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THE IMPACT OF INTEREST RATE HIKES ON SMALL AND MEDIUM
ENTERPRISES (SMES) IN DEVELOPING ECONOMIES
Mador Qosimov
Tashkent State University of Economics
Tashkent, Uzbekistan
https://doi.org/10.5281/zenodo.15572108
Abstract
Small and Medium Enterprises (SMEs) form the bedrock of many
developing economies, acting as vital engines for employment generation,
innovation, and overall economic growth. However, this crucial sector faces
significant threats from macroeconomic policy shifts, particularly increases in
interest rates. This article examines the multifaceted impacts of interest rate
hikes on SMEs within developing economies through a comprehensive review
and synthesis of existing literature. The analysis reveals that rising interest rates
negatively affect SMEs by increasing their borrowing costs, reducing access to
credit, dampening investment, escalating operational expenses, diminishing
consumer demand, and ultimately elevating the risk of loan defaults and
business closures. These challenges are often exacerbated by the unique
vulnerabilities prevalent in developing economies, such as limited access to
formal financial institutions, stringent collateral requirements, underdeveloped
financial infrastructure, and susceptibility to macroeconomic instability. The
study concludes by emphasizing the urgent need for targeted policy
interventions from governments, central banks, and financial institutions to
bolster the resilience of SMEs against interest rate shocks and to foster an
enabling environment for their sustainable growth. A key policy
recommendation includes improving SMEs' access to affordable finance through
various mechanisms.
Key words
: Interest Rates, SMEs, Developing Economies, Economic
Growth, Credit Access, Borrowing Costs, Investment, Monetary Policy, Financial
Vulnerability, Policy Interventions
Introduction
Small and Medium Enterprises (SMEs) are widely acknowledged as critical
contributors to the economic dynamism of developing nations. These
enterprises often constitute the majority of businesses, providing a substantial
proportion of employment and contributing significantly to the Gross Domestic
Product (GDP). For instance, in Ghana, SMEs are reported to provide
approximately 85% of manufacturing employment and contribute about 70% to
the nation's GDP, representing around 9 % of all businesses. This high reliance
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on SMEs underscores the potential for widespread economic repercussions
when this sector faces adverse conditions.
In recent times, a global trend of increasing interest rates has emerged as a
response to rising inflation and other complex macroeconomic pressures.
While
interest rate hikes are a conventional tool employed by monetary authorities to
manage economic overheating, their implications can be particularly
pronounced for developing economies. These nations often possess unique
economic structures and vulnerabilities that amplify the effects of such policy
changes. Compared to their counterparts in developed economies, SMEs in
developing countries may face a distinct set of challenges that make them more
susceptible to the tightening of monetary policy.
Given the pivotal role of SMEs in developing economies and the potential
threats posed by rising interest rates, a comprehensive understanding of the
impact is essential. This article addresses the critical research problem of the
heightened vulnerability of SMEs in developing economies to interest rate hikes
and the need for a thorough analysis of the diverse consequences. The primary
objective of this study is to provide a comprehensive analysis of the impact of
interest rate hikes on SMEs in developing economies, drawing upon a synthesis
of existing academic research and reports from international organizations.
Secondary objectives include identifying the specific challenges faced by these
enterprises, consolidating empirical evidence from various developing
countries, and proposing informed policy recommendations aimed at mitigating
the adverse effects.
Discussion
Mechanisms of Impact
One of the most immediate and significant impacts of interest rate hikes is
the increased cost of borrowing and reduced loan accessibility for SMEs. When
central banks raise their benchmark rates, commercial banks typically follow
suit by increasing their lending rates. This directly translates to higher interest
rates on new loans sought by SMEs for various purposes, such as business
expansion, equipment purchases, or working capital. Furthermore, SMEs with
existing loans that have variable interest rates face an immediate increase in
their debt servicing costs, leading to higher monthly payments and a greater
financial burden. This escalation in borrowing costs can also prompt banks to
tighten their loan eligibility requirements. As the cost of funds increases for
lending institutions, they may become more risk-averse and less inclined to lend
to SMEs, which are often perceived as higher-risk borrowers due to factors like
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limited credit history or lack of substantial collateral. Empirical evidence from
Ghana indicates a negative relationship between interest rates and the demand
for credit by SMEs, highlighting how higher rates deter borrowing. The
increased cost of borrowing not only obstructs SMEs' access to new financing
necessary for growth and daily operations but also strains their existing
financial obligations, potentially creating a detrimental cycle of debt. Higher
interest payments diminish the cash flow available for crucial reinvestment and
operational expenses, making SMEs more susceptible to financial distress and
less attractive to lenders in the future.
Interest rate hikes also have pronounced negative effects on investment by
SMEs. Elevated interest rates increase the overall cost of capital, making
potential investment projects less appealing as the anticipated returns may no
longer justify the higher borrowing expenses. Consequently, SMEs may delay or
entirely cancel planned expansions, reduce investments in upgrading technology
and equipment, or postpone the launch of new products and services.
Research
suggests that rising interest rates can discourage companies and industries from
investing in technological advancements and research and development,
ultimately leading to a slower pace of innovation. This dampening effect on
investment due to interest rate hikes can have long-term ramifications for the
productivity and overall competitiveness of SMEs in developing economies,
hindering their capacity to contribute to sustained economic growth. Reduced
investment translates into slower adoption of new technologies, lower gains in
productivity, and a weakened ability for SMEs to effectively compete both within
their domestic markets and internationally.
The impact of interest rate hikes extends to the working capital and
operational costs of SMEs. Increased borrowing costs make it more expensive
for SMEs to finance their day-to-day operations and manage their working
capital effectively. Businesses might be compelled to raise the prices of their
goods and services to offset these higher costs, which could potentially lead to a
decrease in demand from price-sensitive consumers. Moreover, the strain on
cash flow resulting from higher interest payments can significantly impact an
SME's ability to meet its short-term financial obligations, such as paying
suppliers or covering immediate operational expenses. This immediate impact
on working capital can severely restrict the operational flexibility of SMEs,
particularly those with already thin profit margins, potentially causing
disruptions in their supply chains and production processes. SMEs often operate
with limited financial reserves, and an increase in their operational costs due to
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elevated interest rates can rapidly deplete their available working capital,
making them highly vulnerable to unexpected expenses or delays in receiving
payments from customers.
Furthermore, interest rate hikes tend to lead to reduced consumer demand
in the broader economy. As borrowing becomes more expensive for individual
consumers, they often experience a reduction in their disposable income and
consequently curtail their spending on goods and services. This is particularly
true for non-essential or discretionary items. The overall effect can be a decrease
in market participation and a general slowdown in economic activity. This
indirect impact of diminished consumer demand can significantly affect the
revenue streams of SMEs, especially those operating in sectors that heavily rely
on domestic consumption. The decline in sales revenue further compounds the
challenges faced by SMEs already grappling with higher borrowing costs and
increased operational expenses.
The combined pressures of higher borrowing costs, reduced investment,
increased operational expenses, and lower consumer demand can significantly
elevate the risk of loan default and business closure for SMEs. When SMEs
struggle to manage their increased financial burdens and experience declining
revenues, they may find themselves unable to meet their loan repayment
obligations, leading to defaults. For SMEs that were already operating on the
margins or facing financial difficulties, these added pressures can be the tipping
point, potentially forcing them to cease operations altogether. Empirical
evidence from Ghana indicates a negative correlation between interest rates and
loan repayment, suggesting that higher rates increase the likelihood of default.
The ultimate consequence of prolonged or substantial interest rate hikes can be
a rise in the number of SME bankruptcies, resulting in job losses and a
contraction in overall economic activity within developing economies.
Exacerbating Factors in Developing Economies
The impact of interest rate hikes on SMEs is often more severe in
developing economies due to a number of exacerbating factors. One significant
challenge is the limited access to formal financial institutions and the
consequent reliance on informal lending.
SMEs in these economies frequently
face difficulties in securing credit from formal banks due to various reasons,
including a lack of sufficient collateral, absence of a well-established credit
history, and perceived higher risk.
This lack of access to formal financing
compels many SMEs to turn to informal lending sources, which often come with
significantly higher interest rates and less favorable terms. Consequently, when
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interest rates rise in the formal sector, it can either push more SMEs towards
these expensive informal options or exacerbate the financial strain on those
already borrowing informally, making them even more vulnerable.
Another critical factor is the high collateral requirements and lack of
suitable assets among SMEs in developing economies.
Banks in these regions
often have stringent demands for collateral, typically in the form of fixed assets
like land or buildings, which many SMEs, particularly smaller or newer ones, do
not possess.
This lack of readily available and acceptable collateral severely
restricts their ability to obtain loans from formal financial institutions, even if
their business operations are otherwise viable. Therefore, interest rate hikes
further diminish their already limited access to credit, as they may not even
qualify for loans at the higher rates due to the collateral constraint.
Weak financial infrastructure and regulatory frameworks in many
developing economies also amplify the negative effects of interest rate hikes on
SMEs. Underdeveloped financial markets can lead to inefficiencies in the
transmission of monetary policy, causing interest rate changes to have a
disproportionately large impact on borrowing costs for SMEs. Issues such as
limited availability of comprehensive credit information and inefficient
insolvency practices can increase the perceived risk of lending to SMEs, leading
to higher risk premiums and ultimately higher interest rates charged by
financial institutions.
These weaknesses in the financial ecosystem can
exacerbate the challenges faced by SMEs in accessing affordable finance during
periods of rising interest rates.
Finally, developing economies are often characterized by a higher degree of
vulnerability to macroeconomic instability and external shocks.
These
economies can be more susceptible to fluctuations in inflation, exchange rates,
and global commodity prices, which can either trigger or worsen the impact of
domestic interest rate hikes.
Furthermore, they are often more sensitive to
global financial conditions and capital flows, which can influence domestic
interest rates and the availability of credit.
This inherent macroeconomic
instability creates a precarious environment where interest rate hikes, even if
intended to stabilize the economy, can have unintended and severe
consequences for the already fragile SME sector. SMEs operating in such volatile
conditions possess less capacity to absorb additional financial shocks resulting
from interest rate increases, making them more prone to financial distress and
potential failure.
Empirical Evidence
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Empirical studies conducted in various developing economies provide
compelling evidence of the adverse impacts of interest rate hikes on SMEs. In
Ghana, research has demonstrated a clear negative relationship between
interest rates and the demand for credit by SMEs.
Furthermore, it has been
found that high interest rates, averaging around 5% per annum in some cases,
significantly impair the ability of SMEs to repay their loans.
The study
recommends a substantial reduction in interest rates to approximately 0% to
improve both credit access and loan repayment rates.
Another study focusing on
Accra, Ghana, revealed a significant interdependence between the profitability of
SMEs and interest rate fluctuations. The volatility of interest rates was found to
discourage SMEs from undertaking expansion initiatives, ultimately leading to
potential business closures due to mounting financial obligations.
In South Africa, research indicates a significant negative correlation
between interest rates and credit access for SMEs.
SMEs in the country face
considerable obstacles in securing affordable credit, with interest rates on SME
loans ranging from 0% to as high as 30% annually.
The study suggests that
policymakers in South Africa should consider implementing measures to reduce
interest rates and ease collateral requirements to enhance credit accessibility
for SMEs.
A study focusing on Zambia, particularly retail outlets in the Chipata
district, highlighted the detrimental effects of increased interest rates on SMEs.
The research identified a positive correlation between a lack of collateral assets
and the rejection of credit applications, as well as between higher interest rates
and credit rejection.
To address these challenges, the study recommends that
SMEs in Zambia explore practical and unconventional alternative sources of
finance, such as crowdfunding and forming group partnerships to leverage
collective strength and achieve economies of scale.
Research conducted in Bangladesh examined the impact of interest rates on
the development of the SME industrial sector.
The findings revealed a significant
negative impact of interest rates on SME industries in the short run.
Moreover,
the study indicated that in the long run, interest rates in the SME sector exert a
negative influence on overall industrial development in the country.
Across various developing economies, general empirical evidence supports
the notion that higher interest rates negatively affect SMEs. Studies have found a
negative relationship between the amount of finance provided to SMEs and
prevailing interest rates.
Furthermore, research has revealed an asymmetric
causality, where shocks in interest rates drive changes in SME output, but the
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reverse is not necessarily true.
Notably, one study analyzing data from
developing economies over an extended period found that interest rates below a
threshold of approximately 5. 86% tended to promote economic growth, while
rates exceeding this level were associated with a decline in overall economic
growth.
Study
Location
(Country)
Methodology Used
Key
Findings
Regarding
the
Impact of Interest
Rate Hikes on SMEs
Ghana
McKinnon-Shaw
hypothesis,
Stiglitz-
Weiss model
Negative relationship
between interest rates
and demand for credit;
high interest rates
affect loan repayment;
recommends interest
rate reduction.
Ghana (Accra)
ARDL technique of co-
integration
Interdependence
between
SMEs'
profitability
and
interest rates; interest
rate
fluctuations
discourage expansion
and can lead to
closure.
South Africa
Pearson's correlation,
multiple regression
Significant
negative
effect of interest rates
on credit access; SMEs
face
obstacles
in
obtaining
affordable
credit;
recommends
reducing interest rates
and relaxing collateral.
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Zambia (Chipata)
Mixed
method
(qualitative
and
quantitative)
Positive
correlation
between
lack
of
collateral and credit
rejection, and between
interest
rates
and
credit rejection; high
interest
rates
adversely affect retail
outlets; recommends
alternative financing
sources.
Bangladesh
Johansen
co-
integration,
VECM
technique
Significant
negative
impact
on
SME
industries in the short
run; negative long-run
influence
on
total
industrial
development.
General
Developing
Economies
Various econometric
methods
Negative relationship
between
finance
provided to SMEs and
interest
rates;
asymmetric causality
where interest rate
shocks
drive
SME
output shocks; interest
rates above a certain
threshold
hinder
economic growth.
Policy Implications and Recommendations
The evidence overwhelmingly suggests that interest rate hikes pose
significant challenges to SMEs in developing economies. To mitigate these
adverse effects and foster a more resilient SME sector, targeted and
comprehensive policy interventions are crucial.
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Improving access to affordable finance is paramount. Governments should
implement initiatives that incentivize financial institutions to offer lower
interest rates on loans to SMEs. This could include establishing credit guarantee
schemes to reduce the risk for lenders, providing tax breaks to banks that
increase their SME lending portfolios, and developing regulatory frameworks
that encourage SME financing.
Additionally, exploring and promoting alternative
financing mechanisms such as crowdfunding platforms and peer-to-peer lending
could help bridge the funding gap for SMEs that struggle to access traditional
bank loans.
The role of microfinance institutions in providing small loans to
small businesses and new entrepreneurs, particularly in rural and underserved
areas, should also be strengthened.
Mitigating the impact on borrowing costs requires a multi-pronged
approach. Policymakers should strive to create stable and predictable
macroeconomic environments to reduce the volatility of interest rates.
Exploring the feasibility of differentiated interest rate policies that take into
account the specific needs and vulnerabilities of the SME sector could also be
beneficial. In certain circumstances, governments might consider providing
targeted subsidies or implementing temporary interest rate caps for eligible
SMEs to help them navigate periods of economic tightening.
Support for financial literacy and business development is essential for
enhancing the resilience of SMEs. Governments and relevant organizations
should invest in programs that educate SME owners and managers on sound
financial management practices, including strategies for managing debt and
navigating interest rate fluctuations.
Providing access to business development
services, such as training in business planning, financial forecasting, and market
analysis, can further strengthen SMEs' ability to adapt to changing economic
conditions and improve their overall competitiveness.
Relaxing collateral requirements could significantly improve SMEs' access
to finance. Policymakers should consider reforms that encourage financial
institutions to move away from an over-reliance on physical collateral,
particularly fixed assets that many SMEs lack.
Promoting the use of alternative
forms of collateral, such as movable assets, personal guarantees, and group
lending mechanisms, could broaden access to credit for a larger number of
SMEs.
Strengthening financial infrastructure is a fundamental requirement for a
more robust SME financing ecosystem. Governments should invest in improving
credit information systems to reduce information asymmetry between lenders
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and borrowers, thereby lowering the perceived risk of lending to SMEs.
Establishing and maintaining efficient collateral registries can enhance the
security of loans backed by movable assets. Furthermore, strengthening
insolvency frameworks can facilitate a more predictable and efficient resolution
of financial distress, which can encourage lenders to extend credit to SMEs.
Finally, promoting economic diversification within developing economies
can reduce the overall sensitivity of the economy, including the SME sector, to
interest rate fluctuations.
Policies that support the development of a broader
range of industries and reduce reliance on sectors that are particularly
vulnerable to interest rate changes can contribute to greater economic stability
and resilience for SMEs in the long run.
Conclusion
In conclusion, interest rate hikes exert a significant negative impact on
Small and Medium Enterprises (SMEs) within developing economies. These
increases not only elevate the cost of borrowing and restrict access to crucial
financing but also dampen investment activities, inflate operational expenses,
diminish consumer demand, and heighten the risk of loan defaults and business
closures. The inherent vulnerabilities of SMEs in these economies, stemming
from limited access to formal financial institutions, stringent collateral demands,
underdeveloped financial infrastructure, and susceptibility to macroeconomic
instability, further exacerbate these challenges.
The empirical evidence gathered from various developing countries,
including Ghana, South Africa, Zambia, and Bangladesh, consistently
underscores the adverse effects of interest rate hikes on SME performance
across multiple dimensions. These findings highlight the urgent need for
targeted and comprehensive policy interventions by governments, central
banks, and financial institutions to mitigate these negative consequences and
cultivate a more supportive environment for the sustainable development of the
SME sector.
Future research could delve deeper into exploring the differential impacts
of interest rate hikes across various sub-sectors of SMEs within developing
economies, as well as evaluating the effectiveness of specific policy interventions
in diverse country contexts. Ultimately, recognizing and addressing the
challenges faced by SMEs due to interest rate hikes is crucial for fostering
inclusive and sustainable economic development in developing nations, given
the pivotal role these enterprises play in driving growth, creating employment,
and fostering innovation.
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