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GROWTH results from the realisation of value-generating opportunities. Opportunities are based on ideas. Some ideas are new such as the invention of the smart phone. Often, the opportunities are based on old ideas in a new context.
For instance, Javed is a skilled electronics repairman who works part-time in Lahore. People in his hometown have to travel over 60 kilometres to get their electronic items fixed. They would surely benefit if there is a repair shop in their town. Even though it is a value-generating activity, there is nothing fundamentally new about the idea of opening an electronic repairs shop. It is the context of his hometown that makes it interesting and workable.
It is important to realise that at the core of most opportunities in a developing country like Pakistan are ideas like this. This is very different from what one would expect in a technologically advanced country like the United States. In the US, Costco could only gain an edge over competitors like Target or Sears by thinking of innovative warehousing and distribution mechanisms that had never been tried before.
Opportunities of the former kind (replicative opportunities) do not require much expenditure in resources for discovering them. People discover them as they go through life and gain experience. However, opportunities of the latter kind (innovative opportunities) are more challenging to discover and require that considerable resources are devoted to the discovery process.
Replicative opportunities can be termed the low-hanging fruit of development, and it makes good sense to emphasise them in any growth strategy drawn up for Pakistan.
People like Javed can be found everywhere. They understand their local context, have the necessary skills and are able to spot opportunities that would create value if implemented. However, the traditional financial sector does not extend financing to them because these people cannot provide collateral, and the microfinance sector does not give large enough funding needed for most small new ventures. It is quite clear that there is a missing market here.
In the above context, the prime minister’s youth business loan programme is well intentioned, and aimed at addressing the issue of a key missing market. However, an incorrect financing contract has been adopted as a delivery vehicle for financing. The government intends to provide funding through ‘debt contracts’ or loans at subsidised interest rates.
Under a debt contract, a lender has no share in the upside potential beyond the fixed payoff. So, his focus is naturally on minimising downside risk. The same thing is happening with the Youth Business Scheme. Due to the focus on minimising downside risk, which is inevitable in a debt contract, an applicant for funding is required to provide a guarantor with declared assets at least 1.5 times the amount of funding requested. Also, the applicant is required to bear 10pc of the project cost. These conditions mean that a large number of genuine entrepreneurs with low cost workable ideas are left out. Naturally, a debt contract is not considered a good option for encouraging entrepreneurship. That’s where venture capital financing comes in.
For the Youth Business Scheme, it appears that the reliance on debt contract is due to the lack of institutional capacity to handle other types of contracts that are more suitable for encouraging entrepreneurship.
A better alternative is to run the youth business scheme with a fundamentally different and a state contingent contract. A venture capital or a modaraba contract seems best suited for it. In sharp contrast with a debt contract, a venture capital contract preserves the relationship between risk and reward with riskier projects also getting financed because of greater expected reward.
The consideration of upside potential versus downside risk then determines the financing decisions rather than just the ‘downside risk’, which is the case with a debt contract. And so, financing could be extended to people with the best ideas and not just to people who could provide collateral. A venture capital or a modaraba contract also breaks the de-leveraging-aggregate demand channel so negative shocks are not spread.
How can institutional capacity be developed to implement such a contract? Microfinance institutions have developed extensive monitoring and selection networks that allow for very high recovery rates. Their existing networks can be tweaked for the youth business scheme.
It is not hard to get an idea of how many sales a small venture is generating simply by observing it. And, the peer pressure that mitigates moral hazard in a micro-loan contract can be leveraged upon to mitigate it in small venture capital contracts too. So, I would suggest that the government implement the scheme through venture capital (modaraba) contracts in partnership with selected microfinance institutions.
The writer is a research fellow at the Risk and Sustainable Management Group, University of Queensland, and associate professor of economics at LUMS.
