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Financing small-scale rural manufacturing enterprises.

P. Desmond Brunton*
Caribbean Development Bank

* The Author is a Staff Member of the Caribbean Development Bank (CDB) but the views expressed in this paper are his own and do not necessarily reflect those of CDB.


The contributions which small enterprises make to the economic development process have been well documented.1/ Small-scale enterprises (SSEs) generate more direct jobs per dollar of investment than do large enterprises. They serve as a training ground for developing technical and entrepreneurial skills and by virtue of their greater use of indigenous technological capabilities, they promote local inter-sectoral linkages (particularly with agriculture) and contribute to the dynamism and competitiveness of the economy.

1/Notably Hoselitz, 1959; Staley and Morse, 1966; World Bank, 1978a, 1978b.

Rural SSEs have an added significance in that they provide an appreciable and growing share of the employment and incomes of the rural population, particularly the poorer section of this population - the landless.2/ Rural SSEs help in stabilising rural incomes normally subject to seasonal production cycles and by providing non-farm goods and services to the rural population, they contribute to increases in agricultural output and general improvements in living standards in rural areas.

2/The World Bank (1978b) estimates that for developing countries taken as a whole rural non-farm activities account for roughly one-third of the rural labour force. Ho (1986) suggests that with rural being defined to include rural towns and if part-time employment is also included some 35-65% of the rural labour force is involved in rural non-farm activities. Ho also indicates a strong inverse relationship between farm size and non-farm activities underscoring the importance of SSE development for the poorer members of the rural population.

One way of transporting wood - very costly in terms of time

Within the broad group of rural SSEs, forest-based small-scale enterprises (FB-SSEs) are of major importance in many developing countries - an importance reflected in the number of FB-SSEs, in their contribution to employment and in their relative accessibility to the poor and to women.3/

3/FAO (1985) reports that in a survey of six developing countries, FB-SSEs represented between 13% and 37% of all SSEs and contributed between 13% and 35% of total SSE employment. It appears that the share of women in the total SSE labour force is frequently understated in official statistics and that the percentage of females in SSE labour force averaged around 37% in five of the six countries surveyed.

This significance of SSEs has been recognised by most developing country governments and many have introduced special support programmes. A large number of these programmes have concentrated on the provision of small industry credit, frequently associated with technical advice. It is important to recognise, however, that credit is no panacea for raising the incomes and productivity of low income populations. The poor performance of so many agricultural credit programmes in various parts of the developing world is ample testimony to the ineffectiveness of credit without the existence (or, at least, simultaneous provision) of the other factors required to stimulate agricultural production.

The same argument is valid for manufacturing enterprises, small or large. Simply making credit available will not result in a significant investment if the other factors necessary to encourage this investment are absent. Such factors include markets at remunerative prices, adequate infrastructure, availability of raw materials and other resources at competitive prices and the existence (and knowledge) of relevant technical and organisation systems of production. When these factors are present at the appropriate levels, however, credit can serve as a powerful catalyst in hastening the rate of growth of manufacturing investment. Properly applied, credit can also be used, along with other measures such as appropriate pricing policy, to encourage a particular pattern of investment activity deemed desirable under prevailing economic and social circumstances.

This paper seeks to examine the ways that credit can be made more available to the rural SSEs. The underlying premise of the analysis presented is that credit availability is a function of the operational efficiency of the rural financial market and that traditional approaches to the problem have been unsuccessful because they have failed to take into account the diversity of the interactions occurring in this market.

The definitional context

Small-Scale Enterprises

The two most commonly used measures for defining enterprise size are the level of fixed capital investment and the number of employees. Different countries use different cut-off points for these criteria and what may be considered small in one country may de deemed medium or even large in another.4/ In fact, a high degree of arbitrariness exists. For the purposes of this paper, enterprises considered as small-scale are those employing under 50 persons. No specific reference is made to fixed capital investment as it is felt that the wide diversity which exists with respect to this aspect makes it difficult to come up with a generally accepted cut-off point. In any event, the importance of the employment generation effect of SSEs would seem to justify concentration on the number of persons as a measure of size. Also, in practice, the majority of small-scale rural manufacturing enterprises employ less than five persons and have fixed assets of under US$50,000.5/

4/See for instance Vasiliades (1985) Annex II. The size of the country itself, its stage of development and the policy objectives of the government are factors which would influence the criteria.

5/Frequently referred to as “cottage” industries.

Most small manufacturing enterprises operate in an environment that exhibits characteristics which potentially, at least, constrain their survival and growth prospects. These include limited access to credit and other forms of institutional support, marketing constraints and raw material procurement problems, frequently exacerbated by the internal problems of a small production base and technical and organisational inefficiencies.

In a sense, these characteristics are probably more important than reference to fixed capital investment and number of employees in the context of identifying SSEs, for they help to focus attention on the type of assistance that should be provided if they are to fulfill their potential in the development process.

The Rural-Urban Distinction

A certain degree of arbitrariness also exists in deciding on a dividing line for the rural/urban distinction given the existence of “what is in fact a continuous spectrum of situations” (World Bank, 1978b). In the UN classification, towns of up to 20,000 inhabitants are considered rural. This paper thus defines rural to include:

(a) the obviously rural areas including farm households and rural villages; and

(b) rural towns as defined in the UN classification.

One advantage of incorporating rural towns into the definition relates to the fact that a large proportion of the economic activities of these towns are closely linked to the rural economy. SSEs located in rural towns are involved mainly in the processing of agricultural and other rural products (e.g. forest products) or in the provision of non-farm goods and services to the rural population. Rural towns thus serve as marketing and service centres for the rural economy (Sinha, 1983).

Agricultural and industrial policy and rural SSEs

The intimate relationship between agriculture and rural non-farm activities, by virtue of strong backward and forward production linkages and by the consumption demands of farm households, indicates that the vitality of the agricultural sector will, to a large extent, determine the attractiveness of rural manufacturing investment (Ho, 1986). Governmental policies toward agriculture will thus have a pervasive influence on rural SSE development.

Similarly, a country's industrial development policy will largely determine the extent to which rural SSEs are provided with adequate incentives. In many developing countries measures used to promote industrial development have tended to discriminate against SSEs such that the major beneficiaries of industrial incentives are the larger, often urban-based enterprises.

The development of rural SSEs is thus contingent on the extent to which the macroeconomic context is favourable for such development. In situations where this context is not conducive, the demand for support services such as credit will be severely restricted (World Bank, 1977). Even in the absence of specific support services, much can be done to promote rural SSE development by such things as adoption of appropriate pricing policy for agricultural products and developing agricultural programmes that reach a large share of the low-income farmers “who are more likely to generate demand for rural non-agricultural goods and services” (Ho, 1986).

Financial requirements of rural SSEs

The financial requirements of any enterprise, small or large, can be under two broad headings - fixed capital and working capital. Fixed capital refers to investment in assets such as land, buildings and equipment, the economic lives of which extend for the medium to long term.

Working capital, on the other hand, consists mainly of cash, inventories of raw materials, work-in progress and finished goods, and accounts receivable. Working capital can thus be thought of as representing the funds required to operate the enterprise over the production period. Implicit in this definition is the notion that working capital funds are 'self-liquidating' over the short-term - a period approximating the enterprise's production cycle - whereas funds invested in fixed capital are only recovered from cash-flow surpluses over the medium to long term.

The relative importance of these financial requirements depends on a number of factors, the most important being the size of the enterprise, the industry group in which it operates and the nature of the technology employed. While there are significant differences between countries, regions and sectors, in general, small enterprises tend to have lower relative requirements for fixed as against working capital because of the high degree of labour intensity (or, conversely, the low capital intensity) exhibited.

Rural SSEs in particular, partly because of the lower wage rates generally applicable, show quite high labour/capital ratios. Of significance in this context is the predominance of household enterprises in the rural areas.6/ This has two major implications as far as financial requirements are concerned:

6/Anderson (1982), quoting a number of sources, indicates that around three-quarters of the household manufacturing in India is rural, with somewhat higher percentages for East and West Africa, roughly one-half for the Philippines and Colombia and two-fifths for Korea.

(a) most rural household manufacturing enterprises are part-time activities and the available funds are subject to the competing demands of the farm, the non-farm enterprise and household consumption. Poor returns from farming in a particular period could reduce the availability of funds to the non-farm enterprise. Similarly, unusually high household expenditures could affect both the farm and non-farm operations. Thus, whereas the cash working capital requirements for the household SSE may be relatively low - compared to the enterprise operated off the farm - the competing demands for household resources may still result in working capital shortages with effects on the SSE's operations.

Figure 1: The rural SSE Continuum

(b) When the household enterprise attempts to expand its operations and move out of the household the whole financial complexion of the unit changes. Investment in buildings (or fixed overheads if premises are rented), equipment and other items of fixed capital becomes important. Most of the labour has to be hired (as compared to the high input of unpaid family labour in the household enterprise) and the working capital requirements increases significantly. Also, the SSE becomes the only, or at least the major, source of family income.

Again, while generalisations are difficult given the diversity of SSE activity in developing countries, there is an indication that forest-based enterprises would tend to have a higher working capital demand than other types of rural SSEs. This stems from the relationship between working capital demand and the lengths of the production and marketing periods. The longer the length of these periods the greater the working capital demand and the nature of the forest-based processing enterprise, in terms of both the production process and the products, is such as to suggest relatively high values for these parameters.7/

7/Kilby et al (1984). These writers indicated, for example, that in a survey of small-scale industries in Sierra Leone, carpentry had the highest average inventory/annual sales ratio of all the industry groups analysed. They also suggested that from preliminary analysis of data collected in Jamaica and Honduras similar inferences could be drawn.

Rural SSE Diversity

From the perspective of finance, there exists a continuum of SSE types ranging from the informal household enterprise at one extreme to the relatively modern workshop or factory-type SSE operating outside the household, at the other. The financial characteristics and requirements of the different enterprises along this continuum may vary considerably and a recognition of these differences is critical if SSEs are to be adequately serviced.

Three criteria may be used to make the distinction between SSEs:

(a) the source of finance as between institutional vs. non-institutional or informal credit;
(b) the relative importance of fixed vs. working capital in the capital structure; and
(c) the relative importance of savings as a source of finance.

The significance of the relationships implied by these criteria is illustrated in the schematic shown as Figure 1. At the level of the informal SSE, the major source of finance is in the form of savings and when external finance is sought it is normally from the informal or non-institutional credit suppliers. At this level also, the greatest requirement is for working capital. As one moves up the continuum, the relative importance of savings decreases, the proportion of institutional to non-institutional credit increases and so does the proportion of fixed to working capital.

If SSEs are to improve their contribution8/ to the economic development process the proportion of enterprises in the 'modern' category (i.e. the upper right-hand corner of the diagram) must be increased. In one sense this notion defines the problem of financing SSEs, for whereas the enterprises at either extreme may be reasonably well serviced, it is the intermediary-type enterprises that have the greatest potential and present the greatest challenge.

8/In terms of, say, employment and income generation.

Sources of finance for rural SSEs


A significant proportion of the initial capital - both fixed and working - for SSEs is obtained from personal savings accumulated from other activities.9/ Similarly, expansion of SSEs is mainly financed from internally generated funds. This situation has frequently led to the argument that SSEs, particularly rural SSEs, do not exhibit a high demand for external sources of finance (i.e. credit). It should be noted, however, that whereas the initial capital required to establish a small enterprise may appear meagre, these amounts may account for a substantial proportion of the gross annual family income.10/ The implication being that personal savings alone could not be expected to meet the entire demand for finance by the SSEs, and this situation may be exacerbated in the rural SSEs given the likelihood of smaller savings because of lower incomes. It seems that the question is not so much one of a limited demand for credit by the SSE but rather the inability of existing sources to meet the demand.

9/Kilby, et al (1984) referring to survey work done by various researchers at the Michigan State University indicated that personal savings and loans from family and friends represented 18% of initial capital of SSEs in Sierra Leone, 94% in Jamaica and 91% in Haiti. Similar inferences are made by Meyer (1980).

10/Anderson (1982), who also suggests that this is particularly so when both fixed and working capital requirements are considered.

In the context of rural SSE financing, savings could be viewed from two perspectives:

(a) savings defined as the excess of income over expenditure thus making available surpluses that could be used to finance the SSE; and

(b) savings viewed as one component of the rural financial market and the financial intermediation involved in facilitating the transfer of these savings from depositors to investors.

Viewing savings as part of the financial intermediation process introduces the notion that, as a source of finance, it is a much broader concept than merely one of internal surpluses. For whereas the savings of the individual rural household may be inadequate to finance the totality of the SSE's requirements, efficient mobilisation of household savings by financial intermediaries can significantly increase the availability of funds to rural enterprises.

Informal Credit

The informal financial sector refers to those financial activities that take place “outside the ambit of institutional finance”.11/ A variety of individuals or entities may be involved in this sector including landlords, merchants (wholesalers and retailers), pawnbrokers, moneylenders and such traditional financial entities as rotating savings and credit associations (ROSCAs) found in many parts of the developing world. Loans from family and friends would also be considered part of the informal sector. The characteristics of the various entitles comprising the informal financial sector, given the inherent heterogeneity, vary considerably.

11/Chandavarkar (1985). This sector is also called the non-institutional or the unorganised financial sector, but, as suggested by Chandavarkar, the term “informal” is probably more appropriate given that the informality of the financial activities is its most distinguishing characteristic.

From the perspective of providing finance to the rural SSE, however, there are certain common features which distinguish the informal operators from the institutions operating in the formal sector:

(a) Transaction Costs12/ - Typically, transaction costs of loans from the informal sector are low, essentially because of the informality of the activities. Usually, the lender has an intimate knowledge of the borrower and this facilitates rapid decision-making. Transaction costs are also low because of the low overhead costs faced by the informal lender - frequently the informal lender is one person and little formal documentation is used.
12/In this paper 'transaction costs' are used to refer to the non-interest costs, (to the borrower), of negotiating a loan. Ladman (1984) defines transaction costs as “out-of-pocket outlays required to obtain documents, pay commission and bribes, and travel to and from the lender's office, as well as the opportunity costs of time involved to complete all required procedures”. Transaction costs may also be used to refer to non-interest costs faced by the lender in making a loan. In fact, the two notions are not entirely separate as lender's administrative costs could be passed on to the borrower as fees, etc. To avoid confusion, however, this paper uses the term 'administrative costs' to refer to non-interest lender costs.
(b) Credit Access - There are normally no restrictions on access to credit from the informal sector - except that eventuated by poor repayment performance. Collateral requirements are minimal and usually the knowledge of the borrower on the part of the lender is all that is required. Also, informal operators normally do not place restrictions on how loan funds will be utilised.

(c) Interest Rates - Effective rates of interest in the informal sector tend to be significantly higher than those prevailing in the formal sector. Even in instances where no explicit rate is quoted (e.g. ROSCAs, family and friends) the implicit rates frequently are quite high.13/ At times the monopolistic or near-monopolistic position of informal lenders in rural areas may encourage the charging of extremely high rates of interest (rates above 200% have been quoted in the literature) which bear little relation to the cost of funds.

13/The social obligations incurred when accepting a loan from a friend or relative is one example. The auction system for determining the order of rotation in a ROSCA is another.
(d) Loan Periods - Credit from the informal sector is largely short-term in nature so that it is mainly used to finance working capital requirements. However, the limited availability of medium and long-term funds to the rural SSE, may result in the small entrepreneur utilising short-term credit to finance fixed assets with implications on the ability of the enterprise to service the debt in the required time period.

(e) Financial Market Operations - Most informal operators function only on one side of the market - providing loans but not accepting deposits. Unlike the formal institutions that operate in this way, however, this one-sided intervention does not seem to interfere with the informal lenders access to information concerning financial flows in the market. Also, frequently the informal operator combines the financial operation with non-financial services such as merchandising and marketing.

(f) Central Bank Controls - Informal credit operators usually escape central banking controls such as interest rate and loan ceilings, reserve requirements and “the implicit taxation of the institutional sector through government preemption of funds it controls, i.e. below equilibrium rates of interest (Chandavarkar, 1985). This absence of controls confers on the informal operator a distinct advantage over the formal institutions and could, conceivably, increase the competitiveness of the informal sector.

The actual size of the informal financial sector is difficult to estimate, but observations in different countries suggest that it tends to be more important in rural areas and among the smaller borrowers. Indeed, a significant proportion of the borrowings of SSEs take place in the informal sector. Interestingly too, it has been found that the informal sector operates successfully even in instances where formal institutions offer loans at highly concessionary interest rates and where specific legislation has been enacted to try to reduce or eliminate the informal credit sources. This persistence implies that informal lenders exhibit attributes that are perceived as attractive by the small rural borrower/investor.

Formal Credit

The institutions that comprise the formal financial sector in developing countries exhibit an array of different features and characteristics which to a large extent reflect the types of policy objectives pursued by the government. Ownership may be private, public or a combination. In some instances, particularly with commercial banks and insurance companies, foreign ownership may predominate. The type of facilities offered may involve the full range of financial services, with the institution operating on both sides of the market (e.g. commercial banks) or the provision of loans only, reflecting a one-sided intervention (e.g. development banks). Sector speciality may also be a factor, with some institutions14/ operating in all economic sectors and others concentrating on one sector (e.g. agricultural banks).

14/Though, even with 'multisector' institutions there is frequently a tendency to concentrate on one or two sectors.

One feature common to all 'formal' financial institutions, however, is that they are subject to varying degrees of central bank control. Such controls include interest rate and loan portfolio ceilings, cash reserve requirements, foreign exchange controls and selective credit policies. In many developing countries central bank controls, particularly those related to interest rates15/ can be exaggerated by the existence of an oligopolistic banking system and lead to the phenomenon of financial repression - whereby the financial needs of the large established urban borrowers are well served but the small urban and rural borrowers have limited access to formal credit and must depend on the informal financial sector, frequently on less favourable terms (IMF, 1983). The capital market segmentation implicit in this situation tends to lead to inefficient resource allocation, particularly with respect to capital relative to labour utilization (Steel & Takagi, 1983).

15/That is, maintaining interest rates below so called marketing clearing rates.

A generalized schematic of the formal financial sector in a developing country is shown in Figure 2. At the apex is the central bank which, by the operation of various policy instruments, influences the overall structure. The institutions in the sector differ in the context of the degree of intermediation (reading left to right in the diagramme) and the extent to which they mobilize domestic savings (reading from bottom to top), particularly household savings. The diagramme also attempts to show how funds flow within the sector. Not all of the institutions in the formal financial sector are relevant to the small-scale rural entrepreneur, so the rest of this section concentrates on those considered significant.

Commercial Banks

As a source of finance to the rural entrepreneur commercial banks have never been particularly attractive, despite their predominance in the financial sectors of most developing countries. Commercial banks are essentially urban-based institutions and even when they make 'excursions' into rural areas, the urban underpinnings permeate the operations, as is evidenced by procedures ill-suited to the rural environment.

Small rural entrepreneurs are viewed as high risk borrowers thus increasing the importance of collateral security. The small loan sizes imply high unit administrative costs, aggravated, at times, by the geographical dispersion of potential clients.16/ Given the characteristics of the funds held by commercial banks, with most being in the form of current liabilities, there is an obvious tendency to lend only for short periods (Green, 1970).

16/This partly accounts for the situation in which even when commercial banks operate in rural areas they tend to concentrate on the larger borrowers.

But the small rural borrowers themselves frequently view commercial banks as unattractive sources of credit. The complex procedures, alien attitudes of bank staff, high transaction costs and high collateral requirements are such as to effectively reduce the accessibility of commercial bank credit to small borrowers - a situation that applies even when the bank is publicly owned.

The foregoing is not to suggest that commercial banks have, necessarily, any inherent bias against small borrowers, but is rather a reflection of the economic and financial circumstances which impinge on those institutions. Access to commercial bank credit by the majority of the rural population is thus severely restricted unless these adverse circumstances are mitigated by some intervening factors.

Figure 2: The formal financial sector

Adapted from Abbott (1984)

Development Finance institutions

This inability of commercial banks to meet the financial requirements of large sections of borrowers in the developing countries resulted, particularly during the 1960s, in the establishment of public or quasi-public development finance institutions (DFIs).17/ Many governments placed heavy emphasis on these institutions as essential ingredients in the development process and found theoretical support for this approach by emerging views which suggested that the pace of investment, and hence economic activity, could be significantly enhanced by the establishment of financial institutions and the provision of credit in advance of demand for such services (Patrick, 1966).

17/Nyhart (1967) listed some 340 DFIs in developing countries. In the 1940s only about 12 of these institutions existed.

Development finance institutions were thus supposed to have both a financial function, through the provision of medium and long term finance, and a developmental one, in the sense of supporting only those activities that fulfilled one or more developmental objectives. To the extent that support for small enterprises, both farm and non-farm, is an important component of policy in many developing countries, such enterprises should represent a significant proportion of the loan portfolios of DFIs. With few exceptions, however, the benefits that small borrowers have received from the operations of DFIs in their countries have been limited, certainly to below the potential, a situation related to a number of factors:

(a) Ownership - Though there are privately owned DFIs, the majority of those operating in the rural sectors are publicly owned and controlled. Partly because of the political attractiveness of credit programmes, which may have largely accounted for the ready acceptance of DFIs in the first place, many of them suffer from high levels of political interference with resulting inefficiencies and inequities in the provision of services to clients.

(b) Interest rates - A large majority of DFIs provide loans at concessionary rates of interest - rates which may be negative in real terms. These concessionary rates frequently result in the DPI being unable to compete in the market for loanable funds and having to continue to rely on the government or external financial agencies for loan resources - a dependence which seriously limits the ability of the institution to develop operating autonomy. Low rates of interest also mean that DFIs are hard pressed to cover administrative costs - costs which tend to be higher in rural areas and among small borrowers due to the higher risks, lower loan sizes and the geographical dispersion of clients. This financial cost-price squeeze frequently results in the DFI stringently limiting credit availability, essentially by increasing borrower transaction costs.18/ Small borrowers are thus effectively debarred from obtaining loans, and the resources of the DPI become concentrated in the hands of a relatively small number of larger enterprises almost in direct contradiction to the 'equity' grounds on which many of the DFI programmes are based.19/

18/But also by introducing political, as opposed to commercial, criteria in the loan decision process.
19/A graphic illustration of this is given by Sadeque (1986) based on 1979 data from Bangladesh. In a Special Agricultural Credit project providing short term crop loans, 8.4% of the rural households owning 5 or more acres of land received 545 of the loans. On the other hand 59.4% of households owning less than 1 acre or landless received no loans.
(c) Long-term bias - Almost by definition, DFIs concentrate on medium and long-term loans. But while this is a valid approach given the long-term nature of the financial requirements of development investments, it has two effects which may not be in the best interest of the institution or its clients:
- the long term maturity of its portfolio reduces the ability of the DFI to generate new loan resources from loan capital repayments (Bourne, 1986); and

- DFI clients are unable to obtain working capital loans and must seek alternatives for such funds. Small rural borrowers suffer particularly from this situation, given their restricted access to commercial banks, a situation that is worsened when their limited collateral is already tied up with a medium or long-term loan from a DFI.

(d) One-sided Intervention - With few exceptions, DFIs operate only on one side of the rural financial market - disbursing loans but not involved in taking deposits and other types of money transfer activities. This has the effect of seriously limiting the DFIs' access to funds and to information about the financial transactions occurring in the market (von Pischke, 1980). It also reduces the opportunities available to the DFI to develop productive relationships with rural clients who frequently view the institution as an alien intrusion into the rural area.

(e) Loan arrears and default - A common feature of public DFIs' is high rates of loan arrears and loan default. This stems from a number of factors including inadequacies in the assessment of borrowers' repayment capacity, favouritism in the allocation of credit and an inability or unwillingness to enforce repayment contracts. Regardless of the reason for high arrears and default rates, their existence has pervasive effects. The financial integrity of the institution is significantly eroded, with the result that its very existence is put in doubt. Even when survival is assured, due to continued governmental support, loan concentration becomes more significant and small borrowers' access to credit further eroded. And the effects extend beyond the DFI itself, in the sense that poor credit attitudes encouraged by the DFI may affect other institutions operating in the rural financial market.

(f) Loan Supervision - Supervision of the utilization of loan funds is a function found in many DFIs. Such supervision has two objectives, namely, to ensure that loan funds are used for the purposes intended, and as a means of providing a degree of technical assistance to borrowers. Unfortunately the 'policing' function can seriously erode the effectiveness of the technical assistance function. And small rural borrowers tend to view loan supervision as an unnecessary interference by DFI staff. Also, loan supervision significantly adds to the administrative costs of the DFI.

(g) Agricultural Credit bias - The majority of credit programmes focussed in rural areas tend to concentrate on the provision of loans for agricultural purposes, and many agencies exhibit a reluctance to finance non-farm SSEs. Indeed, in some instances credit institutions are legally prevented from making non-farm loans (Meyer, 1980). But even when there are no obvious restrictions on non-farm lending, the agricultural operations take up so much of the DFI's resources that little funds are available for financing other rural investment activities.

In spite of these problems, DFIs remain an important source of formal credit for SSEs. They also provide the major avenue for the channelling of external funds, from multilateral and bilateral assistance agencies, to SSEs (see later section). Any attempt to improve the accessibility of formal credit to small rural entrepreneurs must, therefore, take the operation of DFIs into account.


Another institutional form favoured by developing country governments in the rural development process is the cooperative. In the context of providing financial services, three types are recognised - the single-purpose credit cooperative, the multi-purpose cooperative providing credit, input supply and produce marketing services, and the cooperative savings and credit schemes or credit unions.20/

20/Some multi-purpose cooperatives, indeed the more successful ones, also provide savings deposit facilities, frequently by allowing the option of leaving the proceeds of produce sales on account.

In theory, cooperatives have considerable advantages over other types of institutions in providing financial services to the rural population. Cooperatives imply a voluntary association of persons with certain common interests, suggesting a high degree of responsiveness to members and the use of policies and procedures well suited to the environment. Thus, for example, the rural cooperative would tend to accommodate financial transactions, the size and timing of which reflect the nature of the rural environment (von-Pischke, 1981).

In practice, however, the performance of rural cooperatives in developing countries has been disappointing. Many cooperatives, particularly the single-purpose credit type, suffer from high rates of loan delinquency, accounting and administrative inefficiency, political interference and, at times, virtual control by the rural elite (Ill y, 1983; Robert, 1979). Much of this seems to stem from the practice of viewing cooperatives as “instruments of public policy” rather than as commercial institutions (Young Johns, 1982). Indeed, in many instances, cooperatives are established almost at the behest of the government instead of being voluntary associations arising out of local initiatives.

Somewhat more successful than the single-purpose cooperative is the multi-purpose operation providing credit, input supply and marketing services and sometimes including deposit facilities. The linking of credit and marketing helps to reduce the incidence of loan arrears and default, and the diversity of activities contributes to a lowering of business risks (Young Johns, 1982). When deposit facilities are offered an important financial intermediary function is performed among persons who have little alternative means of holding financial assets.

But the success of the multi-purpose cooperative, like its single-purpose sister, is contingent on its ability to follow rational commercial practice. When the cooperative is established and supported financially by the government, such commercial orientation may not be possible. The organisation may be forced to lend at unrealistically low rates of interest and purchase members' produce at uneconomic prices with serious effects on financial viability. Under these circumstances continued operation is only possible with further governmental support leading to greater levels of political control and destroying the very basis of cooperative association.

Perhaps the most successful type of cooperative, certainly in Latin America and the Caribbean, is the credit union. Providing relatively attractive savings and credit terms to its members, credit unions perform a vital financial intermediary function based on the concept of periodic savings deposits. In some instances they have been able to expand their activities to include normal commercial banking services such as chequing accounts and foreign exchange transactions.

Government involvement in credit unions tends to be limited to supervisory functions in the context of basic standards of financial and accounting control and through cooperative legislation. Technical assistance to credit union management and, at times, to members for production-type loans, may also be provided, either by the government or by the credit union league - a sort of nationwide umbrella association of credit unions. The degree of actual governmental financial assistance to credit unions is relatively limited, however.

Rural (and urban) credit unions tend to be most successful among wage earners, as savings deposits and loan repayments can be made on a regular basis via payroll deductions. Less success has been achieved among non-wage earners where, for example, the seasonality of farm income precludes such periodicity. But there are examples of successful credit unions involving farmers,21/ indicative of the fact that, properly conceived and operated, such institutions can mobilise rural savings and provide credit to small borrowers in a form (in terms of size, timing and procedures) appropriate to the rural environment.

21/Von Pischke (1981) reports of successful rural credit unions in the Cameroons in which farmers constitute 36% of nationwide membership.

Savings Banks (including Post Office Savings Banks)

Like cooperatives, savings banks operating through a rural branch network can potentially provide a useful financial service to rural people by accommodating financial transactions that are suited to the rural environment. For the basic premise in establishing a savings bank is that of attracting the small savers who are not properly serviced by commercial banks.

In developed countries, most savings banks have developed to the point that they provide more or less the same financial services as commercial banks. In the less developed countries, however, apart from a few exceptions,22/ savings banks limit their financial services to accepting deposit accounts and providing some degree of money transfer facilities.

22/The Sudanese Savings Bank is one exception.

Most of the savings mobilised are transferred to the national treasury via investments in government securities. As a source of finance to the rural SSE, savings banks thus offer limited opportunities, but this is not to suggest that they could not be structured to do so, and, as will be shown in a later section, the savings mobilisation function itself is an important element in the development of the rural financial market.

External Sources of Funds

The growing recognition of the importance of SSEs as a generator of employment and income for the poorer members of the populations in developing countries has led to a substantial increase in financial support from multilateral and bilateral funding agencies. As one example of the magnitude of these transfers, the World Bank, from about 1978, has a specific loan purpose relating to SSE's and, as at June 1985, in excess of US$3 billion of IBRD and IDA23/ credits were approved under this category, representing 2% of total cumulative approvals (World Bank, 1985). A proportion of the more than US$11 billion channelled to DFIs by the World Bank would also have benefitted SSEs.

23/IBRD = International Bank for Reconstruction and Development
IDA = International Development Association

In like fashion, the regional development banks24/ have transferred significant financial resources to SSEs, mainly through DFIs. Indeed, a major rationale for the use of DFIs by multilateral and bilateral funding agencies is that it facilitates the provision of finance to enterprises whose size would preclude direct funding because of administrative cost considerations.

24/The Inter-American Development Bank (IDB), covering Latin America and some Caribbean countries; the African Development Bank (AFDB) which concentrates on the African continent; the Asian Development Bank (AsDB) focussing on Asia and the Pacific and the Caribbean Development Bank (CDB) whose borrowing members comprise the english-speaking Caribbean countries.

But, in spite of the size of these resource transfers, the actual benefits accruing to SSEs have been limited, both as a result of the negative features exhibited by many DFIs as outlined earlier, and because of certain conditions associated with the use of external funds that serve to reduce their accessibility to SSEs. Firstly, most multilateral agencies channelling funds through DFIs tend to limit their financing to meeting the costs of imported goods and services, i.e. the foreign exchange component of project costs. While this is a rational policy when the sub-projects to be financed are large or even medium-scale,25/ it is not relevant for SSEs which tend to have a lower import requirement because of greater use of domestic technology and higher labour/capital ratios.

25/In fact this is a major attraction of external loan funds to developing countries as it eases the short-term foreign exchange burden of the development process.

Secondly, limiting external funds to imported goods and services can result in a bias toward capital-intensive imported technology and, conversely, the discouragement of domestic technological alternatives. In addition, the 'import bias' of external funds may act to preclude domestic industries from bidding on contracts thus reducing the indirect employment benefits (World Bank, 1978a).

Thirdly, related to the provision of funds for financing imported project components is the question of foreign exchange risks. The risk associated with the use of foreign funds, arising from the fact that these funds have to be repaid in foreign exchange and the relevant exchange rates could change drastically, is either borne by the government or the DFI itself. But the SSE is still affected by the incidence off foreign exchange risk in two ways:

(a) in a turbulent economic environment, when risks of adverse movements in exchange rates are high, the DFI or the government may be reluctant to engage in too much external borrowing for SSE financing. This will tend to reduce the availability of foreign funds; and

(b) the DFI or government may impose on the SSE an additional charge to cover the foreign exchange risk, thus increasing the cost of funds to the SSE.

Fourthly, external agencies may impose procedural requirements relating to sub-project appraisal criteria and procurement and disbursement rules that SSEs may find onerous; a situation that can be exacerbated if it stresses the institutional capacity of the DFI such that significant time delays in approvals and disbursements result.26/ In this context it should be noted, however, that an important advantage of external agency funding of DFIs is the possibility of incorporating in the financing programme institution building objectives.

26/Such time delays may be worsened if, above some free-limit, prior approval of sub-projects by the external agency is required. In the context of most SSEs, however, particularly rural SSEs, this should not present a problem unless the free limit is set unrealistically low.

Many credit lines channelled to DFIs from multilateral agencies have components concerned with improving the institutional capability of the institution, and some have been quite successful. In some cases also, the external entity may be able to influence overall financial policy reform as a condition of loan approval, and the government may be able to use the external agency as a “scapegoat” to institute needed but politically unpopular reforms.

Improving rural SSE access to finance

An underlying theme that permeates much of the modern literature on rural finance is the need to view the problem of credit availability from the perspective of the rural financial market (RFM) rather than a narrow concentration on the design of specific projects to increase credit flows, as has been the traditional approach. This view involves the notion that if certain groups (e.g. SSEs) are not being adequately serviced then the problem should be tackled by examining why the RFM is exhibiting the deficiency and determining how it can be induced to provide the service (von Pischke et al, 1980). It may be that a specific credit project is required, and by analysing the RFM the design of the project would take into account any inefficiencies identified. This somewhat holistic approach may be less appealing than the traditional one-dimensional strategy because of its inherent complexity. But it is the very complexity of the rural credit problem and the ineffectiveness of the one-dimensional approach that demands the holistic view.

Improving rural SSE access to finance should thus be concerned with improving the operational efficiency of the RFM. How this is done will depend on the specific factors causing RFM inefficiency and these will differ from country to country. But there are a set of common criteria that can be used to judge how well a RFM is performing (von Pischke et al., 1983). These include the effectiveness with which a RFM mobilises savings as well as disburses credit, in turn a function of the extent to which interest rates are allowed to approach market clearing levels. A well-functioning RFM will have a diversity of institutions (both formal and informal) competing with each other and providing appropriate financial services to the majority of the economically active population. These institutions will be in constant search for new forms of financial technology that will help to reduce costs and facilitate the exploiting of expanding opportunities.

The Mobilising of Savings27/

27/see notably Adams, 1978; Von Pischke, 1978; Ong et al, 1976.

A number of researchers have emphasised the capacity of the rural household to save and have stressed the importance of savings mobilisation, by the use of appropriately designed financial technology, as an important element in rural development strategy.

Two factors underscore the importance of savings mobilisation in the rural context:

(a) a sizeable proportion of the net savings of rural households is held in the form of tangible assets such as inventories (e.g. foodstuff), consumer durables (e.g. jewelry) and real estate; and

(b) the number of potential savers far exceeds the number of people who possess the entrepreneurial and managerial skills to make productive investments.

Effective financial intermediation, a feature of a properly functioning RFM, encourages savers to hold savings in the form of financial assets, in preference to tangible assets, which can then be used by investors to increase the stock of productive assets. In this sense, the financial market is seen as playing a vital role in the rural development process. Savings mobilisation is also significant in the context of the seasonality of farm production. Rural income flows are not spread evenly with respect to time: this creates the need to hold over a portion of the income occurring in periods of 'plenty' to meet requirements during times when flows are low. Liquidity considerations will preclude conversion of these periodic surpluses into tangible assets, and in the absence of appropriate alternatives they are hoarded as cash. A properly functioning RFM will serve to convert such cash holdings into deposits in the financial system.

A further reason for the desirability of developing appropriate financial technology to encourage the holding of rural savings in financial asset form relates to the phenomenon of cash remittances from abroad. In many developing countries, foreign cash remittances account for an appreciable proportion of GNP, and a significant amount originates from emigrants from rural areas in the labour exporting countries (Chandavarkar, 1980). These remittances are a form of transitory income to the household, and available evidence suggests that there is a higher propensity to save out of transitory income than out of permanent income (Chandavarkar, 1980). But in the absence of appropriate financial intermediation (and incentives) the remittances tend to be used for consumption purposes.

How then do rural financial institutions go about attempting to mobilise rural savings? Essentially, this involves designing financial technology that is appropriate to the rural environment. Firstly, the financial instruments used to attract rural savings will need to accommodate the relatively small size of transactions that are characteristic of rural areas.28/ Secondly, the access cost of the financial asset must be consistent with the average transaction size. And thirdly, the financial asset must offer distinct advantages, in terms of convenience, liquidity, security and yield, over the holding of tangible assets or cash.

28/Which in the early stages will tend to be mainly savings (deposit) accounts.

In practical terms these features of appropriate financial technology are manifested in such things as low minimum transaction and balance limits on deposit accounts; fees and other charges associated with opening and using the deposit account being reflective of the small size of the deposits; the location of the institution in a place convenient to the rural people, and opening and closing times consistent with the tenor of rural life; and interest rates on deposit accounts that are attractive in relation to existing alternatives.

The successful experience of the Syndicate Bank in the South Kanana District, Karnatak Province, India, illustrates the application of some of the features mentioned above (Chandavarkar, 1980). The Syndicate Bank caters to small savers through a system know as the Pygmy Deposits Scheme. Under this scheme, small deposts of 1 rupee or more per day are collected on a daily basis on the doorsteps of the small depositors. The bank utilises field agents, called Pygmy Collectors, to collect the deposits, and they are paid on a commission basis. The maturity of the deposits is seven years, implying that the Bank perceives that liquidity is less a factor than security and the convenience offered by the collection system. Earlier withdrawal is possible but attracts penalties, and there is provision for conversion to fixed deposits. The convenience factor also seems to have influenced the decision to offer an interest rate on pygmy deposits lower than that paid on regular savings deposits. The relatively higher administrative cost associated with such small savings, and the absence of alternative investment opportunities (because of the small amounts involved) may also have been considerations in this regard.

Success of the Pygmy Deposit Scheme is reflected in the fact that small depositors (up to Rs 1,500) account for around 90% of the total deposit accounts held by the bank. The Syndicate Bank also disburses credit to SSEs and other small borrowers in amounts of up to Rs 10,000. These small advances comprise around 18% of total advances, compared to the average 10% for all banks.

The Syndicate Bank's practice of encouraging the holding of small deposits for long periods, by charging penalties for earlier withdrawals, raises another aspect of savings mobilisation that unfortunately has been largely neglected in the literature, namely that of contractual savings.29/ Contractual savings are important in the financial development process as their long-term maturities facilitate the financing of long-term investments. The little empirical evidence that is available suggests that whereas other forms of savings tend to substitute for each other, such that an increase in one leads to a decrease in the other, with little increase in total savings, there is negligible substitutability between contractual savings and other forms (Joshi, 1970). This means that an increase in contractual savings would tend to result in an increase in total savings. What is needed therefore is the development of contractual financial instruments that take into account the seasonality of rural income flows, the relatively small size of such flows and the importance of liquidity management in the rural context. This is an area of RFM research and development that potentially has very high returns.

29/Contractual savings are long-term savings which involve a continuous commitment on the part of the saver. Examples include insurance, provident fund and pension fund contributions.

Savings mobilisation can also occur, as suggested earlier, when a marketing service is tied into a deposit facility - whereby the seller is allowed to leave the sales proceeds on deposit and only withdraw amounts as needed. This system is usually associated with multi-purpose cooperatives it need not be limited to this institutional form. Indeed, the same institution may not be involved in both services, as when a marketing firm or cooperative deposits sale proceeds in a commercial bank on behalf of the seller. Subject to considerations of convenience being maintained, such a system can help to encourage the 'banking habit' among rural people and remove the administrative and accounting responsibilities demanded by deposit facilities from the marketing agent.

The tying of credit access to the establishment of deposit accounts is another technique to generate rural savings by encouraging the potential borrowers to build up deposit balances. The technique is also advantageous to the lender by reducing risk, since the deposit account can be used as loan security. And by obtaining a perspective of both sides of the RFM, the lender is able to develop more effective judgements concerning the financial market use and the credit risks of individual borrowers. Further, the lender is encouraged to utilise the local savings locally, thus reducing the so-called 'urban bias' of the financial system in many developing countries.30/

30/See Chandavarkar (1980). The term 'urban bias' here refers to the phenomenon whereby savings generated in rural areas are siphoned off to the urban areas where rates of return on capital are higher.

Interest Rates

There is still considerable disagreement over the role interest rates play in determining the volume of savings and investment. A detailed discussion of the impact of interest rates is beyond the scope of this paper, but it may be useful to outline some of the basic relationships:

(a) while interest rates may have questionable influence on the total volume of savings, empirical evidence suggests that they affect the form in which the savings are held. Negative real rates of interest31/ encourage the holding of savings in forms such as real estate, jewelry and other inflation hedges. Conversely, positive real interest rates increase the amount of savings held in financial form, and hence increase the volume of funds available for investment;
31/That is, interest rates adjusted for inflation.
(b) at the same time when the financial market is only poorly developed (e.g. the RFM of many developing countries) convenience and security appear to be more important than interest rates in attracting financial savings;

(c) despite the opinion of many policy makers to the contrary, the demand for rural credit is more a function of ease of access than of cost. The persistence of the informal sector despite its usurious rates of interest provides ample testimony to this;32/

32/Iqbal (1983) outlines some empirical evidence to indicate that interest rates have a greater effect on credit demand among larger as against smaller borrowers, and suggests that higher rates of interest would improve the allocative efficiency of formal credit and increase the participation of small farmers in the loan market.
(d) low rates of interest on loans, while possibly inducing a higher level of desired investment, may reduce actual investment because of the negative effects on available credit (IMF, 1983). Further, low loan interest rates have an adverse influence on the allocative efficiency of the financial system with effects on the productivity of investment. In particular, low interest rates encourage the use of capital-intensive technologies thus reducing the employment generating potential of investment.

The adverse effects of low rates of interest, and their widespread use in many unsuccessful small industry (and small agricultural) programmes, has frequently led to the argument that the removal of administrative controls on interest rates, to allow them to rise to risk-reflecting levels, should be a quid pro quo for improving the performance of such programmes. While there may be some theoretical validity in this approach, it has little practical veracity given the levels to which interest rates would have to rise. This stems from the high risks associated with SSE financing which in turn are related to the inability, in the early stages of their development at least, of the financing institutions to distinguish good borrowers (low risk) from bad ones (high risk). Indeed, it is likely that the risks of financing SSEs may be perceived so high as to preclude lending completely - for the interest rates needed to reflect the level of perceived risks would be such as to “extinguish any interest on the part of the institution in meeting the demand”.33/ In the first place, the institutions may feel it unlikely that projects would be found that could pay such high interest rates and, secondly, the high rates of interest themselves would tend to attract the riskier investments and, conversely, deter the otherwise viable, but more conservative, ones.

33/Anderson (1982) from which much of this discussion is derived.

In practice, therefore, the removal of administrative controls on interest rates could lead to an actual reduction in the availability of SSE credit. Concessionary rates of interest to SSEs would thus remain a feature of SSE financing for some time. But how concessionary should the rates be or, more specifically, what is an appropriate interest rate for SSE borrowers? Certainly it needs to be positive in real terms.34/ And, to the extent that, as financing institutions improve their screening procedures for SSE proposals, the risks of SSE financing would eventually fall to the levels associated with the larger established borrowers, the rate of interest charged to these established borrowers may be as good a starting point as any. This has the additional advantage of avoiding the political problems associated with significant differentials in interest rates between large and small borrowers. It is important to recognise, however, that such rates would still be concessionary, and for financing institutions to become involved in SSE financing they would either have to be publicly owned, or relevant incentives, such as credit guarantee schemes, would have to be provided.

34/Though negative real rates may occur during short adjustment periods without adverse effects.

Institutional Diversity and Financial Technology

A RFM serves to mediate between a large assortment of people and entities with different requirements for financial services. The diversity of the requirements demands a diversity in institutional forms if all the relevant actors are to be efficiently and effectively serviced. Frequently, however, policy makers, planners and researchers alike concentrate on attempting to devise the perfect institutional form. The approach that is being proposed in this paper implies moving away from searching for one correct institution and concentrating on improving the overall adequacy of the RFM (Argyle, 1983). And one way of doing this is by the active encouragement of institutional diversity and competition.

In many developing countries the informal sector is viewed with considerable disdain by policy makers. This stems from the perceptions that the rates of interest charged in the informal sector are exploitative; that informal loans do not have a developmental impact; and that the operators in the informal sector are unable to expand and improve their services to meet the requirements of an expanding rural economy (von Pischke et al., 1983).

But the size and persistence of the informal sector is indicative of “its inherent strength and economic rationale,” (Chandavarkar, 1985); and despite its limitations it has a critical role in the RFM. Rather than attempting to replace the informal sector, a more rational strategy would therefore be for the formal financial institutions operating in the rural areas to take on some of the features of the informal operators, such as low transaction costs, informal lending procedures and minimal collateral requirements.

An interesting example of how this can be done is provided by the Grameen Bank Project (GBP) in Bangladesh (Sadeque, 1986). In this project, administered by the Bangladesh Central Bank, funds are channelled through rural branches of the state-owned commercial banks to individuals who are classified as essentially landless and therefore with little, if any, access to institutional credit.35/ GBP funds are specifically intended to provide these disadvantaged groups with institutional credit to create self-employment, and are not limited to agricultural activities. Access to GBP funds is initiated by the formation among prospective borrowers of a group, usually of five persons of similar economic status, to whom GBP staff explain the operation of the scheme.

35/That is, whose family assets do not exceed the value of one acre of medium quality land.

Once the group is found suitable, two persons are selected to receive loans and other members of the group only become eligible if the repayment performance of the initial recipients is satisfactory. This is not as inconvenient as it may appear since repayments of the loans are effected on a weekly basis, and it has the distinct advantage of encouraging loan discipline by peer pressure. Also, all members of the group have some say in the granting of loans during weekly meetings at which GBP staff are present. Importantly, there is no collateral requirement for GBP loans, and loan procedures are relatively informal, involving minimum delay. An important element of the GBP approach is the development and maintenance of relationships with the clients - all GBP offices are located in the rural villages (either in a branch of a commercial bank or in separate accommodation), and promotion is an important aspect of GBP staff functions. The commercial banks involved in the project assume the administrative costs of the loans, including GBP staff costs.36/

36/In the source document for this example, the on-lending interest rate was quoted as 13% but no information was provided on the cost-of-funds to the commercial banks or whether a net profit was made on the funds.

Another important aspect of the Grameen Project is the savings mobilisation component. Each group member is required to deposit a minimum of 1 taka37/ per week as personal savings. In addition, 5% of the loan amount is deducted as a “group tax” and deposited, along with the personal savings, in an interest earning group fund account. Members can borrow from the group fund account for any purpose, with the consent of other members. Finally, an additional 50% of the loan interest is contributed by each borrower to an emergency fund as insurance against default, business failure and other unpredictable occurrences.

37/1 US$ = 15 taka.

The success of the Grameen Project is illustrated by some statistics. Between its inception in 1979 and June 1983, the number of groups had grown to 8,844, involving 34,922 borrowers. Total loan disbursements amounted to approximately 132 million taka and savings in the group fund to 11 million taka. Repayment rates have been in excess of 90% (99% in 1982), which is of particular significance given the absence of collateral security. It is difficult at this stage to predict how sustainable this high level of performance is, and how replicable is the project in other countries. But the fact remains that the GBP experience illustrates how appropriately designed financial technology, incorporating some of the features of the informal financial sector, can significantly improve the accessibility of institutional financial services to rural people who previously were denied such services.

Credit Guarantee Schemes

The perceived risk associated with SSE lending has been identified as a major factor militating against the involvement of private commercial banks. A technique for reducing risks should thus provide an incentive for commercial banks to exploit the market opportunities offered by SSE demand. One such technique is the credit guarantee scheme. As the name implies, the essential purpose of a credit guarantee scheme is to transfer all or part of the credit risk from the lender to a third party, thus reducing or eliminating the need for collateral security. Such schemes have been used in a number of developing countries and the experience of their use has been mixed.

A credit guarantee scheme can be established by the government setting up a fund in a public financial institution (e.g. the central bank) and agreeing to guarantee loans to SSEs made by participating financial institutions. The lending institution may pay a fee for the guarantee which can be passed on to the borrower in the form of a higher interest rate. One disadvantage of this approach is that the financial institution may have little incentive to improve its screening procedures to reduce risk since any losses can be passed on to the guarantee agency (Anderson, 1982). This could be avoided, however, by only guaranteeing a part of the loan, so that participating institutions still have an incentive to reduce losses. Also, the likelihood of this “moral hazard” occurring is to some extent related to the degree to which the guarantee fee charged reflects the costs involved.

In many instances, however, the degree of risk in SSE lending, at least in the early stages, may be such that the credit guarantee scheme would not be able to charge the full cost of the service, and some degree of subsidy would be included. In such circumstances there is the real danger that the scheme may become just another avenue for disbursing subsidies, with serious implications for its sustainability. One way of overcoming this problem is by operating a two-tier system (von Stockhausen, 1983). At the first tier a guarantee is provided by the group of borrowers who form an association and establish a guarantee fund with deposits made by each member based on individual loan sizes.38/ At the second tier the association obtains a supplemental guarantee from the government, usually at a subsidised rate.

38/The emergency fund in the Grameen Project is an example of a group guarantee fund.

The two-tier system of guarantee provision has a number of advantages. In the first place, the involvement of the borrowers themselves reduces the likelihood of abuse, particularly since the collective nature of the guarantee increases the incidence of peer group pressure on prospective defaulters. Secondly, there is likely to be within the guarantee association, the necessary technical skills to analyse the degree of risk involved in the guarantee applications, since the members themselves may be involved in similar business activities. And, thirdly, the supplemental guarantee reduces the risk, and hence cost, to the guarantee association.

Credit Controls

'Credit controls' is a generic term used for the set of measures adopted by the government to influence the composition of the loan portfolio of commercial banks. In the context of SSE financing it thus refers to the devices used to induce commercial banks to increase their lending to this sector. Two main types are frequently encountered:

(a) Rediscounting facilities: in which the central bank offers a preferential discount rate for loans granted to SSEs. The rationale behind this device is that the larger interest spread obtainable on the priority loans, compared to other loans, would encourage the commercial bank to increase its lending in the preferred area. Experience has shown that, by itself, the rediscount mechanism is not usually a sufficient incentive to commercial banks, and has to be combined with a credit guarantee scheme if an adequate response is to be obtained.

(b) Differential reserve requirements: whereby the reserve requirements of the commercial bank would differ depending on the composition of its loan portfolio. Banks whose portfolios contain some minimum percentage of loans to SSEs are allowed to maintain a lower reserve than would normally be required. Like the rediscount facility, differential reserve requirements, unless combined with credit guarantees, are not sufficient to induce significant increase in SSE lending.

Some authors suggest that credit controls are basically inefficient means of inducing commercial banks to lend to high-priority sectors.39/ It is argued that these mechanisms impose an implicit tax on financial institutions, lead to a redistribution of wealth that may be socially adverse, and increase inflationary pressure. While not disputing the economic logic of these arguments, the nature of the financial sector in many developing countries, with its elements of oligopoly and concentration, one can seriously question the extent to which economic analysis based on the premise of a developed, relatively competitive, banking system apply. Simply removing control does not lead to the market responses implied by these analyses.40/

39/See in particular Johnson, 1974.

40/See Galbis (1986) for a useful treatment of the effect that such structural rigidities in financial sectors can have on attempted financial reforms.

Credit and Technical Assistance

A major reason for the high level of perceived risks associated with SSE lending is the difficulty involved in obtaining the information on which to base assessments. SSEs very infrequently maintain accounts and other records in a form that would facilitate a financial institution obtaining an accurate picture of the enterprise. Technical assistance to improve the type and quality of documentation can significantly improve SSE access to credit, and is frequently considered an indispensable element in the financing of small industry (Johnson, 1974).

Technical assistance can go beyond the question of advice on record keeping and documentation and extend to such things as advice on appropriate technology, organisation and management, raw material procurement and marketing. Such services can go a long way toward removing many of the constraints affecting SSE developing and, in fact, can lead to an increase in credit demand.

There is some debate as to whether technical assistance should be provided by the financing agency, or whether a separate agency should be involved (World Bank, 1978a). Advantages and disadvantages exist in both systems:

(a) provision of the technical assistance by the financial intermediary can ensure coordination;

(b) at the same time, the objectivity of the loan appraisal function may be compromised and the loan supervision and collection activities may dilute the effectiveness of the technical assistance function;

(c) the high cost of technical assistance can seriously erode the financial viability of the financing institution; and

(d) use of a separate technical assistance agency can create friction with the financing agency and result in poor coordination between financing and technical advice.

Bearing in mind these considerations, one organisational system likely to be successful involves the following:

(a) provision of technical assistance for improving documentation by the financial intermediary itself. This type of assistance is, in fact, a logical component of the institution's loan supervision function; and

(b) use of a separate technical assistance agency for the more elaborate advisory services, but closely coordinating these activities with the financial agency's. This can be done by the financial agency providing a referral service for the technical assistance agency (Anderson, 1982).

But regardless of the organisational system used to provide the credit and technical assistance, it is important that the costs of providing the two services be clearly separated. This will facilitate much easier determination of lending costs, and make the subsidy involved in the technical assistance component explicit, and hence assessable from a cost/benefit perspective.

Another related matter is the manner in which the technical assistance is provided. Experience suggests that single-industry technical assistance schemes tend to be more effective than general purpose support (World Bank, 1978a). The single-industry approach is, however, only feasible where there is a significant concentration of SSEs in the same industrial group, operating in a well defined area. A large degree of diversity and geographical dispersion would render single-industry schemes very costly and impractical.

Some applications to forest-based SSEs

Much of what has already been said on improving rural SSE access to credit would apply to forest-based SSEs. There are, however, certain characteristics of the forest-based enterprise that may deserve separate mention:

(a) working capital is an important requirement for most SSEs and may be even more so in the forest-based enterprise. Indeed, for the household-type of forestry enterprise, it may represent the entire investment. And the criticality of their working capital needs will be affected by the seasonality of rural income flows. DFIs and other financial institutions attempting to foster forest-based SSE development must be sensitive to these factors if their programmes are to be effective;

(b) certain forest-based processing activities lend themselves well to some form of collective or cooperative organisation. For example, cooperative ownership of logging and sawmilling operations by small rural furniture manufacturers can greatly assist in solving the raw material supply problem and facilitate the provision of working capital finance - say by a DFI supporting the provision of trade credit by the sawmill to its members. In this way the DFI avoids having to deal with a large number of small borrowers and the cooperative sawmill is better able (i.e. than the DFI) to control the receivables situation. This type of cooperative organisation can also facilitate the single-industry focussed technical schemes mentioned earlier;

(c) the important role of forestry in environmental preservation needs to be borne in mind in any programme designed to encourage forest-based SSE development. This implies, among other things, a need for well directed technical assistance and very close coordination between financing institutions, technical assistance agencies and government forestry departments;

Cutting wood for rural construction in Jamaica

(d) the significance of overall agricultural and industrial policy on rural SSE development was outlined earlier. Also of importance for the forest-based SSE is forestry policy. In particular, policies related to reafforestation and agro-forestry and to the type of technological alternatives encouraged for industrial forestry activities would influence the nature and type of small-scale processing activity likely to be developed. In this context too, forest legislation could play an important role in the encouragement of SSEs. In many developing countries the, framework of forest legislation goes back to the previous century, to a time when scientific knowledge about forest development and utilisation was far more primitive.

Summary and conclusions

The role and significance of small industries in the economic development process is well recognized. Governments in developing countries, almost without exception, have introduced special support programmes to encourage the growth and development of SSEs. Credit, normally at highly concessionary interest rates, is an important component in many of these programmes. But credit is only one element in the myriad of factors comprising the environmental context of the SSE, and by itself cannot be expected to induce the type and level of response desired. Governmental policies on pricing, on agricultural development, on industrial incentives and, for the forest-based SSE, on forestry development and legislation, are all determinants of the vigour with which the small industries sector will develop.

The access of rural SSEs to formal (institutional) credit is highly restricted even when credit programmes are designed specifically with SSEs in mind. Most rural SSEs thus rely on personal savings and/or the informal sector for finance. Improving rural SSE access to credit, instead of concentrating on the design of specific projects as has been the case in most instances, should adopt a more holistic view and seek to improve the overall functioning of the rural financial market. A lack of appreciation of the complexity and diversity of this market probably explains why so many SSE credit programmes have been largely unsuccessful.

Improved RFM performance involves measures designed to improve the mobilization of rural savings; to increase the competitiveness and institutional diversity of the RFM; and to increase the use of innovative financial technology appropriate to the rural environment. In particular, the formal financial sector needs to adopt some of the more positive features of the informal sector, such as the low transaction costs, the limited collateral requirements and the informality of the procedures. The few successful experiences of promoting financial services to low-income rural people illustrates the effectiveness of this approach.

The widespread use of negative real rates of interest in rural financial markets has had pervasive effects on its allocative efficiency. But the mere removal of controls on interest rates will not lead to increases in the availability of funds for rural SSEs. In fact, it can lead to a reduction. Nevertheless concessionary interest rates are thus likely to be required in any rural SSE financing programme. But these rates need to be positive in real terms and should be at least equal to the rates charged to the established, low-risk borrowers. To induce private financial institutions to lend to SSEs, given the risks involved, some form of credit guarantee mechanism is necessary. Rediscounting facilities and other credit controls, applied within the context of the particular RFM, and supported by credit guarantee schemes, can also be useful devices for inducing SSE lending.

Technical assistance, (both as part of the loan appraisal and supervision function and the more elaborate advisory services dealing with technical, organisational and marketing aspects of SSEs), is an essential element in SSE financing. The way in which the technical assistance is provided, however, needs to be carefully worked out to avoid conflict and to ensure effectiveness. The cost of the assistance also needs to be clearly separated from the cost of financing.

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