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Small & medium sized enterprises: not a silver bullet for growth and job creation

Caroline Freund's picture
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Small and medium sized enterprises (SMEs) are being targeted as never before for their potential to stimulate growth and create jobs. Many of the development agencies (World Bank, EBRD, Islamic Development Bank, among others) have plans to expand programs for financing and supporting SMEs. Most recently at the World Economic Forum in Jordan, government officials from countries in the Middle East and North Africa, as well as from the US and EU, talked up their potential for creating jobs in the region. This would be good news if it was true, but a growing body of evidence suggests that SMEs are not the silver bullet that we had hoped for.

While small firms do create the most jobs, they also destroy the most jobs, and ultimately what matters for the labor force is net job creation. Studies using industrial surveys, which are the most rigorous, tend to find that net job growth comes from large firms and startups.  The most comprehensive work has been done on the United States, where researchers examine firms as opposed to establishments. Enterprise data may lead to size misclassifications; for example, think of McDonald’s where each restaurant is small but the firm is huge. Census data also includes information on entry and exit over time, which is not observable in subsamples of the universe of firms. Recent work on the United States shows that once firm age is controlled for there is no systematic relationship between firm size and job creation; employment creation is all about new and young firms. Using census data for Moroccan and Tunisian firms, we find similar results: startups and large firms account for the bulk of net job creation.

As shown in cross-country studies of Africa, Latin America, and the rest of the world, one reason SMEs are not the main net job creators is that they tend to be less productive than large enterprises and account for a smaller share of productivity growth. A sizable share of the productivity gap between developed and developing countries can thus be explained by the estimated 30 percent share of SMEs in economic activity in developed countries as compared with a 60 percent share for developing countries. Of special concern is that SMEs in developing countries tend to be exceptionally stagnant as compared with their developed country peers. A recent study estimates that the failure of small firms to grow into large firms lowers productivity growth in manufacturing by 25 percent in Mexico and India as compared with the US. 

It is not surprising startups and large firms are more productive and generate both jobs and growth. This is precisely what the theoretical literature on heterogeneous firms tells us. High-productivity firms will attract more resources and grow faster, and in equilibrium be relatively large. A few high-productivity startups will also grow fast and absorb labor. 

Promote Entry and Startups not SMEs

Economic development is about moving resources to their most productive uses.  Promoting entry and startups is therefore likely to make more sense than broad SME promotion schemes. As noted, young firms do account for a sizable share of net job creation and productivity growth.  In addition, the density of startups is a major source of growth. Regions with more startups relative to the working age population in Mexico, India and the US create more jobs and grow faster. Ensuring ease of entry to start a business and access to finance for entrepreneurs is therefore likely to prove more valuable than providing access to finance for mature SMEs.

Do SME Interventions Really Work?

Even if SMEs were found to promote job creation or growth, there would still be the issue of whether programs designed to promote SMEs are effective. Do SME financing, training, or logistics interventions facilitate the creation of jobs and faster growth? And if so, which programs are most effective? 

Unfortunately, there has been no randomized experiment that I am aware of that evaluates whether efforts to promote SMEs lead to improved employment or productivity outcomes.  There have been a number of ex-post attempts to measure whether SME programs work, especially in Latin America, but selection bias haunts these studies. In particular, more productive firms are likely to apply for and receive financing or training, so better performance of the so-called treatment group as compared with a similar control group could be a result of selection. Somewhat surprisingly given this bias towards a positive impact, these studies do not offer an unambiguously strong role for SME promotion, highlighting a need for caution going forward. For example, a study of Chile that examines different types of programs finds no evidence that credit programs alone are successful at promoting employment, productivity, or wages. Only interventions that encourage upgrading or better logistics help firms. A study of Mexican SMEs finds that the implementing agency matters-programs under the Ministry of Science and Technology have positive effects, but programs under the Labor Ministry lead to lower output, sales and exports. This perverse outcome suggests the possibility of capture in poorly designed programs. Thus, choosing interventions and designing programs carefully is critical to ensure against negative results.

If the trend toward SME targeting is to continue, we need a better understanding of the effectiveness of various programs in their stated goals. Assuming SMEs are especially dynamic, leading to the private sector to finance them, SME interventions may be unnecessary. There would need to be a distortion or an externality that the intervention addresses for it to be warranted.  In this case, identifying the distortion is key to designing the appropriate program. A carefully designed randomized experiment on SME interventions and entrepreneurship initiatives should be implemented to ensure that the millions of dollars flowing into this channel are well spent and high expectations not dashed.  

Comments

Submitted by Theodore H. Moran on

Dr. Caroline Freund does a valuable service by introducing the pioneering work of John Haltiwanger and others into developing country policy debates about whether small firms should be singled out for support. The evidence she accumulates shows that larger firms and some start-ups that turn out to be exceptionally successful account for most net job creation, not small businesses in general.

An important extension of this analysis applies to developing country programs to create backward linkages from foreign investors into the host economy. Foreign investors have a self-interest in identifying and helping local suppliers to become low-cost high-quality suppliers. Survey data show the foreigners providing design specifications, help with production engineering, recommendations for equipment purchases, quality control procedures, and advance financing to indigenous firms. The recipients may become certified as OEM suppliers to the entire industry, a vertical externality. Sometimes the foreign investors introduce them to sister affiliates in the region, helping them to become independent participants in international markets, an export externality.

But developing country authorities frequently confound supply-chain creation with support for SMEs. So do CSR advocates, including corporate social responsibility officers within the MNCs themselves. A close look at case studies of supplier-development programs and vendor-development programs does not support the proposition that small firms should be the preferred targets for host country match-makers or MNC talent-scouts. Despite its title, the evidence in UNCTAD’s How to Create and Benefit from FDI-SME Linkages: Lessons from Malaysia and Singapore (Best Practices in Investment for Development series, 2011), for example, shows that medium-sized and larger indigenous companies “are more likely than their smaller counterparts to possess capabilities needed for linkages that result in ‘win-win’ scenarios.” Host countries will be most successful in generating backward linkages from foreign investors to indigenous firms if they do not let supplier-support programs be captured by small-business lobbies.

Theodore H. Moran

Marcus Wallenberg Professor of International Business and Finance

Georgetown University

Submitted by RAOELIJAONA Adrien Roger on

While small enterprises do indeed create the most jobs, they are also the ones that cut jobs the most.” This is true if the business climate is not conducive to the sound development and rapid expansion of small enterprises. In other words, if we want SMEs to be the solution to growth and job creation problems, then an environment conducive to the creation and development of these enterprises must be fostered. (Comment originally posted in French)

Submitted by Caroline Freund on
Indeed, the business environment is key. In many MENA countries, because of high taxes, excessive regulations, and unequal application of the law, the business environment is not conducive to firm growth. As a result, improving the business climate is likely to have a far greater effect on jobs and growth than improving access to finance for SMEs. My concern is that many of the measures to promote SMEs are focused on finance provision, which will have little impact if the business climate remains weak. If firms remain small to avoid excessive regulation, taxes, or associated corruption, this is the main distortion that needs to be addressed.

Still, even in countries with relatively good business environments, it is also the case that SMEs account for a large share of job destruction. This is part of the process of creative destruction where high productivity firms grow to be large and low productivity firms exit. It also explains why age tends to be more important than size. Good firms grow, and they grow fast. This means there are very few small old firms poised for high growth.

Submitted by Anonymous on
I realize that no one has thus far discussed how the party-statals (enterprises owned by the ruling party, state, military and the business elite) dominate the formal enterprise sector... I do not call it private sector because these enterprises are not private. They are not state-owned enterprsies but the agents of party-state capitalism. They do not only drain the state's coffers through their inefficiencies and the state and private banks through loans but also impede on the growth of SMEs. Unless the donors confront those governments and demand transparency and full disclosure and force them to reduce the share of party-statals' economic weight, no effort to grow the SMEs will work. These party-statals are just like the state-owned enterprises of another era need to be confronted directly dn with no intemediation... I propose that you do start first with Ethiopia and Rwanda to make this transformation happen.

Submitted by Caroline Freund on

SOEs are problematic if they absorb resources that could be better spent and do not produce a public good. In addition to budgetary costs, they can be problematic if they are profitable, but keep private firms from entering or expanding in a market. In this case, just then like regulations, they are preventing growth of new innovative firms. Of vital importance for job creation is market contestability.

Submitted by Duncan Campbell on
My compliments to Caroline Freund on very insightful piece. The author notes the disparity in productivity levels between small and large firms as one of the reasons why small firms either fail or do not grow, and consequently why they cannot be relied upon for net job creation. Just an anecdotal point in confirmation. I am working with two small firms in an LDC, and, among a long list of other constraints, the owners tell me that two, in particular, are onerous -- both have to do with exogenous barriers to productivity growth. The first is rather classic -- access to credit is still an enormous obstacle for small firms that have neither a track record nor collateral to put up as a loan guarantee. A loan would therefore have to be made on the basis of a "non-equity-collateralized promise" and little more (as well as other factors impeding lending to small firms, relating to information and transaction costs). This results in downward pressure on output, the numerator in productivity.

The second constraint is abysmal infrastructure, such as power, transportation -- and discrimination in regulatory and market access.

Both of these factors are exogenous constraints on increasing productivity. Both are overcome by larger firms, which in both over-the-table and under-the-table ways have access to credit, and often create their own infrastructure (such as power generation). In short, the hassle factor in doing business is regressive, disproportionately affecting small firms.

Duncan Campbell
Director for Policy Planning in Employment
International Labour Organization

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