Much has been said on how critical small and medium enterprises (SMEs) are for the social and economic uplift of developing economies. This is especially true for Pakistan where over 90 percent of enterprises are SMEs, contributing to one third of the GDP and one fourth of the country’s exports with a potential to contribute a lot more. However, limited availability of financing has greatly limited SME growth options. Access to finance among SMEs has historically remained low, reported at a paltry 5 percent.[1]

This is based on the assumption that there are 3.2 million SMEs in Pakistan but this is likely an underestimated figure since it is based on a 12 year old survey conducted by SEMDA. According to our study’s calculations, the effective access to finance ratio is less than 2 percent.

Despite the Government of Pakistan’s focus on financial inclusion and the measures taken to boost bankability—which includes a revision in prudential regulations by the State Bank of Pakistan (SBP)—the share of SMEs in total bank financing is wanting. In Dec-16, it stood at 6-7 percent of total private sector loans. This lack of financing to SMEs has hindered corporatization in the country as well as entrepreneurship. A recent study launched by Karandaaz Pakistan analyzes this very phenomenon, examining the root of the problem in Pakistan, with specific focus on the supply side and from the policy standpoint. The study explores in detail the singular role high non-performing loan (NPLs) ratios has played in low credit to SMEs. The legacy impact of SME infections ratios and the absence of tailored products for SMEs are significant contributory factors, diminishing financing to SMEs over the years. This blog discusses some of the key findings.

Stunted Growth in Private Credit and Credit to SMEs

Over the past decade, private sector credit in Pakistan has remained low. It peaked at 27 percent of GDP in FY07. By FY17, it had thinned to 15 percent, likely due to excessive fiscal borrowing from banking channels as well as higher non-performing loans (NPLs) in the aftermath of the 2008 balance of payment crisis.

The issue is more prominent among SMEs—the share in loans has nearly halved since 2008. Even at its peak in Dec-07, SME financing was PKR 437 billion i.e., 15 percent of total bank loans. In terms of GDP, the ratio at its crest was 4.1 percent which is significantly low when compared to 24 percent for China, 36 percent for Korea and 37 percent for Thailand; while India, Bangladesh and Sri Lanka are around 9-10 percent.  In Dec-16, SME loans for Pakistan stood at a dismal 1.3 percent of GDP.

The True NPL Ratio

Due to weakening economic fundamentals in 2007-08 (high inflation and interest rates owing to sharp currency depreciation), loans to private sector started going bad. In CY07, private sector NPLs stood at 7.6 percent, increasing to 15.8 percent in CY11. The incidence of NPLs in the SME sector was much higher—moving from 9 to 32 percent between CY07-11.

And even as overall NPLs for the private sector started to decline after CY11, the infection ratio for SMEs continued to mount, reaching 35 percent in CY12. Thereafter it has declined, but slowly, and still remains significantly high (20% in Dec-16).

Digging deeper into the numbers, it is interesting to note that the reason a high SME NPL ratio persists is because banks have not been writing off loans that have been characterized as losses. According to the SBP’s Prudential Regulations for SMEs, the loss category contains all the loans that have been toxic for over 18 months.[2] The trailing legacy of these toxic assets is inflating SME infection ratios. By accounting for this legacy impact, the SME NPL ratio is significantly lower.

Where is the legacy impact coming from? The surge in SME NPLs first came when SME Bank Limited (SMEBL) was encompassed into the banking system. SMEBL reported NPLs at PKR 7.2 billion in FY05. In Mar-17, NPLs stood at PKR 4.9 billion, indicating that many of the previous loans have been carried forward. Similarly, NPLs arising from NIB’s Salam Banking product also contribute a significant share. In fact, according to the SBP, in Dec-16 nearly 70 percent of all SME NPLs were in the loss category. After discounting for the defunct portfolios, the fresh NPL ratio is close to 8 percent, not nearly as high as 20 percent. Clearly, the loans that have been in the loss category for a long time or are stuck in litigation in courts must be accounted for or charged off to get a clearer picture of NPLs on recent SME lending.

Where Do We Go From Here?

The apparently high infection ratios have skewed banks’ perception of SMEs—clearly they are not nearly as risky as they appear. In any case, there are different ways to not only hedge against riskiness but also reduce the riskiness of SMEs. To its credit, the SBP has set SME lending targets for banks which is a step in the right direction, but it is not enough. The issues of collateral, and information asymmetry are the most prominent ones that need meaningful and urgent policy solutions.

To an extent, the Credit Guarantee Scheme launched by SBP with collaboration of DFID has shown some positive results, but the program needs to be developed further to cater to a greater chunk of SME borrowers.[3] Secondly, the Secured Transaction Laws have been passed by the National Assembly which would develop a collateral registry for SMEs—a database of non-property based assets which can be used as collateral. This is a substantive step but again, there is no timeline on the implementation of this reform. Meanwhile, the Credit Information Bureau of the SBP that evaluates the credit worthiness of businesses should be expanded to include more SMEs, while private credit bureaus should be encouraged.

Perhaps change is round the corner but for now, as it stands, Pakistan has a long way to go. The seemingly high SME NPL ratios continue to attach an abnormal risk to SME lending, contributing to banks’ hesitancy in lending to SMEs. The millions of unbanked SMEs could be high revenue assets given the right push from banks in terms of lending models and with collaboration of industry stakeholders, policy makers, funding agencies and supporting organizations.

[1] This is based on the assumption that there are 3.2 million SMEs in Pakistan but this is likely an underestimated figure since it is based on a 12 year old survey conducted by SEMDA. According to our study’s calculations, the effective access to finance ratio is less than 2 percent.

[2] http://www.sbp.org.pk/smefd/circulars/2016/PR_SME_C2_Annex.pdf

[3] http://www.sbp.org.pk/smefd/circulars/2011/C2-Annex/Scheme.pdf