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Labour-intensive SMEs need macro not micro finance to become productive

Dr Dy Sovann, deputy director general at the general department of sub-national administration finance in the Ministry of Economy and Finance
Dr Dy Sovann, deputy director general at the general department of sub-national administration finance in the Ministry of Economy and Finance, became an SME expert for Cambodia through a five-year survey for his PhD. Photo Supplied

Labour-intensive SMEs need macro not micro finance to become productive

The profitability of MFI loans in Cambodia suggests the SME sector is healthy; however, most SMEs have limited access to capital, a situation that may hinder growth in this important sector

Analysis
Microfinance insti-tutions (MFIs) in Cambodia do a great job of supplying the Kingdom’s small- and medium-sized enterprises (SME) with affordable capital.

While the world average for MFI interest rates hovers around 30 per cent, according to the World Bank, Cambodia offers micro loans at an average of 25 per cent (down from 33 per cent just six years ago), according to an exclusive
2013-2014 report that corporate advisory firm Mekong Strategic Partners (MSP) finalised this month.

Referring to the interest rates, former ANZ CEO and MSP managing partner Stephen Higgins explained in an email to the Post that the MFI market has “been fairly competitive and that borrowers are better off”.

With an average annual profit growth of about 37 per cent in the MFI sector since 2009, and 2.1 million customers served, all indications are that the SME sector in Cambodia brims with productivity. SMEs collectively borrowed a sum from the MFI sector that generated a net profit of $53 million at an interest rate of 25 per cent last year.

This can be deceiving, however. While the MFI sector grows remarkably fast in relative terms – and enjoys conditions that Higgins says are favourable compared to the region as a whole – the vast majority of Cambodia’s population still has little to no access to credit.

Only about 40 per cent of the private sector’s output is credit-backed, according to MSP’s report. Cambodia’s larger neighbours Thailand and Vietnam in comparison have credit penetrations of above 160 and 100 per cent, respectively, which means that Cambodia’s economy suffers from a lack of credit availability that leaves growth and development potential untapped.

As available credit is a limited resource, Cambodia’s economy needs to channel available funds into sectors that can use the money most productively and avoid giving money to sectors that can replace capital with the cheap labour that is readily available in Cambodia.

Imagine a commercial bank had to choose between lending $50,000 to a large construction firm for a crane necessary to build and sell a $1 million condominium – or to help 50 farmers buy $1,000 harvesting machines so they can sell a combined rice harvest worth the same $1 million.

The common wisdom here is that the construction company should get the credit in this example because, while the farmers can hire hundreds of extra hands for much less than $50,000, manpower cannot replace a crane.

Content image - Phnom Penh Post
After dropping significantly when Cambodia was hit by the GLobal Financial Crises in 2009, the total sum of loans in Cambodian bank accounts is slowly recovering. Mekong Strategic Partners

Thus far, most economists agree: large enterprises (LEs)like construction companies have more need of capital than SMEs.

Even though LEs make up only about one per cent of enterprises in Cambodia, the commercial banking sector, which almost exclusively finances large enterprises, is five times larger than the MFI sector, according to MSP.

Dr Dy Sovann, however, deputy director general at the general department of sub-national administration finance in the Ministry of Economy and Finance, argues that this division of available capital is not feasible for the development of the Cambodian economy.

“Although SMEs were found to be labour-intensive enterprises, in order to fulfill their potential to contribute to employment generation in Cambodia they must have an equal access to capital,” he told the Post via email.

During a five-year study that earned him his PhD in economics at the London Metropolitan University in 2012, Dy surveyed 500 Cambodian enterprises – 400 SMEs and 100 LEs.

“The smaller the size of enterprises, the more complex the problems they face,” Dy wrote in explaining a core problem of SMEs in achieving higher productivity and profitability. According to this thesis, small entrepreneurs face problems they cannot solve by simply increasing the labour input, but actually need capital to reach the size and structure of their operations to the point where the rule of increased labour input also increases productivity.

In the annual Global Competitiveness Ranking issued by the World Economic Forum, Cambodia traditionally scores lowest in the entire region, and this year ranked 95 of 144 countries in the world – behind even Lao PDR (rank 93).

Looking at the productive performance of SMEs that do receive credit from MFIs, this productivity gap among SMEs of different sizes must be owed to the large number of smaller SMEs that barely contribute to the GDP.

But it’s not just the size of SMEs that negatively affects their productivity.

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Despite falling interest rates in the finance industry, only 40 per cent of the Cambodian economy is funded by loans. Mekong Strategic Partners

Dr Dy identified obstacles that all SMEs in Cambodia share – a “lack of necessary inputs to increase productivity, such as skilled workers, capital to buy new machines and modern tools, information on new machines or production tools, and know-how to improve their methods of production”.

External factors such as weak property rights, poor access to formal credit and policies that don’t incentivise other actors in the economy to engage and contribute to SMEs’ development have combined to prevent SMEs from invigorating the economy.

These productivity issues that Cambodian SMEs face cannot be solved through simply increasing labour input, according to Dy.

“Micro and small enterprises, especially, in Cambodia [are] traditional enterprises adopting manual modes of production, for example, with a low degree of mechanisation,” he said.

Caught up in traditional production modes and effectively isolated from knowledge that drives innovation outside their sphere, the gap between SMEs and large enterprises increasingly broadens with the difference in size, according to Dr Dy.

He explains this problem with the help of the local food and beverages industry.

“Micro enterprises [are] very simple food and beverage processing units mostly for local markets, as compared with large enterprises, such as Coca-Cola and Nestlé, [whose] production processes were much better managed and organised, and who generally employed highly skilled workers,” he said.

While large and often international companies like Coca-Cola are dynamic and innovative, Cambodian SMEs such as coconut sellers are often unable to capture market opportunities that require large production quantities, homogenous standards and regular supply.

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Cambodian credit penetration compared to the region and the world. Mekong Strategic Partners.

Coconuts grow on trees, are harvested and then sold. A can of Coke, however, is the product of a complex back-end system encompassing everything from the Coca-Cola recipe kept in their Atlanta headquarters to mines in Venezuela that produce aluminum for cans.

With increasing size and complexity, LEs have almost infinite opportunities to adapt to market requirements and influence productivity and profitability.

Of course, this is what Dr Dy confirmed in his study of Cambodian SMEs: the larger an enterprise, the bigger is its return on invested capital.

Stephen Higgins, managing partner at MSP told the Post in an email that the “commercial banking sector has always been bigger in Cambodia than the MFI sector and always will be.”

Regardless, SMEs in Cambodia need the initial funding to build the necessary capacities that allow them to capitalise on the factor that is supposed to secure their growth and development – cheap labour.

Creating incentive policies for SMEs
Dr Dy argues that the necessary push for credit penetration in the Cambodian private sector cannot come solely from the private sector itself. “There is no incentive provided to SMEs by the government, in contrast with the government’s incentive policies for LEs,” Dy said in an interview.

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Actors in the private sector that engage in the borrowing of capital yield high returns and further boost capital available in the financial sector. Mekong Strategic Partners

He suggests that creating tax incentives for establishing factories to process agricultural products could hold the solution for a larger chunk of Cambodia’s farmers. Processing existing natural resources such as cotton, sugar, palm oil, cashew nuts, rubber, cassava and fruit seems like the next natural step for SMEs.

The capital input could allow SMEs to buy in bulk, achieve optimal scale in the use of machinery, and pool together their production capacities to satisfy large-scale orders. Ideas are exchanged and developed and knowledge shared in a collective attempt to improve product quality and occupy more profitable market segments – SMEs have to become larger, he says.

In his position at the Ministry of Finance and Economy, Dy has continued to monitor the needs for SME development at the commune level in every province on a week-to-week basis, and finds it has only confirmed his theory.

“These [processing factories for agricultural products that need larger initial funding] are the best way to improve the living standards of people in rural areas,” he said.

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