Future Improvements

Attempts to link crises in the SMEs to financial sector reforms have been met with a number of controversies. It is quite easy to enumerate reform measures and instances of crises in the system, but a lot of caution is required here in establishing causality.

Sundararajan and Balino (1991) identified several ways by which financial reforms could increase the fragility of both financial and non-financial firms. These include:

a. The relaxed freedom of entry into the financial sector and freedom to bid for funds through interest rates and new instruments, which could lead to excessive risk-taking.

b. Changes in the institutional structure of the banking system that emerge during reforms, which could lead to concentration of power in banking, and interlocking ownership and lending patterns.

c. Excessive increases in interest rates arising from sharp increases in credit demand because of high business expectations and unsound liability structures – distress borrowing results and end result is financial crisis.

d. Inadequacy of instruments of monetary control or insensitivity to the need for the control of interest rates during deregulation.

e. Instability in the credit markets during deregulation, arising from inelastic demand for credit or credit rationing.

f. Excessive reliance on economic rather than prudential regulations, which should focus on bank solvency and credit risk.

g. Mismatch of investments – the deregulation of interest rates could affect financial institutions that have a large exposure to long-term assets funded by short-term liabilities, which carry fixed interest rates (Ikhide and Alawode 2001).

There is no doubt that the prior existence of an unstable macroeconomic environment and weaknesses in the industrial policy could have existed prior to the operation of these channels during reforms, but the manner of the implementation of the reform may facilitate the occurrence of any of the listed events, leading to industrial crisis.

The significance of finance in the drive for economic growth is fairly well established and generally accepted. Nnanna (2001) observed that the take-off and efficient performance of any industrial enterprise, be it small or large , will require the provision of funds for its capitalization, working capital and rehabilitation needs as well as for the creation of new investments. Apart from the entrepreneur, funds are required to bring together the other factors of production together before production can take place. Provision of funds to the industrial sector, particularly, for the SMEs has been of critical interest to policy makers in both the private and public sectors.

The role of finance has been viewed as a critical element for the development of small and medium-sized enterprises. Previous studies have highlighted the limited access to financial resources available to smaller enterprises compared to large organizations and the consequences for their growth and development (Levy, 1993). Typically, smaller enterprises face higher transactions cost than large enterprises in obtaining credit (Saito and Villenuella, 1981). Poor management and accounting practices have hampered the ability of small enterprises to raise finance. Information asymmetries with lending to small-scale borrowers have restricted the flow of finance to smaller enterprises.

Stiglitz and Weis (1981) observed that small and medium scale firms with opportunities to invest in positive net present projects may be blocked from doing so because of adverse selection and moral hazard problems. Adverse selection problems arise when potential providers of external finance cannot readily verify whether the firms have access to quality projects. Moral hazard problems are associated with the possibility of SMEs diverting funds made available to them to fund alternative projects or develop the propensity to take excessive risk due to some pervasive incentive structure in the system.

Steel and Webster (1992) observed that high transaction cost, risks associated with small loans, lack of collateral and a historical orientation towards larger enterprises continue to restrict small scale enterprises access

to formal credit. The manufacturing sector is acknowledged to have huge potentials for employment generation and wealth creation in any economy, yet in Nigeria, the sector has stagnated and remains relatively small in terms of its contribution to gross domestic product (GDP) or to gainful employment. To worsen the situation, SMEs in Nigeria do not have access to public capital markets; they naturally depend on banks for funding. Dependence on banks makes them more vulnerable for the simple reason that shocks in the banking system can have significant impact on the supply of credit to SMEs. Thus, SMEs are subject to funding problems in normal times and these problems are exacerbated during periods of financial instability.

Berger and Udell (2001), notes that shocks to the economic environment in which both banks and SMEs exist can significantly affect the willingness and capability of banks to lend to small and medium scale enterprises. These shocks according to them come in variety of forms such as technological innovation, regulatory regime shift in competitive conditions and changes in the macroeconomic environment. However, financial institutions respond to these shocks in a number of ways, one way is to develop stringent lending rules that not only avail them of full information about the firm and the owner, but also to also ensure that their investment in such firms are guaranteed in both the short and long term. They further noted that while the importance of the industrial sector in modern economies is universally accepted, the developing countries have since the 1970s shown greater interest in the promotion of the growth of small and medium scale enterprises SMEs for three main reasons:

a. The failure of past industrial policies, which were anchored on the establishment of large firms to generate efficient self-sustaining growth.

b. Increased emphasis on self-reliant approach to development, and

c. The greater attention paid to aspect of development other than investment and output.

He also argued, that other elements of growth which SMEs contribute to include:

more economic use of resources; more employment creation per unit of capital investment; mobilization of domestic savings for investments; development of domestic entrepreneurship; personnel development; greater utilization of local resources; and more equitable income distribution.

Obitayo(2001) stated that SMEs are noted for their immense contributions to development processes and as the engine of growth. They are promoted as a critical segment of the manufacturing sub-sector as an effective strategy for tacking unemployment, diversifying output and achieving trade and balance of payment. He argued that successive Nigerian government had recognized the strategic importance of SMEs that subsidies and other support services had been provided to SMEs since independence. The growing concern about unemployment among the youth especially graduates of tertiary institutions and diminishing growth potentials in the economy have further drawn increased attention to the need to ensure the survival and growth of

SMEs. Udechukwu (2007) argued that a major gap in Nigeria’s industrial development process has been the absence of a strong and virile small and medium enterprises sub-sector. He noted that the little progress recorded from the efforts of the first generation of indigenous industrialists were almost wiped out by the massive dislocations and traumatic devaluation which took place under the structural adjustment programme(SAP). He stated that the policies of SAP are rooted in the neo-classical theory of perfect competitive markets whose assumptions do not adequately reflect the constraints on SMEs in the developing countries. So much has been written on the possible factors that determine economic growth in any country. Traditional growth theory looks at capital accumulation as the most important factor in growth process, hence countries with high level of capital accumulation tend to have high rate of growth (Solow and Swen, 1956). Empirical studies have actually shown the cardinal importance of capital in economic growth. In a study covering 119 countries, Levine and Renalt (1992) found the relationship between growth and investment to be very positive. There is widespread evidence that the development of financial market sectors and institutions play a crucial role in economic growth and development.

Recent concerns about the growth and efficiency of SMEs have become prominent (Mazunder, 1997). Piere and Sabel (1984) have argued that small enterprises are more efficient because they have adopted a flexible specialization approach and have provided the backward and forward linkages which an economy needs for self-dependence and sustenance. In the utilization of local resources; small and medium scale industries are known for their creativity in the utilization of local raw materials that do not require high level technology process. They produce intermediate and final consumption goods needed by larger enterprises and the economy as a whole, the symbiotic relationship is so developed that the sectors extensively depend on each other for survival. Most economies have transited from household artisan industries over time to the modern industrial set-up which has witnessed phenomenal upgrading in skills, machinery and equipment, and management practices. Historical evidence indicates that most of today’s giant corporations began as very small firms. These include: Guinness of Dublin and Philips international of the Netherlands, as well as Sony and Honda of Japan. Developing countries can learn from the experiences of these giants and create a conducive environment that can enable SMEs to adapt imported technologies, modernize their process and grow to become large corporations.

Empirical Analysis

Table 2.2.1 below shows the two results for the impact of financial sector reforms on output performance of SMEs (Poisson regression and ordinary least estimation). In model 1, the results indicate that the coefficient of credit facilities, equity loans, business age and type of business organization are positive and statistically

significant, which suggests that financial sector reform, business age and type of business organization have a direct effect on output performance of SMEs in Nigeria.

Specifically, a unit change in type of business organization and credit facilities will have about 8 percent and 5 percent effect on output performance of the SMEs. These results also suggest that business asset do not have any comparative advantage on output performance of SMEs.

In model 2, the estimation suggests that 67 percent of changes in output performance of SMEs were explained by comparative advantages and disadvantages of financial sector reform, firm characteristics and firm ownership. With respect to output performance, the estimates suggest that firm characteristics particularly business asset, origin of business and ownership of business are less likely to serve as the main determinant of output performance of SMEs. For example, a unit percentage change in business asset would have an inverse impact of about 2.9 percent of output performance of SMEs. Also, a unit percentage change in origin of business and ownership of business lead to about 0.5 and 0.3 percent respectively on output performance of SMEs. Additionally, the results indicate that age of business, type of business and reforms (credit facilities and equity loans) have significant impact on output performance of SMEs. A one percentage increase in age of business and type of business will lead to about 35.4 percent and 21.8 percent increase in output performance of SMEs. Financial sector reforms will have 11.1 percent and 3.8 percent direct impact on output performance of SMEs. This provides evidence to the fact that financial sector reforms, firm characteristics, firm ownership and credit facility have a significant impact on output performance of SMEs. Evidence also tends to suggest that financial sector reforms tend to exhibit multiple banking relationships with SMEs

SELF –ASSESMENT EXERCISE 2

Do the financial reforms in Nigeria have positive and negative effect on the financial sector?

Table 2.2.1: Effect of Financial Sector Reform on Output Performance of SMEs

Variable Model 1(Count) Model 2 (OLS)

Constant term 0.203 (1.65)* 0.979 (4.11) **

Firm Characteristics

Business Assets - 0.012 (- 0.80) - 0.029 (- 0.95)

Age of Business 0.173 (5.92) ** 0.354 (6.50) **

Type of Business 0.088 (2.92)* 0.218 (2.88) *

Organization

Location of Business 0.0008 (0.037) 0.17 (0.21)

Origin of Business 0.003 (0.009) 0.005 (0.30)

Firm Ownership

Ownership of Business 0.002 (0.011) 0.003 (0.14)

Financial Sector Reform

Credit facilities 0.056 (2.15) * 0.111 (2.22) *

Equity loan 0.019 (2.10) * 0. 038 (2.10) *

R2

- 0.62

R-2

- 0.67

Pseudo R2 0.028 -

DW 1.81