# **Unlocking SME Finance in Fragile and Conflict Affected Situations**

## **1. Introduction**

There is growing recognition that the private sector, and more specifically small and mediumsized enterprises (SMEs), can play an impactful role in fragile and conflict affected situations (FCS). On the one hand, SMEs can contribute to improve people’s livelihoods (Assaf et al 2021). SMEs can generate employment and directly provide necessity goods and services such as food, water, health, education, and transportation. They can also contribute to the resilience of local populations during periods of conflict. On the other hand, SMEs can play a positive role through noneconomic contributions. For example, increased employment and trade can generate positive social externalities, increasing the level of trust in society, while paying taxes can contribute to restoring the legitimacy of often weak states (Hoffmann and Lange 2016).

While SMEs have the potential to contribute in many ways to the foundations of social stability and resilience, the circumstances in which they operate make it very difficult for them to flourish. First, in conflict situations, businesses are constantly faced with lack of security, threatening their staff, assets and the infrastructure they rely on. Second, a high level of political volatility and weak legal frameworks and institutions create an unpredictable environment for doing business. Finally, difficulties in accessing critical resources often make it even more challenging for SMEs to operate in FCS countries (Peschka 2010). Chief among key inputs is external finance, especially bank finance, which is needed to fund SMEs’ working capital and investment needs.

This paper seeks to identify the main constraints to SME financial inclusion in FCS countries, highlighting the key priority areas to reduce the financial inclusion gap of SMEs. Though access to finance is widely understood to represent a major obstacle to the development of SMEs in FCS countries, to our knowledge the topic remains relatively unexplored in the literature. Yet understanding the key drivers of SME financial inclusion in FCS countries can help policy makers design and implement more targeted interventions.<sup>1</sup> To that end, this paper looks at the impact of macroeconomic and financial sector variables, the legal and institutional constraints, and the role of the business environment. In particular, using the responses from formal SMEs in the World Bank Enterprise Surveys (WBES), this paper attempts an answer to the following question: to what extent do economic fundamentals and institutional characteristics affect SME financial inclusion in FCS countries _relative_ to non-FCS countries?

Economic fundamentals matter for SME financial inclusion. Higher incomes and better physical infrastructure increase savings and the pool of funds in the economy and improve access to finance (Dabla-Norris et al 2015), while macroeconomic and financial stability can positively affect credit and other financial services to SMEs (Rojas-Suarez 2016). Banking market structure

> 1 Increasing support for private sector development is, among others, a critical pillar of the World Bank Group’s strategy for FCS countries (WBG 2020).

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