SME Financing Dilemma: Unlocking Economic Growth in Emerging Markets

A new World Bank report, Unleashing Productivity through Firm Financing, sheds light on the severe financing gaps faced by small businesses in emerging markets. The report calls for targeted interventions to close these gaps, particularly by enhancing access to equity financing, which is crucial for innovation. Addressing these challenges could lead to substantial productivity gains, especially in middle-income countries.

A new report by the World Bank has revealed a critical financing gap that is stunting economic growth and productivity in emerging markets. Small and medium enterprises (SMEs), considered the backbone of global job creation, are struggling to access the funds they need to expand, innovate, and remain competitive. The findings, published in Unleashing Productivity through Firm Financing by Tatiana Didier and Ana Paula Cusolito, highlight a pressing need for reforms in financial systems that could significantly boost economic output, especially in developing economies.

Small Businesses, Big Impact—But Underfunded

SMEs are vital to the global economy, contributing significantly to employment and GDP. Yet, in emerging markets and developing economies (EMDEs), these businesses are often left out in the cold when it comes to accessing external financing. The report shows that smaller firms face severe financing constraints compared to larger corporations, particularly in middle-income countries (MICs).

This lack of access to debt and equity financing creates a bottleneck for economic growth. Many SMEs are forced to rely on internal funds, limiting their ability to innovate, expand, or improve productivity. The World Bank's research quantifies the potential impact of these financial gaps, revealing that if properly addressed, productivity in MICs could see an 86% improvement—dramatic gains that would unlock untapped economic potential.

Larger firms, especially those in high-income countries (HICs), fare much better. They typically have better access to a wider range of financial products and services, allowing them to grow and innovate. This disparity is evident in the significant differences in debt-to-asset ratios between small firms in MICs and their counterparts in more developed economies.

The Untapped Power of Equity Financing

While debt financing remains crucial for businesses of all sizes, the report makes a compelling case for the importance of equity financing, particularly for SMEs that engage in innovation. Equity markets in EMDEs are underdeveloped, making it challenging for smaller, more innovative firms to access the capital they need to thrive.

Debt alone is often insufficient for these businesses, which require more flexible funding options that allow for higher-risk ventures like technology development or research and development (R&D). In knowledge-based economies, where innovation drives productivity, equity financing becomes essential. Countries that develop robust equity markets for SMEs would reap substantial rewards in the form of higher productivity and stronger economic performance.

However, the current state of equity financing in EMDEs is far from ideal. Smaller firms, especially those undertaking high-risk projects, have little access to external equity. In fact, private markets for equity financing in these regions are significantly smaller compared to those in developed economies. Most of the available venture capital is directed toward large, well-established firms, leaving smaller enterprises with limited options.

The report highlights the need for governments and policymakers to focus on fostering the development of private equity markets. Supporting smaller, innovative firms with access to equity would allow them to innovate and grow, contributing to overall economic resilience and competitiveness.

The Pandemic’s Stark Reminder

The COVID-19 pandemic laid bare the vulnerabilities of financially constrained firms, particularly in EMDEs. SMEs that were already struggling to access capital were hit hardest, with many forced to close their doors. In contrast, firms with diversified sources of finance, including access to equity markets, were better positioned to weather the storm.

These firms were able to preserve jobs, avoid defaulting on loans, and maintain investment levels during the economic downturn. The pandemic underscored the importance of having robust financial structures in place, not only for day-to-day operations but as a buffer against unforeseen crises.

As the world moves towards economic recovery, the report suggests that improving SMEs' access to diversified financial resources is more critical than ever. Capital markets, in particular, can play a crucial role in mitigating risks, reducing job losses, and maintaining economic stability in times of crisis.

Policy Recommendations: A Call for Targeted Interventions

The findings in Unleashing Productivity through Firm Financing offer clear policy directions. First and foremost, governments in EMDEs must recognize that one-size-fits-all solutions will not work. Debt and equity financing play different but complementary roles, and policy interventions should reflect the unique needs of SMEs.

For example, targeted support that addresses the more acute financing gaps faced by smaller firms should be a priority. Rather than blanket support, policies must focus on “de-risking” SMEs to encourage private investment, improving information on small firms, and creating a conducive environment for both debt and equity financing.

Moreover, it’s not just about making funds available. The report emphasizes the importance of building financial infrastructure, such as improving credit information systems and strengthening insolvency frameworks. A supportive environment will help unlock resources, encourage firm growth, and reduce the likelihood of firms becoming "zombies"—firms that continue operating despite being unable to generate sufficient profits or growth.

Addressing the SME financing gap is more than just an economic necessity—it is a pathway to sustained growth, innovation, and job creation. By rethinking how financial resources are allocated, especially for small, innovative firms, EMDEs can unlock their full economic potential.