Radical Economic Transformation: SMME funding

South Africa has a bipolar economy – pockets of first-world prosperity in a sea of third-world underdevelopment. The SA government has sought to bridge this gap using fiscal stimulus delivered through the social grant system in addition to other infrastructure spending. This has had the effect of lifting, on aggregate, swathes of our people above the poverty line.

However, stubbornly high unemployment, underemployment, overemployment and joblessness rates demonstrate that this stimulus can only do so much. So the question arises as to how can government sustainably stimulate aggregate demand in the economy. That is, how can government boost the economy to promote higher levels of prosperity, lower levels of joblessness and narrowed inequality.

This article proposes that government adopts a developmental finance framework for funding SMMEs. This developmental finance framework would sit parallel to (if not antecede in the business lifecycle) the current finance framework (comprising banks, asset managers, pension funds, etc.).

A key distinguishing characteristic of the developmental framework would be a break with the current project-finance philosophy of funding SMMEs. The new approach would be based on a stimulus-based philosophy. A project-finance model seeks to evaluate each request for funding on its merits and prospects; in other words, tests if each funding proposal has prospects for repaying the funding extended.

A stimulus-approach would, instead, seek to grant funding to all applicants on a best effort basis. The stimulus-approach is based on the understanding that if the money remains trapped within the SA economy then on an aggregate basis it is doing some good. By metaphor, the stimulus approach is boiling a gas in a closed container, you are not worried about individual atoms (SMMEs) getting heat (profit) but rather that on aggregate the whole gas (economy) would heat up.

By alternative metaphor, the stimulus-approach from a financial portfolio construction perspective one would see it as a portfolio of SMMEs where many of them are likely to fail but one or two unicorns may emerge to make the whole portfolio break even.

The project-finance approach to funding SMMEs has led to asymmetric funding allocation wherein there is a preference for connected people, experienced entities and people with assets to place as collateral. Further, this project-finance approach has a bias towards ideas that are proven elsewhere and thus inhibits the type of innovation the SA economy needs.

We do have components of this developmental finance framework already. These would be entities like the IDC and many other scattered government funded finance houses. However, these suffer from this project-finance approach of having each and every project be required a priori to be a profitable and viable entity.

A new SMME funding entity, called the Spaza Fund, should be created. The Spaza Fund would be annually capitalized from the fiscus. The Spaza fund would grant/loan a sum total of around R4bn each year. It would annually grant

20 000 SMME loans of R50k
2 000 loans of R500k
200 loans of R5m
20 loans of R50m

The Spaza Fund would extend funding to all applicants with criteria grounded on a stimulus approach and not on a project-finance approach. Applicants would only submit a one page application which answers: what are you selling, to whom, at what price and what is it costing you. There would be higher due diligence for bigger loans. Names of loan recipients and amounts of loans would be published on a publically searchable platform. Thus instead of burdening the entity with a cumbersome and expensive compliance department, the Spaza Fund would publish information such that NGOs can perform this policing function.

With SA’s debt funded fiscal deficit of 3-4% (about R40bn) is this Spaza Fund expenditure justified? It’s either we do more of the same which has failed or we try radical solutions. Corporate tax contributions which currently amount to about R200bn and only contribute 20% of tax revenues, are a potential source for this R4bn needed.

The common refrain is that the banks should be playing this SMME developmental finance role. Much as this view may have political currency within the SA public discourse, I, however, believe it is misguided given SA context. Yes, SA banks are averse to funding new businesses. The high failure rates of SMMEs means that bank balance sheets loaded with SMME loans would lead to banks with higher impairment rates. Higher impairment rates in a financial system as tightly integrated as ours, are a problem. The failure of African Bank demonstrated this.

In other words, failing banks would inevitably impact on the pension funds (contributed to by peoples of SA) which are often used to fund banks. Failing banks would impact on the property and life insurance component of the financial system. Failing banks would impact on the medical insurance component of the SA financial systems. These impacts are over and above the fact that banks hold retail depositor funds and serve as payment gateways. The tightly integrated manner in which our financial system is wound up means we have to create a parallel developmental finance framework.

In a proper SMME financing system, you have seed funders, venture capital firms and private equity firms sitting at the beginning of the funding chain then followed by banks and the capital markets (through IPOs, equity and debt issuances). Seed funders take risks with ideas drawn on paper. Venture capitalist usually come in when the SMME is still not a fully formed business. It is cheaper to fund at this stage but much higher risk (since SMME will likely fail). Private equity typically likes to come in after the SMME has become viable but it needs to be scaled. So private equity would then pay a premium for the reduced risk as compared to venture capital. Banks would then ideally be lending to stable entities. In SA the government has tried to promote venture capital through tax break interventions such as section 12J of the Income Tax Act. However, SA is still not an SMME haven.

We have tried other approaches, maybe it’s time we consider a Spaza fund.

Twitter: @melomagolego