Financial Crisis, Trade Finance, and SMEs: Central Asia

An Expert's View about Banking, Finance and Insurance in Turkmenistan

Posted on: 16 Apr 2010

This paper surveys studies of the importance of Central Asian small- and medium-sized enterprises (SME) in the economy and their experience during the Russian financial crisis. It also uses survey data from the World Bank and the European Bank for Reconstruction and Development's Business Environment and Enterprise Performance Surveys to infer noteworthy characteristics, features, and dependencies on financing of Central Asian SMEs and, consequently, derive the potential impact of the crisis on the sector. The paper also assesses government support for SMEs and the necessary market reforms that will give a boost to the sector’s development in the region

ADBI Working Paper Series Financial Crisis, Trade Finance, and SMEs: Case of Central Asia Gloria O. Pasadilla No. 187 January 2010 Asian Development Bank Institute Gloria O. Pasadilla is a Research Fellow at the Asian Development Bank Institute. The paper was written while the author was Senior Fellow at the Philippine Institute for Development Studies, Manila, Philippines. The author wishes to thank participants in the Conference on Global Financial and Economic Crisis: Impacts on SMEs and Trade Finance and Policy Challenges, 20 May, 2009, ADBI, Tokyo, for valuable comments and suggestions. The views expressed in this paper are the views of the authors and do not necessarily reflect the views or policies of ADBI, the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms. The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI?s working papers reflect initial ideas on a topic and are posted online for discussion. ADBI encourages readers to post their comments on the main page for each working paper (given in the citation below). Some working papers may develop into other forms of publication. Suggested citation: Pasadilla, G.O. 2010. Financial Crisis, Trade Finance, and SMEs: Case of Central Asia. ADBI Working Paper 187. Tokyo: Asian Development Bank Institute. Available: http://www.adbi.org/working-paper/2010/01/25/3440.financial.crisis.trade.smes.central.asia/ Asian Development Bank Institute Kasumigaseki Building 8F 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: info@adbi.org © 2009 Asian Development Bank Institute ADBI Working Paper 187 Pasadilla Abstract This paper surveys studies of the importance of Central Asian small- and medium-sized enterprises (SME) in the economy and their experience during the Russian financial crisis. It also uses survey data from the World Bank and the European Bank for Reconstruction and Development?s Business Environment and Enterprise Performance Surveys to infer noteworthy characteristics, features, and dependencies on financing of Central Asian SMEs and, consequently, derive the potential impact of the crisis on the sector. The paper also assesses government support for SMEs and the necessary market reforms that will give a boost to the sector?s development in the region. JEL Classification: E44, G01, G18, G28, G38 ADBI Working Paper 187 Pasadilla Contents 1. Introduction ................................................................................................................ 1 2. Financial Crisis, SMEs, and the Economy ................................................................. 1 2.1 Channels of Transmission From Finance to the Real Economy ..................... 1 2.2 Banks? Role in Trade Finance ........................................................................ 2 2.3 Finance and SMEs ......................................................................................... 3 3. Importance of SMEs in Central Asian Economy ......................................................... 3 3.1 Brief Overview of Central Asia ....................................................................... 3 3.2 SMEs in Central Asia: Definition and Contribution in the Economy ................ 6 3.3 SME Characteristics: Ownership, Establishment, and Export Activities ........ 10 4. Experience of SMEs in Crisis ................................................................................... 13 4.1 Effect of the Russian Financial Crisis in General .......................................... 13 4.2 Effect on SME .............................................................................................. 15 4.3 Effects on Trade Finance ............................................................................. 20 5. Effect of Global Financial Crisis ............................................................................... 23 5.1 Transmission Channels................................................................................ 23 5.2 Macroeconomic Effects ................................................................................ 24 5.3 Effects on Trade Finance and SMEs ............................................................ 25 6. Government Support for SMEs ................................................................................ 29 6.1 Market Reforms ........................................................................................... 30 6.2 SME Perceptions of Various Obstacles to Growth ....................................... 33 6.3 Cost and Access to Finance ........................................................................ 38 6.4 Characteristics of Bank Loans...................................................................... 38 6.5 Bank Loan Usage by SMEs ......................................................................... 41 7. Summary and Policy Recommendations ................................................................. 42 References ......................................................................................................................... 45 ADBI Working Paper 187 Pasadilla 1. INTRODUCTION Major stumbles in economic growth have had something to do with banking system problems. This was true of the Great Depression, true with the Asian financial crisis, and now again with the current global financial crisis. The illiquidity in the global financial market has affected the world, halting more than a decade of exuberant economic growth. It has particularly impinged on trade through reduced provision and high cost of trade finance. Problems in finance impact business operations, and usually especially affect the small- and medium-sized enterprises (SMEs) more. Thus, there is a need to focus research on SMEs and their performance during this time of crisis. 1 The chapter focuses on SMEs in Central Asia . SMEs in the former Soviet Republics were newly born following the breakup of the Union of Soviet Socialist Republics in 1991. While they quickly adapted to the new market economy, they struggled through the very challenging transition period characterized by, among other problems, an institutional vacuum. Then, when the economy had relatively normalized, the Russian financial crisis hit them towards the end of the 1990s. Now, after experiencing stable growth throughout the first half of this decade, the global financial crisis is again threatening to undo many of their past gains. The paper surveys SME importance and noteworthy features, and tries to assess, based on past surveys and in the absence of available official information, the likely impact of the crisis on this sector. Everywhere, government support is important for the development of SMEs, but in Central Asia, good economic stewardship and appropriate implementation of regulations by the government are more critical than any other form of government financial support. The paper first provides a broad?brush discussion of how a financial crisis affects the real economy, the central role of banks in the lubrication of trade transactions, and why SMEs have difficulties accessing bank financing in general and trade finance in particular. Section 3 provides an overview of the Central Asian economy and discusses SMEs importance and discernible characteristics and features. Section 4 and Section 5 put forward a few pieces of evidence on the impact of the 1998 Russian and the current global financial crises on SMEs, drawing heavily from inferences based on firm surveys conducted in 1999 and 2005. The paper relies heavily on the Business Environment and Enterprise Performance Survey (BEEPS, or BEEP Survey) conducted by the World Bank and the European Bank for Reconstruction and Development (EBRD) to derive plausible conclusions on the likely effect on SMEs of the two crises, basing them on sector characteristics and features as well as revealed perceptions by the respondent firms. Section 6 discusses government support of SMEs, particularly their financing needs and problems. Section 7 summarizes and provides policy recommendations. 2. FINANCIAL CRISIS, SMES, AND THE ECONOMY 2.1 Channels of Transmission From Finance to the Real Economy The economic literature has identified various channels through which financial crises 2 spread to the real economy . There is a monetary channel, as well as channels for credit, bank capital, wealth effects, exchange rate, uncertainty and cost of capital that provides various explanations as to how, starting from a financial crisis, real economic output gets 1 Central Asia is composed of Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan. 2 See Furceri and Mourougane (2009). Box 6 in their paper talks about transmission mechanisms from banking crises to activity. ADBI Working Paper 187 Pasadilla depressed. Often, these channels may be active at the same time; for example, as a currency crisis ensues from the financial crisis?causing a rise in interest rates and bankruptcies as well as significant drops in domestic output and employment?significant asset price reductions can take place at the same time, leading to a decline in private consumption (wealth effect) and, thus, to further drops in output. For the current global financial crisis, the bank capital channel and credit channel may be the most relevant transmission mechanisms to understand. The ?bank capital channel? holds that financial crises can erode bank capital, making banks extremely averse to lend, thus leading to a deeper economic downturn (Bernanke, Lown, and Friedman 1991). The ?credit channel? argues that during financial crisis, banks tighten their lending standards and reduce credit availability. These credit constraints lower consumption and investment, thus worsening the economic downturn. Moreover, the credit channel holds that, on the demand side, the crisis reduces the value of collateral and thereby the ability of firms and households to borrow, leading once again to a deeper domestic output cut. Either of these transmission channels is likely to be the main reason for the current global slump. Whether the increased risk aversion exhibited by banks is due to weak capitalization or merely motivated by extreme cautiousness, the effect is a cutback in available funds for trade finance which, in turn, impinge on the volume of trade. Trade finance is considered a relatively low-risk, routine activity, but where bank margins are also low. The low risk stems from the fact that the usual collateral for trade finance is clear and tangible? the value of the 3 cargo it finances. But the low margin income for banks means that, because lenders tend to concentrate most funding on the most profitable segments of financial markets, in times of a tight liquidity squeeze, low value-added products such as short-term trade finance can be easily abandoned or reduced. Besides its low margins, trade finance?s preferential treatment had changed since the 1980s sovereign debt crisis, leading banks to consider trade finance as a less preferred source of profit. Previously, trade finance had preferential treatment in London Club debt restructurings; today, they are no longer distinguished from other loans by creditors, and are hence subject to the same restrictions in the case of risks. In the current global crisis, while only anecdotal evidence exists that point to difficulties in accessing finance, and, so far, there is no evidence that traders are unable to ship because of lack of trade financing, the cost of trade finance instruments has, nevertheless, tripled since last year. The increase in cost points to the same root causes as the lack of access. 2.2 Banks? Role in Trade Finance 4 But what, exactly, are banks? role in trade finance? First, banks provide working capital to exporters, through short-term loans, credit lines or an overdraft facility, or advance payment of exporters? bonds, or discounting of receivables. This pre- or post-shipment financing enables exporters to produce and ship products during the entire cash cycle. Banks in the exporting country can also extend buyer?s credit to a foreign buyer to finance the purchase of exports. Often, the availability of financing such as this can affect the relative competitiveness of the exporters and enable them to attract more contracts. Second, banks render services that facilitate the receipt or transfer of payment in a less costly and risky way (from simple intra-bank money transfers to relatively complex instruments such as leasing, letters of credit [L/Cs], and foreign exchange-related services). They can accept and confirm L/Cs as a counterparty of the importers? bank, or be the issuing bank in the case of importers? L/Cs. Third, banks can provide insurance against trade-related risks, through freight and export credit insurance or forward contracts. 3 There are different trade financing instruments that require different collateral. These are further discussed subsequently. 4 This part draws from Finger and Schuknecht (1999). 2 ADBI Working Paper 187 Pasadilla Of course, there are also forms of trade financing that do not require the intermediary role of banks. The transaction can be done purely between the importer and exporter on a ?cash-in- advance? basis or on an ?open account? basis (when shipment occurs before payment is due). The former is akin to a supplier credit while the latter is like a consumer credit. 5 Companies can also directly issue Bills of Exchange or Promissory Notes . Some countries also make use of counter-trade or barter system by which they exchange goods at an agreed value without cash or credit terms. All these different forms of exchange have varying levels of risks and would not apply to all types of enterprise. For example, only financially stable exporters and those linked with vertical production networks and have long history of buyer-seller relationship can afford to export on an open account basis, while almost 90% of trade transactions are done via documentary credits. 2.3 Finance and SMEs Banks, in both normal and crisis period, usually give priority to low-risk borrowers like large enterprises with profitable investments and sound collateral. SMEs are usually at the bottom of banks? preferred customers, except when the government requires banks to provide loans to this group. Why are SMEs, generally, unable to obtain financing? For banks, SMEs, especially in developing economies, are always considered higher risk because of their opacity, and lack of collateral and audited financial statements. Sometimes, they have no good, profitable projects, no clear titles to real estate and other collateral, no clear managerial targets and succession plans, and no available credit history. SMEs hesitate to approach banks because of a cultural barrier, i.e., they do not want the strict monitoring by banks. At times, too, they may not have adequate information of all that banks can offer. This is particularly true of trade finance instruments. In the succeeding sections, this general interlinkage of bank liquidity problems, collateral issues, SME weaknesses, and trade financing will come into play as the effect of the crisis on SMEs is discussed. 3. IMPORTANCE OF SMES IN CENTRAL ASIAN ECONOMY To tackle the crisis effects on Central Asian SMEs, I first begin with a brief overview of the region?s economies. The section then proceeds with the discussion of SMEs? importance in the economy, drawing from various previous studies, and extracts some noteworthy SME characteristics based on firm surveys. 3.1 Brief Overview of Central Asia Central Asia was among the more underdeveloped regions in the world when the states 6 comprising it became independent in 1991 . Per capita incomes ranged from just over 50% of the Soviet Union average (Tajikistan) to about 90% (Kazakhstan). The region is rich with agricultural, mineral, and fuel resources, but because of its landlocked geography, many countries were heavily dependent on the Soviet system of trade routes and energy pipelines to reach world markets. Transport and trade infrastructure were outdated and, except for the Kyrgyz Republic, all countries in the region either have internal and regional conflicts or are near conflict zones. None had tasted modern statehood; rather their political institutions were legacies of the old communist system, with closed, autarkic, and heavily distorted industry and infrastructure serving mostly military purposes. 5 In both, a buyer undertakes to pay by a specified future date but the latter offers less legal protection. 6 This part draws from International Monetary Fund (IMF) (1999). 3 ADBI Working Paper 187 Pasadilla After the dissolution of the Soviet Union, fast reformers (Kazakhstan and the Kyrgyz Republic) embarked on privatization of many state-owned enterprises (SOE), while gradualists (Uzbekistan and Turkmenistan) moved much more slowly. Tajikistan was in a state of civil war until 1995. SMEs surfaced during the post-break up period amidst a challenging macroeconomic environment marked by hyperinflation, financial system collapse, major structural adjustments, and an institutional vacuum. Some of the privatized SOEs became medium-sized or large enterprises, while all small firms and some medium- sized enterprises were built up from scratch. Buoyed by a more favorable external environment and the high prices of its main export products (e.g. natural resources), Central Asia recovered from a decade of transition-related problems. Now, the most advanced economy of the group, Kazakhstan, has a gross national income (GNI) per capita of more than US$6,000, which is within the upper middle income bracket globally. The score remains below the average of that income group, but is close to other relatively developed economies like Argentina, Brazil, Chile, South Africa, Mexico, Malaysia, and Poland. The Kyrgyz Republic, Tajikistan, and Uzbekistan remain in the low income group of countries globally, but have GNI per capita figures that are more than 20% higher than the group average. Turkmenistan is in the lower middle income group, like many 7 Southeast Asian economies. Table 1 summarizes salient economic features of Central Asia. Kazakhstan and the Kyrgyz Republic fully embraced the market economy, evidenced in the large share of the private sector in its economies, starkly contrasting with Turkmenistan where the private sector 8 remains insignificant . Poverty in Kazakhstan is well within advanced economy levels, but Uzbekistan?s poverty level is extremely high. Literacy rates, even after the deterioration of education levels due to civil strife, remain high throughout Central Asia, reaching almost the same level as in high-income economies. Mortality rates are worse than the upper middle income group average for Kazakhstan, but the mortality rates for the Kyrgyz Republic and Tajikistan are significantly lower (better) than the low income country group average. Turkmenistan?s mortality rate is higher than the lower middle income country group average. As for infrastructure indicators, Kazakhstan is again above the average of the upper middle income group in the number of internet users per 100 people, as is the Kyrgyz Republic with respect to the low-income group. Uzbekistan, though, has an extremely poor internet access figure, with only 1.5 out of every 100 people using the internet. Mobile and fixed telephone subscribers are again high for the three low income Central Asian economies relative to their income group?s average, but Kazakhstan is slightly below the upper middle income group average. Although Turkmenistan might have a higher GNI per capita than the three other Central Asian countries, its infrastructure and social indicators are significantly worse than 9 the three low income Central Asian countries. 7 The World Bank uses the following income classification of countries: Low income US$11,456. A caveat is in order for Turkmenistan?s GNI because statistics are considered state secrets in the country and the published GDP data are subject to wide margins of errors. 8 In Turkmenistan, the private sector share is significant only in food processing and consumer trade and services. 9 See Footnote 7 on Turkmenistan?s statistics. 4 ADBI Working Paper 187 Pasadilla Table 1: Central Asia: Selected Indicators, 2007 Kazakhstan Kyrgyz Tajikistan Turkmenistan Uzbekistan High Low Lower Upper Republic Income Income Middle Middle Economies Economies Income Income Average Average Economies Economies Average Average GNI per capita PPP (current US$) 6,134.8 695.8 701 1,373.7 701.2 37,571.6 574.4 1,905.0 7,107.0 a GNI per capita : group average 0.86 1.21 1.22 0.72 1.22 FDI Inflows per capita (current US$) 470 40 25 124 27 FDI Inward Stock (% of GDP) 41.9 21.8 28.2 49.1 7.4 Private Sector (share in GDP) - 2008 70.0 75.0 55.0 25.0 45.0 Poverty headcount at less than US$1.25 b a day (% of population) 3.1 21.8 21.5 ? 46.3 Land area ('000 sq. km) 2,699.7 191.8 139.9 469.9 425.4 Infrastructure Indicators Mobile and fixed-line telephone 100.5 50.6 39.9 16.2 28.7 150.4 25.5 54.1 106.7 subscribers (per 100 people) Internet users (per 100 people) 12.3 14.3 7.2 1.4 4.5 65.7 5.2 12.4 26.6 Social Indicators Literacy rate, adult total (% of people 99.6 99.3 99.6 99.5 ? 99.0 63.5 82.6 94.1 ages 15 and above) Mortality rate, infant (per 1,000 live 28.0 33.5 56.6 44.9 35.6 5.9 80.2 38.3 20.8 births) Population growth (annual %) 1.1 0.8 1.5 1.3 1.4 0.7 2.2 1.0 0.7 a Notes: Kazakhstan- Upper Middle Income; Turkmenistan - Lower Middle Income; Kyrgyz Republic, Tajikistan, Uzbekistan - Low Income b Kazakhstan, Turkmenistan, Uzbekistan- 2003; Kyrgyz Republic, Tajikistan ? 2004 PPP= purchasing power parity. GDP= gross domestic product.. Source: World Development Indicators, World Bank; http://data.un.org/CountryProfile.aspx 5 ADBI Working Paper 187 Pasadilla 3.2 SMEs in Central Asia: Definition and Contribution in the Economy The definition of SMEs varies per country and even per sector but is, generally, based on the number of employees and capital thresholds. According to a United Nations Economic 10 Commission for Europe (UNECE) study , Kazakhstan, Kyrgyz Republic, and Turkmenistan base SME definitions on maximum levels of capital, assets or income, and number of employees, while Tajikistan and Uzbekistan base the definition only on the number of employees. The threshold for the number of employees likewise varies per sector. For example, in Uzbekistan, to be considered ?small?, the average number of employees should not exceed 40 in industry, 20 in construction, agriculture and other production spheres, 10 in retail trade and other nonproduction spheres. Other Central Asian countries likewise follow different thresholds for the maximum number of employees for different sectors of the economy. Of the five countries, only the Kyrgyz Republic provides a definition for medium- 11 sized enterprises, while the rest leave medium-sized enterprises undefined (see Table 2). 10 UNECE (2003a). 11 Importantly, none of the official definitions of SMEs coincide with the classification that this paper uses in subsequent discussions. The paper follows other studies on SMEs that simply base firm classification on the number of employees or, if available, the amount of annual sales/turnover. Micro and small enterprises are those with less than 50 employees, medium with 50 to 249 employees, 250 and above are large firms. 6 ADBI Working Paper 187 Pasadilla Table 2: Definition of SMEs in Central Asia Country Official Definition of SME Kazakhstan Small: Average annual number of employees not more than 50; Assets not exceeding 60,000 fold monthly estimated index (in 2002 the monthly estimated index equalled 823 tenge) Medium: No definition Kyrgyz Republic Small: Production sphere: Number of employees up to 50; Net turnover up to Som500,000; Non-production sphere: Number of employees up to 15; Net turnover up to Som500,000; Medium Production sphere: Number of employees: 51?200; Net turnover: Som500,000?Som2,000,000; Non-production sphere: Number of employees: 16?50; Net turnover: Som500,000?Som2,000,000 Tajikistan Small enterprise: The average number of employees should not exceed - in industry and construction ? more than 50 - in other spheres of activities ? 15 Medium: No definition Turkmenistan To be considered as a ?small enterprise,? 80% of an enterprise?s income should come from the sale of primary activity goods (services) in the reported quarter. Small enterprise: 50 employees ? for the enterprises that produce goods for industrial/technical consumption purposes, goods for public consumption and enterprises that carry out constructional and maintenance-constructional activities; 10 employees ? for the wholesale enterprises and those deriving revenues from intermediary and supplying activities; 25 employees ? for the enterprises with other types of activities Medium ? No definition Uzbekistan Micro enterprise: Average annual number of employees shall not exceed: 10 ? in industry; 5 ? in trade, services and other nonproduction spheres Small enterprise: Average annual number of employees shall not exceed: 40 ? in industry; 20 ? in construction; agriculture and other production spheres; 10 ? in retail trade and other nonproduction Spheres Medium ? No definition Source: UNECE (2003a). Various studies on SMEs compiled by the World Bank/ International Finance Corporation (IFC) from different sources usually define an SME based on the number of employees. On this basis, the collected information shows that Uzbekistan has more than 200,000 micro- and small- and medium-sized enterprises (MSMEs), 86% of which are micro-sized 7 ADBI Working Paper 187 Pasadilla enterprises (see Table 3). The Kyrgyz Republic has more than 100,000 MSMEs largely comprised of both micro- and small-sized businesses. There are close to 30 MSMEs per 1,000 people in the Kyrgyz Republic while the ratio is 14 and 10 MSMEs per 1,000 people for Tajikistan and Uzbekistan, respectively. In terms of employment, MSMEs? share of total employment range from 25% (for Tajikistan) to 60% (Turkmenistan). Uzbekistan and Tajikistan?s MSME share of employment is below 12 the average of 58% for low income countries , while the Kyrgyz Republic and Turkmenistan is slightly over the average. The average SME employment share for upper middle income economies, where Kazakhstan belongs, is 40%? much higher than the 25% employment share in Kazakhstan. The importance of MSMEs in the economy is shown in the high contribution of MSME to total domestic production. In Uzbekistan, the MSME share of GDP is about one third, while it is more than 40% for Kazakhstan, Turkmenistan, and Kyrgyz Republic. The average GDP 13 share of MSME for transition economies, based on data collected by UNECE , is around 40%, while it is 37% for transition economies considered to be making slow progress on reform. 12 Based on the collected information from the IFC, I averaged all the collected share of MSME employment according to economic income category. 13 UNECE (2003a). 8 ADBI Working Paper 187 Pasadilla Table 3: Importance of SMEs Source Structure of the MSME of MSME Definitions MSME Participation in the Country Name Year Sector MSME (number of employees) Economy (% of all MSMEs) Data MSMEs MSME MSME per Share Micro Small Medium Micro Small Medium MSMEs employment 1,000 of GDP (% total) a people c 0-9 10-49 50-249 59.4 35.3 5.3 170,612 11.3 Kazakhstan 1994 UNECE 24.6 43.1 Kyrgyz Republic 0-9 10-49 50-249 99.4 0.6 142,475 28.3 e f 2003 UNECE 59.0 42.7 b <50 51-200 99.8 0.2 92,964 14.3 25.0 Tajikistan 2002 IFC ? f d IFC <10 10-39 40-99 85.7 11.2 3.1 212,424 10.5 57.0 / 49.7 Uzbekistan 2003 31.0 f 60.0 Turkmenistan 45.0 Notes: a. UNECE (2003a). b. Includes individual entrepreneurs and Dekhan farmers. Source: IFC. Business Environment in Tajikistan as seen by SME Businesses 2003 c. No. of MSEs and MSE Participation taken from USAID SME Statistics (as of October 2005, divided by population and employment in 2005). Share to GDP is for 2003. Number of operating MSMEs only, not total registered MSMEs d. IFC. Business Environment in Uzbekistan as seen by SMEs. 2003 (without individual entrepreneurs, employment share is 9% and share in GDP is 15% (ADB, Private Sector Assessment for Uzbekistan. 2005). Active number only. e. UNECE (2006). f. Employment share data (alternative figure) is from UNECE (2003a) Source: Kozak (2007), UNECE (2003a), UNECE (2006), IFC Business Environment Surveys, ADB. 9 ADBI Working Paper 187 Pasadilla More than one third of SMEs in Central Asia are engaged in trade. In the Kyrgyz Republic, services and manufacturing likewise constitute a big portion of SME totals, while in Uzbekistan, SMEs in manufacturing constitute the majority. Tajikistan has most of their small enterprises engaged in agriculture, primarily related to cotton farming and related services (Table 4). Table 4: Structure of Incorporated SMEs by Sector (2001) Distribution of Small and Medium-Sized Enterprises (%) Trade Manufacturing Construction Services Other Activities Kyrgyz 35.8 21.1 9.3 28.2 5.6 Republic Tajikistan 38.4 15.0 12.1 11.0 23.5 Uzbekistan 34.0 43.0 8.0 8.0 7.0 Note: Other activities comprise of: agriculture; fishing; production and leading of electricity, gas and water; transport; public administration; institutions of education; exterritorial organizations; financial mediation; real estate transactions; healthcare; arrangement of recreation and entertainment facilities Source: UNECE (2003a). 3.3 SME Characteristics: Ownership, Establishment, and Export Activities I use the 2005 BEEP Survey by the European Bank for Reconstruction and Development 14 (EBRD) and World Bank to get a better look at SME characteristics in the region. The 2005 sample is comprised of 1,002 respondent firms from Central Asia, of which 690 are micro- and small-sized enterprises, 209 medium-sized firms (micro, small, and medium hereafter), 15 and 103 large firms, using the number of employees as the basis for classification. I find that among small firms, the number of those that are single proprietor (where a shareholder owns 100% of shares) ranges between 54% and 71%, while among large firms, the share of single-owned enterprises is much less. More than half of the firms in Central Asia have been private firms from the beginning. In Kazakhstan, the number of private start-ups was up to 75% while only 20% were established as privatized SOEs. Across all Central Asian countries, the number of private start ups exceeded the number of privatized SOEs which possibly implies a growing entrepreneurial class of citizens in these former communist countries. Among small firms, the majority were established as private start-ups. In Kazakhstan, for example, more than 80% of small firms started as a private enterprise right at the beginning. In the Kyrgyz Republic, the share is 61% and in Uzbekistan 77%. In contrast, relatively more medium and large firms were established from the privatized state-owned enterprises, rather than as private start-ups (Figure 1). 14 The main BEEP Survey in 2005 is composed of 300 firms each from Kazakhstan and Uzbekistan, 202 from Kyrgyz Republic, and 200 from Tajikistan. For both 1999 and 2005, the survey sample used stratified sampling, with various quotas on the basis of sector, size (based on number of employees), and location. For the 2005 survey, additional targets were included in the sample design, namely: at least 10% small enterprises (2-49 employees), and 10% large (250?9,999 employees); at least 10% of firms should be foreign controlled (more than 50% shareholding) and 10% under state control; at least 10% of firms export at least 20% of total sales; and at least 10% should be from a small city/countryside. Furthermore, the sectoral composition of the sample was determined according to the relative share in GDP. The sample excluded firms with only one employee, or those in sectors that are subject to government price regulation and prudential supervision like banking, or utilities (electric power, rail transport, water). See methodological notes on the BEEPS from the European Bank for Reconstruction and Development at www.ebrd.org. 15 In subsequent discussion, the results do not materially change when I used both number of employees and amount of turnover/sales. So I opted for the more simple classification using employment. See Footnote 10. 10 ADBI Working Paper 187 Pasadilla Figure 1: Characteristics of SMEs: by Establishment and Ownership (in %) Kyrgyz Republic Tajikistan Kazakhstan Uzbekistan 90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 % of firms that are originally private from start up % of firms established through privatisation % of firms owned 100% by the largest shareholder to total number of firms Source: BEEPS (2005). How important are exports in SME activities? I grouped the firms in the BEEP Survey into 16 those that export directly as well as those that export indirectly . The sample contains few firms, only 14% of the total, that directly or indirectly export (i.e., with positive export sales). But for these few firms, average direct and indirect exports constitute 45% and 28% of their total sale, respectively. Direct exports as a share of total revenue range from an average of 27% for Kazakhstan to 62% for Tajikistan, while indirect export revenue is between 14% 17 (Uzbekistan) and 45% (Kazakhstan). Only 10% of SMEs in the sample directly export, yet in these firms, exports are a significant portion of their income. What is particularly striking is that, in Uzbekistan and Tajikistan, the share of export sales in small firms of 58% far exceeds the Central Asian sample average. In the Kyrgyz Republic, large firms? exports dominate their total sale, while in Kazakhstan and Tajikistan, large firms? exports were roughly a third of sales (Table 5). 16 Indirect export is when firms sell to a distributor or direct exporter. 17 This is merely the targeted quota for exporters in the sample. 11 All Firms small medium large All Firms small medium large All Firms small medium large All firms small medium large ADBI Working Paper 187 Pasadilla Table 5: SMEs and Export Activity Total No. No. of Percentage share No. of Firms that Percentage share of of Firms Firms that of direct exports Exported through indirect exports to total Export to total sale (by a distributor sale (only firms that Directly exporting firms) exported through a distributor) Central Asia 1,002 136 45 21 28 SME 899 93 45 15 27 Large 103 43 42 6 6 Kazakhstan 300 31 27 7 45 SME 268 21 24 5 45 Large 32 10 31 2 6 Kyrgyz Republic - All 202 38 46 8 20 SME 128 25 39 6 20 Large 21 13 62 2 10 Tajikistan - All 200 25 62 2 25 SME 123 19 58 1 40 Large 20 6 30 1 5 Uzbekistan - All 300 42 49 4 14 SME 219 28 58 3 8 Large 30 14 47 1 3 Source: BEEPS (2005) and author's own computations. 12 ADBI Working Paper 187 Pasadilla 4. EXPERIENCE OF SMES IN CRISIS Central Asia experienced its first post-independence economic crisis in 1998, which lasted up to 1999 following the Russian financial crisis. The channel through which contagion spread was through trade when Russia devalued its currency by 68% in 1998 and 326% in 1999 relative to pre-crisis ruble to US dollar exchange rate levels. Russia and the Commonwealth of Independent States (CIS) were Central Asia?s main trading partner in the 1990s. This devaluation led to a loss of export markets in Russia and globally, as well as import penetration by Russian products in Central Asia. The exchange rate devaluation and volatility was compounded by weak commodity prices and by the banking system disruptions related to the crisis. 4.1 Effect of the Russian Financial Crisis in General The Russian ruble devaluation led to the relative appreciation of Central Asian currencies, causing their exports to slump in their major trading market. The hardest hit were the countries that had significant trade links with Russia and other members of the CIS, especially Kazakhstan. Kazakhstan?s GDP contracted by 2% in 1998, but also quickly recovered in 1999. Before the crisis, a significant share of Central Asian countries? exports went to Russia and other CIS countries. Russia was a key export market for Uzbek cars and electronics, Kazakh chemicals, metals, food items, and light industry products. Both these countries exported more than a third of their total exports to Russia. Tajikistan exported (and still does) a huge number of laborers for Russian construction sector. Thus the ruble devaluation caused a significant rise in the region?s current account deficit as a percentage of GDP (Table 6). However, some countries like Kyrgyz Republic and Turkmenistan felt the export contraction not mainly through the depressed Russian market but, in the case of the former, more from the low prices and production problem in the mining sector, and in the case of the latter, from 18 the suspension of gas exports to Ukraine . The imbalance in trade between Russia and Central Asia continued until the domestic currencies in Central Asia were allowed to float. Average depreciation in Central Asian currencies against the US dollar in 1998 and 1999 ranged from 147% in Kazakhstan to more than 1,500% in Turkmenistan. Kazakhstan?s currency appreciated vis-a-vis the ruble by 39%, from a rate of 13.03 tenge to a ruble to 8.07, in 1998 and appreciated further to 4.85 in 1999, or a whopping 63 % exchange rate adjustment since the beginning of the crisis. Except for Turkmenistan, Kazakhstan had the deepest rate of adjustment from the precrisis levels relative to other Central Asian countries. The Kyrgyz Republic had the least exchange rate adjustment by 1999, appreciating only by 47% from the 1997 level (Table 6). Aside from allowing their currencies to float, Central Asian economies also adopted various trade restrictions in a futile effort to initially maintain the peg to the ruble. Examples of these measures included: introduction of 20% value added tax (VAT) in Kazakhstan on all personal imports from Russia, Uzbekistan, and Kyrgyz Republic; imposition of import quotas after local producers complain about unfair competition from imports; new licensing procedures; etc. In Turkmenistan, the government required all export and import contracts to be approved by the State Commodity Exchange. In Uzbekistan, the government banned the free unlicensed sales of food, mostly imported from Russia. Except for the Kyrgyz Republic, none of the Central Asian countries was a member of the World Trade Organization (WTO) at the time of the crisis, hence they were able to make discriminatory tariff changes against imports from specific countries, a violation of the most-favored nation principle which is 18 For this subsection, the paper draws from IMF (1999) which discussed in greater detail the Central Asian crisis following the Russian financial crisis. 13 ADBI Working Paper 187 Pasadilla sacrosanct to the WTO. On exchange flows, Uzbekistan increased the surrender 19 requirement on exports, while Kazakhstan increased it on invisible transactions and current transfers. Other Central Asian countries adopted other similar measures to favor domestic producers. Besides being hit by the ruble devaluation, Central Asia likewise suffered through the weakness in world commodity prices. At the time when oil prices were hitting a low of US$10 per barrel, the heavily commodity export-dependent economies had little else to offset the adverse impact of the exchange rate volatilities. It was not until 1999 when the price of oil and metals increased that Central Asia was able to raise export levels and revenues. The decline in capital inflows due to the crisis and the disruption in banking activities raised foreign borrowing costs for all emerging markets. Kazakhstan, in particular, was severely affected as its banks intermediated huge flows of foreign capital and plowed them into the domestic economy, especially the mining sector. But as foreign investors became more circumspect about the former Soviet republics, the sources of capital dried up. Reportedly, international banks limited total loan exposures to these countries and made granting them more stringent. For example, the approval of any loans to Kazakh entities had to be obtained 20 from the highest level of their headquarter offices .The Kyrgyz Republic, in turn, suffered from the drying up of liquidity when Russian and Kazakh bank subsidiaries operating in its domestic market limited funds and became extremely cautious. Compared to the first half of the 1990s, with three or four digit inflation in some Central Asian countries, inflation was not a significant concern during the Russian crisis, except for the Kyrgyz Republic which saw its inflation soar to 36.0% in 1999 from 10.5% in 1998. Relative to precrisis inflation, price changes seemed to have slowed, perhaps as a result of the significant appreciation of their currencies with respect to the ruble, increased control in the regulation of monopoly markets, changes in VAT rates, and cheap prices for raw materials (Kalyuzhnova and Vagliasindi 2006). 19 This usually refer to services related transactions in a country?s current account. 20 IMF (1999). 14 ADBI Working Paper 187 Pasadilla Table 6: Selected Crisis Indicators 1997 1998 1999 1997 1998 1999 GDP Growth (%) Unemployment (%) Kazakhstan 1.6 -1.9 2.7 13.0 13.1 13.5 Kyrgyz Republic 9.9 2.1 3.7 5.7 5.9 7.2 Tajikistan 1.7 5.3 3.7 2.6 3.2 2.2 Turkmenistan -11.3 6.7 16.5 1.9 2.0 2.1 Uzbekistan 2.5 4.3 4.3 0.3 0.4 0.4 Current Account Balance Inflation (% growth in CPI) (% GDP) Kazakhstan 17.4 7.1 8.3 -3.5 -5.5 -0.2 Kyrgyz Republic 23.4 10.5 35.9 -7.8 -21.7 -14.5 Tajikistan 88.0 43.2 27.5 -4.0 -7.3 -0.9 Turkmenistan 83.7 16.8 24.2 -21.6 -32.7 -14.8 Uzbekistan 70.9 29.0 29.1 -4.0 -0.7 -1.0 Fiscal Deficit (% GDP, current prices) Lending interest rate Kazakhstan -3.7 -3.9 -3.5 ? ? ? Kyrgyz Republic -5.2 -3.0 -2.5 49.4 73.4 60.9 Tajikistan -4.1 -2.7 -2.4 75.5 50.9 26.2 ? ? ? Turkmenistan -0.2 -2.6 0.0 ? ? ? Uzbekistan -2.4 -2.0 -1.7 Exchange rate (LCU/US$) Exchange rate index (LCU/Ruble, 1997=100) Kazakhstan 75.4 78.3 119.5 100 61.9 37.2 Kyrgyz Republic 17.4 20.8 39.0 100 71.3 52.7 Tajikistan 0.6 0.8 1.2 100 79.5 47.0 Turkmenistan 4,143.4 4,890.2 5,200.0 100 70.4 29.5 Uzbekistan 62.9 94.5 124.6 100 89.6 46.5 Notes: CPI= Consumer Price Index; LCU= Local Currency Unit. Sources: Asian Development Bank (2008); IMF (2009) 4.2 Effect on SME 4.2.1 Capacity Utilization The Russian crisis had different effects on different sectors of the economy. For example, relative to other producers, import substituting sectors have felt the pinch harder due to the huge inflow of cheap Russian goods to Central Asia. Kalyuzhova and Vagliasindi (2006) validate this through a panel data econometric estimate of capacity utilization of firms in Kazakhstan. The argument is that when firms face reduction in demand, they run down inventory, thus leading to a lower level of utilized capacity.21 The authors show that import substituting sectors exhibit lower capacity utilization during the period of the Russian crisis 21 This actually depends on whether the reduction is temporary or permanent. The reduction in capacity utilization will ensue if reduction is permanent. However, because of demand uncertainty, firms can also cut capacity even if the demand reduction is temporary. 15 ADBI Working Paper 187 Pasadilla relative to other sectors, implying that the sector was more heavily affected by increased competition from cheap Russian imports. One would have thought that many of the import substituting sectors must have been SMEs since the large enterprises in Kazakhstan are normally associated with the extractive sectors and export sector, and that, therefore, SMEs were those that should have suffered more severely from the Russian crisis. The authors, however, showed that this did not appear to have been the case. Their result, in fact, showed that, relative to other sectors, SMEs were less affected by the crisis evidence by their higher degree of capacity utilization. 22 According to the authors, the higher capacity utilization, in turn, is due to the more flexible production structure of SMEs compared to large firms that are mostly SOEs or still partially owned by the government which has, therefore, ?social obligations? towards the community and forced to retain employees as much as possible. 4.2.2 Sales, Investments, Exports, Employment, Debt This apparently puzzling result appears to be also corroborated by the 1999 BEEPS. I consider only firms in the sample with annual sales not exceeding US$15 million which, as 23 per definition used by the World Bank, is the limit for medium enterprises . I could not use the number of employees, as I did with the 2005 survey because the 1999 survey did not contain this information. As in 2005, the 1999 survey was conducted using a quota sample with targeted quotas on the basis of sector, size (based on number of employees), and location. One of the questions in the survey that can be interpreted as providing some assessment of the Russian crisis? impact on SMEs asks whether the firm?s sales, investment, and employment have changed over the past three years. As a result of the crisis, one would expect sales of SMEs to plummet and investment to take a back seat, but the result of the survey is, surprisingly, the reverse. The number of firms that reported an increase in sales and investments over the three preceding years exceeds those that report a decrease (Figure 2). Among exporters, the number of those that report an increase is roughly the same as those that experienced a decrease in exports. Only for ?employment? did more firms report a decrease, while all the other variables appear to signify that firms were not that badly affected by the Russian crisis after all. Though the question in the survey relates to the three preceding years, the answers of the enterprises in 1999 are still telling of the relatively little impact of the Russian financial crisis on Central Asian SMEs. It is as if the SME responses were saying that relative to how they were during the earlier part of the decade with all the transition difficulties brought about by the break up of the Soviet Union, the financial crisis is almost like a ?non-event?. If the crisis had been highly significant in reversing whatever gains they have had since earlier times, many enterprises would have reported ?decreases? in sales, investments, and exports over the past three years. But the survey result shows more number of SMEs reporting increases. For the lack of actual data of impact on SMEs, I take this evidence to mean that the result of the Russian crisis might not have been so dire, consistent with the same findings by Kalyuzhova and Vagliasindi (2006). On the other hand, that many firms report decrease in employment may be indicative of the restructuring programs of many privatized SOEs, whereby many superfluous laborers were removed. Is there a difference in the perception between exporting and non-exporting SMEs, and importing and non-importing ones? Further 22 SMEs in their study are enterprises with less than 500 employees. This definition is different from most studies e.g. by EBRD or World Bank, where SMEs are defined to be those with 250 employees and less (300 employees for World Bank studies). 23 In many studies, the World Bank uses the following definition for SMEs: medium ? up to 300 full time employees and annual sales up to US$15 million; small ? up to 50 employees and annual sales of up to US$3 million; and micro?up to 10 employees and annual sales of up to US$100,000. 16 ADBI Working Paper 187 Pasadilla classification of the respondents did not exhibit any significant difference between exporters and non-exporters, nor between importers and non-importers. Figure 2: Percentage Share of Reporting Firms in 1999 (in %) 50 40 Increase 30 Decrease 20 10 0 SALES INVESTMENT EXPORTS EMPLOYMENT DEBT Q: Have your company's sales, investment, exports, employment, and debt changed over the last 3 years? The response is indicative of how firms saw the 1999 financial crisis relative to transition difficulties during earlier part of the decade Source: BEEPS (1999) 4.2.3 Arrears Other corroborating evidence of the relatively little impact of the Russian crisis on SMEs is the number of firms in arrears on payments for taxes, utilities, salaries, and supplies. An overwhelming majority of respondents reported that they had no accounts payable in arrears (90-day overdue accounts) either to the government or suppliers or workers. Of the firms that had arrears, many more said that the amounts were modest than those that said substantial (see Figure 3). If there were significant amounts of arrears, they stemmed from late payments on accounts receivables, as customers were either unable to pay or requested to delay payments. Even then, most firms reported that the overdue accounts receivable amounts were modest. Since firms usually make use of liability payment arrears, especially tax arrears, as a cheap source of financing, this data indicates that, indeed, the SMEs did not appear to have been that badly scathed from the Russian crisis. 17 ADBI Working Paper 187 Pasadilla Figure 3: Number of Reporting Firms (share of total in %) 80 70 60 50 40 30 20 10 0 Utilities Suppliers Government Local Taxes Workers Customers Taxes (1) Substantial amount (2) Manageable amount (3) Modest amount (4) Non-existent Source: BEEPS (1999). 4.2.4 Perception of Major Obstacles Comparing the firms? perception of major obstacles in 1999 and 2005, the surveys show that the SMEs? concern during the financial crisis was over the macroeconomy (see Figures 4a and 4b). The survey asked firms to rate specific factors from 1 (not an obstacle) to 4 (major obstacle). I took the number of firms that considered the different factors as major obstacle as a share of the total sample, shown in Figure 4. More than 50% of surveyed firms considered inflation and exchange rates as major obstacles to their business, while only 46% indicated that financing was an obstacle. Other high-ranked factors are corruption, taxes, and policy/regulatory uncertainty. This result indicated how macroeconomic uncertainty posed a threat in the operations of many firms then and, by implication, financial crises exact real costs to the economy through the volatilities they create for firms. This concern over macroeconomy contrasts markedly with the result of the 2005 survey, taken at a time when the economy was generally stable. In 2005, macroeconomic considerations were not a major concern of firms. High taxes were a concern both in 1999 and 2005, but in the more stable period, it took a dominant place. Financing, too, was considered a major issue in both periods but, especially in the case of small firms, the cost of finance was a top concern in 2005. The other difference between the two surveys is that there was no single factor that was overwhelmingly considered as a major obstacle in the later survey. In 2005, 18 ADBI Working Paper 187 Pasadilla for example, the top ?vote-getter? (taxes) concerned only 21% of the firms, while in 1999, macroeconomic factors received ?votes? from more than half of the sample. The 1999 and 2005 BEEP Surveys were not conducted on the same set of firms to make a panel data. The BEEP Surveys included a panel component of 1,500 firms from the 2002 and 2005 surveys, but not from the 1999 round. The change in perception between two groups of respondents, however, still reveals an overall shift of business sentiment even if the set of respondents may have been different, in relatively the same vein as how the random surveys that are usually carried out on various population groups are used to assess the public sentiment on any social or political issue. These random surveys of public perception are, likewise, not panel data, but rather to be considered a snapshot of the public pulse at different points in time. Figure 4a: Percentage of Firms Considering Factor as Major Obstacle in 1999 Notes: (a) Refers to practices by government or private enterprises; (b) Infrastructure refers to telephone, electricity, water, roads, and land. Source: BEEPS (1999). 19 ADBI Working Paper 187 Pasadilla Figure 4b: Percentage of Firms Considering Factor as Major Obstacle in 2005 25 20 15 10 5 0 Source: BEEPS (2005). 4.3 Effects on Trade Finance Some questions in the BEEP Survey focused on financing obstacles. Here, more than 50% of SMEs considered high interest cost as a major obstacle and this share was the same among different groups: exporters, non-exporters, importers, and non-importers. The next three major obstacles cited in 1999 - collateral requirements, access to long-term loans, bank bureaucracy? were cited by a far lower percentage of firms that considered them as major obstacle (Figure 4). Interestingly, the ranking of these three factors permutes depending on whether the firms engaged directly in trade or not. In particular, for direct exporters and importers, collateral requirements came second, followed by access to long- term finance, and bank bureaucracy, while for non-exporters and non-importers, access to long-term finance was second, then bank bureaucracy, and collateral requirements. Among the different formal financing arrangements that banks offer, trade finance is usually the least attractive to them, because it is typically a low-margin activity. However, it is also among the safest because they have clear, tangible collateral in the cargo that they fund. The 1999 BEEP Survey did not dwell in particular on trade finance, but Figure 5, below, indicates it must have been likely that, along with other financing, the cost of trade finance had likewise surged during the Russian financial crisis. 20 Tax rates Tax administration Cost of financing (e.g., interest rates Corruption Uncertainty about regulatory policies Macroeconomic instability (inflation, Anti-competitive pract ices of Business licensing and permits Access to financing (e.g., collateral Functioning of the judiciary Customs and trade regulations Street crime, theft and disorder Access to land Skills and education of available Title or leasing of land Contract violations by customers and Organised crime/mafia Electricity Telecommunications Labour regulations Transportation ADBI Working Paper 187 Pasadilla Figure 5: Number of SMEs Indicating Factor as Major Obstacle to Financing in 1999 (in %) 60 50 40 30 20 10 0 s t s s s s s s y s ed l r r n n n e n c k c n a e e t a a o e i o n n i e i a r l c n o t t a a i m r l c m t f u o o u b r n t u p f i k t tt i t a f s i i a o ns n t u t p e t e y g s k u s r a i / q r r e n c s e b n n e e o u i i r n t ra p l b r n l o o n o m b a t x i / a o o f i r i s k m f f e c c h e r n o e o t n k e n t d g o o v i - c i a c n a e s n g t H w a n i sn o n s l a i n r i ii / a l f f e t y o e s a / n m / c l t i i p p ks r s ic f c u o a k n ko a u e r t e f p n a r n q s k p s a B n a k o e i c s a s b b n C l a e k e o f l a L a c h n t i o t c B o c a i s t a s b s n t w s a k e n ns c c n s e e i o c a nf c n a L / m o c t i i k e t oa t c r d c i k a e e s u c L r n s q a c e n e L c r e o c t c l a a l a r u a k i e q c c t e a e a L l d l p a s o n C I d e e N Source: BEEPS (1999). 4.3.1 Weak Financial System There are some factors that can explain the difficulty of access to finance, especially trade finance, of firms in Central Asia. One factor that the region shares with other transition and emerging economies is the weakness of the banking system. When the Russian financial crisis occurred, both Kazakhstan and the Kyrgyz Republic had just gone through a serious financial system crisis. The unstable financial position of the region?s commercial banks, which was further aggravated by the Russian crisis, made them high risk counterparties of western banks in any trade financing deal. Various reports during the period on conditions in the CIS, of which the Central Asian countries are members, indicate that prior to the 1998 financial crisis, western banks were generally ready to confirm L/Cs issued by CIS banks. During the crisis, only very few banks remained willing to accept L/Cs issued by CIS 24 banks. It is likely the case that the same situation, if not worse, held true in Central Asia during the period. Since SMEs tend to get less favorable treatment from banks relative to 25 large enterprises even during normal periods, it can be surmised that during the Russian financial crisis, the financing situation for SMEs, could have only gotten worse. 24 Various issues of the EBRD Transition Report discussed some of the financing problems in CIS countries. A similar situation happened to Indonesia forcing the central bank to deposit part of their foreign currency reserves in foreign banks as guarantee or collateral for the L/Cs issued by Indonesian banks. 25 This is due to various factors. SME creditworthiness is hard to evaluate, and in the region, many of them are new and have no credit history. 21 ADBI Working Paper 187 Pasadilla The weakness of the banking sector does not only affect trade finance through the lack of trust from foreign counterparties; it directly affects the domestic provision of trade and working capital financing services to local exporters and importers. During a financial crisis, banks? weak condition makes them very selective in granting trade financing loans. In Central Asia, many local private banks issued L/Cs only to customers with the requisite funds on their account. This was almost equivalent to a cash collateral requirement by the issuing banks, making the financing operations of the firms more challenging. As the region is dependent on commodities exports, Central Asia?s trade financing needs are more for working capital and pre-shipment financing. Generally, without a working capital source, exporters have higher performance risk, i.e. the risk of not being able to deliver on time and according to desired quality. Hence, access to pre-shipment trade financing can help firms attract more international business. If exporters cannot deliver goods on time because of a lack of working capital, repeat business will be more difficult to obtain. But a weak banking system and a financial crisis make pre-shipment trade financing for working capital purposes more difficult and costly to obtain because the reluctance of banks to extend credit without burdensome collateral requirements is heightened during this period. 4.3.2 Knowledge Deficit Besides the undercapitalization of Central Asian commercial banks, they also offer a limited range of services and relatively inefficient loan monitoring capacity. Particularly in the 1990s, they lacked experience in documentary trade operations as well as knowledge in other trade financing instruments such as forfaiting or factoring. Western banks often indicate that only a few banks in the region have sufficient know-how to act as an advising bank in an L/C transaction where a western bank acts as an opening (issuing) bank. In some cases, the region?s banks also have standards for trade finance operations that differ from international ones. Moreover, the document-processing technology is out-of-date (UNECE 2000). 4.3.3 Risk Perception and Payment Method The other major factor is the perception of a high risk level in Central Asia that affects conditions of payment for trade transactions. For example, the French Export Credit Agency (COFACE) classified Central Asia as a high risk area and, thereby, advised exporters to the region to negotiate on pre-payment terms if possible. In contrast, other former Communist 26 countries like Poland and Hungary had been able to negotiate on open account and documentary credit terms. The high risk perception, along with the lack of know-how of banks in documentary credits transactions, could be the reasons for the predominant use of the prepayment method not only in import, but also export, transactions in Central Asia and many CIS economies. 4.3.4 Trade Alternative In Central Asia, countertrade among traditional Soviet-era partners still exist and, in fact, helped in times of financing difficulties. When access to bank financing was difficult, countertrade among CIS countries played a major role in maintaining trade volumes and supply in individual regions. Even in some countries where cash withdrawals were strictly monitored and controlled, barter activities thrived for some basic materials and consumption goods. To a certain extent, it is alleged that barter trade may actually be less costly and more convenient than cash- or credit-based trade due to high taxes, insecure property rights, imperfect credit markets, and rent-seeking behavior of financial intermediaries (UNECE 2000). 26 Open account is essentially like a trade credit given to importers by the exporter where payment may be delayed even as ownership of the exported goods had already been transferred to the importers. It takes an enormous deal of trust among parties for open account to be granted. This normally takes place, especially among vertically integrated firms or parent-subsidiary trade, where risk is extremely low and repeat business characterizes the relationship. 22 ADBI Working Paper 187 Pasadilla 5. EFFECT OF GLOBAL FINANCIAL CRISIS 5.1 Transmission Channels While the main channel for transmission of the Russian financial crisis to Central Asia was through trade links, the global crisis impacts the region directly through the financial illiquidity in the global markets. The most affected of the countries in the region is Kazakhstan which had fuelled its rapid growth through heavy private sector external borrowing from foreign capital markets. Kazakh banks balance sheets are estimated to have 50% in foreign 27 liabilities which, during the boom period, were plowed into the economy to finance major construction, rea
Posted: 16 April 2010