Doctoral Dissertation Doctoral School in Social Sciences Local Development and Global Dynamics University of Trento Essays on the demand and supply of small business finance in Kenya By Edoardo Totolo (April 2015) Supervisor: Prof. Giuseppe Folloni (University of Trento) Co-supervisor: Dr. Mary Njeri Kinyanjui (University of Nairobi) [Page intentionally left blank] i ACKNOWLEDGEMENTS Writing this dissertation gave me the chance to see new places and meet extraordinary people in different parts of the world. I’ve incurred many debts along the way. I want to express gratitude towards everyone who helped me finalizing the thesis and achieving this doctoral degree. I want to thank my supervisor Giuseppe Folloni for the patient guidance, support and advice he has provided throughout this doctorate. He has always encouraged me to pursue my own interests and to keep the end goal in sight. I am grateful to my co-supervisor Dr Mary Njeri Kinyanjui who gave an invaluable help in contextualizing the research and understanding more of the local economy in Kenya. I want to thank also Prof. Emanuele Taufer for the feedback provided at different stages of the research, and Prof. Mario Biggeri for the valuable comments. I received crucial support from the Institute of Development Studies at the University of Nairobi, and I thank in particular prof. Dorothy McCormick, prof. Winnie Mitullah and Dr. Radha Uphadyaya for giving me feedback at different stages of the dissertation. I want to thank every single entrepreneur in Kariobangi and Korogocho who participated in the research and welcomed me in their community. Spending over a year in Kariobangi was a life-changing experience, where I learned a lot about the potential of the local economy, the resilience of the entrepreneurs and great challenges that people face on a daily basis. It won’t be easy to give back as much as I received during my time there, but I will certainly try my best. The fieldwork research benefitted greatly from the assistance of Andrew Muinde and the late Ignatius Mayero, as well as the great support from Ann, Maurice, Bosco, Peninah, Frederick, Margaret, Tobias, Meshack, Peter, Albert, Charles, Evelyne and many others. This work could have not been done without your support. I benefitted immensely from my interaction with Financial Sector Deepening Kenya (FSD-K). I want to thank Amrik Heyer who mentored my work since I came to Nairobi; James Kashangaki who helped me understand more about SMEs in Kenya and David Ferrand for his continued support. I want to thank also my family for being close to me in the good and the bad times; especially Elia who keeps my mind curious at all times. I thank all the friends I met in Nairobi, Verona, Trento, Berlin and Amsterdam at different stages of this journey. Thanks for being patient and supportive all the way through. *** This doctoral thesis is dedicated to the memory of Ravindra Ramrattan, who was one of the 67 victims of the terrorist attack at the Westgate Mall in Nairobi on the 21st of September 2013. Ravi was a close friend and a colleague, as well as a talented young economist with a bright future ahead. He helped me throughout this dissertation, from identifying relevant research questions to formalizing econometric models and interpreting the findings. Ravi had an impressive speed of thought and was fun to work with. I want to express my gratitude to the Ramrattan’s family: Bisnath, Parbattee, Rishma and Rajiv for making me feel home during my visit in Trinidad and Tobago. This dissertation is dedicated to you as well. SUMMARY This PhD dissertation is a collection of four essays focusing on the demand and supply of small business finance in Kenya. The studies are the result of primary research conducted over three years with both demand-side players, more specifically micro and small-scale entrepreneurs operating in a low-income area in Nairobi. And the main suppliers of small businesses finance in Kenya - commercial banks - which provided data on the size, characteristics and evolution of their SME finance portfolio between 2009 and 2013. Since commercial banks are not the only players in the provision of finance to small firms, the dissertation studies the entire financial landscape of both formal and informal financial providers, including institutions such as microfinance institutions, savings groups and moneylenders among others. The dissertation is divided in two parts: the first half of the dissertation analyses the determinants, effects and challenges of access to formal and informal finance by small enterprises in Nairobi (Essays 1 and 2). These two essays use primary data collected through a survey questionnaire with 344 micro and small enterprises in a low income neighbourhood in Nairobi. The analysis describes the financial landscapes in which businesses operate and the effects of access to credit on firm performance (e.g. investments, profitability and employment growth.). The second half of the dissertation analyses the supply-side, more specifically the relation between formal financial sector development and economic growth (Essay 3) and the characteristics and development of bank financing to SMEs (small and medium enterprises) in Kenya (Essay 4). Essay 3 relies on secondary time-series data taken from the World Bank databases, whereas Essay 4 uses original survey data administered to commercial banks in Kenya in two survey rounds in 2012 and 2014. Each essay in this dissertation is a standalone study with its own literature survey, research questions, data and methodological approach. The main findings of the demand-side chapters is that informality has significant effects on access (or exclusion) to bank finance, but is less relevant when we investigate informal financial instruments such as self-help groups and family/friend loans. Essay 2 of the dissertation shows that different types of loans have different effects on the performance of businesses, and that loans from commercial banks seem to incentivize investments and employment creation more than other types of loans. The supply- side chapters on the other hand show that there is a long-term association between financial sector development in Kenya and economic growth, and that there is a reciprocal relation of causality over the long-run. Finally, Essay 4 shows that bank financing to SMEs has grown steadily over the last few years and that banks are increasingly exposed to small businesses in their lending portfolio. However, the financial products to SMEs tend to be unsophisticated and concentrated in few sectors. TABLE OF CONTENTS Introduction ……………………………………………………….………………………………………………………………………….. 1 1 Background: placing this dissertation in the broader context of economics, finance and development ................................................................................................................................................. 1 1.1 The rise and crisis of microfinance, and its transformation into “financial inclusion” ................. 2 1.2 From micro to macro: financial deepening, economic growth and development ....................... 7 1.3 Enterprise informality and private sector development .............................................................. 8 2 Contextualizing the research: a brief introduction to the Kenyan economy...................................... 12 3 Objectives, structure and limitations of the dissertation ................................................................... 15 4 List of References ................................................................................................................................ 18 Essay 1: The determinants of access to finance among micro and small enterprises in Nairobi ………19 1. Introduction ........................................................................................................................................ 22 2. Review of literature ............................................................................................................................ 23 2.1 Financial landscapes - a survey ................................................................................................... 23 2.2 The determinants of access to finance ....................................................................................... 27 2.2.1 The role of formality/informality ........................................................................................ 27 2.2.2 The role of Networks .......................................................................................................... 28 2.2.3 The life-cycle theory of capital structure ............................................................................ 31 2.2.4 Adapting capital structure theory for businesses in developing countries: ....................... 33 3. Empirical analysis ...................................................................................................................... 34 3.1 Questions and objectives ............................................................................................................ 34 3.2 Data ............................................................................................................................................. 35 3.3 Descriptive statistics: analysis of financial landscapes ............................................................... 39 3.2.1 Basic characteristics of the sample ..................................................................................... 39 3.2.2 Start-up financing and