Funding Businesses in the Middle East: Challenges and Opportunities
13 Aug 05:20 AMSector : Economy & Int'l Relations Country : Qatar
By: Dr. Tarek Coury
The private sector is the main engine of economic development, creating jobs and wealth. Small and medium-sized enterprises (SMEs) contribute the bulk of this wealth creation. For example, the International Finance Corporation (IFC) estimates that more than half of both gross domestic product (GDP) and job creation is attributable to SMEs in the Middle East and North Africa (MENA) region. This is also true in parts of the world with developed economies: SMEs account for more than than 99 percent of enterprises in Europe and two thirds of all jobs created, according to thebanker.com. So, why is it that SMEs have such difficulty obtaining funding for their business activities? This article looks at this issue and focuses in particular on some of the challenges of bank lending in the region.
The shortfall in funding is well documented: The World Bank finds that the average share of SME loans in total bank loans is a little under 8 percent in the MENA; this compares to an OECD average of 26 percent. In the Gulf Cooperation Council (GCC) countries, this share is only 2percent , and 13 percent for the remainder of the MENA. This amounts to a funding gap of somewhere between $110 billion to $140 bn for SMEs in the MENA, and nearly double that if one includes micro-enterprises – the so-called MSME segment – according to an IFC-McKinsey report. These figures suggest that banks are not providing adequate supplies of loanable funds for the SME segment.
This is a bit of a surprise – after all, the GCC is home to over $4 trillion in onshore and offshore holdings by high net worth individuals. Is the lack of bank financing holding back SMEs? Yes, in that this lending shortfall is clearly impeding wealth creation in the MENA. But banks are not the only source of funding. An article in thebanker.com reports that bank financing accounts for just 20 percent of real economy funding in the US, while that number is 80 percent for Europe. The remainder, in each case, is provided by capital markets and non-bank financing. The “real economy” also includes larger companies that raise money through initial public offerings (IPOs) in stock markets, but generally the lesson here is that banks are not the only way to unlock capital for SMEs.
A complicated task
A few comments are in order at this point. First, bank financing generally targets the SME segment to the detriment of micro-enterprises. This is unlikely to change because banks typically have cost structures that make investing in micro-enterprises financially unappealing. There are, however, some notable exceptions: Some banks (in Egypt) are financing micro-enterprises through dedicated portfolios and teams, while other banks (in Sudan) have initiated dedicated micro-finance units. Second, banks in the GCC tend to lend a much smaller proportion of their portfolios to SMEs when compared to other MENA banks; this is likely due to the importance of the hydrocarbon sector, which causes the real effective exchange rate to be high, making products destined for export expensive. Also, GCC banks have recently focused their efforts on mobilizing capital for government or quasi-government entities involved in the region’s ambitious construction projects; there are over a trillion dollars in infrastructure projects ongoing and planned for the coming decade in the GCC. These last two points suggest that the greatest impact that can be achieved, in terms of job and wealth creation from the SME segment, is to mobilize capital from the GCC (through banks or otherwise) to enterprises located in other MENA countries.
This is a complicated task. One mechanism that has been used in Europe to mobilize capital is to securitize SME loans and sell them back to investors through a bond issue, with tranches corresponding to varying degrees of risk. The advantage of this approach is that banks can tap capital markets (the private sector) instead of relying on government-backed schemes intended to support the SME segment. This also allows banks to offload risk on capital markets and hence increases their capacity for further lending. Tapping capital markets directly is especially important in (non-GCC) MENA countries, as these currently have very limited fiscal space in which to operate. The downside is that SME loans are far more complicated and diverse than other income-generating assets. Mortgages, for example, have been securitized, but these tend to be fairly homogeneous products, unlike SME loans. An added complication for the region is the lack of a common regulatory framework that would allow an investor in the GCC to invest in confidence in other parts of the MENA. Still, with recent bond issuance of over $500 mn in Europe, this mechanism has potential to mobilize vast amounts of capital from the GCC to the SME segment.
Another potential way forward may lie outside of the conventional banking space.
With Middle Eastern countries predominantly Muslim, Islamic banking holds the potential to unlock capital for the SME segment. While conventional banking remains the dominant mode of financial intermediation in the Middle East, Islamic banking—a set of banking practices that conform to principles of Islamic jurisprudence—has become more popular in recent years due to both growing demand and growing wealth. Islamic banks have so far been successful in mobilizing capital for large scale project financing in the GCC (through PPP arrangements, for example) and sourcing capital for government related entities and publicly traded companies through exchange-traded Sukuk (debt) issuance. They remain, however, small players in the MSME lending space despite significant pent-up demand. It is estimated that about one third of MSME owners in the region would only consider sourcing capital that conforms to Shariah law.
The challenges faced in mobilizing further capital from Islamic banks are altogether different when compared to conventional banks. While Islamic banks benefit from common guidance in developing their product offerings to SME owners, experts point to the lack of a common legal framework and a fragmentation of products being offered. As a result, SME owners have difficulty finding a wider range of loan products that suit their particular needs. This fragmentation, combined with greater costs associated with issuing financial products that conform to Shariah law, also suggests that securitization of SME loans may offer a way forward, as this would result in economies of scale, greater standardization in loan offerings and lower costs for loan issuance.
For both conventional and Islamic banks, however, the climate for bank lending is likely to get more difficult in years to come – first, new regulatory requirements are forcing banks to reduce their risk and become more conservative in their lending. Second, actions by the US Federal Reserve is pushing up interest rates in the emerging markets (EM) space, making it more expensive for banks to lend. We are currently at the beginning of this narrative, with the Fed lowering its asset purchase program but maintaining a zero rate forward guidance on its benchmark interest rate. As the US economy recovers, yields in the EM space will gradually inch up, increasing borrowing costs in MENA, including those for SMEs seeking to raise capital.
Banks, therefore, face both structural and cyclical challenges in lending to the SME segment. The funding gap clearly illustrates an important wealth creating opportunity for banks and regional capital markets. With mounting unemployment problems in the region, these opportunities will result in much needed job creation in the MENA, especially in those countries not blessed with natural resources.