Role of leasing in SME sector

Governments of growing economies are increasingly recognising the potential of SMEs in providing jobs and in assisting poverty alleviation programmes. In many countries close to 50% of the population is younger than 16-17 years of age hence the pressure for rapid job creation. Focus on SMEs is understandable. Data for developing and developed countries indicate that SMEs account for between 60-90% of all enterprises. The same percentage of workers (60-80%) is employed by SMEs (excluding agricultural workers). Their contribution to GDP, however, is not as large. In Pakistan this is about 30%. But therein lies the opportunity and the reason for government's attention. Expansion of SMEs has a direct and significant impact on GDP growth.
Quite often the impression, even amongst the informed sections of the public, is that SMEs are a phenomenon of lesser developed economies that big enterprises don't exist in sufficient numbers due to lack of resources and skilled workers. I said earlier that in some countries 90% of the enterprises are SMEs. This refers to Japan and Korea.
Behind Toyotas, Hondas and Samsungs there are hundreds of small family-owned units supplying parts and accessories. These big corporations have assumed the responsibility of assisting and improving the skills and resources of the small suppliers and in turn increase their own productivity and quality. In Germany, too, I understand 90% of all enterprises are classified as SMEs.. Based on this, the same must be the case in the rest of Europe and USA.
Leasing is a big business internationally. Total lease volumes reported through leasing companies are in excess of $500 billion annually. USA is the predominant market where volumes exceed $200 billion, followed by Japan in the second place with $68 billion.
The top five countries account for 75% of the world's leasing business. Significant volumes are also generated by banks but data are not available. China and India - two of the fastest growing economies-have very small leasing markets - $2.1 billion and $1.4 billion respectively. The scope for expansion is huge.
In Pakistan leasing has made good progress and its share of new investment is estimated at 14%. Annual volume of the 31 members of the Leasing Association of Pakistan is around Rs 28 billion (or $0.47 billion) and total assets are Rs 84 billion. Banks are also active players in leasing and I believe their volumes are significantly higher.
ADVANTAGES OF LEASING: The main attraction of leasing is that it is asset-based financing as opposed to collateral-based approach applied by banks. Let me elaborate. The basic premise is that a business enterprise earns its profit from the use of assets, not ownership of these assets. In leasing, the lessor remains the owner until full payment is made. If the cash flow generated by a machine is able to cover its lease rent, the proposition is viable from a leasing company's point of view.
This simplistic approach gets a bit more complex in reality as we live in times of regulatory supervision and prudential rules. Thus audited financial statements, ratio compliance, positive cash flow, etc become essential tools of appraisal. In Pakistan, considerable reliance is placed on alternative tests since financial statements from SMEs are not readily available. But the underlying difference between asset-based lending and collateral-based finance does not get distorted. Leasing does not require a lessee to have land or building for mortgage and usually does not seek additional security from the borrower.
This distinction and advantage are significant particularly for SMEs which lack collateral and are thus not able to approach the formal banking sector. I feel government policies in most countries have not yet made this obvious connection between leasing and SMEs' financing needs.
In Pakistan under the new SME regulations issued by SBP, collateral requirement has been removed. This is a major step forward. Countries, which recognise leasing's potential, have used it widely. Before the 1998 financial crisis of South East Asia, the Asian Tigers -Korea, Malaysia, Thailand, Indonesia and Taiwan had vibrant and large leasing sectors.
In Korea, leasing's share of capital investment was around 28% in 1996 which translated into annual lease volume comes to $16.3 billion. Main beneficiaries of leasing in these countries were SMEs. After the crisis, banking controls became stringent and leasing, too, became subject to these rules. Recently, there has been a modest recovery in the leasing sector in these countries but it is nowhere near what it used to be. Barring the excesses of the pre 1997 period in the Tiger economies, we can learn a lot from their experience of supporting SMEs.
Besides the most significant advantage of security just discussed, other benefits of leasing are:
-- Simple documentation (since no mortgage registry is required)
-- Tax benefits - full lease rental is an expense
-- Working capital facility - sale and lease back unlocks capital
-- Medium-term finance -3 to 5 year leases are common
These are the economic advantages.
ISLAMIC ASPECT: In Pakistan and other Muslim countries, leasing has another inherent advantage. It is an accepted mode of financing under the Shariah rules. There is a misconception that finance lease is not Shariah compliant and only operating lease. This is not so. Both types of leases are recognised under the Shariah. In its purest form ljara is almost the same as an operating lease. Over a period of time, finance lease or Ijara wa lktina developed to meet business needs. If the documentation complies with Shariah rules both types of leases are acceptable, otherwise both can be non-compliant.
LEASING EXPERIENCE IN PAKISTAN: Leasing started in Pakistan in 1983 and has had the benefit of government support from those early days. Rules have been clear and have undergone regular scrutiny and change as and when difficulties and impediments were highlighted. The leasing association is grateful for the support of the Regulators- State Bank of Pakistan until December 1997 and thereafter SECP.
In Pakistan, as elsewhere, SMEs have traditionally been core customers for leasing companies. Leasing companies cannot compete with banks for big business - ORIX Corporation, the largest Japanese leasing company, still has SMEs as its core business. During the 1980s and the early part of I 990s leasing companies were the main source of medium-term finance for SMEs and many small enterprises benefited widely from lease financing and came in contact with the formal sector for the first time. Innovative lease arrangements helped numerous businesses.
Transport sector, which was almost entirely a captive customer of the informal lenders, was introduced to formal lending by leasing companies. Prudential rules were explained and transporters began preparing financial statements for the first time. Some even took the step of incorporating their businesses as limited companies. This sector is today amongst the best customers of leasing companies, and I believe banks as well.
In the early phase of automobile industry when assembly plants were established, there weren't too many reliable suppliers of spare parts. The growth of the car/truck industry depended on local availability of quality parts as deletion requirements increased. The vendor industry was caught in the traditional problem of funding shortage due to lack of collateral leasing.
The companies solved the problem by giving them the required machinery or moulds on the strength of their agreements with automobile companies which assured future cash flow. There are many other examples and I could go on for a long time. Our experience with recoveries from small businesses is within our acceptable levels and their record is as good, if not better, than big businesses.
It is disappointing that some of the traditional SME sectors in Pakistan - cutlery, surgical instruments, fan industry and sports goods, barring a few exceptions, have not availed of the facilities available to them and have not progressed to a higher level of quality standards which they are capable of achieving,
Leasing industry will continue to innovate and will take bold steps to keep expanding. We cannot compete with banks and should not try to do so. Neither are we project finance or venture capital companies. But we do break new ground. Car sales took off with leasing support and now leasing companies are beginning to enter agricultural sector through tractor lease, farm loans and operating leases for harvesters. Microfinance is another area which leasing companies have recently started focusing on.
We have requested the SECP to allow leasing companies unrestricted access to the property sector which is closed for us. We feel with rising property prices we can help the small entrepreneur with the financing of shop premises and working capital needs.
IMPEDIMENTS TO GROWTH OF SME SECTOR: Lack of access to formal credit and equity sources is cited as the main constraint to SME growth. We have heard this today in earlier presentations. In Pakistan, at least, I feel this is not entirely the case. Whilst extension of formal credit is still required on a bigger scale, the existing network is not that weak. I feel the problem for SMEs lies more in the area of rules, regulations, registration, taxation etc, which keeps them out of the formal sector, thence away from banks and financial institutions.
I come in contact with SME entrepreneurs regularly as they are our main customers. I have heard many of them say over the years that they don't mind paying corporate taxes and fees levied by various departments but what is not acceptable is the time they lose in dealing with these departments and inspections. Since there is no remedy, they don't enter the formal sector, they remain unregistered, unrecorded and thus deprive themselves of financing which is readily available.
A lot has been done in simplifying rules and consolidating many regulations but much more needs to be done. More radical steps are required to encourage SMEs to become registered both as corporate entities and for tax purposes. The association of SMEs should actively encourage its members to obtain NTNs and to understand the requirements of prudential regulations. Better communication will certainly dispel the notion that these are troublesome steps. More to the point, they should be advised that staying out of the formal sector has become troublesome.
In Pakistan, governments had early appreciation of the potential of leasing for SME growth and active encouragement was regularly provided. Since the introduction of Prudential Regulations for SMEs by the State Bank of Pakistan, bank financing to this sector has increased substantially. According to a State Bank report, the amount of lending by banks to the SME sector amounted to Rs 251 billion in 2004, 72% higher than 2003.
It is an accepted fact that the unorganised sector forms a substantial part of our economy. Removal of legal constraints will encourage more SMEs to enter the formal sector. The potential for further growth of the SME sector is immense and leasing with its numerous advantages, including the Islamic aspect, can play a crucial role in achieving this.
(The writer is Chief Executive of Orix Leasing (Pvt) Ltd.)