Image courtesy of Centre for Poverty Analysis

Small and Medium Enterprises (SMEs) are the backbone of the Sri Lankan economy. The sector accounts for nearly 80% of all businesses and contributes to 52% of the Sri Lankan Gross Domestic Product (GDP). It is one of the main sources of employment generation with an estimated 2.25 million people working as unskilled, semi-skilled or skilled workers in the non-agricultural sector. Despite the sector’s role as a significant driver of growth and job creation, interventions to create the right business environment and to develop entrepreneurial skills have been poor. Thus, in the absence of factors enabling SME development, small and medium scale enterprises have faced increasing difficulties in responding to a severe external shock such as the COVID-19 pandemic.

Despite the adoption of an export-oriented growth strategy following the liberalisation of the economy in 1977, support to the sector was initially skewed towards incentivising and financing large scale enterprises. In fact, it has taken the government well over two decades to acknowledge the SME sector’s true potential,  having established a task force for SME sector development in only 2002, followed by the acceptance of the National Framework for SME Sector Development and SME Development Action Plan in 2015. These are important steps as the Framework, in particular, proposes the facilitation of mechanisms for easy and affordable access to finance to SMEs through various schemes. But how far these schemes have supported the SME sector, especially during the pandemic, is unclear.

The SMEs sector has been one of the hardest hit by the COVID-19 pandemic, affecting the lives and livelihoods of Sri Lankans who rely on the sector for an income. Among the most severely affected SMEs, both directly and indirectly, belong to the tourism value chain, apparel sector, footwear and leather sector, processed food industry and handloom and handicraft industry. With the pandemic, the disruptions and, at times, breakdown of the supply chain have added further strain on the sector.

What is worrying is that conditions that affected the sector even before the pandemic hit have been exacerbated as a result of the pandemic. Some of these pre-pandemic factors include the predominantly male workforce, limited access to finance, high cost of transactions, low innovations and inadequate social protection – the latter a major concern during such emergencies as the pandemic. Among these many factors, a key concern has been access to finance partly to keep the sector afloat but also to help it with recovery. Limited access to finance is also triggered by the actions of both the government and the entrepreneurs. On the one hand, heavy government spending leads to a spike in interest rates and drives down private sector investments. On the other hand, in a climate where maximum loans ceilings exist, some enterprises take multiple loans but this reduces the availability and access to such schemes for small-scale enterprises.

Micro and small-scale enterprises, which usually do not maintain proper accounts and lack financial literacy to maintain necessary documentation, more often struggle to obtain loans as opposed to their medium and large-scale counterparts. Even for businesses that have maintained proper bank accounts, cash flow records and audits, which would have placed them at a relatively advantageous position pre-COVID-19, obtaining loans has become increasingly difficult. In this climate, the hardest hit ventures are those that are already vulnerable: micro and small-scale enterprises, infant SMEs who have only maintained short term engagements with banks and unregistered SMEs that operate in the informal sector.

Despite the Central Bank allocating Rs 15 billion in aid to the SME sector in the aftermath of the first COVID-19 outbreak, financial support has not trickled down to smaller scale enterprises. Commercial banks too have been reluctant to extend loans to micro and small-scale enterprises and unregistered companies against the possible risk of default.

As a result micro and small-scale enterprises, in particular, tend to rely largely on about 2,000 micro finance institutes established across the country. Micro finance institutes usually charge an interest rate significantly higher than that of commercial banks. In fact, a UN DESA report reveals that in some cases the interest rate charged can be as high as 24%, or 30% per annum in the case of pawn brokers. Worryingly, micro and small-scale enterprises count on micro finance institutes because they are unaware of other financial instruments available to them and also because they feel these other financial instruments are not as popular as micro credit. Relying on the financial support of these institutes, at a time like this when cash flows and trade volumes are disrupted, further aggravates the financial constraints endured by SMEs.

While short term refinancing schemes are needed to help SMEs to overcome the challenges imposed by the pandemic, the government should also focus on a sustainable plan that is suited for medium to long term recovery. The key message we must draw out is that a sustainable mechanism of SME financing has been requisite even before the pandemic. A possible avenue to explore that is successfully adopted by India and Bangladesh is the enhancement of financial literacy and discipline of SMEs through banks and training bank officials to assist SMEs. The end goal is not to rigidly take back the money lent but to empower SMEs, turn them into profitable ventures and retain them as long term clients of the bank. This allows both banks and SMEs to overcome the fear element associated with lending and borrowing and grow.

This article draws from insights and experiences of SME sector service providers and entrepreneurs who shared their views with us in a focus group discussion held in May 2021.

This article is the fourth of five published on the CEPA Blog as part of a series to understand the impacts of COVID-19 on poverty and inequality.