unclaimed trust accounts. The government can come up with creative ways of freeing this up to support the growth and development of SMEs.

Breaking barriers to growth

Finally, an African finds it much more challenging to obtain visas and to travel across Africa than an American. Transportation within the continent can be more difficult than trans-Atlantic trips and, according to the United Nations, though intra-Africa trade has enormous potential to create employment and catalyse growth, intra-Africa trade is only about 10% of total trade compared to 50% for Asia and 70% for Europe.

Governments need to allow the free flow of capital across borders into neighbouring countries and this can be achieved through trade. SMEs need to be incentivised to do business within the larger economic region, for example the ECOWAS common external tariff system that seeks to eliminate duties on trade between West Africa countries.

Already the mobile phone revolution is allowing contact beyond national borders. We must go further: the use and development of special banking applications/services to transact across borders must be actively encouraged. Africa has leapfrogged the rest of the world in freeing up its banking platforms and providing financial services to the rural poor.

Moving forward

Compared with large corporates and multinationals, most African SMEs operate, for the most part, at unsophisticated levels. They have a high cost-base, limited product range, and do not benefit from economies of scale. This must change.

For SMEs to compete and benefit from the economic growth sweeping across Nigeria, and other African countries, they need: better infrastructure, macro-economic stability, operational support, longer-term financing at single-digit interest rates, and better financial management principles.

SMEs are the spark that will ignite and launch the economic rocket that is Africa. The untapped capital is there. PE institutions and DFIs are eager to provide long-term capital. Governments are also making progress in getting systems in place. Stand by for lift-off!

David Okwara

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