Abstract
Major attention is received by investment policies that support small and medium-sized enterprise (SME) and technology-driven starts-ups. In this research, we investigate the role of the banking and finance policies that support SMEs self-development in Nepal. After joining the World Trade Organization (WTO), the country’s government has commenced numerous policies that support entrepreneurial activities. This study’s empirical-research results show that, regardless of the funds and plans supporting SME self-development, Nepal still needs a regulatory framework that backs innovative business enterprises and other societal organizations. That will help the country transition to an innovation-driven economy, by enhancing the competitiveness of its SMEs. The insights gained are applicable to other developing and emerging economies, particularly through comprehending the vital role that financial mechanism play in building an innovative economy. Moreover, SMEs often struggle to adopt new and innovative managerial practices. Besides that, also need a bank for lending the loan only to SMEs.
Introduction
Nepal is a developing country with more than 28.6 million people (CBS: 2016) situated on the lap of Himalayas bordering two emerging economies of the world, China and India. Gross domestic product (GDP) is 20.88 billion USD and GDP per capita in Nepal is 710 USD (2016). More than 90% imports and exports of Nepal belong to India. Small and medium-sized enterprises (SMEs) are backbone of developing country like Nepal. They are main contributor to economy of the country. SMEs and private sectors generate an employment opportunity for 2.75 million people who support their families. It counts for more than 22% value added products of national GDP. In Nepal, more than two hundred thousand small and medium enterprises are in operation, among which nearly 95% businesses are registered. Mostly manufacturing and retail business are operated as SME in Nepal. Government of Nepal is realizing the role of small and medium-sized enterprises in innovative economy. To enhance and strengthen the innovative economy, the government is introducing many new policies and schemes for skilled and creative minds. Banks and private sectors are helping skilled people with financing issues to own their dream business. Since last decade, Nepal has been politically unstable and has been through new constitution making process which had a negative impact on the economic growth of the nation. In Nepal, banking sector has a huge market for SME lending. Currently, SMEs sector have 22% contribution to the nation’s GDP. However, proper management of these lending opportunities can lead to increased contribution to the national GDP by creating millions of job opportunities. To our knowledge, this study is first of its kind to investigate the investment policies that support SMEs in Nepal. Here, we present the perspective of Nepalese government, banking and financial agencies, and business people.
The article is structured as follows. Initially, the two main concepts, namely, banking and finance policies to support SME development, and venture capital financing to SME development are discussed. Subsequently, the research methodology is introduced followed by the analysis of results. The next section analyzes the findings and the conclusions made.
Theoretical framework
Banking and finance policies to support SME development
Bank and financial agencies that provide credits play significant role to support the economic growth. Financing by either bank or finance company is vital to the functioning of the economy because it is a main source of funding to support SMEs. Nonetheless, bank and finance organizations are disinclined to make credit lending available to SME sector due to the possibility of risks like early stage ventures in terms of insufficient assets, low capitalization and having no proven track [1, 39]. As a consequence, they do not consider this sector as a profitable industry. In other words, either they do not notice worthwhile returns on SMEs investments or a potential pay-off.
Figure 1 depicts the valley of death i.e. the funding gap, the hindrance in accessing the required capital to grow the business by all SMEs. The period before a company is capable of generating revenues is referred to as the valley of death, which makes it difficult to get the financing required to grow a business in the start-up period [9]. The target-returns by investment stages are shown in Table 1. High level of risk in early stage investment needs the highest return (internal rate of return over 50%) to balance the risks that are higher than those in other stages which is seen in Table 1 [5].
Valley of death faced by SME.
Target returns by investment stages
Banking and finance agency are significant determinants as well as the mainstream innovation system of the entrepreneurial knack to develop the new economy from the perspective of an economic development [36, 37]. The roles played by the entrepreneurial firms are crucial to the economy as it creates jobs that contribute to the economic growth and stability.
Many governments realizing the high risk nature of SMEs have tried to bridge the valley of death to improve capacity of SMEs. They see the financial gap (valley of death) as a tricky task and introduce policies to manage the financial risks SMEs face with an aim to help them cross the valley of death. To improve the financial constraints faced by SMEs, establishment of specialized development banks to offer special type of loan could be a part of government policies [7, 29].
In recent decades, building an innovative economy has been emerging which has received an increased attention on issue of SME financing. Many economists argue that despite the large firms having heavy concentrations on research and development (R&D), small firms are the ones that report for most of the important inventions and innovations [13]. According to Schumpeter’s Mark 1 theory [36] hypothesis, small firms predominate in the process of innovation when considering the conventional models of innovative economies. The ability to innovate by entrepreneurial small firms is stressed in Mark 1 model whereas technological innovation development by large firms is discussed in Mark 2 model. For innovation and industrial development, small firms arguably play an important role [13, 40]. Many governments with an aim in building an innovative economy have developed policies to support SME financing after realizing the trend of knowledge-based economy [19, 29].
Life cycle of SME development along with the funding requirement is shown in Fig. 2. The source of finance for new ventures is fairly limited due to high uncertainties and risks in early stage of development. To support early stage venture, the source of capital is mainly seed funds, business angels, venture capital (VC) financing whereas to provide finance in the growth and mature stages, commercial banks and stock markets cooperate and play a significant role (stock markets providing finance in the form of equity capital and commercial banks providing finance in the form of loan capital) [4, 39].
Funding requirement along the life cycle of SME development.
Venture capital (VC), a start-up financing provides an important source of business finance to support SME development. Venture capital by definition is potentially high-return investment to support business creation and growth with very high-risk. Typically it is the source of funds that finances new and rapidly growing companies through equity participation [6, 17]. In many cases when business ideas are innovative, but lack of collateral, venture capital funds them. Venture capital has characteristics that sets it distant from traditional capital markets as well as debt financing alternatives [16, 17]. Venture capitalists usually expect high returns in the form of capital and dividends since it is high-risk financing investment [8, 34]. The concept of modern venture capital is defined by Ref. [31] as “a professionally managed pool of money raised for the purpose of making equity investments in growing private companies with a well-defined exit strategy” [15].
A major influence in the economic development by small and medium sized enterprises is employment and creation of new innovations [3, 35]. Nevertheless, in general, SMEs face difficulties in getting financed, since investment in SMEs is not preferred by investors due to risky nature of business operation. At the early stage venture, very small fraction of monies are to be allocated, therefore, the provision of risk capital by venture capital firms may be the most suitable form of external finance. This type of investment mitigating the capital constraints brightens the prospects of small and medium-sized enterprise [6, 39].
Presently, several developing countries have commenced venture capital as an economic tool while these countries’ government performs an operational role in development of venture capital industry [21, 38]. Venture capital in these countries has similar main focus i.e. to provide seed capital and financing for technology and innovation development. Nonetheless, Venture capital financing structure differs among countries due to different set of interacting organizations and structures of the national innovation systems [24–28].
This is a qualitative research that is designed to follow case study methodology [10, 41]. This research is focused to support small and medium enterprises from the policy perspective in case of Nepal, the growing economy among the developing countries. The research obtains proof from a collection of various documents and annual reviews to investigate and analyze the relation between SMEs financing and role of banking and finance in Nepal. Kathmandu and Birgunj are major financial centers of Nepal. Research fieldwork and interviews were undertaken with the help of Skype by using semi-structured questionnaire. Nepal Rastra Bank (central government bank of Nepal) coordinated to conduct fieldwork interviews in financial sector of Nepal, securities board and exchange commission and Nepal chamber of commerce. The interviews were conducted with banks, finance corporation and government agencies as shown in Table 2.
List of organizations to conducted research interviews
List of organizations to conducted research interviews
The aim of carrying out fieldwork research is to extract the views on the government policies and tactics to support SMEs and innovation business that can lead to improved innovation capacity. The main research questions are: What are the tactics of government of Nepal to support the development of SMEs? To what scope the government policies in bank financing can support small and medium-sized enterprises and promote the development of an innovative economy?
Interviews data are supported by an assessment of secondary data to provide a cross check of internal validity. This case study has facilitated the development of conclusion and recommendations for this research. The investigations provide lessons and insights that would be useful for other developing nations to use as policy guidelines in supporting small and medium enterprise development. Secondary data were extracted from the financial statement of bank and finance company provided by central bank of Nepal.
Nepalese economy and government policies to support SME development
Nepal is one of the developing countries in the world having average growing economy and relies extensively on foreign aid and remittance generated by foreign employment with an average gross domestic product growth rate of around 3% (Fig. 3.) The overview of economic and innovation performance of Nepal is shown in Table 3. Agriculture is backbone of the developing countries, nonetheless, economic transformation from rural agriculture to SMEs or modern industries is the fundamental necessity to attain high and sustainable growth. The contribution of agriculture to national GDP, despite involving more than 70% of population, has decreased from 41.8% in 1995 to 33.7 % in 2014. Therefore, the government of Nepal has given high priority to the promotion of SMEs to remodel itself from an agriculture-based economy towards an innovation-driven economy to accelerate the pace of the industrial development. The governments of Nepal to support SME development after joining WTO in 2004 has launched various innovation policies to grasp with leading-edge countries.
GDP growth rate of Nepal compare to SAARC countries. Source: The world bank.
An overview of economic and innovation performance of Nepal
In Nepal, the Industrial Enterprises Act-1992, which was amended in 2008 and the Industrial Policy Act 2011 defines SMEs as follows. Small size business which has fixed assets between Nepali currency two hundred thousand and thirty million, medium size business which has an investment of between more than thirty million to hundred million are identified as small and medium-sized enterprises in Nepal according to definition of Industrial Enterprise Act.
In 2015, the numbers of registered SMEs in Nepal are approximately two hundred fifty thousand, which contribute to generate employment of more than two and half million people. Therefore, SMEs are significant in driving the Nepalese economic growth that the government cannot afford to overlook. Table 4 presents an overview of indicator to maintain entrepreneurship in SMEs according to the Global Entrepreneurship monitor (GME) report 2016, world’s leading research consortium dedicated to comprehend the relations between entrepreneurship and national economic development. The indicators list in the first column influences entrepreneurial activities in various magnitudes. The box shows the performance of Nepal compared to Asia and Oceania which also includes Nepal and others like North American, Africa and Europe. It can be seen that supporting entrepreneurship SMEs activities by Nepal is closer to average performance of other continents. In some indicators Nepal’s support to SMEs is better than other countries, however weak in R&D, infrastructures and entrepreneurial finance.
Entrepreneurship overview of Nepal in various indicators
Source: Global Entrepreneurship Monitor (GEM) report 2016 and other agencies.
Being thoughtful about the importance of SMEs in economic development as they represent more than 95% of all the firms in Nepal, government of Nepal has positioned on SME development to drive the national economy. Figure 4 gives a picture of major bureaucratic hierarchy of agents and stakeholder group that allegedly support SMEs as well as high-growth innovative SMEs in Nepal. The government of Nepal as well as other international and local organization play a significant role in building up policies and tactics as well as technical and financial assistance to support the change to an innovation-driven economy. For example, establishing funds such as the Technology Development Fund, the Small Industries Development Fund, and the Industrial Investment Protection Fund by twelve national plan (2011–2014) to promote innovation commercialization. Government policy allowing tax deduction for research and development expenses encourages foreign investments and attracts new technologies. The ministry of Science and Technology provides major policies and guidelines to the national medium and long-term development program during the period of 2012–2030.
Bureaucratic hierarchy of agents and stakeholder groups that allegedly support SMEs in Nepal.
The ministry of Science and Technology of Nepal and its associated organization play a significant role towards building an innovative economy by design and implementation of national innovation policies. Information Technology (IT) park and Special Economic Zone (SEZs) are established to promote new technology development. To promote high-technology enterprises, government has lowered the income tax rate and value-added tax. The Nepalese government offers funding, loans and other incentives (such as lowering tax for R& D, exemption of local tax) to drive innovation and growth. To fulfill the small and medium-sized financing gap, by the intervention of government of Nepal, SME financing policies have been developed.
Nepalese SME sector is overwhelmed with several problems and one of them is financing constraints. The government of Nepal attempts to improve small and medium enterprises access to finance by establishing Start-Up fund in budget statement for 2014/15 in order to encourage SMEs. Investors and industrialist with innovative ideas but lacking investable resources, are providing seed money, a provision that is made to extend credit through banking and finance by using the Start-Up fund. Five big Nepalese banks are Nepal Bank Limited, Rastriye Banijye Bank, Nabil Bank, Standard Charter Bank, and Nepal SBI bank, which provide the major source of credit for small and medium sized enterprises in Nepal. Performance of five big banks accounting more than one third of total markets share is shown in Table 5.
Performance of the big five banks (NRS million)
Performance of the big five banks (NRS million)
According to 2014/15 monetary policy of Nepal Rastra Bank (NRB) also known as the central bank of Nepal, banking and finance company is required to disburse 20 percentage of their total credit to small and medium-sized enterprises. As a result, the loan disbursement stood at 16.8 percent in mid-June 2016. Before that monetary policy 2014/15 was put into effect, NRB put special refinance rate of 1.5 percent interest applicable to SMEs. In the monetary policy of 2016/17, the special refinance rate has been kept at 1 percent interest to encourage SMEs in poverty stricken areas and earthquake affected areas. NRB has been monitoring the small and medium enterprise by setting up a desk at financing organizations that eases the credit availability to those who are not in the targeted group of banking and finance and are not financially stronger. Credit granted in Nepal is shown in Table 6. The NRB monetary policies put greater emphasis in expanding corporate relation and developing information system to provide financial service and credit by “A", "B” and “C” class banking and finance for SMEs.
Credit granted in Nepal (NRS millions)
In Nepal, most of the commercial banks and majorities of finance organizations are public. The credit granting system of each bank and finance agency is according to the guidelines of central bank. Central bank sets a range for interest rate and inside range, banking and finance can vary the values. Most of the commercial banks prefer to grant loans to large enterprise because granting credits to SME is more risky. To overcome the problem faced by SMEs during the credits granting, Nepalese government has encouraged the bank and finance agency to increase access to credits and supports to SMEs through Nepal Rastra Bank. NRB monitoring the performance of policy implementation or effectiveness of bank’s non-performing loan (NPLs) rate credit granting system. The proportion of NPLs to GDP in 2016 is 2.75% compared to 30.4% in 2002; that is loan losses which is the result of government or NRB policy to take steps to build solid economy balance in Nepalese banking system by controlling NPLs.
Table 7 summarizes the government or NRB policy on SME financing and coverage of banking and finance to support SMEs from the interviews. Most of the banking and finance status have consistent view, that the introduction of recent tactic by NRB does have an influence over the banking and finance lending policy in terms of increasing SME loans as the bank and finance companies are working on the strict guidelines of central bank of Nepal. They view that the recent policies implemented by NRB is an encompassing tactic plan defined by the government. However, in practice the policy implementation differs across banks and finances depending on the policies of each bank because they lack a specific definition for SME lending and the knack to take the credit risks that each bank can bear.
Summary of interview results on govt. policies of banking and finance to support SME development in Nepal
At current, large number of SMEs depend on informal loans outside the banking system which charge relatively high interest rate that limits the ability to grow. Consequently, the government of Nepal makes an effort to terminate this informal lending system so as to help SMEs. Recent, national plan policy (12th) has not only increased lending but also placed emphasis on capital market financing to build an innovative economy because the plan encourages the opening up of the capital markets for technology based firms to improve the potential of the economy to innovate. The interviewees articulated their views that bank’s credit direction changed from lending to heavy industries to new industries like information technology (IT), energy-based, agro-and forest-based, and other high-tech sectors according to 12th National plan.
According to the interviews with banks and finance companies of Nepal, they state that they have to follow by setting up SME special unit to provide SME financing. However, the policy is not compulsory, but non-compliance with these directives may create problem in business relation with government in future. Most of interviewees indicate that policy makers attempt to favor SMEs. However, by complying with directives, the banking and finance expressed their concern about high risks of SME financing which would result in high incidents of non-performing loans. Bank and finance organization admitted that the biggest issue in SME financing is borrowers not having well maintained account books as required by central bank of Nepal besides insufficient collators.
Venture Capital, another important mechanism of financing that fills the gap between entrepreneurs provides access to finance companies to support SMEs. Venture Capital industries have been in existence in the most rudimentary structure in Nepal and still has a long way to go to broaden the VC industry. A lack of proper legislative provisions and draconian investment climates related to venture capitals makes investors more cautious about investing in Nepali startups, while the concept of VC is beginning to gain importance especially in the areas of SMEs funding in Nepal’s market. To the best of our knowledge till now there are no any government financed venture capital funds. However, in 2011, during a Constituent Assembly sub-committee meeting for amendment of banking and finance Act, some lawmaker proposed that bank and financial agencies should allocate minimum five percent of their total loan exposure for venture capital to encourage small and medium-sized entrepreneurs and little progress has been made in this regard. At present, a few international organizations have entered the SME market in Nepal by investing venture funds into SMEs that are in need of scaling up their businesses. One of them, the International Finance Company’s (IFC) of the World Bank group was the first to introduce the concept of Venture fund in Nepal that provides risk capital financing and complementary advisory services to small and medium enterprises businesses in Nepal. Another is Dolma Development Fund (DDF), structured as a non -profit domiciled in United Kingdom, which is currently raising US $10 million for investment in SMEs in Nepal. However, other International VCs focus on target sectors like rural connectivity (internet/mobile), healthcare, affordable private education, clean drinking water, eco-tourism and off-grid renewable as can be seen from the successful enterprises like Dalle Restaurant, Le Sherpa etc. Investment opportunities are also arising in more niche sectors like organic agri-business and handicrafts.
Figure 5 presents comparative venture capital investment in Nepal and other country during 2011 to 2014 and it is clearly shown that Nepal’s venture capital industry is still in its pre-fledgling phase and small portfolio. The major hindrance to venture capital development in Nepal is a lack of government policies to encourage venture capital investments and private equity. Besides that, political instability, perpetual “in-house” hurdles like militant labor, extortion, difficult to exit, local opposition arbitrary government policies, lack of market innovation, red tape, corruption, and strikes pose further challenges. Nepal’s foreign VC attracting capability is also undeveloped and fragile. Furthermore, the industry also suffers from a lack of skilled professionals with experiences in venture capital management. Nepalese government has been identifying such difficulties and continuous attempts are being made to improve regulatory policies so as to support the growth of venture capital investment in Nepal. For example, the recent relaxation made in blacklisting provisions by Nepal Rastra Bank for foreign equity investors is encouraging and sends a positive signal to attract foreign VC capital in Nepali start-ups. The establishment of mass Alternative Investment Funds (AIF) under the security board of Nepal (SEBON) regulation would open the institutional and private funds pooling to invest equity capital in the infrastructures including hydro-electric to roadways projects and SMEs, including export oriented to service sectors. AIF as an investment vehicle includes infrastructure fund, private equity (PE) and venture capital (VC) fund, SMEs fund, hedge fund and so on.
Venture capital investment of Nepal compared to other countries (millions in USD).
We discussed the challenge of the government tactics to construct an innovative economy by developing the SMEs. This empirical investigation is focused on the banking and finance policies to maintain SMEs in Nepal. The investigation has exposed that the introduction of 12th National plan and new monetary policies have impacted over the bank’s policy in provision of SME lending. However, the venture capital or private equity policies and financing mechanism are still weak to contribute and build-up the national innovative capacity. The research has shown that the Nepalese economy is driven by constant change in political scenarios that ranges from being a monarchy to being ruled by the communist party. The investigation also points out the lack of Nepalese government regulatory policies to improve and support innovative business. Improvement of national innovative capacity arguably plays a very important role to strengthen Nepal’s position in the global competitive landscape. Thus, the Venture capital financing must escalate it’s role in supporting high-tech and innovative SMEs in future because at present, Nepalese venture capital business is not yet fully developed. Considering the long term policy for increasing and sustaining national competitiveness, government must encourage the private sector to proved more venture capital and business angel investment to maintain high-tech business start-ups and SMEs.
SME’s management also needs some kind of formal and informal training about how to transform their business from old system to innovative business. They also need some good guidelines about how to keep them smart for adopting new and innovative managerial practices for innovative business. SME management needs specific definition of SME lending, a government bank that provide the lending only to SMEs. Setting up VC fund by government is another milestone for SMEs.