Argentina - Small and medium-sized enterprises in Argentina - a potential engine for economic growth and employment

Report No. 22803-AR Argenti na Small and Medium-Sized Enterprises in Argentina A Potential Engine for Economic Growth and Employment August 2002 Finance, Private Sector and Infrastructure Sector Management Unit Country Management Unit 7 Latin America and the Caribbean Region Document of the World Bank  CURRENCY EQUIVALENTS Currency Unit: Argentine Peso (AR$) AR$ 1.0 = US$0.2739726 (August 1, 2002) WEIGHTS AND MEASURES Metric System FISCAL YEAR July I -June 30 ACRONYMS ABPPRA Association of Banks AFIP Administraci6n Federal de Ingresos Publicos BCRA Banco Central de la Republica Argentina BDS Business Development System BICE Banco de Inversi6n y Comercio Exterior BNA Banco de la Naci6n Argentina CDE Centros de Desarrollo Empresarial CEDES Centro de Estudios de Estado y Sociedad CEMA Universidad del CEMA (Argentina) CEPAL Centro de Estudios para America Latina CFI Consejo Federal de Inversiones CONICET National Council for Science and Technology (Argentina) CUlT Clave de Identificaci6n Tributaria DPPJ Direcci6n Personas Juridicas de la Provincia de Buenos Aires. DGI Direcci6n General de Impuestos DOP Direcci6n de Obras Particulares EMS Environmental Management Systems EPH Encuesta Permanente de Hogares FDI Foreign Direct Investment FIEL Fundaci6n de Investigaciones Econ6micas Latinoamericanas FONCYT Fondo para la Investigaci6n Cientifica y Tecnol6gica FONTAR Fondo Tecnol6gico Argentino FUNDES Fundaci6n para el Desarrollo Sostenible en Anidrica Latina IADB-FUNDES Inter-American Development Bank-Fundaci6n para el DesarroLlo Sostenible en Amdrica Latina IAMC Industrial Asset Management Council ICT Information and Communication Technology IDEB Instituto para el Desarrollo Empresarial Bonaerense IERAL Instituto de Estudios sobre la Realidad Argentina y Latinoamericana IMPE Instituto de Producci6n y Empleo INDEC Instituto Nacional de Estadfstica y Censos de la RepubLica INTI Instituto Nacional de Tecnologfa Industrial IPO Initial Public Offer LAC Latin America and Caribbean Region MIF Multilateral Investment Fund MSME Micro, Small and Medium-Sized Enterprises OECD Organization for Economic Cooperation and Development PIU Project Implementation Unit RGS Sociedades de Garantfa Reciproca SECyT Secretarfa de Ciencia y Tecnologia (Argentina) SEPyME Secretaria de Pequeiias y Medianas Empresas SMEs Small and Medium-Sized Enterprises TFP Total Factor Productivity UIA Uni6n Industrial Argentina UIA-IDB Uni6n Industrial Argentina/Inter-American Development Bank IBRD ' Vice President David de Ferranti Chief Economist Guillermo Perry Country Director Axel van Trotsenburg Sector Leader Juan Gaviria Task Manager J. Luis Guasch  Small and Medium-Sized Enterprises in Argentina: A Potential Engine for Economic Growth and Employment* Table of Contents Executive Summary .............. 1. Introduction .x 2. SMEs are critically important but have not realized their potential .xii 3. SMEs are very heterogeneous agents .xiii 4. Business Environment Ridden with Institutional Rigidities .xv 5. Significant Problems with Access to Finance .xix 6. Weak Demand for Knowledge .xxi 7. Current Government Policies: Multiplicity of Programs, Uncertain Impact. xxi 8. The Path Ahead: Towards Incentive-Driven SME Policies ......................................... xxiii 1. Introduction...1 1.1 Objectives .1 1.2 Data and Methodology .2 1.3 Main Findings .3 1.4 Organization of the Report .4 2. SMEs as Potential Engines to Economic Growth and Employment: Anatomy of the Sector . 5 2.1 The Role of SMEs in Argentine Economy .5 2.2 SMEs in the City of Buenos Aires .6 2.3 SMEs are Different from Large Firms: Size Matters .8 2.4 Productivity in the Manufacturing Sector .9 3. SME Response to Economic Liberalization: Determinants of Success and Growing Heterogeneity of Firms ...12 3.1 Uneven supply response to reforms ............................................................... 12 3.1.1 Manufacturing SMEs: Inter-industry Differential Responses ......................................................... 13 3.1.2 Intra-industry Heterogeneity of Manufacturing SMEs ............................................................... 15 3.2 Evidence of Successful Exporting SMEs................................................................s15 3.2.1 Successful SME exporters.................................................................16 3.2.2 Exporting as an incremental learning process ............................................................... 17 3.2.3 Export Project Cycle: From Identification of Export Opportunity to Sustainable Exports . 17 Identification of exports oppopunities .17 Acquisition of sustainable export capabilities .18 3.3 Dynamics of Industrial SMEs................................................................D.18 3.3.1 W hat Detem ines Sales Growth? .................................................................20 This report was written by Jose Luis Guasch (Task Manager), Yevgeny N. Kuznetsov, and Susana M. Sanchez (LCSFR). Contributions by Osvaldo Giordano, Jorge Colina, Gerry McDermott and FIEL are gratefully acknowledged, as well as FUNDES for their gracious courtesy of sharing their work and data for this report. Cara Zappala and Jocelyn Troncoso provided research assistance. Peer reviewers: Paul Ballard, Claudio Frischtak, Margaret Miller, Juan Llisterri, Peter Mousley and Javier Gonzalez Fraga Danny Leipziger, Paul Levy and-William Maloney provided useful comments. iv  3.3.2 Determinants of Labor Productivity in the City of Buenos Aires ................................................... 22 3.4 The Service Sector SMEs: Preliminary Evidence ............................................ 23 3.5 Implications for SME policy ............................................ 23 4. Institutional Rigidities: Environment for Business Activities ................................................. 26 4.1 Business Registration System .26 4.1.1 Commercial Registration .27 4.1.2 Operational Permiits and Licenses at the Municipal Level .28 4.1.3 Registration for Tax Purposes .30 The Simplified System to Pay National Taxes - The Monotributo ......................................... 30 4.1.4 Labor registration .31 4.2 Periodic Costs of Business Formalities .32 4.3 Labor Market Rigidities .32 4.4 Logistics and Infrastructure Issues .34 4.5 The Consequences of a Complex Business Environment .35 5. Financial Markets and SMEs ............................ 38 5.1 Participation in Credit Markets .38 5.2 Capital Structure .......... 39 5.3 Bank Lending to Small and Medium Enterprises .40 5.3.1 What are the Determinants of SME Lending by Banks? .41 5.3.2 What Explains the High Interest Rates of SME Loans? .45 5.3.3 Relationship Lending .46 5.3.4 Borrowing Concentration .47 5.3.5 Financing Exports .48 5.4 Leasing and Factoring .48 5.5 Risk Capital Investment - Private Equity Investments .48 5.6 Reciprocal Guarantee Societies .50 Regulation of Reciprocal Guarantee Societies .50 5.7 Under-developed Financial Infrastructure .51 5.7.1 Information Problems .51 5.7.2 Regulation Problems .52 5.7.3 Legal Framework for'Secured Transactions .53 6. Knowledge Constraints ......................................................................... 54 6.1 Low-level equilibrium trap as a result of the knowledge constraint ............................................... 56 6.2 Knowledge constraints common to all SMEs ......................................................................... 56 6.3 Differentiation of knowledge constraints according to capabilities of firms .................................. 57 6.4 Agencies and programs to alleviate knowledge constraints: lessons from evaluation .................... 58 7. Toward the Reform of SME promotion: current policies and lessons from best practice ........................ 62 7.1 Why Foster SME Development? .62 7.2 Current government policies and programs .63 7.2.1 Government Efforts on Business Deregulation .63 Simplification of Labor Regulations .64 Simplification of Tax Regulations .64 7.2.2 Financial Markets .65 7.2.3 Business Development Services .67 8. The Path Ahead: Policy Recommendations .74 8.1 General Strategy .74 8.2 Reform of SME promotion system: Crisis as a window of opportunity .77 8.2.1 The growth pay-off to dramatic reform of SME promotion system are both significant and immediate 77 8.3 Eliminating Government Failure: Business Deregulation .82 v  Managing the Process: Deregulation for growth. Short, medium, and long-term horizons ............................. 82 8.4 How to Deepen Financial Markets? ......................................................... 83 8.5 SME Assistance Programs: Institutional Design and Directions for Reform ................ ................. 84 8.5.1 Consolidation of existing programs ......................................................... 84 8.5.2 Piloting of new demand-driven decentralized SME programs ....................................................... 84 8.5.3 Design and nation-wide discussion of a new system of business development services to SMEs. 84 8.6 Longer-term options to reform the SME promotion system ................ ......................... 85 8.6.1 Transition at the Federal level ......................................... 85 8.6.2 Institutional design of the new decentralized system ......................................... 86 The Matching Grant Principle .......................................... 87 The Business-Climate Ranking System ......................................... 87 8.7 Conclusion ......................................... 91 9. References .......92 vi   List of Tables Table 2.1: Argentina's SMEs and International Comparison ......................................................6 Table 2.2: Characteristics of Argentine Enterprises in the City of Buenos Aires, 1999 ...........................8 Table 2.3: Comparing SMEs and Large Firms in Argentina ......................................................9 Table 2.4: Average Productivity of Labor by Firm Size (Total Index = 100) ......................................... 11 Table 2.5: Average Productivity of Capital by Firm Size (Total Index = 100) ....................................... 11 Table 2.6: Working Capital (As a Percentage of Sales) ............................... I11 Table 2.7 Capital-Labor Ratio According to Size (Total Index = 100) ................................................ 11 Table 3.1: Rates of Changes in SME Production and Employment ........................................ : 14 Table 3.2: Economic Liberalization: SME Winner and Losers ....................................... 14 Table 3.3: SME Production space: Changes in Output Share and in Foreign Trade Ratios in Sectors with 'Active', 'Passive' and 'Adaptive' Responses, 1984-93 .15 Table 3.4: SME Production Spacea: Changes in Employment in Sectors with 'Active', 'Passive' and 'Adaptive' Responses, 1984-93 ...................................... 15 Table 3.5: Structure of Industrial Exports in 1999 ...................................... 17 Table 3.6: Kendall's Correlation Coefficient ...................................... 20 Table 3.7: Industrial SMEs in 1996 ...................................... 21 Table 3.8: Industrial SMEs ...................................... 22 Table 3.9: Industrial SMEs - Determinants of Success 1996-1998 ...................................... 23 Table 3.10 Regression Results: Determinants of Labor Productivity Among Manufacturing SMEs in the City of Buenos Aires, 1999 ...................................... 24 Table 3.11: Taxonomy of SMEs in Argentina: 'Success', 'Muddling Through', 'The Case for Exit' ..... 26 Table 4.1: Business Registration in Selected Latin American Countries ............................................... 29 Table 4.2: Costs of Complying with Business Formalities by Business Size . 31 Table 4.3: Structure of Labor Taxes .............................................. 35 Table 4.4: Logistic Cost as % of product value per country .............................................. 36 Table 4.5: Direct Import Costs .............................................. 36 Table 4.6: List of Steps (Tramites) to Create and Register a Business .............................................. 38 Table 5.1: Number of Financial Intermediaries .............................................. 42 Table 5.2: Commercial Debt Balances with Banks by Firm Size: 1998-2000 ........................................ 43 Table 5.3: Determinants of SME Lending among Argentine Banks .............................................. 46 Table 5.4: Non-performning loans by Type of Firms (%) .............................................. 47 Table 5.5: Borrowing Concentration among Debtors in 1998 ............................................................ 49 Table 5.6: Sociedades de Garantfa Recfprocas (September 1999) .......................................................... 52 Table 8.1: Summary of Market-Oriented SME Interventions ............................................................ 68 List of Figures Figure 2.1: Underemployment by Firm Size (Percentage) ............................................................ 10 Figure 2.2: Unit Labor Cost (in constant pesos 1992=100)* ............................................................ 10 Figure 2.3: Median Labor Productivity by Firm Size (Total=100) ........................................................... 10 Figure 4.1: Average Explicit Costs of Business Registration in Argentina .............................................. 30 Figure 4.2: Labor Registration: Firm's Tramites ............................................................ 33 Figure 4.3: Periodic Cost of Business Formalities ............................................................ 34 Figure 4.4: Share of Informal Workers in Buenos Aires ............................................................ 37 Figure 4.5: Creating a Business is a Complex Process ............................................................ 39 Figure 5.1: SMEs' Access to Finance ............................................................ 40 Figure 5.2: Access to Bank Loans among Industrial SMEs in 1998 ........................................................ 41 Figure 5.3: Financial Structure of SMEs ............................................................ 41 Figure 5.4: Estimated Share of Lending to SMEs and Growth Rates of SME Lending by Bank Size for Foreign and Domestic banks in Argentina ............................................................ 44 Figure 5.5: Evaluation of Credit Services by Exporting SMEs ............................................................ 49 Figure 6.1: Surveyed Argentine SMEs Knowledge on E-Commerce Subjects ........................................ 56 Figure 6.2: SMEs that Perform Electronic Transactions ............................................................ 56 Figure 6.3: Reasons Why Surveyed Argentinean SMEs do not Perform Electronic Transactions ........... 56 vii  Figure 6.4: Obstacles to the Development of E-Commerce in Argentina ...........................................:.56 Figure 7.1: BDS Programs for SMEs/GDP .64 List of Boxes Box 3.1: - Working Hypothesis - Fundes' Study .18 Box 5.1: Main shortcomings of the legal framework for risk capital investment in Argentina. 50 Box 6.1: Legal Aspects to be Considered for the Development of Electronic Trade .57 Box 7.1 Credit Guarantees .63 Box 8.1: Performance Oriented SME Organizations: Factors of Success .73 Box 8.2: Govermment as Facilitator of Private Learning: SMEs Adopt ISO-1400 Standards Through Innovative Supplier Development Program .74 Box 8.3: From top-down to bottom-up SME promotion .76 Box 8.4: Factors of Success of Sub-National Private Sector Development Agencies .77 Box 8.5: Argentina: Co-Investment and Business-Climate Ranking as Criteria for Funding Provincial Public Works .80 Box 8.6: Contests for federal funds between sub-national govermnents: Lessons from the World Bank projects .82 viii  Executive Summary 1. Introduction In Argentina, convertibility law and economic liberalization in the early 1990s brought about dramatic changes in economic performance. For a while, the structural reforms proved reasonably successful in attracting FDI and generating growth through the expansion of large domestic conglomerates and multinationals. In the end, however, the economic path induced by the previous policy regime proved unsustainable and finally the Argentine economy precipitated into a deep and prolonged crisis. But even before the advent of the current difficulties, this growth was very unevenly distributed between regions, sectors, and economic agents. The productivity gap across the macroeconomic cycle between small and medium-sized enterprises and large firms remained significant signaling unrealized opportunity of SMEs as a potential source of dynamism, flexibility and growth diffusion as well as employment. To adjust effectively to increasing globalization and a series of external shocks (the crisis in East Asia, the default by Russia, the devaluation of the Brazilian real), SMEs were confronted with'the task of developing business strategies to secure their niches in the new arena. The, viability of these strategies, however, were obstructed by various constraints in the legal and economic framework, difficulties in acquiring information and technology, and insufficient access to finance. Ten years after the beginning of economic reforms, and in the midst of one of the worst economic and financial crisis of Argentina's history, SMEs, with small exceptions, still need to take off and realize their potential. The purpose of this report is to assess the constraints affecting Argentine SMEs in terms of creation, development, and performance, and identify appropriate and justifiable policies and institutions that can help improve their performance, and contribute to economic growth and job creation. In addition to the serious problems that SMEs face because of current macroeconomic and financial conditions, Argentine SMEs face constraints from many sources. Although this report cannot examine all of them, it focuses and analyzes the three key groups of constraints: (a) inadequacies of the business environment; (b). insufficient knowledge, information and technology; and (c) access to finance and high cost of borrowing. The central policy questions of this report are how to address these constraints; how to correct or ameliorate the effects of market and government failures; how to eliminate unnecessary regulations; what kind of support is appropriate and how best to design SMEs assistance programs. Overall, the report proposes policy interventions in the business environment and in the financial sector and proposes the facilitation of efficient institutions of public and/or private service delivery that as a public good benefit all firms, but particularly SMEs. This report shows that such institutions are better created at the state and regional level, then scaled to the national level. This second-generation institutional agenda is at the center of a sustainable and market-driven incentive framework for SME development. This report presents seven main messages: a) The SME sector is critical to the Argentine economy both from a growth/efficiency and equity standpoint yet on average, it has failed to realize its potential. SMEs account for 69-78 percent of employment and 61 percent of production. Another reason why the SME sector is critical to the Argentine economy is that it can constitute the basis for the reconstruction of a network of local dynamic firms. In fact, the evidence in many developing economies suggests that the lack of a national entrepreneurial basis can be the source of macroeconomic and even institutional instability, and also that its presence is crucial for fully taking advantage of the benefits derived from FDI and other features of the current process of globalization. In other words, localization of decision making matters. Small and medium-sized enterprises have not realized their potential, partially because of their own deficiencies but also because of government failures and standard market failures affecting economic activity. Hence the current predicament of SMEs is also an opportunity. Once onerous regulatory burden is relieved, one can expect SMEs to become x  a source of growth and employment. The current crisis, and the need to jump-start growth is an important window of opportunity to reduce regulatory burden and start the reform of SME policies and programs. b) Smal and medium-sized enterprises are highly heterogeneous and are not just smaller-sized replicas of large firms. SMEs have special organizational and technological characteristics, which would have been irrelevant in the world of perfect markets and perfect govemment. It is market and/or govemment failure, which makes SMEs distinct: they have much lower adaptive capacity to deal with market and govemment failures, and they are the most cost impacted by burdening regulations, lack of markets deficient business environment. Of course, not all of those differences demand or justify public sector interventions but there seems to be a broad consensus on the positive impact that a well designed and implemented policy can have on SMEs performance. c) Argentina's business environment suffers from a high degree of institutional rigidities, which partly explains why roughly one quarter of economic activity is performed outside laws and regulations and only half of the labor force is registered with the social security. Registration and creation of a legal entity is a time consuming process for SMEs, with official costs of compliance ranging in 2001 from $1,755 to $6,500 depending on business size. Overall, the regulatory burden of the business registration system is very high, falling more heavily on small firms and giving large firms a comparative advantage. d) There is a need for policy action to deepen financial markets for SMEs. Small and medium enterprises received, on average, about 9.8 percent of bank credit during 1998-2000, but they contribute to about 61 percent of Argentina's value added. Other countries present similar findings, such as Peru, where SMEs receive 15.1 percent of bank loans, while generating 42 percent of the country's GDP. Nonetheless, until the recent collapse of the financial system access to finance per se did not seem to be a big problem. In fact, about 58 percent of SMEs in the City of Buenos Aires had access to finance in 1998-1999. The problem lied rather in the conditions under which SMEs received credit. Overall most SMEs had access to very expensive short-term loans in the form of overdrafts from current accounts, which may not be the most effective form to finance working capital or investment needs. At present, given the current conditions of the banking system, access probably became the most pressing SME's problem regarding financing matters. e) Knowledge constraints are significant. In Argentina, most SMEs do not use training and technical assistance because services available are directed towards large firms and are too expensive for SMEs. Overall, about 38 percent of SMEs purchased technical assistance services and 62 percent received training courses during 1997-1998, leaving 30 percent without such services. Although the data to date is scarce, small and medium enterprises appear on average to suffer from isolation. The special nature of knowledge of markets, technologies, and supplies, plus the fact that such knowledge would still require substantial effort on the part of the firm to assimilate it, put greater weight on demand factors for information rather than on supply factors. This ability to incorporate lessons and new ideas is a key factor to remain competitive in the new economic environment. f) In Argentina, there is a striking multiplicity of SME programs, yet with uncertain impact. The type of public intervention is important. It is not so much a matter of additionality of resources to the sector (as the amount spent for the sector in Argentina is ample) as it is the issue of the focus targeting, and particularly the incentive structure and the delivery of those services. g) Argentina needs to overhaul its SME policies and programs to make them more incentive- and demand-driven. Not all SMEs are created equal, and they respond differently. Assistance xi  programs for them to be effective have to be discriminatory and responsive to performance. Those programs have to induce self-selection, be incentive driven, adapted to the capabilities of SMEs, and the assistance gradual, matched to the fi-ms' performance. 2. SMEs are Critically Important but have not ReaL;zed their Potential Small and medium-sized enterprises play a much more important role in economic growth than had been acknowledged previously. They are the single most important source of employment in many countries, while in Argentina they account for about 69-78 percent of employment. For some sectors, their share of employment is greater than their. share of production, indicating lower levels of productivity. In terms of dynamics, both employment and number of establishments in manufacturing SMEs have decreased quite significantly in the manufacturing sector, but increased in the service sector in inter-census period 1984- 94. h) The SME sector is characterized, on average, by a lack of dynamism and low productivity, (mainly in the service sector), and low rates of entry and growth. Although superficially some of the SME subsectors-i.e., manufacturing- look healthy, a deeper examination reveals that SMEs face major problems, including difficulties to start-up and to grow. Most SMEs in Argentina are still struggling to adapt to competition in the global marketplace ushered by trade liberalization and the reduced state role in the economy. Despite their continued economic importance, a limited number of new SMEs enter the marketplace and many more struggle to survive or die of attrition. Though the data is scarce, recent estimates by the Central Bank suggest that mortality rates reached 18 percent, about twice the birth rate during the 1990s. In many cases, SMEs focus on survival in the short-term rather than on repositioning for domestic, regional, and international competition. Hence, they are in a precarious position to integrate their activities into the global economy. The current situation of the Argentine's economy has certainly worsened their already weak position. SMEs are Differentfrom Large Firms: Size Matters Argentine SMEs, like those in other countries, have special features of their own: their economic rationale is of a particular kind, their behavior is specific, and they are impacted quite differently by regulations and risk factors. Generally speaking, these firms are family businesses and their administration falls directly on the owners (often untrained). Thus, their management often relies on untrained individuals, and the owner's outlook (generational cultural factor) is especially important in deciding actions that determine a firm's evolutionary process. In fact, SMEs not only differ in regard to how effective they are at strategic planning, but may also even pursue goals that differ from profit maximization, such as market survival, maintaining their jobs and sources of income, or keeping up the family business tradition. For all these reasons, SMEs might need to be treated as economic agents, which are not merely "smaller-sized large ones." There are significant differences relating to the size of the firm. Of particular relevance in the comparison between SME and large firms, are factors that significantly impact their unit costs, interest rates and transaction and logistics costs, all significantly higher for SME. While differences are to be expected and should not be, in principle, a cause for intervention, components of those differences that are induced by market and government failures are. xii.  Productivity in the Manufacturing Sector Productivity and usage of inputs differ significantly according to firm size. Again this is not surprising given differences on modes of production, scale effects and the myriad of costs with differential impact according to size. In any event, it does clearly impact the prospects for growth and development of SMEs. According to Fiel (1996), among manufacturing firms, labor productivity for larger firms was 2 to 4 times higher than that of smaller firms both whenfirm size was measured by number of workers and gross production value. In 1999, the manufacturing sector of the City of Buenos Aires presented the same pattern. In terms of productivity of capital, Fiel (1996) presents the same dramatic differences by size of firm. Also, SMEs require a much higher proportion of working capital as a percentage of sales than larger firms, impacting unit costs and productivity. In summary, the case has been made that SMEs are characteristically and behaviorally different from large firms and are impacted differently as well (Table 1). That in itself need not be a reason for intervention. A closer look at the environment under which they operate, and the causes behind those differences, are essential in evaluating the case for intervention, at least on efficiency grounds. To unleash their potential, unit costs have to come down, and productivity and quality standards have to increase. Firms on their own can and should take measures to improve their predicament, but the government also needs to address and correct inefficiencies and market and government failures that enhance those differences across firms of different sizes. The questions remain who should intervene and what is it that needs to be done in order to achieve those results. Table 1: ComparingFirms by Size in Argentina Concept Small Medium Large Organization Individual Owner S.A. S.A. Avg. age 28 years 38 years 57 years % that sub-contract 4.5% 9.5% 52% Operate with bank Loans 76% 86% 98%- Avg. annual interest rates on >25% >23% 12% bank loans Informality (% of workers) 70% 32% 10% Transaction Costs (% of sales) 15% 7% 1% Logistic Costs (% of sales) 35% 26% . 15% R&D investment 0.3% 1.5% 3.8% Technological support Customers and Providers Custoners and Providers Providers and other sources Initial development based on: Previous experience Experience and access to new Access to new technology I _________________I________ ___________________________ technology Source: FIEL (1996, 2001) and Bank'Staff estimations. 3. SMEs are very Heterogeneous Agents As expected there was a highly uneven supply responses to economic liberalization of SMEs, highlighting how diverging firm-level trajectories affect inter-industry and intra-industry heterogeneity. The growing heterogeneity of SMEs emerges as the single most salient feature of the aftermath of economic liberalization. Small and medium-sized enterprises, like all other economic agents, differ from each other. This chapter identifies three types of SMEs: 'successful', 'muddling through' and 'failing' firms. This class of heterogeneity merits special consideration. Although inadequacies of the business environment, knowledge, information and technology constraints, and low access to finance affect all types of SMEs, each type of SMEs have different capabilities to face those growth constraints. Firm surveys, case studies and econometric analysis of panel data all pinpoint existence of three classes of SMEs: successful firms, 'muddling through' SMEs and 'clear failure'. Although these three ideal types are best to be perceived as the extremes and the middle point of a continuum of widely heterogeneous xiii  economic agents, yet for the policy purposes it is useful to summarize the main features of these three types of SMEs (Table 2). The heterogeneity of SMEs and their responses to economic liberalization implies heterogeneity of Business Development System (BDS) and financing needs and constraints. Successful SMEs tend to have quite advanced technical, managerial and marketing capabilities whereas the 'persistentfailure' SMEs have none of these capabilities. The 'muddling through' firms fall somewhere in between. It does not mean that successful SMEs do not face BDS constraints and do not have BDS needs. On the contrary, as the surveys of successful exporters of FUNDES clearly demonstrated, successful finns display the highest effective demand for BDS services. What it does mean, however, that BDS services required by successful SMEs will be quite different from the services for 'muddling through' and 'surviving firms'. Successful finms require high intensity specialized services and are willing to pay full market costs for these services. Muddling through firms may require 'light touch' inexpensive BDS and may require limited-time subsidies on a matching fund basis to show the value of the BDS to the firm and to assure subsequent market demand for the services. 'Loser firms' in contrast may require very basic benchmarking design and assistance to the owner/manager to exit or switch activities of the firms to more promising and profitable lines of business. To cope with such heterogeneous features and needs it is crucial to stress the importance of local level involvement in the design and implementation of SME policies. Table 2: Taxonomy of SMEs In Argentina: Implications for Policy Muddling througb - surviving Clearly Unsuccessful, on their Successful SMEs SMEs Way to Liquidation The major chalenge Expansion and growth: Re-founding the firm on new Exit. Phasing out of production facing the firm specialized marketing and foundations on the face of activities technical support, access to dramaticaUy new opportunities and finance challenges opened by economic liberalization Capacity for auto- Quite high, in particular vis-&- Limited to very basic comparison vs. Virtually non-existent. There is a diagnostics and vis the domestic and Neighborhood firms and most direct need to convince the family owners benchmarking international competitors competitors that exit is in his/her best interests Technological capabilities Formal depamnent or informal Informal technology/ engineering - technology development teams groups may exist Marketing and managerial Usually there are formal Quite weak and tend to develop on ad- Rudimentary capabilities marketing departments (taking hoc basis up to 5% of personnel) Alliances with other firms 80% of successful exporters If alliances exist, they are mostly No alliances/networking. Survival involved in some kind of informal orientation and very short planning aliance. Transition from horizon precludes participation in infonnal agreements and inter-firms networks alliances to formal agreements Subcontracting Staring to emerge. The Occasional Almost non-existent arrangements owner/manager is actively seeking subcontracting arrangement with large firms Focus of public policies Facilitation of high-intensity Faciltation of 'light touch' relatively Assistance in exploring marketing and technical support inexpensive marketing and technical employment opportunities for based on almost full cost- support services. owners and employees to ease the recovery of services. exit and closure of the business Development of private-public service Development of private service providers (e.g. BDS centers of UIA) providers and thickening of the market for business development services xiv  4. Business Environment Ridden with Institutional Rigidities The environment for business activities refers to norms, rules, regulations, laws, and procedures that shape the behavior and operations of businesses in an economy, particularly those dictated by government policies. As a set of rules, the business environment can constrain or encourage business activities, with significant impact on productivity and unit costs. Business Registration System Business registration is an important element for start-ups in any economy, and the relative ease or difficulty in registration is an important component of vitality of the private sector. It is the first point of contact between an entrepreneur and the government, and as such it sets the tone for their entire future relationship. In Argentina, this relationship does not start off in the most positive way since SMEs typically face a process that can take up to several months and require several hundred dollars in fees. Compared to other Latin American countries, Argentina ranks among the worst performers next to Guatemala and Venezuela. It takes about 130-150 working days to comply with all registration requirements. As in other countries, business registration procedures can be grouped into four types: (a) commercial registration of businesses; (b) acquisition of operational permits and licenses at the municipal level; (c) compliance with tax regulations; and (d) labor and social security registration. To comply with each component of the registration process, businesses must perform a number of formalities (trdmites) at different levels of government, visit various agencies, provide documentation and fill out forms, and pay fees and commnissions. Moreover, for each formality, businesses have to wait a certain number of days for approval. Some registration requirements occur once usually when becoming formal, while other requirements entail periodic costs of formality (e.g., tax payments and workers' social security contributions) (Table 3). Overall, in 2001 the cost of commercial registration in Argentina ranged between $800 and $1,900, depending on the business size. Although small firms would pay a lower absolute value, relative to their monthly company value added, the fixed costs of commercial registration could reach 18 percent of the firm's monthly value added, with wide differences by business size (Figures 1 and 2). Figure 1: Periodic Cost of Business Formalities ~~~~~~~1 11 -25 2 4 41 0 Ag Source:, Authiors' calculations xv  Figure 2: Average Explicit Costs of Business Registration in Argentina 25~~~M 120 181 *L~~-L Rgbkdbn klon Wr (jeimb & IbWane) Table 3: Costs of Complying with Business Formalities by Business Size (2000) US$ BusinessSize (rY oemplovees) 1 2 - 5 6-10 11- 25 26 - 40 41 - 50 51 + Avg. Average Monthly Value Added per Business a/ 980 2,W 11,873 23,746 59,409 82,83 340,565 6,125 1. Registration Costs at the National Level Cost of documents 270 270 270 270 270 270 270 270 Professional or consulting fees (includes cost of an 400 400 400 600 800 800 1,500 700 accounting study) Application for "urgent procedure 130 130 130 130 130 130 130 130 Total cl 800 800 800 1,000 1,200 1,200 1,900 1.100 % of avg. Monthly value added 82 31 7 4 2 1 1 18 2. Registration Costs at the Municipal Level b/ Cost of documents 200 200 200 200 200 200 200 200 Tax advances 200 250 300 350 400 400 400 329 Professional or consulting fees 300 300 600 800 1,000 1,200 1,500 814 Total 700 750 1,100 1,350 1,600 1,800 2,100 1,343 % of avg. Monthly value added 71 29 9 6 3 2 1 22 3. Costs of Tax Registration Cost of documents d/ 70 70 70 70 70 70 70 70 Cost of tax advances e 55 75 75 75 100 100 100 83 Professional or consulting fees 50 80 150 200 300 400 1,000 311 Total 175 225 295 345 470 570 1,170 464 % of avg. Monthly value added 18 9 2 1 1 1 0 8 4. Costs of Registering Workers Total f 50 80 150 200 300 400 1,000 311 % of avg. Monthly value added 5 3 1 1 1 0 0 5 5. Total Registration Cost (1+2+3+4) . - 1.725 1,855 2,345 2,895 3,570 3,970 6.170 3,219 -%bf avg. Monthly value added .. . 176 72 20 .12. 6 5 2 53 6. Cosis of Fonnaliies to Pay Taxes and Laor 50 - 100 499 . 807 1.485 1,988 5.108 165 Obligations per Month - _ - - - - - % ofavg. Monthly value added 51 39 4.2 3.4 2.5 2.4 15 2.7 Source: a/ Authors' calculations based on information fom the 1994 Economic Census, INDEC, Argentna b/ Authors' calculations based on information presented in FUNDES-IDB (2000), which are representative for the municipalities of the city of La Plata c/ Includes: costs of publication in the official gazette, costs of certifying documents, and costs of hiring professional accounting studies. Excludes: initial payment of one percent of capital for the Stamps Tax, annual levy as percentage of capital required by the Province of Buenos Aires, stamp tax to register accounting books. d/ Assumes a cost of $70 to obtain certified copies of the business' by-laws and rental contract or real estate ownership deed e/ Includes the cost of making tax advances the for the Gross Income Tax f/ Includes an estmate of the prices charged by accounting firms for this type of professional consulting and the costs of depositing the amounts deducted and in paying contributions. xvi  The Judiciary and Supervision Slow and high cost legal procedures, and lack of arbitration mechanisms to solve commercial disputes between firms impose a heavier burden on SMEs than on large fimns. In many cases SMEs are left without the option to use existing regulatory and supervisory institutions. Deficient regulation of noncompetitive markets, like public utilities, impair the performance and competitiveness of the economy and, in particular, of SMEs. SMEs face noncompetitive markets even in the markets of some tradable inputs (i.e. steel). As is often the case, the creation of an institution like the "Secretarfa de Defensa de la Competencia" (Competition Agency) did not improve the situation. In the case of many tradable inputs, trade liberalization was undermined through special regimes for those sectors. Labor Market Rigidities In Argentina, workers have historically enjoyed strong job rights, including the right to a generous severance payments and to ultractivity clauses (collective bargaining agreement remains in place until a new one is signed). The level of non-wage labor cost is significantly high and its imperfect link to direct benefits induces a high tax wedge, one of the highest in LAC. Moreover Argentina has a very highly centralized collective bargaining agreement system. All types of firms, small, large, and independent of their geographical location and predicament are subject to the same agreements negotiated by the heads of the union (cupulas). Clearly, that adversely impacts SMEs not providing them with the flexibility they need to address their particular and individual needs and predicament. Some attempts to provide SMEs with additional flexibility have been tried but very lirmited practical success. In addition to a cumbersome and costly labor registration system, labor regulations also introduce other distortions, such as expensive costs of dismissal and hiring restrictions. Similarly, firms must contribute to union-sponsored health programs with limited benefits to show for. Finally, firms have limited flexibility in the type of labor contracts used. In short, labor regulations in Argentina remain rigid, resulting in substantial costs for all firms, particularly SMEs. As an example, according to a recent study on the effect of labor regulation on firms' employment decisions in Argentina, tightening of labor regulations reduces the number of jobs while increasing hours worked of those workers that kept their jobs, which is the opposite effect sought by regulators through the 1990s. Argentina has made efforts to reform the sector securing marginal improvements but with mixed results. The Labor Reform Law of 2000 aims at improving labor market conditions. Additional regulations and actions are required to achieve a larger impact. Logistics and Infrastructure Issues Cost related to logistics is a major factor impacting the way of doing business in Argentina. Logistics costs are a significant obstacle to the development of SMEs, reducing productivity, increasing unit costs and with the detrimental effect on the competitiveness of Argentine firmns. Among the major LAC countries, Argentina remains the second (after Peru) with the largest logistic costs in the Region. The Consequences of a Complex Business Environment Among other factors, shortcomings of the regulatory framework for business formalization have important implications for private sector competitiveness and efficiency, particularly among SMEs. These include: * Business Informality. Not surprisingly, given the onerous compliance costs associated with business formalities, a significant share of SMEs' activities is performed outside the laws and regulations. The regulatory framework is biased towards smaller firms. First, the costs of registering a business, such as those documented here are much higher, relative to the fimn's value added for smaller firms. Second, the monthly costs of complying with tax and labor regulations amount to a staggering 3 to 7 percent of the firm' s value added for fnrns with less xvii  than 25 workers. Thus, labor and tax regulations are biased against smaller firms. The amount that they must spend on bureaucratic red tape is almost equivalent to what they must pay in income tax and the value added tax through the monotributo, and other local taxes. Thus, growth and development of SMEs are hindered. It is not only the individual firm that loses, but society as well, since the benefits, such as fiscal impact, social coverage, access to formal financial markets and access to the contract system, originate from compliance with laws and regulations. Business formality can be viewed as a necessary input to production, which firms decide how much to purchase along a continuum Rise in Labor Informalitv. * Rise in Labor Informality. The high bureaucratic cost of labor regulations may explain, among other factors, increasing labor informality. Argentina, for being a middle-income country, has one of the lowest compliance index on social security registration, not exceeding 50 percent. During 1980-1998 the share of informal salaried workers increased for all firm sizes, especially among smaller firms. This obviously has serious implications for the costs and coverage of social programs, especially health insurance, pensions, and income support during bouts of unemployment. * Reduction of Business Innovation. Although governments have good reasons to regulate economic activities, the Argentine cumbersome business regulation system imposes a constraint to business innovations, especially among businesses in the manufacturing and commerce sectors. For example, a cafe shop (negocio de gastronomia), which is an activity typically dominated by small businesses, will require municipal authorization to offer espresso coffee services, as well as approval of the location of the coffee machine and auxiliary units. * Disincentives for Geographical Expansions. To sell products or services and to buy supplies from businesses in other provinces, a business must register with the Convenio Multilateral (Multilateral Agreement). The multilateral agreement is a mechanism for transferring the corresponding part of Gross Income Tax to other provinces when a company generates income from a sale or makes payment for a purchase of goods in a province other than the one in which it is located. * Uncertainties about Compliance and Enforcement. An excessive amount of red tape creates losses for society and is highly susceptible to the discretion of government authorities and corruption while leaving plenty of room for errors and creating judicial insecurity. For businesses with operations in different municipalities, the three-tiered system of business formalities adds additional uncertainties during municipal inspections because definition criteria of economic activity vary widely across municipalities. Labor registration inspections are very ineffective due to lack of good information. * Inefficient Use of Government and Firm Resources. Argentina's cumbersome labor registration system imposes substantial costs on businesses. According to recent estimations, businesses used to spend about $700 million per year, representing 1.5 percent of overall salary costs (Giordano et al., 1999). For government agencies, the labor registration system entails duplication of activities and collection of information, and thus expenses. * Reduced Productivity and Increased Unit Costs. The increase transaction and operating costs due to that unfriendly business environment, with a large number of both fixed and variable costs-rule driven- adversely impact productivity and unit costs to all firms but particularly to SMEs * Reduced Number of New Economic Activities. The increased cost hinders the formation of new fiums and reduces investment expenditures of existing firms with the obvious adverse impact on employment and income generation. xviii  5. Significant Problems with Access to Finance Comparing SME's contribution to output with distribution of bank loans, we find severe imbalances and a need for policy action to deepen financial markets for SMEs. Small and medium enterprises receive, on average, about 9.8 percent of bank credit during 1998-2000, but they contribute to about 61 percent of Argentina's value added and to 69-78 percent of employment. Other countries present similar findings, such as Peru where SMEs receive 15.1 percent of bank loans, while generating 42 percent of Peru's GDP. The need for both short and long-term policy action in the fmancial markets has become particularly urgent in Argentina nowadays because the current collapse of the banking system is harming economic activity as a whole but is especially damaging for SMEs, particularly in terms of access to finance. Participation in Credit Markets Contrary to the widespread perception that SMEs lack access to finance, a recent survey showed that until the triggering of the current financial crisis a substantial share of SMEs borrowed money. Firms paying interest -our measure of access to finance- hovered around 58 percent in 1998 and 1999 among SMEs in the city of Buenos Aires. The manufacturing sector presented the highest rate of access to finance while the service sector presented the lowest rate. As expected, access to fmance was positively related to firm size. Firms with more than 50 employees not only were more likely to have access to finance, but also their access improved between 1998 and 1999. Smaller SMEs, with 6 to 50 employees, had lower rates of access and their access worsened in recent years. Bank Lending to Small and Medium Enterprises What are the Determinants of SME Lending by Banks? SME lending was never a main line of business for Argentina's banks. According to a recent Central Bank study, overall, SME lending accounted for around 20.9 percent of banks' loan portfolio in 2000, a decline from 23.6 percent in 1998, partly explained by the economic recession. Although the volume of lending to this sector declined 4.5 percent during 1998-2000, it did so at a lower rate than loans to large firms (5.8 percent). Lastly, loans to the non-financial public sector grew about 125 percent over the same period. Because a decline in the share of small business lending could arise from small business loans increasing or decreasing at a slightly slower rate than all types of lending, Clarke and others also analyzed the impact of foreign bank entry in the real growth rate of small business lending. They found that small business lending by domestically owned banks appeared to be growing faster than lending by foreign-owned banks in Argentina. Moreover, the authors found that bank size was positively correlated with growth of small business lending with a large effect among foreign banks. This indicates that small business lending was growing faster for large foreign banks than for small foreign banks. Lastly, one of the most interesting findings of the authors was that Argentine public banks did not come to the rescue of this sector and did not appear to surpass private banks in the extent to which they lent to small businesses. Thus, arguments saying that eliminating government resources invested in public banks or privatizing public banks would hurt small business lending do not have strong empirical evidence. What Explains the High Interest Rates of SME Loans? Argentine SMEs cited the high level of interest rates of bank loans as an important constraint. Several factors may explain the high levels of interest rates paid by SMEs: Credit Quality. Differences in credit quality may explain why SMEs paid higher interest rates on bank loans. According to the BCRA study, SME loans presented substantial higher levels of non-performing loans than large firm loans. Type of Products. When SMEs borrow from banks it is via credit cards and overdraft current accounts that carry interest rates much higher than rates of other types of loans, ceteris paribus (Sepyme's web xix  page). In 1999, about 42 percent of SMEs with access to the banking system were using overdrafts in their current accounts (decubiertos). Moreover, the UIA's survey of 2000 found that about 50 percent of industrial SMEs were using overdrafts, paying on average an interest rate of 2.7 percent per month or 38 percent annually when prices were stable or even showed a declining trend. Administrative Costs. The transaction cost of lending to SMEs is high in relation to the size of loans, making such lending in many cases unprofitable. The lack of documentation available makes it difficult to obtain a clear picture on the financial situation and prospective success of such businesses. Most banks were using lending technologies based on standardized credit policies and standard information. Informational distance contributes to increase the costs of generating borrower-specific information. Collateral. Collateral may reduce the cost of intermediation. Banks may find it easier to assess collateral value than to evaluate project creditworthiness and in case of default, expected losses may be lower. Various studies have found that SMEs' loans presented a higher fraction secured by collateral. This seems to indicate that the legal framework for secured transactions present serious shortcomings. Using a database of business debtors as of October 2000, a team of researchers from CEMA and the BCRA assessed the determinants of the interest rate paid by large firms on their bank overdraft account, which averaged 3.1 percent monthly. After controlling for various explanatory variables, the econometric results show that firms that paid lower interest rates were larger, in terms of assets, had better ratio of sales over assets, and had a lower leverage ratio. Moreover, firms with poor credit quality and with loans with lower guarantees paid higher interest rates. Under-developed Financial Infrastructure Argentina has an under-developed infrastructure to support financial transactions that limits the variety of credit products available for SMEs. * As shown in Chapter 5, inadequate laws and regulatory regimes have had the unintended consequence of detracting risk capital investment, especially for SMEs. These shortcomings increase transaction costs for evaluating, structuring, managing, and exiting equity investment operations. Because investment size and firm size are related, these higher transaction costs have a disproportionately negative effect upon investments in SMEs. * Information problems are particularly acute for SMEs. Many of the smallest firms do not have audited financial statements that can be used by banks. Moreover, they maintain parallel accounting books to circumvent government regulations, rendering audited financial statements useless to assess creditworthiness. For some banks, knowledge about a client is more important for lending decisions than cash flow analysis from financial statements. Hence, lack of detailed micro data on small businesses is likely a major reason why banks have not developed large portfolios, as SMEs often cannot credibly convey their risk quality to banks without offering collateral. Although the Argentine Government has taken several steps in reforming the environment for secured transactions, partly improving some areas, many problems remain, suggesting that the Government may consider a full reform of its system, instead of piecemeal reforms. Registries are inadequate for registering security interests and for searching existing encumbrances. Each geographical area has its own pledge registry, requiring re-registration of goods that move between jurisdictions or against debtors that have multiple business locations. Registries operate manually and data can only be transmitted in person because fax or mail is not allowed. The execution of guarantees of movable goods is lengthy and cumbersome and the associated court fees are high, reaching between 4 to 6 percent of the total claim depending on the province. xx  6. Weak Demand for Knowledge SMEs face significant sources of knowledge constraints, examining the areas of marketing, managerial skills and technical capacities. There is an important difference between finance and business environment on one side and knowledge on the other as factors of SME growth. Special nature of knowledge - marketing, managerial and technical capabilities of SMEs - the fact the knowledge could be readily available but would still require substantial effort on the part of the firm to assimilate it, puts much greater weight on demand factors rather than supply factors. Whereas any SME would demand good business environment and credit which do not require sophisticated capabilities to consume and assimilate (any one can spend money or benefit from simpler regulations), advice from consultants is only as good as the firm's ability to assimilate and act on it. Consequently, weak SMEs do not even understand the nature of their problems. They tend to list finance constraint as the major problem whereas in most cases it is conspicuous lack of marketing, managerial, and technical capabilities. For example, a recent survey of SMEs finds that only 5.1 percent of the firms consider that ties with other organizations, such as firms and SME institutions, are important for their growth. One of the few systematic studies of non-financial support programs for SMEs in Argentina estimated that approximately US$222 million dollars was being spent annually by national, provincial, and municipal governments and non-government organizations for such programs. This figure was equal to about 0.08 percent of the GDP and 0.26 percent of total public sector spending of Argentina and translated into about US$2,800 per SME that was using some support program. However, if the support programs would expand their coverage the amount for each SME could drop to US$280 in the unlikely case that all SMEs are covered. Moreover, the prospect of a sharp decrease in the public resources that will be available in the future, given the current macroeconomic and fiscal conditions, adds extra concem on the continuity of those programs. A small number of SMEs use non-financial programs. Despite the growth in the 1990s of technical assistance and training programs in Argentina, the existing evidence reveals that SMEs have low access to or low motivation for such services. For example, the FUNDES- UNGS study shows that only 16 percent of SMEs have access to training and consulting services. It also shows that a staggering 78 percent of firms surveyed used no instrument of SME support (e.g., training, technical assistance, credit, export promotion) during 1996-1998, even when the Argentine economy was rebounding in 1996-97. Low-level Equilibrium Trap as a Result of the Knowledge Constraint Conspicuously low demand for knowledge sets the stage for a low level equilibrium trap - a vicious circle of mutually reinforcing lack of basic understanding of where the problems are, erroneous actions following the wrong diagnosis and resulting poor performance. Poor designed SME programs can easily reinforce this vicious circle and be strongly counter-productive if, for instance, they pump credit resources to firms which main limitation is on managerial and marketing side. Weak knowledge capabilities imply that the credit would be poorly utilized which would put both the SME in question and the bank in jeopardy. 7. Current Government Policies: Multiplicity of Programs, Uncertain Impact Argentina has a myriad of specially designed programs to offer training and technical assistance as well as financial support to small and medium-sized enterprises. According to the Secretary of Small and Medium-Sized Enterprises (Secretarfa de Pequefias y Medianas Empresas, SEPyME, created in 1997 under the Presidency but moved in 2000 to the Ministry of Economy, and again in 2002 to the Ministry of Production) Argentina has approximately 300 programs and lines of credit to support SMEs. xxi  Business Deregulation During the past decade Argentina has experienced a radical change in the organization of its economic institutions. From a vastly over-regulated and state led model, which has driven the country to 25 years of economic decadence, the 1990s witnessed a structural reform emphasizing modernization through deregulation and market oriented policies. In spite of the deep ongoing crisis, the Argentine government still seems to keep interest in fostering private sector competitiveness by reducing the costs of business regulations. Recent efforts were focused on deepening the deregulation process initiated in the 1990s. The main activities in this regard are: competitive plans, one-stop-windows, and simplification of tax and labor regulations. Business deregulation is a complex process that requires and ongoing rather than a "one-shot" set of "massive deregulation" measures. Modern societies are involved in a permanent regulation - deregulation process. Financial Markets Throughout the world, governments have intervened extensively in financial markets. Argentina has not been immune to this ipproach. The Argentine government has a long history of using directed credit and subsidized lending to increase SMEs' access to credit services. By designing credit lines with subsidized interest rates, the Argentine Government tended to assume that banks face liquidity shortages and that SMEs cannot support high funding costs. Overall, in Argentina, as well as in other countries, these interventions have not been effective in lowering the total cost of credit for borrowers and have not resolved problems of asymmetric information, partly explaining their low penetration. It is important to point out that public credit guarantee programs, in and of themselves, do little to encourage banks to learn about SMEs and build relationships with them, creating another layer of transactions. Nevertheless, it is also worth to notice that private credit guarantee institutions (the so-called Sociedades de Garantia Recfproca) are relatively new in Argentina (and their legal framework was modified during 2000), and that during a four year recession it is difficult to evaluate its impact. Business Development Services In the 1990s, the number of business development programs for SMEs grew substantially. These programs offer services, such as training and technical assistance, human resource management, technologies, and export capacities. Overall, these government programs are characterized by the lack of strategic vision, coverage, coherence, and follow-up, raising questions about the elements of success and the cost-effectiveness of those programs. The existing evidence reveals that SMEs have low access to or low motivation for such services. For example, the Fundes study shows that only 38 percent of SMEs received consulting services in 1997- 1998. Public institutions (including municipalities) provided only 16 percent of all consulting services. Also, about 62 percent of SMEs received training services. More importandy, the Fundes study also shows that 30 percent of firms surveyed used no instrument of BDS support (e.g., training, technical assistance, export promotion), which adds extra concern about their growth potential. xxii  8. The Path Ahead: Towards Incentive-Driven SME Policies Policy recommendations are urgently needed to reform current government efforts to enable the business environment, increase the availability of financial services while reducing the cost of credit, and promote a market for business development services. Analytical considerations suggest the following reasons for government interventions: * Addressing the market failures that create cost disadvantages for SMEs, restrict their access to markets, and inhibit the development of markets for a diverse range of financial and non-financial services appropriate for small firns. This reason is stressed by the current collapse of the banking system; * Improving transactional efficiency in financial, product, and input markets relevant to SMEs, by facilitating access to information and developing mechanisms to manage risk; * Reconsidering public policies and regulations that discriminate against small fins or produce fixed costs that create a competitive disadvantage for them; and * Investing in public goods that open market access and build enterprise competitiveness- including infrastructure (information, communications, power, water, and transport) as well as education, technology development. Elements of an Effective SMEs Assistance Program A large number of SME interventions have failed, both in Argentina and worldwide. Few have succeeded. An efficient and efficacious SME program is even more rare. This crucial observation brings us to central policy issues: the identification of factors of success of efficient and efficacious SME initiatives and their adoption in the design a successful SME programs and related institutions in Argentina. Leaving momentarily aside the particular short-term requirements posed to SME policies by the ongoing economic crisis, evaluation studies in Latin America and Argentina allow discerning the following factors of success of good SME programs and institutions: * Development of a standard set of metrics to measure performance of SMEs and SME programs. For example SME growth and productivity rates, repayment rates, start-up survival rates, export growth, employment levels, linkages levels or index etc. This is essential to monitor effectiveness and adjust assistance and design. * Critical importance of entrepreneurial management. Successful organizations supporting micro, small and medium-sized enterprises (MSME) are often initiated by social entrepreneurs, individuals with unusual problem-solving and management skills and motivation for MSME development. In the examples of Foundation Chile and ProChile, success of MSME agency is predicated on such entrepreneurial manager at the top of the organization. Successful MSME organizations tend to evolve from a reliance on top key individual to a robust organization with efficient corporate governance. * Cost recovery. Successful MSME organization should target for growing cost recovery. For example, if most MSMEs learn mostly from each other and that by demonstrating that MSMEs can improve their business using business development services, some MSME organizations have been able to secure a stable demand for new business development services. Matching grant subsidies to accelerate the demonstration effect can be justified until such demand develops. xxiii  * Extensive use offollow-up techniques (benchmarking). Successful programs helps-through benchmarking indicators- diagnose where firms are, what do they need to do to improve and alternatives for those unlikely to survive. * Facilitate and reward linkages within the supply chain. Successful program should inform and facilitate opportunities to link with relevant supply chains and provide coordination assistance * Leverage their effectiveness with use of ICT. Develop SME internet portals, internet immersion institutes, improve access to the internet; provide access to ICT instruments, train firms accordingly and inform about the benefits. A number of these initiatives should be developing at the state level and coordinated at the federal level, with the public sector as a model user, for example through e- government. * Participation of clients in the design of the programs. Clients not only need to pay for the services; they need to participate in the design and evaluation of programs. To assure that they do, SME programs shall never be run by the governments (whether federal or sub-national), rather by an autonomous private management contractor working in cooperation with the government but independently from it. * Incentive driven components and private sector participation. Successful programs are incentive driven and managed by the private sector. For example one of the most widely used are limited time matching grants to first movers. First movers that develop new ways of doing things, such as breaking into non-traditional export markets, are critical agents for economic development. Because SMEs learn most productively from each other, the success of a first mover provides powerful examples to follow and thus has positive spillover effects. Although some public subsidy to first-movers is justifiable because of the spillover effect, the main question for governments is how to deliver such subsidy. To avoid capture and resulting misallocation of resources, government shall not be involved directly in delivering such subsidy. Rather, a firm-level management governance scheme has proved to be a promising solution in various countries. This scheme included the creation of a temporary public fund managed by a private management service provider. To offset certain fixed start-up costs of breaking into export markets the government cover costs of knowledge (consultants' costs, travel to trade fairs), usually on a 50/50 basis. Once eligibility criteria are met, funds are provided on a "first come, first served" basis. The fund is temporary with a typical duration of 3 to 4 years because once exporting ceased to be innovative activity, thereby not leaving any learning spillovers, there is no reason for the public fund to exist. The private management service provider administering the fund operates under a time-bound contract with performance benchmarks and acts as global network information broker (by providing relevant information to firms), markets the scheme to the firms, provides up-front, free support in preparing firm's programs and acts as an impartial administrator. The relevant knowledge (about export markets and on the upgrading of the firm) is highly specific and can be provided only by independent service providers. Nevertheless, experiences like PREX (financed by WB) or PRE (financed by IDB) programs show shortcomings of this approach. The private sub-contractor often does not have a full understanding of local SMEs problems. Additionally, when the program finishes, the global network information broker role goes away together with the private operator. * Facilitating collective learning of SMEs. The government (or central authority in general) orchestrates decentralized learning by monitoring and assuring information sharing between local experiments. Central authority does not direct--it facilitates information sharing, encouraging improvisation, and experimentation. Information exchange through continuous networked interaction) is the underlying principle of the decentralized learning in many areas of SME performance. Box 7.3 presents an example. xxiv  * Performance orientation. The successful programs are loaded and driven by incentives and induce self selection among SME firms, helping those that help themselves, illustrating how they can and should help themselves and suggesting exit to those that are not capable for internal or external factors to improve themselves. * Gradualism and Assistance Linked to Performance. Not all SMEs are created equal, as we have seen. Successful programs link assistance with performance and gradual assistance as SMEs improve themselves. A touch of realism assisting SMEs to identify their possibilities and potential is essential, followed with assistance on exit for those not viable. This approach contrasts sharply with traditional SME promotion strategies, which rely heavily on the direct and subsidized provision of financial and non-financial services to SMEs. It places much greater emphasis on creating an enabling environment for SME competitiveness, and on developing markets for SME-relevant services rather than substituting for them. It attempts to broaden the coverage and impact of government programs by using the private sector to deliver services, and utilize scarce public resources for facilitating market transactions and investing in public goods. Policy Chalenge The challenge is to initiate institutional development at the local and national level, which encourages transition from inward-looking firms, narrow search routines, and information-poor markets to learning-oriented firms and mature, information-rich markets. Securing an appropriate incentive framework involves amelioration of both government failure (deregulation and economic liberalization) and market failure. A strategy to improve the incentive framework for SMEs should be based on three blocks. The first block is the so-called first generation reform of elimination of government failure - deregulation and economic liberalization and better regulatory environment for businesses and investors. The second block should address the issues relating to SMEs' access to finance and to improve the now under- developed financial structure, including the new constraints posed by the current disruption in the functioning of the banking system. The third block -- second-generation agenda -- encompasses a set of initiatives of horizontal interventions to ameliorate market failure and accelerate positive changes in business' behavior. The latter includes schemes such as matching grants, business incubators, private-public seed funds, and facilitation of private-to-private collaboration through business associations and information centers. xxv  Table 4. Summary of Market-Oriented SME Interventions Policy agenda U - Building Institutional Capacity and Measuring the Delvery of SME Policy agenda - Benchmarks and Poli agenda I -Deregulation Investment in Public Goods Performance Indicators Business Environrnent Business Registration * Evaluate whether it is worthwhile to expand the pilot Monitor progress on simplification of business registration in aUl provinces by * Streamline business registration procedures by reducing ject initiated in May 2001 by SEPyME surveying firms on the investment climate. Items to monitor are: licensing and registration requirements and administrative Take advantage of information and communication * Business registration process - cost (for all areas, cost includes in time fnologies to facilitate interaction between government and and fonmal and informal types of payments and contributions, including Eliminate labor registration requirements beyond the MEs bribes), procedures required, delays ocal security one Institute systematic monitoring of SME performance and * Business licensing - number and type required, cost, time and payments Agree on cost-benefit analysis to eliminate the of policies and interventions required gulations that accrue little or no net benefit for the economy a Improve access to information about markets, standards, a Acquisition of business premises - fonnalities, costs, constraints, and Coordinate business registration between national and and technologies) delays ocal authorities * Evaluate the experience of "competitive plans" to see * Import, export and customs regulations - formalities, costs, and delays Disseminate information about registration whether deregulation agenda can work in that context * Product, input,.and equipment certification - types, incidences, equirements and procedures. Create process of innovation formalties, costs, and delays where firms' feedback is incorporated to simplify business Tax administration - requirements, constraints, costs, number of taxes registration and forms * Business inspections - types (and agency responsible), costs, number, Labor regulation reform: and process followed Review labor taxes to identify which taxes do not bring * Quality of infrastructure and services benefit to the government, firms, and the labor force * Labor relations * Aow SMEs firms to sign decentralized-at the firm Conflict resolution and legal environment evel, collective bargaining agreements Number of collective agreements signed at the SME firm level Reform the severance payment regime to reduce its * Amount reduced of tax wedge ts and.make it more transparent and less prone to litigation Consider substituting the severance payment regime for vidually capitalized accounts Tax reform: Simplify the tax regime and compliance procedures Improve comiercial ransactions law xxvi  - | Policy agenda 1 - Building Institutional Capacity and Measuring the Delivery of SME Policy agenda - Benchmarks and Policy agenda I -Deregulation Investment in Public Goods Performance Indicators Financial Markets Improve legal environment for secured transactions. * Creation of a registry for lien on movable property allowed Monitor number of security interest registered in the registry for liens on With WB assistance the GOA drafted a secured transaction nder a new secured transaction law ovable property law within the SSAL that could be submitted to Congress Promote innovation in loan products, lending Reduction of direct lending through public financial institutions Eliminate shortcomings of the legal framework for risk methodologies, delivery mechanisms, and risk assessment Reduction in volume of subsidized credit lines pital investment to promote equity investments in SMEs. nethodologies Share of SME lending and growth rate of SME loans Promote and allow information sharing of a'l positive Develop a credit-scoring tool for the SME market in Quality of SME loan portfolio d negative credit information histories from all types gentina using information available in all commercial banks sactions to eliminate fragmentation of credit histories. Build institutional capacity in private banks by Improve efficiency of database of social security ssemiating best-practice on SME lending by commercial detors banks Improve legislation and monitoring of reciprocal Reduce public sector involvenent in SME lending arantee societies Prepare a phase-out program of subsidized credit lines and nterest rates subsidies. Redesign interest rate subsidies programs o avoid perverse incentives and guarantee additionality of funds Rethink govemment participation in guarantee funds by owing greater involvement of private sector Business Development Services (BDS) I Target subsidies for market development to specific * Facilitate innovation in delivery mechanisms Cost recovery indicators for publicly-provided or subsidized services narket failures a Develop performance and impact indicators Coverage (number of SME clients), in particular outside major urban * Structure assistance on a gradual mode as SMEs * Improve training and technical assistance to private BDS espond to incentive structure providers Decentralization (extent of participation of municipal and provincial Facilitate poor perfonner exit mechanisms a Llrnit long-term subsidies for BDS to public goods (e.g., overments in BDS programs financing and design) information, labor and management training) Reliance on private provision of services (rather than in-house service Improve management and cost control in public BDS livery) institutions' Characteristics of program management (extent to which remuneration * Accelerate access, usage of ICT for SMEs f management or BDS services is tied to the performance of the programs) a Condition budgetary allocations to the achievement of impact a Reduce duplication across agencies in services provided * Decentralize service provision to provincial level a Introduce pilot initiatives combining deregulation and provision of business development services at a provincial level xxvii  1. Introduction In Argentina, convertibility law and economic liberalization brought about dramatic changes in economic performance. At least before the current macroeconomic problems, the structural reforms proved reasonably successful in attracting foreign direct investment and generating growth of large domestic conglomerates and multinationals. But even before the advent of the current difficulties, this growth was very unevenly distributed between regions, sectors, and economic agents. The productivity gap between small and medium-sized enterprises and large firms remains large signaling large unrealized opportunity of SMEs as a potential engine of growth and employment. What are small and medium-sized enterprises? The most frequently used variables to define SMEs are number of employees, sales volume, financial assets, and productive assets. According to the Economy Ministry the legal definition of SMEs in Argentina requires calculating an index number that summarizes number of employees, annual sales and productive assets in reference to pre-determined maximum values.' Due to the complexity of the official formula, and for consistency with recent studies that did not use the recent redefinition of SME, this report considers as SMEs independent firms employing fewer than 200 employees. Small-enterprises have generally less than 50 employees, while micro-enterprises have at most 10, or in some cases less than five employees. 1.1 Objectives The purpose of this report is to assess the constraints affecting Argentine SMEs -creation, development, and performance- and identify appropriate and justifiable policies and institutions that can help improve their performance, and contribute to economic growth and job creation. Argentine SMEs face constraints from many sources. Although this report cannot examine all of them, it focuses and analyzes the three key groups of constraints that emerge as a consensus among SMEs surveyed in a recent study:2 (a) inadequacies of the business environment; (b) access to finance and high cost of borrowing; and (c) knowledge, information and technology constraints. While clearly SME performance, and that of any other type of firm is highly impacted by the macroeconomic environment, and that has been quite an adverse factor in Argentina in the last few years, this report tries to stay away from the impact of such environment on SMEs. Most of the focus is in the impact of those three types of generic constraints and through the analysis of SMEs heterogeneous performance in the imputing of the determinants of success and proper assistance programs. 'The firm-specific index number equals P, = 310 o' * 10- 10 iA , where PO = number of employees, V OR VAR APR VA=annual sales and AP = productive assets. The sub-index R refers to the maximum value for the corresponding variable. Microenterprises have an index below 0.3, small enterprises between 0.3 and 1.5, and medium-sized enterprises between 1.5 and 10. 2 Obviously, growth constraints arise from tax and regulatory burdens, high input prices, financing problems, lack of competitiveness, low productivity, labor market rigidities, and an inadequate business environment (with some of them being much more severe than in other countries, i.e. labor market, regulations, registry, taxes). A recent study carried out by Fundes, shows the lack of consensus about the ranking of the main problems facing SMEs attributed to the heterogeneity of the sector, and the plethora of important problems, but nevertheless, most business problems can be grouped into three areas: (a) access to finance; (b) business environment and barriers to formalization and transaction costs; and (c) knowledge constraints. Obviously, an over-valued exchange rate has adversely impact the competitiveness of Argentine firms. 1  The central policy question of this report are how to address those constraints; how to correct or ameliorate the effects of market and government failures; and more important how to eliminate unnecessary regulations; what kind of support is appropriate and how best to design SMEs assistance programs. Overall, the report policy interventions in the business environment and in the financial sector and proposes the facilitation of efficient institutions of public and/or private service delivery that as a public good benefit all firms, but particularly SMEs. This report shows that such institutions are better created at the state and regional level, then scaled to the national level. This second-generation institutional agenda is at the center of a sustainable and market-driven incentive framework for SME development. 1.2 Data and Methodology The analysis of this report relies a combination of quantitative analysis and literature review, which together permits to consolidate the current knowledge about the three growth-constraints addressed in this report. The report uses a number of databases: * Argentine bank level database. The central bank of Argentina provided bank level information on balance sheets and income statements for all the commercial banks and the distribution of bank lending by size for the period 1998-2000. Total SME lending is approximated by adding to components: (a) loans between US$200,000 and US$1,000,000 from any individual bank; and (b) all commercial loans under $200,000 that are directed towards SMEs.4 This database is used to evaluate the impact of bank ownership and foreign entry on SME lending. * Firm survey of the City of Buenos Aires (INDEC- 1999). To estimate the geographic domestic product the statistical agency of the city of Buenos Aires carries out a comprehensive survey of firms operating in commerce, service, and industry sectors. This survey includes a limited number of variables on the composition of revenues, expenses, and employment as well as other information about the firm. In the case of industrial firms, the questionnaire contains a wider range of information about investment behavior and exports. * Survey of SME exporters of FUNDES. To impute the determinant of success for exporting SMEs, FUNDES undertook an extensive survey of exporting manufacturing SMEs. This is s very rich survey at the firm level. * Firm survey of FIEL. Based on sample form the Observatory Of Industrial SMEs of the Industrial Union of Argentina. Most of those firms are relatively successful, so it is not a random sample. The purpose of the study was to impute the dynamic patterns of industrial SMEs. The paucity of information about SMEs imposes four main limitations to the analysis. First, the overall characterization of SMEs relies on the 1993 economic census data since most recent data do not exist for Argentina. A more recent picture of SMEs is circumscribed to the city of Buenos Aires. Second, lacking panel data on SMEs it is difficult to characterize firm dynamics and evaluate thoroughly the determinants of success and failure. Third, although the data do not allow an empirical analysis of the relative impact of the three main constraints examined in this report, it provides an impressionistic view of the magnitude of the problems. Finally, the data do not permit a complete evaluation of government programs. The report takes advantage of various on-going research related to SME performance. The Inter- American Development Bank organized a regional research on the determinants and consequences of 4 To promote lending to small businesses, the Argentine Central Bank allows banks to treat commercial loans less than $200,000 as consumption loans for purposes of information and provisioning requirements, simplifying the approval process for banks. 2  financial constraints of firms that includes two studies about Argentina: (a) an assessment of relationship lending and the determinants of interest rates among a sample of medium and large firms carried out by a team of researchers from CEMA and the Central Bank of Argentina; and (b) the determinants of industrial SME receiving loans carried out by CEDES. 1.3 Main Findings This report presents seven main messages: i) The SME sector is a critical sector of the Argentine economy both from growth/efficiency and equity standpoint yet it failed to realize its potential. SMEs account for 78 percent of employment and 61 percent of production. Small and medium-sized enterprises have not realized their potential, partially because of their own deficiencies but also because of government failures and the standard market failures affecting economic activity. Hence the current predicament of SMEs is also an opportunity. Once onerous regulatory burden is relieved, one can expect SMEs to become an engine of economic growth and employment. The current crisis, and the need to jump-start growth is an important window of opportunity to reduce regulatory burden and start the reform of SME policies and programs. ii) Small and medium-sized enterprises are highly heterogeneous and are-not just smaller- sized replicas of large firms. SMEs have special organizational and technological characteristics, which would have been irrelevant in the world of perfect markets and perfect government. It is market and/or government failure, which makes SMEs distinct: they have much lower adaptive capacity to deal with market and government failures, and they are the most cost impacted by burdening regulations, lack of markets deficient business environment; not all of those differences, demand or justify public sector interventions. iii) Argentina's business environment suffers from a high degree of institutional rigidities, which partly explains why roughly one quarter of economic activity is performed outside laws and regulations and only half of the labor force is registered with the social security. Registration and creation of a legal entity is a time consuming process for SMEs, with official costs of compliance ranging from $1,755 to $6,500 depending on business size. Overall, the regulatory burden of the business registration system is very high, falling more heavily on small firms and giving large firms a comparative advantage. iv) There is a need for policy action to deepen financial markets for SMEs. Small and medium enterprises receive, on average, about 9.8 percent of bank credit during 1998-2000, but they contribute to about 61 percent of Argentina's value added. Other countries present similar findings, such as Peru, where SMEs receive 15.1 percent of bank's loans, while generating 42 percent of the country's GDP. Nonetheless, access to finance per se does not seem to be a big problem, about 58 percent of SMEs in the City of Buenos Aires had'access to finance in 1999 and 1998. The problem lies rather in the conditions under which SMEs receive credit. Overall most SMEs have access to very expensive short-term loans in the form of overdrafts from current accounts, which may not be the most effective form to finance working capital or investment needs. v) Knowledge constraints are significant. In Argentina, most SMEs do not use training and technical assistance because services available are directed towards large firms and are too expensive for SMEs. Overall, about 38 percent of SMEs purchased technical assistance services and 62 percent received training courses during 1997-1998, leaving 30 percent without such services. Although the data to date is scarce, small and medium enterprises 3  appear on average to suffer from isolation. The special nature of knowledge of markets, technologies, and supplies, plus the fact that such knowledge would still require substantial effort on the part of the firm to assimilate it, put greater weight on demand factors for information rather than on supply factors. This ability to incorporate lessons and new ideas is a key factor to remain competitive in the new economic environment. vi) In Argentina, there is a striking multiplicity of SME programs, yet with uncertain impact. The type of public intervention is important. It is not a so much a matter of additionality of resources to the sector (as the amount spent for the sector in Argentina is ample) as the issue of the focus targeting, and particularly the incentive structure and the delivery of those services. vii) Argentina needs to overhaul its SME policies and programs to make them more incentive- and demand-driven. Not all SMEs are created equal, and they respond differently. Assistance programs for them to be effective have to be discriminatory and responsive to performance. Those programs have to induce self-selection, be incentive driven, and adapted to the capabilities of SMEs, and the assistance gradual, matched to the frms' response. 1.4 Organization of the Report This report is organized in eight chapters. Chapter 2 states that small and medium-sized enterprises play a much more important role in economic growth than had been acknowledged previously. In Argentina, SMEs are the single most important source of employment. Chapter 3 presents the highly uneven supply responses to economic liberalization of SMEs, highlighting how diverging firm-level trajectories affects inter-industry and intra-industry heterogeneity. The following chapters analyze business constraints arising three sources. Chapter 4 describes the main features of the business environment in Argentina. It describes business registration procedures, finding that the regulatory burden of the business registration system is very high, falling more heavily on small firms, and giving large firms a comparative advantage. The subjects of lack of access to finance and bank lending to SMEs are considered in some detail Chapter 5. Chapter 6 moves to explains the sources of knowledge constraints, examining the areas of marketing, managerial skills and technical capacities. Chapter 7 analyzes current government policies to address the three main constraints analyzed in previous chapters. Lastly, Chapter 8 outlines policy recommendations to revise current government efforts to enable the business environment, increase the availability of financial services while reducing the cost of credit, and promote a market for business development services. 4  2. SMEs as Potential Engines to Economic Growth and Employment: Anatomy of the Sector Any assistance program with (the limited) government resources to assist exclusively SME, requires a motivation orjustification. The usual arguments ought to be based on efficiency grounds-market or government failures types-or on equity and poverty grounds. Often both types of arguments are used. To make that argument for SMEs, it is useful to analyze their similarities and their differences with the other firms. This chapter presents a set of characteristics by furm size and a bit of an anatomy of the Argentinean SME sector, and argues that indeed there are significant differences among firms of different sizes and a number of those differences might be linked to market imperfections and transaction costs. The economic importance of small and medium-sized enterprises (SMEs) in Argentina is also reviewed here. 2.1 The Role of SMEs in Argentine Economy Small and medium-sized enterprises play an important role in economic growth. They are the single most important source of employment in many countries. As shown in Table 2. 1, Argentine SMEs account for about 69-79 percent of employment. For some sectors, their share of employment is greater than their share of production, indicating lower levels of productivity. In terms of dynamics, both employment and number of establishments in Table 2.1: Argentina's SMEs and International manufacturing SMEs has decreased Comparison... NuCber mNetpannualiAvg.sNo. % of % of quite significantly in the Country (000's) Nrt annual Wo;kers eo n %oof of| manufacturing sector, but increased USA 6 2,1% 11 54% 31% in the service sector in inter-census EU-12 18,500 2,0% 7 72% 15% period 1984 -94. Overall, the MERCOSUR 5,700 2,9% 10 620% 12% numbers remain overwhelming. Chile 40 4,0% 1 0 80%/ 1 9%/ Argentina a/ 1,000 2,2% 10 69 - 79% 10% Given those numbers and the Uruguay 170 3 7% 67% 18% standard elasticities, productivity Brazil 4,050 3,0% I1 5 90/o 9Y. increases in SMEs would have a TOTAL 3020 2,2% 8 164% 1 90% Source: IAMC (I 999, p. vii) using data from Eurostat (UE); SBA (USA); CORFO major effect on economic activity (Chile); IMM (Uruguay) and IGBE (Brazil). and employment. That is the a/ net rate obtained by extrapolation between the 1994 and 1998 estimates. challenge. The geographical distribution of SMEs reflects the relative concentration of the population and economic activity in Argentina. The province of Buenos Aires, the Federal Capital, and the province of Santa Fe hold about two-thirds of all SMEs, while presenting a slightly higher share ofjobs created by SMEs. An interesting finding of the 1994 economic census is that the firm size distribution varies by geographical regions, with microenterprises being more active in less populated areas than SMEs and large firms. These differences in the geographical concentration of firms of all sizes reflect wide disparities in terms of business opportunities and linkages between large firms and SMEs and between SMEs and microenteprises. Overall, there are 29 SMEs per large firm in the country, compared to about 303 microenterprises per large firm. Another finding is that the workforce of SMEs also varies by geographical regions. Misiones and the Federal Capital SMEs have the largest contribution in terms of number of jobs. The SME sector is characterized, on average, by a lack of dynamism and low productivity, (mainly in the service sector), and low rates of entry and growth. Although superficially some of the SME sub-sectors, such as manufacturing, look healthy, a deeper examination reveals that SMEs face major problems, including difficulties to start-up and to grow. Most SMEs in Argentina are still struggling to adapt to competition in the global marketplace ushered by trade liberalization and the reduced state role in the economy. Despite their continued economic importance, a limited number of new SMEs enter the 5  marketplace and many more struggle to survive or die of attrition. Though the data is scarce, recent estimates by the Central Bank suggest that mortality rates reached 18 percent, about twice the birth rate during the 1990s. In many cases, SMEs focus on survival in the short-term rather than on repositioning for domestic, regional, and international competition. Hence, they are in a precarious position to integrate their activities into the global economy. Most SMEs are relatively older than micro and large firms, especially in the manufacturing sector. According to the 1999 INDEC survey of firms in the City of Buenos Aires, 42 percent of SMEs have been in business for at least 15 years, compared to 39 percent of large firms and to 30 percent of microenterprises (less than 5 workers). Furthermore, manufacturing SMEs are much older than SMEs in other economic sectors. Both the 1999 INDEC and the Uni6n Industrial Argentina (UIA) surveys illustrate this, with more than 40 percent of them operating for more than 30 years. There are indeed sectoral differences on SME performance. SMEs operate in a wide range of economic sectors, but their sectoral distribution presents substantial differences with respect to large and micro firms. For example, most SMEs operate in the service sector (44 percent), compared to microenterprises that work mostly in the commerce sub-sector (58 percent). Although SMEs in Argentina sell goods and services at the national and international levels, they have a limited scope of activities. SMEs concentrate their activities in local markets, purchasing and sales activities within the same locality and even within the same province, indicating a weak capacity to expand their geographical area of operation. Although SMEs are providers of goods and services to other businesses, many of which are large enterprises, the number of business clients is rather small. 2.2 SMEs in the City of Buenos Aires Using a 1999 survey of enterprises in the City of Buenos Aires, Table 2.2 presents indicators by firm size on the main characteristics of entrepreneurial activities. Businesses are divided into three subsectors. Service, which includes hotels and restaurants, transport, warehouse, real estate services, rental services, and business related services. The commerce sector includes retail and wholesale shops and the industry sector includes manufacturing enterprises. The main highlights are: * The dominance of the service sector in the City of Buenos Aires is consistent with the increasing percentage of GDP contributed by the service sector and with previous economic census data. In Argentina, the participation of the service sector has increased in the last two decades, reaching 67 percent of the GDP in 1999, up from 48 percent in 1989. According to the 1994 economic census, SMEs employed 62.6 percent of workers in the service sector, generated 61.7 percent of the aggregate value, and 63.2 percent of the gross productive value. * Although the service sector makes the largest contribution to both firm number and employment, it is clear that the commerce sector holds the greatest share of total income for firm with more than 5 workers. * The distribution of firm size varies by sector. Microenterprises (less than 10 workers) comprising most of the service and commerce sectors, and small firms (11-50 workers) accounting for the lion share in industry.5 * Industrial firms are substantially older than firms in the service and commerce sectors. About 60 percent of industrial firms have been in operations for at least 20 years. The youngest firms seem to be concentrated in the service sector. 5 Differences in economies of scale between operations in the industry sectors and other sectors may explain this finding. 6  * Service enterprises are the least likely to be stock corporations; this starkly contrasts with the industry sector, which has both the oldest firmns and the greatest proportion of limited companies among the three sectors. * Few industrial firms sell their goods in foreign markets. On average, about one in five industrial firms will export, but larger firms are more likely to export. * Labor regulations impose substantial costs for smaller firms, explaining their lower level of salaried workers. The reported non-wage expenses as a fraction of gross wages ranged between 57 percent and 36 percent for firms with less than 50 workers in the service and commerce sectors. These high rates may explain why the share of informal workers has soared for smaller firms as is shown below. Table 2.2 Characteristics of Argentine Enterprises in the City of Buenos Aires, 1999 Number of employees T_otal < 5 6 - 10 11 - 50 51-100 101-200 201-500 over 500 Service Market Share (lo in column category) Firms 63 90 62 50 42 60 81 88 Employment 62 90 63 51 44 61 84 88 ncome 34 77 48 33 19 26 39 48 Ceneral Characteristics /o firms 100 37 21 34 4 2 2 0 /o workers 100 5 7 32 11 10 23 13 /o income 100 14 9 52 9 5 7 3 /o age of firm with more than 20 years 20 15 15 26 33 22 19 29 /o limited companies 33 16 27 49 82 27 73 47 /osalariedworker 84 41 71 84 80 87 91 100 Gross wages/ total expenses (%) 21 6 13 18 28 35 40 37 Non-wage expenses / gross wages (%) 45 125 54 47 57 35 25 28 Commerce Market Share (%l in column category) irms 24 9 31 31 27 11 7 12 Employment 20 9 30 28 25 11 6 12 ncome 53 22 48 58 61 42 41 52 General Characteristics h firms 100 26 21 43 6 2 1 0 / workers 100 1 9 54 19 6 5 5 /oincome 100 3 6 59 19 5 5 2 age of firm with more than 20 years 29 6 24 34 33 29 39 60 A limited companies 62 49 42 71 93 87 83 100 A salaried worker 88 69 74 88 89 94 94 100 ross wages/ total expenses (%lo) 6 4 4 6 5 6 8 15 Non-wage expenses / gross wages (%/6) 29 32 40 28 36 27 30 11 ndustry tarke Share (/a in column category) Firms 13 1 7 20 32 29 12 n.a. Employment 18 2 7 20 31 28 10 n.a. ncome 12 0 4 10 20 33 20 n.a. General Characteristics % firms 100 2 12 66 14 5 I n.a. A workers 100 0 3 45 27 16 9 n.a. D income 100 0 2 42 27 18 10 n.a. %age of firm with more than 20 years 58 46 52 58 63 71 38 n.a. A limited companies 69 69 51 69 77 91 74 n.a. % salaried worker 94 79 86 93 94 97 99 n.a. ross wages/ total expenses (%/o) 21 6 13 18 28 35 40 n.a. on-wage expenses / gross wages (%) 26 65 27 30 19 17 13 n.a. Investment % firms that invested 57 44 21 55 85 92 100 n.a. nvestment outlays/total income (%) 3 11 2. 3 3 3 9 n.a. Export D firms that exported 19 - 7 18 28 44 56 n.a. exports/sales (%) 2 2 2 4 3 7 n.a. Source: Authors' calculation based on the 1999 survey of firms in the City of Buenos Aires carried out by INDEC. 7  2.3 SMEs are Different from Large Firms: Size Matters Argentine SMEs, like those in other countries, have special features of their own: their economic rationale is of a particular kind, their behavior is specific, and they are impacted quite differently by regulations and risk factors. Generally speaking, these firms are family businesses and their administration falls directly on the owners (often untrained) Thus, their management often relies on untrained individuals, and the owner's outlook (generational cultural factor) is especially important in deciding actions that determine a firm's evolutionary process. In fact, SMEs not only differ in regard to how effective they are at strategic planning, but may also even pursue goals which differ from profit maximization, such as market survival, maintaining their jobs and sources of income, or keeping up the family business tradition. For all these reasons, SMEs might need to be treated as economic agents, which are not merely "smaller-sized large ones." Table 2.3 and Table 2.4 illustrate some differences according to size. Of particular relevance in the comparison between SME and large firms, are factors that significantly impact their unit costs, interest rates and transaction and logistic cost, all significantly higher for SME. While differences are to be expected and should not be, in principle, a cause for intervention, components of those differences that are induced by market and government failures are. Table 2.3: Comparing Firms by Size in Argentina Concept Small Medium Large Organization Individual Owner S.A S.A. Avg. age 28 years 38 years 57 years % that sub-contract 4.5% 9.5% 52% Operate with bank Loans 76% 86% 98%- Avg. annual interest rates on 25% 23% 12% bank loans Informality (%of workers) 70% 32% 10% Transaction Costs (0/oof sales) 15% 7% 1% Logistic Costs (0/%of sales) 35% 26% 15% R&D investment 0.3% 1.5% 3.8% Technological support Customers and Providers Customers and Providers Providers and other sources Initial development based on: Previous experience Experience and access to new Access to new technology technology Source: FIEL (1996, 2001) and Bank Staff estimates. Labor market features also have a differential effect on SMEs. First, the heavily regulated structure of Argentina's labor market, again impacts adversely all types of firms but more so SMEs, mostly on the nature of costs spread over various scale levels as shown in Table 2.3, and also due to the lumpiness of some of those costs. For example non-wage costs reached 125 percent of gross wages for microenterprises in the service sector. Unemployment rates, another feature of labor markets, are substantially higher among small firms-the poverty impact angle. Small firms report four times larger unemployment rates than large firms, while medium firms report two times larger unemployment rates than large firms (Guasch, 2000). Additionally, as Figure 2.1 shows the underemployment rate of small and medium firms is over 50 percent while that of large firms is about 9 percent. Figure 2.2 displays unit costs by sector, showing their evolution through the 1990s. The service sector-mostly SMEs and non- tradables- shows its dismal performance, relative to other sectors. 8  Figure 2.1: Underemployment by Firm Size Figure 2.2: Unit Labor Cost (in constant pesos (Percentage) 1992=100)* 6D ---- ------ ------115 _ - _ 10~~~~~~~~~~~~~~~~~~~~~~~~~1 1~~~7o _ _ _ _ _ _ _ _ 7 E 0 - 105 7 40 - 1 S61 ' ) 2D unfmm E1 / +Cvus . 1 10 e 5 - . d s I h1 (1)EldbdbyMhtfi&&g Source: Guasch (2000). 2.4 Productivity in the Manufacturing Sector Productivity and usage of inputs differ significantly according to firm size. Again this is not surprising given differences on modes of production, scale effects and the myriad of costs with differential impact according to size. In any event, it does clearly impact the prospects for growth and development of SMEs. According to Fiel (1996), among manufacturing Firm Size (Totala100) firms, labor productivity for larger firms is 2 to 4 times higher than that of smaller firms both when firm size is measured by number of workers and - > . ,., gross production value (Table 2.5). In 1999, the .2. ,..,,manufacturing sector of the City of Buenos Aires o s_', _ ,_ napresents the same pattern (Figure 2.3). In terms of __i 9 1 !... I.X0 productivity of capital, Fiel (1996) presents the : - -.r;- _ r * 3 t- L same dramatic differences by size of firm (Table 2.6). Also Table 2.7 shows the working capital requirements according to size, illustrating the differential impact and costs. SMEs require a much higher proportion of working capital as a percentage of sales than larger firms, impacting unit costs and productivity. 9  Table 2.:' Average Productivity of Labor by Firm Size (Total Index = 100) Firm Size by Firm Size by Gross Employment PmeL PmeLH PMeLHC PmeL PmeLH PMeLHC Production Value Total 100.0 100.0 100.0 100.0 100.0 100.0 Total 1-5 65.2 59.9 . 64.3 45.5 37.3 40.8 Size 1 6-10 62.4 43.0 48.1 58.8 56.4 58.3 Size 2 11-50 68.1 81.6 85.4 79.8 104.1 110.7 Size 3 51-200 182.8 157.3 157.2 | 139.0 147.5 128.6 Size 4 201-500 119.0 128.6 112.2 101.6 193.8 186.6 Size 5 501+ 82.7 129.9 131.2 1630.0 878.3 912.1 Size6 PmeL = Average Productivity of Labor (defined as valued added per worker) PmeLH =Average Productivity of Labor (per hour worked) PMeLHC = Average productivity of work hour standardized by human capital Source: FIEL (1996, Table 12, p.152). Table 2.5: Average Productivity of Capital by Firm Size (Total Index = 100) Firm Size by Gross Production Firm Size by Employment Average Average Value Total 100.0 100.0 Total 1-5 36.2 31.8 Size I 6-10 53.2 79.6 Size 2 11-50 . 99.0 129.6 Size 3 51-200 148.6 199.9 Size 4 201-500 131.9 120.7 Size 5 501+ 77.1 71.3 Size 6 Source: FIEL (1996, Table 13, p. 152). Table 2.6: Working Capital (As a Percentage of Sales) Firm Size Standard Standard Firm Size Gross Employment Average Deviation Average Deviation Production Value Total 44.6 . 44.7 44.6 44.7 Total 1-5 45.1 27.4 54.4 36.6 Size I 6-10 52.7 32.5 47.0 36.8 Size2 11-50 50.2 41.5 45.2 64.5 Size 3 51-200 43.6 66.7 36.6 29.9 Size 4 201-500 30.9 . 27.1 28.0 23.4 Size 5 501+ 26.0 25.0 10.0 11.2 Size 6 Source: FIEL (1996, Table 16, p. 155) Regarding the capital labor ratio, as Table 2.7 shows, it increases with size of the firm, illustrating informality and the bias to use labor for capital in SMEs, again dissuading and delaying investments and the use of more effective technologies for product or process. Table 2.7: Capital-Labor Ratio According to In summary, the case has been made that SMEs are Size (Total Index = 100) characteristically and behaviorally different from Firm Size large firms and are impacted differently as well. by Gross Firm Size by Production That in itself need not be a reason for intervention. Employment Avg Avg. Value A closer look at the environment under which they Total 139.7 89.5