Finance and economic development: The role of the private sector


The importance of finance in economic growth and development follows the works of Schumpeter (1934), Goldsmith (1969), McKinnon (1973), and Shaw (1973). Extant literature suggests three main channels through which financial development can influence economic growth, including the level of financial intermediation, composition, and efficiency by which finance is allocated to productive activities to stimulate economic growth. However, without effective regulation, financial systems can become unstable and trigger crises that devastate the real economy. The ongoing repercussions of the global financial crises signal how large these effects can be (Spratt, 2013).

The effects of financial markets on economic growth may be either transient or lasting, depending on the theoretical framework used. In the traditional growth theories, the effects are transient, suggesting that they are present only during the transition to an economy's steady-state growth path. In new theories of endogenous growth, the effects can be lasting, meaning they can permanently lift the economy to a higher growth path (Deabes, 2004). The financial system may, therefore, influence growth permanently in one of the following ways:

  • 1 Improving the average productivity of capital.
  • 2 Facilitating the flow of investment funds to firms in the intermediation process.
  • 3 Accruing savings.
  • 4 Reallocating resources into productive sectors.

The financial sector can be growth inducing and growth induced. This suggests finance is important in ensuring the growth of an economy, at both the macro level and the micro level, and that growth is a driver of financial sector development. Both domestic resource mobilisation and a suitable level of external capital inflows are necessary to finance growth and development. This is the focus of development finance. An important issue to consider is the means by which finance affects the private sector, which is considered the engine of growth and development.

However, the issue of financing has been a major constraint to private sector growth and economic development in Africa and other developing regions of the world. The private sector in developing economies is confronted with less-developed financial markets, thus limiting access to finance. This situation is more severe in the case of small and medium-size enterprises (SMEs) that often lack the requisite qualification to obtain formal finance. Financial systems in developing countries are said to be small, shallow, and costly, with limited outreach. This is reflected not only in the aggregate financial development indicators but also in the firm and household data gauging the use of formal financial services (Beck & Cull, 2014a). The problem of financing a developing country's private sector thus raises a number of issues worthy of policy consideration. As mentioned earlier, it is imperative to consider the issue of financing the private sector, which is regarded as the engine of economic growth. Thus, addressing the financing constraints of the private sector, especially SMEs, is necessary to drive growth in developing and emerging economies.

This chapter examines the role of finance in private sector development. The chapter is organised as follows. We overview private sector and economic development in the next section. This is followed by the financing and investment behaviour of firms. We then examine how various forms of development finance contribute to private sector development and economic development. The final section concludes.


This section discusses prominent features of developing countries' and Africa's private sector, its contribution to development, and the challenges it faces.

Features of Africa's private sector

Africa's private sector has at least three characteristic features: its relatively large size, its highly informal nature, and the dominance of micro and small firms in the formal sector. According to African Development Bank (AfDB, 2011) estimates, the private sector in Africa accounts for more than 80% of production, 68% of total investment, and 75% of total credit in the economy. Furthermore, it offers employment to 90% of the working population in the continent. The large size of Africa's private sector implies that interventions geared towards bolstering the sector will have wide-ranging impacts. On the one hand, the informal sector is broadly characterised as consisting of units engaged in the production of goods or services, with the primary objective of generating employment and incomes to the people concerned. On the other hand, the formal sector encompasses all jobs with normal hours and regular wages and is recognized as an income source on which income taxes must be paid (International Labour Office, 2000).

Beyond its large size, Africa's private sector is highly informal in nature. With the exception of Latin America and the Caribbean (LAC), Africa has the largest informal sector in the world. According to estimates by Medina, Jonelis, and Cangul (2017), from 2010 to 2014, Africa's informal sector constitutes about 38% of its GDP. In LAC, the informal sector constitutes about 40% of GDP, while in South Asia and Europe, the informal sector's share in GDP is 34% and 24% respectively. Africa's largest informal sectors are concentrated in fragile states, and low- income countries (AfDB, 2011). This relatively large private sector in Africa presents opportunities as well as challenges: opportunities in the sense that if it could unleash the potential of this large sector through policy reform, the impact on accelerated growth would be massive and challenges in the sense that a large informal sector connotes low productivity and lower revenues from taxes, since a lot of the activities are outside the tax net.

Even Africa's relatively small formal sector is dominated by micro and small businesses with a few large firms, which are mostly foreign owned. Compared to other parts of the world, Africa has little representation in medium-size and large enterprises. Medium-size and large enterprises constitute a little over 30% of all enterprises in Africa (AfDB, 2011). Thus, Africa's private sector has a 'missing middle' where the economy has a large share of micro and small enterprises relatively to its size (GDP). These micro enterprises are often encumbered by volatile revenues, red tape, poor technical knowledge, and low managerial competence, while the medium-size enterprises are hindered by inadequate access to capital, technology, and electricity (Fjose, Grtinfeld, & Green, 2010). These characteristics of Africa's private sector are akin to what pertains in the private sector of other developing regions of the world.

The role of the private sector in economic development

Worldwide, the private sector is pivotal in the economic development process. Some of the contributions of the private sector to economic development include income and growth, employment and job creation, productivity, access to finance, and revenue mobilisation. One of the key contributions of the private sector is that it is a crucial driver of economic growth. Economic growth is important because it forms the basis for the generation and broad-based distribution of resources. Although, economic growth does not necessarily lead to poverty reduction, in areas of the world where poverty has declined significantly over the years, this has been associated with high levels of growth. Thus, economic growth is imperative for widespread reductions in poverty and inequality. SMEs (both formal and informal) contribute between 60% and 70% of the global GDP (Ayyagari, Beck, & Demirgiic-Kunt, 2003). With the right distribution policies and mechanisms in place, this growth can translate into income, job opportunities, and prosperity for the vast majority of the population, leading to a reduction in poverty and inequality.

Self-employment or earning a wage or salary employment is one of the surest means to exit poverty. In developing countries and in Africa as well, the private sector is responsible for creating about 90% of all jobs (Australian Government, 2014). An analysis based on African data shows that firms with over a hundred workers employ about 50% of the workforce in the formal sector; medium-size enterprises (20-99 employees) employ 27% of the labour force; small firms employ the remaining 23% of the labour force (Page & Soderbom, 2015). Thus, large firms are the leading employment category, followed by medium-size and small firms respectively. Generally, in the developing world, small firms create a disproportionate share of new jobs. As the private sector expands and transitions from informal to formal employment, it is important to put in place the right legal and institutional mechanisms that will ensure decent employment and provide job security for the weak and marginalised.

Generally, privately owned firms are considered to be more productive (efficient) than public sector firms (Atkinson & Halvorsen, 1986). Thus, the private sector contributes to economic development through the effective use of scarce resources to produce goods and services. International Labour Organisation (ILO) estimates based on World Bank Enterprise Surveys show that, on the whole, large firms are more productive than SMEs. This is because large firms profit from economies of scale; invest more in machinery, skilled workers, research and development; and outsource some of their activities (ILO, 2015). Large firms are therefore more likely to churn out new innovations and new products than are SMEs. Small firms tend to be the least productive. In Africa, the large informal sector complicates the productivity problem. Evidence shows that in Africa, the productivity of small formal firms is 120% higher than that of informal firms, while wages are about 130% higher (La Porta & Shleifer, 2011).

Another way that the private sector promotes economic development is through the provision of revenue for the central government. The World Bank estimates that the private sector accounts for over 80% of government revenue in low- and middle-income countries. The sources of these revenues are taxes, resource rents, and income tax on employees. These revenues, when applied judiciously in the provision infrastructure such as roads and transport, electricity, banking and finance, water and sanitation, and education will bring about drastic improvements in the livelihood of a large section of the population.

Obstacles to private sector development

As indispensable as the contribution of the private sector is to economic growth, the private sector cannot succeed without strong support from the public sector. The public sector plays a critical role in providing public services such as health, roads, transportation, electricity, and education. It also leads the way in safeguarding the environment, providing security, seeing to law and order, and providing a conducive economic, institutional, regulatory, and operating environment for private businesses to thrive in. Indeed, in the Asian Tigers (and China), the public sector has been instrumental in catalysing growth and private sector development. The degree to which the public sector plays its role determines the scope and scale of the constraints that the private sector is faced with, which in turn determine how effectively the private sector can contribute to economic progress.

The World Bank Enterprise Survey datasets contain information on the ranking of 15 obstacles by firms in 98 countries. These 15 obstacles are access to finance; access to land; business licensing and permits; corruption; courts; crime; customs and trade regulations; electricity; inadequately educated workforce; labour regulations; political instability; practices of competitors in the informal sector; theft and disorder; tax administration; and tax rates and transport. Kushnir, Mirmulstein, and Ramalho (2010) analysed this dataset and found electricity and access to finance to be the top two constraints faced by firms in developing countries. The top six constraints are electricity, access to finance, practices of the informal sector, tax rates, political instability, and corruption. The severity of these constraints varies with firm size.

Small firms are more likely to cite access to finance as an obstacle (Dai, Ivanov, & Cole, 2017; Cenni, Monferra, Salotti, Sangiorgi, & Torluc- cio, 2015), while large firms are more likely to cite political stability as a constraint. Small and medium-size firms are more likely to lack high-value collateral and less likely to have consistent cashflows and the necessary documentation to facilitate access to credit in the formal credit circuit than are large firms. The inadequate access to credit prevents micro, small, and medium-size firms from moving to the next phase of their development owing to underinvestment and inability to take advantage of viable investment opportunities.

Lack of sufficient investment and inefficiencies in the power sector lead to a situation where many firms in developing countries lack access to an affordable and stable electricity supply (Grainger & Zhang, 2019). Firms in the manufacturing sector are hit the hardest in an environment with energy shortfalls. If developing countries must unleash the creative potential of the private sector, then they must actually bring about energy self-sufficiency.

Competition from the informal sector (Purnama & Subroto, 2016; Bali, McKiernan, Vas, & Waring, 2016), erratic power supply (Grainger & Zhang, 2019), tax rates (Ameyaw, Korang, Twum, & Asante, 2016), political instability (Rahman, Uddin, & Lodorfos, 2017), and corruption (Mendoza, Lim, & Lopez, 2015) are also cited among the obstacles hindering the development of formal sector firms. The private sector in developing countries is encumbered by high tax rates, request for bribes from tax officials, and the pressure to make and receive informal payments to 'get things done' (bribery and corruption). These tendencies erode the little capital that the private sector has to work with. The lack of a merit system and the lack of entrenchment of a set of mores and core values lead to a situation where a number of contracts are awarded without regard to due procedure, while the lack of innovative ideas on the part of the fiscal authorities leads to a situation where formal firms are overtaxed to fund inefficient state bureaucracies. Democracy and good governance are not well established in a number of developing countries. As a result, civil wars and politically related disturbances still occur in some parts of the region, making it difficult for firms to have the peaceful environment needed to nurture and grow their businesses.

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