Increasing Youth Entrepreneurship Rates in Serbia through a New Law on Microfinance Companies:

A Policy Brieffor Microeconomics of Policy Analysis

taught by Bryan RobertsSpring 2012

Yvonne Chenychen@gwu.edu

202-957-9662

May 11, 2012

Abstract

Youth unemployment is an economic and social problem in Serbia that is constrained by

limited access to finance, which is characterized by the failures of public funding

schemes that supply affordable startup funds and the high interest rates of commercial

loans. This paper offers a policy analysis of one policy alternative that will likely increase

the entrepreneurship rate among youth by increasing access to finance: introducing a new

law on microcredit companies. The paper is organized in the following fashion: the first

section provides a description of the current state of access to finance for Serbian youth;

the second section provides an overview of the economic model that will be used to

analyze the proposed policy option, called the supply of loanable funds model; the third

section provides an overview of proven solutions and assesses them in terms of their

feasibility; and the fourth section provides an evaluation and recommendation for the

proposed alternative, which is to introduce a new law on microcredit companies that

would increase the number of microfinance institutions and loan supply in Serbia.

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Introduction

Youth unemployment is a crucial issue facing Serbia’s economic development. In the

National Youth Strategy, youth are persons 15 – 30 years of age. In Serbia, there are

about 1.5 million young people, which constitute twenty percent of the total population.

The youth unemployment rate in 2010 was as high as 46.4 %. This rate is incredibly high

and exceeds more than double the EU average. Only 15 % of the population aged

between 15 and 24 was listed as employed (in comparison to 47.2 % for the whole

working age population). In 2007, only 2% of job seekers tried to establish their own

business. Instead of working and learning new skills, many young graduates are

forced to either search for part-time work, often in the grey market, or make plans

to emigrate.

While traditional employment will play a key role in solving the unemployment

problem, promoting youth entrepreneurship will also be essential. In fact, demand

for self-employment among young people is high and remains unmet. In 2011, youth

made up roughly 25% of the 20,000 people who inquired about Government of

Serbia (GOS)-sponsored startup grants from the National Employment Service

(NES) and 25% of the 12,000 people who completed the NES two-day business

training in 2011. Because all of the NES grant recipients are unemployed, these

figures imply that through this program alone, 3,000-5,000 young people could

potentially leave the unemployment registers each year. i In addition, a recent

survey shows that 33% of young people would prefer to have their own business

rather than the safe but low-paying jobs that are generally available; ii however,

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these young people feel that a wide range of constraints make it difficult to realize

their entrepreneurial aspirations.

This paper offers a policy analysis of one policy alternative that will increase the

entrepreneurship rate among youth by increasing access to finance: introducing a new

law on microcredit companies. The paper is organized in the following fashion: the first

section provides a description of the current state of access to finance for Serbian youth;

the second section provides an overview of the economic model that will be used to

analyze the proposed policy option, called the supply of loanable funds model; the third

section provides an overview of proven solutions and assesses them in terms of their

feasibility; and the fourth section provides an evaluation and recommendation for the

proposed alternative, which is to introduce a new law on microcredit companies that

would increase the number of microfinance institutions and loan supply in Serbia.

I. The Current State of Access to Finance for Serbian Youth

Youth who own businesses recognize access to finance as one of the biggest

constraints to doing business. Two main barriers that affect youth entrepreneurs’

access to finance were mentioned most frequently: problems with public funding

schemes and lack of commercial credit.

1. Problems with Public Financing Schemes

Among our survey respondents, government funding is the second commonly used

source to finance startups. However, even though eight people took government

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funds, no one expressed satisfaction with the government’s role in supporting youth

entrepreneurs. As noted above, the Government of Serbia plays an important

financial role in the face of the private banking sector’s failure to adequately serve

youth businesses. There are a number of existing governmental and non-

governmental programs to support young entrepreneurs in Serbia:

o The Ministry of Economy and Regional Development offers EUR 1,600

startup grants to entrepreneurs through NES. Young entrepreneurs are a

priority group and account for about 25% of the annual grant recipients. iii

o The Fund for Development offers start-up loans for both youth and adults

with no business experience. Loans are between EUR 5,000 and EUR 40,000,

with annual interest rates of 2.5-3%. iv

However, there are two main issues that significantly inhibit the effectiveness of the

public funding: transparency issues and lack of strategic focus.

a. Public funds lack transparency

First, the selection process and the disbursement of government grants and loans

are often criticized for their lack of transparency and accountability. While both NES

grants and Fund for Development loans are given based on the soundness of the

business plan, information about how the money is disbursed and its results are not

made publicly available. Moreover, there is currently no external monitoring and

evaluation of how these public programs are managed. This opaqueness, combined

with the widespread perception of corruption, causes distrust in public funding and

raises questions about whether they are delivering the intended benefits. For

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example, in early 2010, of 1,705 clients in the AgroInvest branch office of

Kragujevac, only two met the criteria to apply for loans of the “Serbian Development

Fund” and applied. Both of these client applicants were rejected for a loan.

Figure 1: Empirical evidence that public funds do not current demand for startup capital

b. Public funds lack strategic focus

Second, people working with the youth on the ground, such as NGOs, business

incubator and Youth Office coordinators, often point out the lack of strategic focus of

the government programs. There is currently no government funding that targets

the youth business exclusively and those that are available to startups are often

insufficient to incentivize young people to start their business. In addition, the

overall pool of public funding has been shrinking in the last few years due to the

ongoing economic recession. These factors may have discouraged many young

entrepreneurs from seeking public funds as startup capital.

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There are also major market distortions that result from a risk-averse business

environment for lending. This has led to significant lack of commercial credit for

most startups.

2. Lack of Commercial Credit

a. Poor Banking Terms and Conditions

According to the Civic Initiatives study, 55% of survey respondents reported that

they would consider starting their business if the loan terms were more favorable.

Our survey findings also suggest that barriers such as collateral requirements, loan

terms, and loan size are important constraints to finance. Most Serbian banks target

only existing businesses, as they require at least one year of profit-loss statement

from their borrowers. Additionally, banks commonly require cash or land collateral

from their borrowers. There are few non-collateral loans offered by Serbian banks.

For a non-collateral loan, but those loans require the borrower is still required to

substitute collateral with a guarantor signatory who is an experienced

businessperson.

b. High Interest Rates

High interest rates are another major factor that contributes to the lack of

commercial borrowing by youth entrepreneurs. According to a survey of 25 youth

entrepreneurs that the author conducted in Serbia for Chemonics Internationalv,

high interest rates are the primary reason that the young entrepreneurs did not take

out commercial loans (see figure 2).

Figure 2: Constraints to Finance

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The typical interest rates charged on an established youth business are 22%-24%,

while the rates for non-collateralized microloans can be as high as 36%.vi

There are several reasons for such high interest rates. The next section explores the

problems with interest rates from the perspective of the loanable funds model. It

also describes one solution that can serve to lower them to increase access to

finance for youth entrepreneurs in Serbia: introducing the supply of microfinance

loans through a new law on microfinance companies.

II. The Economics of Interest Rates: Supply of Loanable Funds Model

The loanable funds model is similar to the aggregate supply-aggregate demand model. It

is a comparative statics equilibrium model that use supply and demand curves to arrive at

an equilibrium price. The price in this model is the cost of credit –the interest rate, r. By

High interest rates

Collateral require-ments

Financial terms are too com-

plex

Loan size does not match

needs

Lack of suffi-cient business

experience

0

2

4

6

8

10

12

14

16

18

20

Please rate the following factors in terms of how much they have constrained your ability to procure financing for your business.

Very constrainingSomewhat constrainingSlightly constrainingNo effect

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way of simplication, the loanable funds model assumes there is one interest rate, which

can be thought of as a proxy average for all interest rates. The quantity axis represents the

volume of bank credit where the unit being measured is millions of Serbian dinars or

euros. The demand curve represents the demand for credit by borrowers and the supply

curve represents the supply of credit by lenders.

The demand for credit consists of two components: (1) the direct demand for credit

through loan applications (by consumers, for example) and, (2) the sale of all classes of

interest-bearing financial assets as a means to raise money. For simplification, the

demand for loans in this model for this paper represent the retail and corporate loans for

short-term working capital as well as long-term fixed assets investments because these

are the products that are typically demanded by startup businesses in Serbia. The supply

of loans is represented by lenders, and includes direct lenders, such as banks, mortgage

companies, credit card companies, and auto and equipment leasing companies. A final

component of the model is that the monetary and credit system is regulated by the central

bank. Through reserve requirements, the National Bank of Serbia has the ability to

directly affect the supply of credit in Serbia. Higher reserve requirements will reduce the

supply of credit and vice versa. Factors that affect demand for credit are:

DemandInterest rates (–)government budget deficits (+)S&L govt. municipal borrowing (+) Consumer borrowing (+)Business borrowing (+)Residential mortgages (+)Business mortgages (+)Foreign demand for Serbian funds (+) Inflationary expectations (–)

Supply Interest rates (+)Consumer savings rates (+) Business savings rates (+) Mandatory savings (+)National bank credit creation (+) Foreign purchases of Serbian assets (+)Inflationary expectations (+)

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Additionally, consumer confidence, rates of profit, demographic variables, wealth and

income growth rates, foreign exchange rates, etc. can influence any of these categories to

indirectly affect the supply or demand of credit. Any change in the values of any of these

variables will cause a shift in the appropriate curve and a movement to a new market-

clearing equilibrium.

The actual movement of interest rates will depend upon the net impact of all the

aforementioned variables acting upon them. However, understanding the impact of key

variables is very important and serves as a reasonable basis for predicting how a mix of

events causes interest rates to rise or fall over a time period. It should be noted that for

the model to be accurate, the isolated effect of each single variable must first be known.

Loanable Funds Model and Serbia

Many aspects of Serbia’s private sector lending landscape can be analyzed with the

loanable funds model. First, from the banks’ perspective, it is too costly to perform

the necessary due diligence to assess each loan applicant’s risk premium. vii By way

of cost-effectiveness, banks automatically place the highest risk premium to first-

time startups, which most youth businesses are. This phenomenon relates more to

the loan size and rate of return, where rate of return decreases as the size of the

loan decreases. There is a wedge in rates of return and interest rates after a certain

point, as it becomes expensive to perform the underwriting services necessary to

assess risk. Therefore, banks charge higher interest rates to small and startup loan

borrowers as a policy, instead of performing the underwriting services.

Second, Serbia’s low sovereign rating (BB-) makes it expensive for banks to borrow

euro-denominated funds from the rest of the world.viii In terms of the loanable funds

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model, the more demand there is for these euro-denominated funds there are form

the public coffers, the higher the interest rates will become.

Third, the high reserve requirementix set by the Central Bank of Serbia that aims at

enhancing the overall financial sector’s resilience to external shocks further

increases the cost of lending for banks. In terms of the loanable funds model,

interest rates increase because of these restrictions on the credit supply by banks.

These macroeconomic factors, though difficult to tackle, need to be taken into

consideration when working with banks to lower interest rates for startups.

Last, the Serbian financial sector lacks adequate microloan service for startups even

by Eastern European standards. According to the model, the demand for the low

interest rates (microloans) is below equilibrium because the supply of loans is not

large enough to meet demand at an equilibrium price.

Although the country has 32 banks competing for a relatively small domestic market

of seven million people, only three banks -- Pro Credit Bank, Opportunity Bank, and

Erste Bank -- have loan products designed for startup businesses that are run by

young people.

The limited amount of microloan products is attributed to Serbia’s legal framework,

which currently does not provide a way for non-banking microfinance institutions

to administer loans. It is necessary to note that passing the current Law on Banks

replaced the previous Law on banks and other financial organizations in 2005. It

eliminated legal possibilities for the existence of other (non-banking) forms of

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financial organizations. Consequently, the total of eight MFIs were closed down and

one was transformed into savings bank.

NGOs and private institutions that strive to ease the financial burden of youth

businesses must operate through existing banks. Today there are three MFIS that do

their business illegally because they are not defined as MFIs by Banking Law or by

any other law, and in line with that makes them de jure out of National Bank

jurisdiction. They are registered as citizen associations and must pay commissions

to banks that administer loans on their behalf. Because they operate through local

banks, which take up to one third of the margin, they offer high annual interest rates

of 28-36%.

III. Policy Options

Best practice offers several ways to promote access to finance. The government can

implement a number of new programs, such as: soft specific-purpose loans from

public sector; public sector credit guarantees for commercial credits (including

leasing arrangements); subsidizing commercial banks’ interests for start up credits;

grant for new employment (non-returnable funds for every newly-created work

position, including that of an entrepreneur; vouchers for subsidizing non-financial

support (in the range from 30-70% for service expenses, and depending on the type

and phase) in public - private - NGO sectors partnership. However, the existing

public programs are already experiencing cuts due to budget cuts, and there is not

enough supply for the demand, as mentioned earlier.

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It is unlikely that, given the tense political situation—the need to make reforms to

enter the EU which will require fiscal diligence and polemic party politics that

prevent most new public programs from moving forward in Parliament—that any of

these options are politically feasible.

A market solution is necessary, especially one which can tap into foreign capital. Of

those, Serbia could increase the supply of funds, by reducing the high reserve

requirement or printing more money. However, because of its pre-EU accession

status it is unlikely it will do either. One intervention that is common in many

developing countries with credit crunches and high reserve requirements such as

Serbia is to introduce credit guarantees on banks’ business loan funds, such as those

offered by USAID’s DCA fund, to lower the risk of lending to certain kinds of

enterprises.

Last, increasing the number of microloans through increasing the number of

microfinance institutions has proved to successfully lower interest rates and the

supply of loans to startups and small enterprises. To that end, given the lack of

feasibility of most options that could work, this paper will analyze the option of

passing a new law that will allow microfinance institutions to administer startup

and SME loans without working through a bank.

IV. Evaluation and Recommendation: Pass law on microcredit companies

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1. Overview of Policy Alternative

The draft Law on Microcredit Companies was introduced in 2005, again in 2010,

and received the support of World Bank/CGAP and the EBRD, but it has not yet been

passed. The law will provide a legal status and supervision to microcredit companies

and allow them to legally administer loans. The Ministry of Finance will serve as the

key regulator of the microcredit sector in Serbia. The proposed law also determines

the appropriate role for the international community in terms of funding and

capacity building for microcredit actors.x Loans must be less than EUR 25,000. No

deposits are taken so there is no risk to financial sector stability. The MFI founders

and donators obtain the necessary funds for founding and starting business. There

is a clear differentiation of sources and purpose of MFI’s own business assets and

fund assets for microcredit financing. The sources of microcredit loans funds are

limited on donations and soft loans. It is also not a systematic risk to the financial

sector, particularly if access to the high quality credit bureau is authorizedxi In terms

of business operations, it is non-for-profit, earned revenue can be used solely to

cover current expenses and business operations improvements. The loan rate is not

source of retain capital or assets. Income is made from commission and business

development services.

2. Expected Impact of Proposed Alternative

The MoF envisions the Law will correct the government failure, which has allowed

for a situation in which, despite a large number of banks for a country of its size,

there is barely a market for microloans because of the Law on Banks. The new Law

is expected to add 10-15 internationally based MFIs to Serbia’s financial sector.

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According to Serbia’s Microfinance Working Group and the two leading MFI’s

estimate, if the proposed Law passes, interest rates can be reduced to 22-24%,

which is lower than business loan rates offered by commercial banks.

Figure 3: Increase in supply of loans reduces interest rates and meets demand for affordable loans

As shown in Figure 3, the supply of loan can increase as foreign donor flows enter

microfinance institutions and increases the supply of loanable funds. When supply

shifts from the original amount, S1, to the amount under a favorable microfinance

law, S2, the equilibrium price (interest rates, r) moves down from r1 to r2. If the

change is enough to meet the rate that startup businesses and small business

demand, then this law has the potential to create entrepreneurship and reduce the

magnitude of unemployment problem in Serbia.

One MFI, Agroinvest Serbia (AIS), currently reaches over 14,2000 rural clients, with

an average loan size of EUR 1,120, and over 35% of its clients take out a loan of less

r1

r2

v1 v2

D

S1S2

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than EUR 800 for start-up businesses. They estimate that the remaining market

demand for its microcredit products, but at a lower interest rate comparable to

banks, is over EUR 200 million in Serbia.

Moreover, allowing microcredit companies to administer loans in Serbia will lead to

other benefitsxii, such as: increase amount of lending support to youth by accessing

high levels of donor and loan funds from outside Serbia (increase the supply of loans

in Serbia) and encourage more youth to start businesses.

Apart from solving the market distortion (high interest rates) that is created by the

restrictive Law on banks, the reform will allow have some impact on distributive

equity. Under this draft Law the role of microcredit is to provide a model of

development that promotes entrepreneurship and gives people the means to fight

poverty. Additionally, loans will have spillover effects because it will result in

thousands of jobs, increased tax receipts and reduced government outlay for

poverty assistance.

Case studies from several other countries offer some insight into the potential

success of increasing the number of MFIs in a country. Of relevance to Serbia are

other transitioning economies. According to a study that compares Eastern

European experiences with microfinance, Poland offers the best example: “A unique

micro finance schemes called Fundusz Micro was established in 1994 by the Polish-

American Enterprise Fund. Based on the results of the pilots, it has, since February

1996, built a nationwide network of 11 branches and 1 main office (Headquarters).

As of February 1998, it had a loan portfolio of over $8 million and served over 8,000

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clients. In September 1999, Fundusz Micro reached operational break-even. As of

December 1999, it had disbursed over US$ 50 million and serves 18,060 clients. The

star-up loans are limited to US $1,200 for a period of six months. This loan is

secured by personal guarantee of three co-signers, who form a group of borrowers.

In addition, the beginner entrepreneur has to fulfill all the requirements prescribed

by the Agency. Fundusz Micro has been developed an innovative, computerized loan

portfolio risk assessment system, or tool, which is used to control default risk at a

time when Fundusz Micro is undergoing rapid expansion of its lending

operations.”xiii

3. Considerations of Policy Alternative

Achieving high loan repayment rates among the borrowers and finding national and

local contributors to the fund are the key to the sustainability of the fund. Another

concern is the high cost of performing due diligence on youth borrowers, who are

riskier clients than older adult business owners. Microcredit companies can mitigate

this issue by using the credit bureau to assess risk of its borrowers, asking for

training certificate as part of the eligibility criteria, establishing expert panels to

select loan recipients based on the quality of the business plan and asking for a

guarantor.

V. Conclusion

In summary, it is recommended that Serbia pursue a policy change to provide a

status and regulation for microfinance institutions under the proposed Law on

microcredit companies. Other proven interventions are most likely not politically

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feasible in the current political environment. As such, a market-oriented solution

that draws in foreign donor funds is necessary. The proposed policy will likely

increase the number of microfinance institutions, increase the supply of loans and

reduce interest rates for youth borrowers. Improvements in access to finance will

incentivize youth who are interested in starting a business but who feel burdened

by the high interest rates to feel encouraged to start a business. Youth

unemployment is an important issue and it would behoove the Serbian government

to make the serious next step to pass the Law on microcredit companies in the next

parliamentary session to take place in the fall of 2012.

End Notes

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i Interview with Dragana Djokic, March 20, 2012ii Ibid. note 1.iii National Employment Service, Accessed April 8, 2012, Accessible at "http://www.nsz.gov.rs" iv Ministry of Economy and Regional Development, Accessed April 8, 2012, Accessible at http://www.merr.gov.rs/v Jared Hutchinson, Matthew Guttentag, Yvonne Chen and Karen Mo, “Youth Entrepreneurship in Serbia: Constraints and Opportunities”, The George Washington University, 2012vi Interview with ENECA, March 16, 2012.vii Interview with Opportunity Bank, March 21, 2012.viii Interview with Dusan Dobromirov, March 12, 2012.ix Depositors in Serbia are provided with a high level of protection through high required reserve in the amount of 40% for the new foreign currency savings., of which 80% of reserves in foreign currency and 20% in dinars. Moreover, following the crisis in 2008, required reserves for funds taken in overseas aren't being calculated retroactively from October 1st 2009 for bank loans from abroad (untill then the required reserve was 45%, subordinated capital from abroad 20%, and borrowing of the financial leasing companies 20%. Source: National Bank of Serbiax Daniel Gies, “Access to Microcredit in Serbia: Perspectives and Positions”, presentation to Ministry of Finance, December 9, 2010xi Since instituting the credit bureau in 2008, the percentage of nonperforming loans to all loans has decreased to x%. xii Daniel Gies, “Access to Microcredit in Serbia: Perspectives and Positions”, presentation to Ministry of Finance, December 9, 2010xiii ESDC – Entrepreneurial Society Development Centre Study on Micro-finance Support to Start-up in Serbia, 31, 2005