Oscar Abello

Time to Grow Up: Financing SMEs With Local Capital

It’s not uncommon around the world for aunts and uncles to surprise nieces and nephews with lavish gifts. While the occasional gift does no harm, spoiling a child can undermine the child’s journey to adulthood. The same can happen to nascent financial sectors.

A piece in last week’s Fortune Magazine argues that “In developing economies, equity beats microfinance.” Impact investors, featured in the article, are growing into the roles of angel investors or venture capitalists in developing economies. Meanwhile, multilateral development banks like the International Finance Corporation (IFC), African Development Bank and Asian Development Bank have been growing their private SMEs portfolios-bucking their tradition of only financing public entities, as outlined in a recent Center for Global Development (CGD) report.

While impact investing and multilateral SME financing are encouraging trends, could they also undermine the journey to adulthood for financial sectors in developing economies?

Too much foreign capital from impact investors or multilateral development banks can prevent local financial intermediaries from gaining valuable experience leading to mature financial sectors that can finance SMEs on their own.

Thirty years ago it was much harder to make the argument that foreign capital, however well-intentioned, could undermine local capital. Things have changed. The dual emergence of microsavings and mobile money has transformed the landscape for local capital in developing economies.

India’s 5.9 million rural self-help groups for example had accumulated over 1.2 billion dollars in savings as of March 31, 2009-though none of that is currently invested in SMEs. The CGD report mentions multilateral banks could provide more technical assistance to microfinance providers moving up to financine SMEs-like Aunts or Uncles sharing important life lessons with nieces and nephews. But financial sectors need more than familial advice to mobilize local capital for SME financing.

Poor regulatory oversight including lax or nonexistent insolvency and bankruptcy procedures, and weak corporate governance are just a few of the obstacles besides lack of technical capacity for today’s microfinance providers and tomorrow’s venture capitalists to finance SMEs in developing economies. In India, microfinance institutions are still legally prohibited from taking deposits. Credibility and reputation also present some unique challenges in nascent financial sectors. It’s hard enough to pick out the few enterprises in position and capable of scaling up; local financial intermediaries have to be able to deny loan applicants without losing trust and depositors from the community.

But why should financial sectors traverse the difficult path to maturity if impact investors and multilateral development banks are taking all the SME investment opportunities?

In part due to an earthquake and in part to a decades-old legacy of social and political upheaval, Haiti is one country whose SMEs remain off the radar screen for impact investors and multilateral development banks. That’s why Fonkoze, Haiti’s largest microfinance institution, decided it had no choice but to grow up and mobilize its remaining capital from over $3.6 million in pre-earthquake microsavings deposits, alongside crowdfunding via its Zafen.org platform, to invest in SMEs. This week Forbes.com documented Fonkoze’s efforts at SME financing and the thinking behind them.

Growing up to finance SMEs means some tough choices for microfinance providers, including possibly giving up microcredit for microenterprises. Cambridge economist Ha-Joon Chang and Overseas Development Institute Research Fellow Milford Bateman argue in “The Microfinance Illusion” that not only has microcredit failed to reduce poverty, it actually prevents poverty reduction because job-creating SMEs cannot gain a sustaining market share if they have to compete with a flood of informal microenterprises.

Mobilizing local capital to finance SMEs isn’t going to be the path of least resistance, but it’s the path to adulthood for nascent financial sectors. Hopefully Auntie Impact Investor and Uncle Multilateral Development Bank won’t spoil them.

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impact investing, microfinance