SME defined by SBP as an entity having less than 250 employees and Rs. 300 million revenues. SMEs account for a substantial part of the economy; there are about 3.2 million enterprises in Pakistan, of which about 3 million (93%) are SMEs. SMEs spread across the economy with varying density: see exhibit 1-A for the sector wise division of SME sector. According to a survey conducted by SMEDA, this sector contributes more than 30% to GDP and 25% to the country’s total export earnings, and employs close to 70% of the labor force in the manufacturing industry, services, and trade. Their share in manufacturing value addition is estimated to be around 35%. Small & medium businesses play a very critical role when economies are transiting from low to middle income levels yet Pakistan has paid less attention to the growth and development of this crucial pillar of economy. Our report mainly focuses on the financial constraint to growth of this sector.
Capital requirements:
According to SMEDA there’re 800,000 SMEs in Pakistan that are eligible for bank loans. Another 2.4 million potential businesses that can’t qualify for bank loans mainly rely on other sources of finance for their business needs. Approximately 89% of working capital and 75% of fixed investments are financed from retained earnings. (See exhibit 1-B) Remaining financing needs are fulfilled from external sources which include family and friends, bank loans and other small sources as depicted in exhibit 2-A.
Despite the importance of SMEs in the economy, as of December 2007 fewer than 200,000 borrow from the banking sector and SME lending volumes (that is, loans of up to Rs 75 million) account only for 16% of total credit. ADB survey results show that that there is a particularly acute financing gap for loan sizes between Rs 100,000 (the maximum loan size that microfinance institutions (MFIs) can offer) and Rs 5 million (the loan size range required mainly by small businesses).
SMEs access to Finance:
Despite the increase in credit provided by banks to private sector and SMEs, access to financial services remained quite low. The banking sector, having predominant share of the financial system, is mostly focused on large enterprise lending neglecting SMEs due to various reasons. SMEs, which are mostly family owned businesses in Pakistan, remain outside the formal financial system and rely majorly on informal credit market for working capital finance. Exhibit 2-B shows a cross-country comparison of access to financial services.
14% of Pakistanis are using a financial product or service of a formal financial institution (including savings, credit, insurance, payments). If informal financial access is taken into account, this number rises to 50.5%. The remaining 49.5% remains excluded from the formal and informal financial system. About 19% have voluntarily excluded themselves due to lack of understanding, complex loan procedure or various other reasons. See exhibit 3-A.
Financial access is extremely important to generate economic growth which in turn helps address issues like unemployment, income disparities and social dependence. However, due to low awareness and limited information about market and instruments, access to finance remains low.
Reasons of restricted financial access
SME’s access to finance reflects the Pecking order theory of financial choices: the asymmetric flow of information between investors and entrepreneurs inclines SMEs to first finance investments through internal funds, then through debt and finally through outside equity.
Supply Side issues
Private Banks are the leading lenders in the SME finance market with 5 banks providing a major chunk of financial services. See exhibit 3-B for a complete overview. Due to global economic crisis, banks have adopted a cautious approach in lending to the SME sector since it is considered a risky sector of an economy. Excessive government borrowings for commodity operations financing is also a major reason of lesser availability of finance for the SMEs.
 Risk aversion of Banks: Pakistani banks emphasize security, especially immovable collateral (97.8%), audited financial statements, and business plans, rather than doing first-hand research on cash flows and business performance. This makes it more difficult for financial institutions to extend loans to SMEs, which usually have poor track record and weak financial systems; they don’t prepare accounting statements or manage to get audit reports, which keep banks dubious of their investment returns. What aggravates the matter is the poorly enforced creditors’ rights in Pakistan that cause delays in collateral recovery that can take 8- 24 months. In order to cope up with the default risk, banks ask for valuable, immovable collateral which in turn defeats the purpose of ‘borrowing’ of SMEs at all. The cost of borrowing has also increased for banks because of large nonperforming loan portfolio, which rose to Rs. 101billion by the end of March, high overheads and the imposition of advance income taxes. High risk free returns offered by national saving schemes also raised cost of borrowing for banks and other institutes.
To remove this barrier for SMEs, SBP introduced a regulation in 2004 allowing uncollateralized lending for loans up to Rs 3 million and without financial statements for loans up to Rs 10 million. Despite the new legality of this lending, the lending practice is proving to be too risky for conservative Pakistani banks. Currently SME financing is focused on merely few cities of Pakistan see Exhibit 4-A.
 Lack of technical evaluation: Pakistani SMEs have little or no credit history which makes financial institutions more hesitant to lend to this segment. Banks primarily evaluate loans on collaterals and not on cash flows. Also the cost of verifying the credentials of borrowers becomes a large percentage of the total cost which makes it uneconomical for banks to lend to SMEs. To tackle this problem SBP has established CIB that keeps records of all the credit histories of businesses and the assets they use as collaterals. With the implementation of e-CIB and two privately owned credit bureaus, credit history is now readily available. Still the coverage remains restricted to only 10-20% of the borrowers and very few SMEs. SBP now requires all banks to report loans of less than Rs. 75 million on quarterly basis, which makes reporting more complex and might discourage banks to not lend at all.