A review of constraints to small and medium enterprise financing : A review of constraints to SME financing

36756 CAMBODIA No. 1, November 2003 A REVIEW OF CONSTRAINTS TO SME FINANCING The owners of small and medium enterprises in Cambodia consider the lack of affordable long- term financing one of the greatest obstacles to their growth. MPDF investigated why banks and other financial institutions are reluctant to make long-term loans at affordable rates, and how to overcome this barrier to economic growth. We interviewed bank regulators, commercial lawyers, and 12 out of a total of 17 banks.1 With 92% of all Cambodian jobs created by the private sector, and the private sector comprised primarily of small and medium-sized enterprises (SMEs), most would agree that economic growth depends on SMEs.2 However, important as they are to the economy, SMEs face considerable obstacles that constrain their growth. One of the most frequently mentioned constraints is the lack of access to finance. The total loan portfolio for 11 out of the 12 banks3 that MPDF surveyed was US$190 million, representing only 5.9% of GDP.4 Although 85% of Figure 1: A comparison of lending to SMEs by term (weighted) this amount was lent to SMEs, very little of that was for long- term loans. As Figure 1 indicates, only a tiny fraction of loans made to SMEs are for more than two years. The issue here is not so much a shortage of banks available to make loans (although this is certainly an issue in some parts of the country), rather, it is that a variety of barriers discourage banks from Source: Harner, M. Stephen (2003) "Financing SMEs in Cambodia: Why Do Banks Find it so Difficult?" Mekong Private Sector Development Facility, p. 15. lending to SMEs, and in particular for lending long term. Barriers that result from the legal system Barriers related to the legal system include insufficient protection of lenders' interests under existing laws, the absence of relevant commercial laws, and lenders' lack of confidence in the judicial system. While the absence of The "Business Issues Bulletin" provides those relevant commercial laws and the complexity of existing interested in business issues with a short summary ones are causes for concern, how cases are handled by the and analysis of a particular topic affecting the courts contributes to mistrust of the judicial system. According business environment in Cambodia, and exposure to bank directors interviewed by MPDF, "justice is seen to to different opinions held by various stakeholders on the topic. be for sale to the highest bidder."5 This bulletin is published with support from the Mekong Private Sector Development Facility 1Harner, M. Stephen (2003). "Financing SMEs in Cambodia: Why Do Banks Find it so Difficult?" Phnom Penh: Mekong Private Sector Development Facility. (MPDF) , a multi-donor funded initiative managed 2Asia Development Bank's Private Sector Assessment Report, First draft, May by the International Finance Corporation (IFC), the 2003, Phnom Penh, p. 32 private-sector arm of the World Bank Group. 3Data from the state-owned Rural Development Bank is not included since it only performs on-lending of donor funds. The statements and opinions presented here are 4Total loan portfolio for the whole banking system was US$242.30 million, only meant to provide additional reference material representing only 7.5% of GDP. Nominal GDP in 2001 was US$3,234 million. Source: Sok Hach and Acharya, Sarthi (2002) "Cambodia's Annual Economic and do not reflect the official opinion of the Mekong Review-2002" Phnom Penh: Cambodia Development Resource Institute, p. 86. Private Sector Development Facility or IFC. 5Harner, M. Stephen (2003)  The Government is improving the banking The legislation that could encourage long-term system by: (1) encouraging competition lending relates to company law, commercial through re-licensing and re-capitalization of arbitration, bankruptcy law, a commercial court, banks, (2) helping to find cheap and stable contract law, and secured transaction law. The sources of funds, such as concessionary loans legislation concerning the first two are already at to the Rural Development Bank, and (3) the National Assembly, while the bankruptcy law is requiring banks to standardize their chart of still with the Council of Ministers. Regarding other accounts (how and when they report on their legislation on the list, we are still waiting for final accounts). modifications from legal experts. H.E. Dr. Sum Sanniseth, Secretary General of H.E. Mao Thora , Secretary General for the National Bank of Cambodia Technical Affairs, Ministry of Commerce Because they do not consider their interests well protected by the law and by the court system, banks are reluctant to lend to SMEs. And when they do lend, banks consider it necessary to charge high interest rates (see Figure 2). Banks are also unwilling to make the larger, and longer-term loans that SMEs need to finance expansion and the purchase of new equipment. The combination of the high cost of borrowing and the lack of long-term financing are serious constraints to SME growth in Cambodia. Barriers that result from SMEs and banks There are several other barriers besides those of the law and the court system. First, the poor quality of financial records maintained by many SMEs makes it impossible for banks to judge whether a company is credit-worthy. Second, few bank staff have extensive experience in assessing and managing risk. Third, banks lack the funds needed to make medium- and long-term loans. The lack of financing limits both my ability to increase investments in assets and my ability to increase production levels even when assets are increased. For example, some time ago I saw the potential for saving costs if I had a production plant close to corn farms in Sampov Loun in Battambang. However, I had to wait for two years before I could secure a loan of $300,000 to set up another factory in Sampov Loun. Now that I have a plant there, I still face financial difficulties because my working capital is not sufficient to buy all the corn available (60,000