2001 Annual Report

The Economic Crisis and Small and Medium-size Companies

The worldwide economic crisis discussed in more detail in another section of this annual report could very well hit small and medium-size companies disproportionately hard. A credit crunch, falling local sales, and declining exports could ripple through the sector, leading to widespread job losses and even company closures. This section of the IIC's annual report summarizes the devastating effect that the current economic crisis could have on small and medium-size companies in Latin America and the Caribbean and discusses measures that could be taken to alleviate weaknesses and thus strengthen the sector over the longer term.

Economic reports being published in late 2001 point to production declines, falling profits, abandoned acquisition plans, and a looming worldwide recession. If these indicators do not augur well for developed economies, they hint of severe adversity for the emerging economies and entrepreneurs of Latin America and the Caribbean. Such a bleak forecast poses a challenge to large, well-capitalized companies with relatively easy access to financing. It could spell disaster for those small and medium-size enterprises the IIC is mandated to foster.

The ensuing period of economic uncertainty and volatility and anticipated risk aversion will weigh heavily on the region's small and medium-size enterprises. With lower production and export levels usually come lower growth rates and higher unemployment. Whereas large companies may need assistance to maintain their status quo or to guard against too severe a decline, the small and medium-size companies will need assistance just to survive.

Small and medium-size companies are the first to be affected by economic downturns. Above all, they are at higher risk because they tend to concentrate on only a few productive or commercial activities. And their sometimes-tenuous access to funding on reasonable terms can make them especially fragile. Large corporations have broad product lines, so their economic activity and revenues are diversified. But small and medium-size companies usually specialize in a few goods or services, meaning that they have only two or three sources of revenue. So when a small or medium-size company runs into difficulties, it takes a major hit and must make decisions that have company-wide impact. Large companies have many options because diversification enables them to isolate a problem, strengthen successful areas, and offset losses on one product by generating more revenue on another. Obviously, these are options that are not open to small and medium-size companies.

Their natural concentration on a few products or services can make small and medium-size enterprises particularly vulnerable during hard times because a downturn in sales could mean losing their sources of funding. Uncertainty scares away investors and lenders; the long-term ones go first, and, if the situation does not improve quickly, the short-term ones also disappear. Among small and medium-size enterprises as a group, which are the most quickly affected by such circumstances? It depends on the sector in which they operate. In times of crisis, the consumption of unnecessary or luxury items drops immediately. So, any company that produces intermediate goods for such sectors or final goods of this nature will be hit hard. By the same token, companies that produce subsistence goods like food and beverages will be affected to a lesser degree. But when the crisis is worldwide, as is now the case, the demand for regional exports will fall. Small and medium-size companies that produce such commodities will sell less, have less revenue, be forced to cut costs, and may even have to lay off a large part of their workforce.

Falling commodity prices

The Latin American and Caribbean region is principally a producer, end user, and exporter of many commodities. Obviously, the impact of falling commodity prices will depend on whether the small and medium-size company in question is a producer or user. For producers, falling commodity prices will squeeze revenues and profits unless cost savings can be implemented quickly to offset declining sales. And in Latin America, where there is minimal margin for losses, not only do the small and medium-size entrepreneurs suffer; the thousands of workers and families that rely on these businesses are also affected.

The World Bank forecasts a negative long-run trend for commodity prices. Some specific examples are discussed below.

Coffee, one of the main export commodities of the region, has been suffering from two years of sliding prices, putting tremendous pressure on growers. Prices have fallen following an oversupply caused by better growing techniques and a quick rise in output by some countries. Coffee futures prices reached a thirty-year low in October 2001. With such low market prices, it is extremely difficult for growers to harvest the crops at cost effective prices. Particularly hit are small and medium-size producers that often have a high cost of production.

In 2001, coffee exports from the region were off almost 10 percent, partially due to crop problems and partially due to bad weather. The ripple effect of lower market prices and lower export levels is felt globally but is particularly acute in Latin America, which accounts for 60 percent of world coffee output and where coffee is an integral part of the economy and one of the region's strongest export earners.

It is here that small and medium-size companies face great challenges but also have many opportunities. Some producers are already meeting this challenge, producing and marketing coffee as a differentiated product rather than as simply a commodity. A good example is Café Soluble S.A., a Nicaraguan company for which the IIC approved a loan this year. Instead of exporting unprocessed coffee beans, Café Soluble exports high value added coffee products.

Sugar has seen its price decline during 2001, reaching eighteen-month lows after a period of oversupply. Recent climatic events that threaten to shrink supply may temporarily bolster this commodity's price.

Copper is another important export commodity; its futures prices are at thirteen-year lows. Weakening economies simply have reduced demand for wires and pipes and hence their primary raw material. And while copper prices have steadily declined over the past year, the subdued global demand continues to exacerbate the negative outlook for this commodity.

Oil, an important export commodity for the region, is hovering at two-year lows in the face of production surpluses and stagnant or falling demand due to warmer climatic conditions and slowing economic production. World demand for oil is growing at its slowest rate in almost two decades, and short-term forecasts are equally bleak. At the current levels of worldwide production and inventory, there is a risk that prices could plunge to late-1998 levels of around $10 a barrel.

Oil producers are usually large corporations, and small and medium-size companies might actually benefit from a drop in the price of oil as an input for their own production processes. However, falling oil revenues could trigger internal and external imbalances in oil producing countries, worsening the economic environment that disproportionately affects small and medium-size companies. This would be particularly true in the case of companies that are suppliers of goods and services to the oil industry.

Falling exports

The trade sensitive economies in the region will surely continue to suffer from a sharp slowdown in the global economy. Most affected will be those countries that rely on exports. The threat of a prolonged downturn of the U.S. economy is reducing demand for commodities and other exports so crucial to the Latin American and Caribbean economies. Falling exports and weaker demand from the region's consumers themselves may slow regional economic growth indiscriminately.

Declining tourism revenues

Global economic distress coupled with the unsettling events of late 2001 have had a damaging effect on tourism. According to the World Bank, 50 percent of planned Caribbean travel was cancelled during the last quarter of 2001. Hotel occupancy rates in the region dropped by as much as 30 percent. Surely the sector will rebound, but it will clearly take time. Latin American and Caribbean tourism entrepreneurs faced with falling revenues will have to identify and implement cost savings.

Scarce capital, credit, and foreign direct investment

Long-term investment by foreign companies in Latin America fell 21 percent during 2000 and decreased approximately 10 percent more during 2001 because of doubts about the region's economy and the global slowdown. The credit market remains largely open to top banks and corporations in most countries, but there is very little, if any, credit available for smaller enterprises.

Small and medium-size companies can be adaptable. Their overhead costs are usually lower than those of large companies because they have fewer layers of management. These companies can make advantageous use of local production factors and foster domestic entrepreneurship.

In the face of declining export volumes and falling commodity prices, Latin American and Caribbean entrepreneurs must act with celerity to save profitability. Their proven flexibility can enable them to implement cost savings techniques, redesign production processes, identify and market differentiated products, and broaden their customer base to offset declines. Entrepreneurs in the region can also leverage their proximity to customers and suppliers not enjoyed by foreign producers. For example, they can seek economies of scale through vertical integration. A good example is Invertec Pesquera, a Chilean company that received an IIC loan this year.

Loans and direct and indirect equity investments from the IIC can help finance measures of this nature. But over the longer term, small and medium-size companies need an environment that allows them to perform efficiently and effectively and makes them less vulnerable to economic crises. To this end, developmental institutions need to focus on strengthening markets in the region, as well as on other long-range goals. Some of these goals are

• help increase investment in education and healthcare in order to develop and protect local human capital and reduce poverty
• improve access to financing, especially equity, and financial intermediation services for small and medium-size companies
• work toward open, transparent regulatory environments
• develop efficient, regulated capital markets

These goals are part of the IIC's current business plan. They also represent key issues that must be addressed, not only to help the region's small and medium-size companies weather the current economic crisis but also—and in a way more importantly—to make the sector as a whole stronger in the face of new challenges yet to come.

How well an economy and its components (investors, lenders, businesses, and the public) weather an economic downturn has a lot to do with the underlying climate of confidence. All of these stakeholders are more likely to withdraw their support—thus exacerbating the crisis or delaying recovery—if they feel their interests are not protected. According to a study by Yale University professor Florencio López-de-Silanes commissioned by the IIC: "In the absence of a good legal environment, financiers are reluctant to surrender funds in exchange for securities, and hence the scope of capital markets is limited. Specifically…poor legal institutions result in high levels of ownership concentration, low availability of external equity financing, narrow equity markets, and small debt markets."

Some of the areas in which the region needs to improve in order to provide a more stable, attractive environment for investors are

• legal protection for investors—including minority shareholders—and creditor rights, which help ensure the availability of funding and the breadth and resilience of debt and equity markets
• enforcement of laws and regulations by courts and market regulators, including quality of accounting standards, corporate law, securities laws, and reorganization and bankruptcy laws

These areas fall into the general category of governance. According to Mr. López-de-Silanes, "A cross-country analysis makes it clear that improving corporate governance should be at the top of the policy agenda in Latin America."