dd ee zz riri oo hh utut AA e e rr uu ss March 2003 oo clcl ss DiDi c c OECD Development Centre blibli uu PP dd ee zz oriori hh utut “Financing small, medium and micro enterprises in post-conflict situations AA e e rr uu Microfinance opportunities in the Democratic Republic of the Congo” ss oo clcl ss DiDi c c blibli uu PP by Nuno Santos dd ee zz riri oo hh utut AA e e rr uu ss oo clcl ss DiDi c c blibli uu PP dd ee zz riri oo hh utut AA e e rr uu ss oo clcl ss Discussion Paper produced for the seminar “Public Private Partnership for the Development DiDi c c of the Democratic Republic of the Congo” to be held in Kinshasa on April 7, 2003. blibli uu PP Contents Summary……………………………………………………………………………………………….………p 3 1. Introduction……………………………………………………………………………………………….p 5 2. The importance of small medium and micro enterprises (SMME) in post-conflict situations………p 7 2.1 The role of SMMEs in African economies 2.2 SMMEs as policy priority in post-conflict situations 3. Financing: a cap on SMME development……………………………………………………………….p 11 3.1 Market failure in financing SMMEs………………………………………………………………..…p 11 3.2 The need for capacity building in post-conflict……………………………………………………….p 13 4. Microfinance in post-conflict situations………………………………………………………………....p 15 4.1 Overview of microfinance 4.2 Microfinance technology 4.3 Current challenges in microfinance 4.4 Microfinance impact 4.5 The post-conflict situation: additional challenges 5. Topics in setting up a strategy for microfinance in PCS…………………………………………….....p 30 5.1 Relief and development: when to intervene? 5.2 Type of intervention: selecting clients, products and technology 5.3 Regulation: weighting cost and benefits 5.4 Donor coordination 6. Opportunities in the DR Congo’s context……………………………………………………………….p 44 6.1 Overview of the economic and political situation 6.2 Main obstacles to SMME development 6.3 Financing SMMEs 6.4 Opportunities in the development of microfinance 7. References………………………………………………………………………………………………...p 62 2 Summary This paper was produced as part of the OECD Development Centre’s project “Public Private Partnership for the development of the Democratic Republic of the Congo (PPP DRC)”. The document hopes to provide useful discussion topics on the subject of financing small, medium and microenterprises (SMME) in a post-conflict situation (PCS) through microfinance initiatives. Such discussion tools are intended to help promote a constructive dialogue on this issue among public and private sector representatives in the DRC, as well as international organisations and civil society members1. The document underlines the importance of SMME’s in African economies and argues that they should be given particular attention in a post-conflict scenario when national reconciliation and peace consolidation are at the center of policy-making. SMMEs play an important role in poverty alleviation and reducing vulnerability of poor households, potentially providing a quick response to the need of jump-starting the post-conflict economy. Financing is one of the most important obstacles facing SMMEs in developing countries and the document discusses the particular difficulties to be found in post-conflict. It also highlights the fact that in PCS, financing is usually not sufficient to support the development of SMMEs as there is a strong need for capacity building. As a possible solution to the financing needs of SMMEs in post- conflict, the paper focuses on microfinance, giving a brief overview of the sector and its lending technologies, which include peer selection and monitoring, dynamic incentives and collateral substitutes. Economic agents face substantial challenges in PCS such as political uncertainty, macro- economic instability, disrespect for the rule of law, rapid growth of the informal sector and depleted human and physical infra-structure. Microfinance operators are negatively impacted by this adverse business climate, but also face additional challenges, which reduce the efficiency of several of their specific lending methodologies. Such factor are population movements, disruption in social capital, lack of collateral and donor induced distortions. Bearing in mind the context for microfinance in PCS and that there is no unique solution to the development of financial institutions, the paper introduces some general discussion topics for designing a strategy for microfinance drawn from experiences of other conflict affected countries. It suggests a greater coordination of relief and development efforts in deciding when to introduce microfinance operations in PCS and that microfinance is not always successful, especially with the severly destitute. On the business model of MFIs in PCS, experience shows broad client targeting works best and that technical assistance should be contemplated. Successful MFIs often adopt business 1 The Monterrey Consensus adopted in March 2002 by the UN Conference on Financing for Development recognises in its paragraph 24 that knowledge broadening PPPs are important tools for building business enabling environments. 3 like approaches with strong marketing orientations to signal intentions and products. They also pay close attention to the development of human resources and creating performance incentives for its personnel. Coordination of donor efforts is seen as major success factor in developing a sustainable MFI sector due to their fundamental role in financing microfinance projects. Some of the major problems identified in respect to donor coordination are the confusion created between grants and credit, giving continous support to inneficient operations and promoting just temporary credit programmes with no exit strategy. The paper gives an overview of the current economic and political situation in the DRC and the enormous challenges faced by the government, private sector and international organisations. The DRC is now one of the poorest in the world following a long lasting war and deep economic mismanagement. According to The World Bank, around 80% of its 52 million inhabitants survive with less than US$ 0.2 per day and some estimated 16 million are estimated to be starving or malnourished. There is, however, some positive developments with the Joseph Kabila administration managing to gather international support for the country’s reconstruction and accomplishing major steps into a political solution to start the process of national reconciliation. Unsurprisingly, the country’s financial sector is at this stage unable to provide support to the DRC’s private sector development and much less to SMMEs. Besides the need for a deep restructuring of the financial sector, which should take time, it is also necessary to contribute to the development of strong MFIs capable of providing financing to small scale entrepreneurs. Based on a short analysis of the DRC’s situation, several opportunities are identified in this context. There is a strong case for a regional coordinated approach to the development of MFIs, exploring “islands of stability” where conditions for microfinance are closer to optimal and avoiding those areas where emergency grants and other safety nets are more appropriate. Since technical assistance to micro-entrepreneurs is identified as a major success factor, partnerships between public and private sector players or including donors are an opportunity for sharing costs in providing training and simultaneously separate pure financial services from “social services”, increasing visibility of each MFIs performance. In promoting an enabling environment for microfinance in the DRC, local MFI associations and donors may promote the use of ratings and attract international microfinance specialists. Finally, on donor coordination, it is important that international aid organisations communicate well among themselves eventually setting common standards for microfinance development and that they leverage on the existing MFI associations already operating in the country for better project coordination. 4 1. Introduction Following peace agreements with its neighbour countries and the start of the reunification process, known as the inter-congolese dialogue, the DRC is currently facing major challenges, as it is starting its transition to development. The country has suffered enormously from conflict and economic mismanagement and, despite its well-known natural resources potential it is currently one of the poorest in the world with its 52 million inhabitants living on an average of less than US$ 0.2 per day. The process of reconstruction of the country has already started through close cooperation with the World Bank and the IMF, as well as other bilateral and multilateral donors. During the two years of President Joseph Kabila’s administration results have been quite encouraging with the DRC starting many economic reforms, putting a halt to hyper-inflation and managing to gather increasing international support. Post-conflict situations always present a big challenge to local governments and international institutions taking up the different, but inter-related tasks of consolidating peace and economic reconstruction. An extensive literature has analysed different cases of difficult transition of post- conflict countries and the need of giving priority to peace keeping in any development strategy. Peace keeping is to a large extent a question of raising rapidly the living standards of the post-conflict society. It means a successful re-integration of displaced people, demobilisation of military men and restoring confidence of other war-affected populations. This discussion paper discusses the role of small medium and micro enterprises (SMMEs) in a successful post-conflict transition, as a bottom-up development tool and a way to reinforce the success of post-conflict transition. It then focuses on financing, which is one of the main obstacles to SMME development. In the DRC situation today, credit activity is extremely low, as the formal banking sector has been substantially downsized. Traditional SMME lenders in the country such as the COOPEC (credit and savings cooperatives) suffered from plundering and monetary reforms and are still in a difficult situation to be able to provide adequate financing. The discussion paper is organized as follows. The first chapter gives a broad view of the importance of SMMEs in post-conflict situations and the second chapter focuses on financing as one of the main obstacles to SMME development. The third chapter introduces microfinance and analyses how some of the main components of its lending technology are impacted by the specific environment of PCS. In the fourth chapter some topics on developing the microfinance sector in a PCS are introduced. Finally the last chapter of the paper looks at specific case of the DRC and suggests opportunities for the development of microfinance. 5 2. The importance of SMMEs in post-conflict situations In developed countries, great attention has been given to creating an enabling environment for promoting small, medium and micro-enterprises. In June 2000, the OECD issued the “Bologna Charta on SME policies” (OECD, 2000), in which governments from OECD member countries and invited non-member states recognised the importance of the SME sector and recommended policy orientations conducive to SME growth. Policy orientations have been backed by research work highlighting some of SMMEs appealing characteristics such as being more labour-intensive than larger corporations and thus more capable of employment creation. Some studies suggest that SMME’s create more value added per unit of capital and thus generate both more employment and output for a given investment (Haggblade, Liedholm and Mead 1990; Steel and Takagi 1983). 2.1 The role of SMMEs in African economies The development of small and medium sized companies has often been regarded as a “missing link” in development strategies of African countries, as several import-substitution policies have favoured large corporations at the expense of SMMEs1. Several arguments have been given for putting SMMEs at the centre of development strategies. The main reason lies on the simple observation that they constitute the largest portion of employment in developing countries (especially the micro-enterprise segment). It is, however, somewhat difficult to assess the weight of SMMEs in the developing world’s economies. This is mainly the result of lack of statistical data and research on industrial structures in developing countries, but also of problems associated to including the informal sector2. However, SMMEs are normally considered to employ a significant part of the working population in developing countries. Liedholm (2001) review of national surveys conducted in several African countries3 estimates that between 17% to 27% of the working age population is employed in micro and small enterprises, being nearly twice the employment of large scale enterprises and the public sector. USAID considers that microenterprises often employ a third or more of the labour force in low income countries4. In Uganda, a survey of small and medium enterprises commissioned by USAID in 1995 established that 22% of all households in the country engage in some sort of small business activity and that these activities employ around 29% of the country’s labour force. In Kenya, for example, 1 Parker et al. (1995) p.18 describe some of the regulatory and policy constraints impacting SMMEs in Africa. 2 Liedholm (2001) examination of surveys of micro and small enterprises conducted in Africa and Latin America reports that “a key finding from the house-to-house baseline surveys is that the micro and small enterprise sector is far larger than is reported in most official statistics, which often cover only registered firms”. 3 The countries surveyed are Botswana, Kenya, Lesotho, Malawi, Swaziland, Zimbabwe and South Africa. 4 USAID’s Office for Micro-enterprise development defines micro-enterprises as very small, informally organised, non- agricultural businesses. 6 Mullei & Bokea (1999) indicate that the SMME sector employs around 2.3 million people and generates around 14% of the country’s GDP. Besides the relative weight of SMMEs in total employment, other reasons have been suggested to justify policy-makers giving special attention to the SMME sector. The main arguments given are usually related to SMMEs labour-intensiveness. Some of the available empirical evidence shows, however, that labour intensity is more related to industry types rather than firm size (Snodgrass and Biggs 1996), which in developing countries (due to the particular industry mix) translates into SMMEs being more labour-intensive than large corporations. Labour-intensity results into a lower capital cost being associated to job creation and therefore SMME’s are associated with higher employment generation. In addition, SMME’s “labour-intensiveness” is also responsible for SMME’s being closely linked to “labour force supply-driven” survival strategies1, most common during recessions, natural disasters, conflict and post-conflict situations. Another factor is that SMMEs are more able to succeed in smaller urban and in rural areas. This is mainly the result of SMMEs having less need of capital and support infrastructure, when compared with larger firms. The regional reach of SMMEs is a critical factor for African countries where agriculture represents up to 46% of GDP and where it employs on average 72% of the economically active male population and 85% of the female population2. SMMEs are therefore responsible for a more even income distribution and also play a very important role in stopping migration flows from rural areas to cities. SMMEs are also seen to be more able to leverage on and expand local capacities. As opposed to larger companies, which usually import know-how from developed countries. Moreover, they are also often recognised as being a breeding place for entrepreneurs. Finally, SMMEs are considered to be more flexible in adapting to client requirements, being known for their ability to adapt quickly to market trends, as most of the operating costs are variable. 2.2 SMMEs as policy priority in post-conflict situations Post-conflict situations are characterised by partially destroyed economies with human capital and infrastructure being depleted, institutions not functioning well or at all and a high level of dependency on foreign aid. 1 Liedholm (2001) finds evidence that in periods of economic decline, employment growth was more linked to net firm creation then expansion of new firms. In periods of recession several of these new firms are just one-person enterprises. 2 1990 data for Sub-saharan Africa excluding South Africa and Nigeria: World Bank African development statistics 2000. 7 A deep discussion on post-conflict transition is, of course, outside the scope of this paper, namely the triple transition usually analysed (from conflict to peace, from exclusion to national reconciliation and finally from economic mismanagement to quality economic growth)1. However, it is important to highlight the fact that post-conflict situations are characterised by a great challenge to local policy makers and international organisations: the one of simultaneously starting the heavy work of reconstruction while achieving the consolidation of peace. These tasks are usually inter-related as the re-establishment of a stable economic environment conducive to growth is normally needed to secure peace as returnees, refugees, internally displaced persons, the inhabitants and former soldiers have to be re-integrated into the post-conflict society. The success of post-conflict transitions requires a very efficient co-operation between international organisations and local governments, especially regarding the tasks that are assigned to each counterpart during transition. In post-conflict situations, the emergence of SMMEs is, to a large extent, the natural result of excess labour supply from re-integration of war-affected populations, an increasing fragmentation of the private sector due to economic decline and structural adjustment measures taken by governments as they start rebuilding the economy. Moreover, it is a consequence of the lack of social and physical infrastructure, as well as insecurity and political instability, which do create an enabling environment to attract large investments. The SMME sector is therefore the emerging private sector in the post- conflict regions and its development has a positive impact on the post-conflict situation, as it can help support the “political priority”, i.e. peace consolidation. Small sized and micro-enterprises can have a key role in jump-starting economic activity following conflict, as they need much less requirements to start operations and are also on average less dependent of political and physical infra-structure. The main arguments supporting a leading role for SMMEs in post-conflict situations are the following: (cid:1) SMME’s contribution to new employment generation. The fact that SMMEs are seen as more efficient in employment generation and short-term poverty alleviation (often being a result of supply-driven survival strategies) makes them a preferred vehicle for improving living conditions of the poor and therefore contributing to reducing the probability of new conflict. Measures aimed at providing even just temporary employment could have a very positive impact on the social environment while longer term development strategies, which need a higher infrastructure level take time to be implemented. (cid:1) Social impact of SMMEs through greater income distribution. In a post-conflict situation, there is often the need to disregard equity principles in order to maintain peace (for example through entitling the conflicting parties to some of the country’s wealth)2. This can lead to more 1 For a discussion on the challenges of post-conflict reconstruction (in particular the case-studies of El Salvador, Kosovo, East Timor and Democratic Republic of Congo) see del Castillo, 2001 and 2002 2 An example of such a situation was the post-conflict re-integration strategy for Mozambique’s war-affected population. The bulk of re-integration benefits was awarded to demobilized soldiers, while refugees and the dislocated (by far the largest groups) just received very little assistance (mainly in the form of emergency relief supplies such as food). 8 dramatic economic situations for the poor and vulnerable. Development of SMMEs in poverty affected areas can lead to reduce the negative impact of such post-conflict policies. (cid:1) Strong support to re-integration efforts of the existing military. A key issue in preventing a new conflict situation is a successful re-integration of refugees, returnees and military men. SMME promotion strategies can be useful in re-integration efforts, as they open new opportunities to this group of conflict-affected people. In particular, SMME targeted strategies including technical assistance and working capital finance can have a positive effect on achieving sustainability of the numerous micro-enterprises created with donor funds channelled to the demobilised. (cid:1) Role in mitigating negative impact of restructuring of state-owned companies. Post conflict economic policy is often directed towards rehabilitation and privatisation of state-owned companies. The process of restructuring state-owned companies can have an important social impact and lead to political de-stabilisation due to massive lay-off schemes (in Mozambique, for example trade unions and the local press refer to around 100,000 workers having lost their jobs since structural adjustment and privatisation). SMME development strategies may help incorporate a large number of these workers through adequate training and financial aid. 9 3. Financing: a cap on SMME development SMME development is constrained by a certain number of factors such as: input availability (financing, labour, technology), regulatory constraints (high start-up costs such as licensing and registration, costs associated to settling legal claims), managerial constraints (lack of entrepreneurial and business management skills) and institutional under-development (SMMEs are often not capable of defending their collective interests due to lack of representation). In post-conflict situations, the amount of restrictions to SMME development is even higher due to the difficult overall socio- economic environment. Among the large number of problems commonly associated with SMME development, financing is often mentioned as a key issue. Parker et al. (1995) in their review of surveys on small and micro enterprises in Africa observe credit constraints relative to working capital and raw materials being cited by micro and small-scale enterprises as one of their major problems (between 24% and 52% of respondents in Malawi, Mali and Ghana). The same World Bank document reports that micro and small enterprises considered access to credit and its cost as the main constraint to new investments1. In a survey of literature and based on interviews of representatives of SMME promotion institutions, Erastus-Sacharia et al. (1999) concluded that lack of financial services was one of the main obstacles on SMME growth in Namibia. In South Africa, a 1999 World Bank survey of SMMEs in the Greater Johannesburg area2 showed that interest rates and credit access were considered as the most important conditions for employee expansion following growth in demand. 3.1 Market failure in financing SMMEs Corporations finance their investments (initial and for further growth) through internal financing (retained earnings) and external finance (equity and debt). Despite the preference for internal finance in funding most investments (pecking order of financing choices), there is usually a stage at which external finance is inevitable to sustain growth. The financial sector through institutional investors, banks and other financial institutions, play therefore a central role in the development of the private sector. The argument of a market failure in financing SMMEs is usually based on the fact that they are the victims of adverse selection resulting from information asymmetry. Credit rationing results from the 1 Access to credit was quoted as a major problem by more than 90% of the sample in Senegal, 81% in Ghana, 65% in Malawi and 76% in Mali. 2 The survey included 792 formal firms across 4 manufacturing sectors and 4 service sectors. 10