Government aid to small business should be done indirectly through reinforcing competition in the capital market, the Bank of Israel said Wednesday.
"A significant part of the difficulties encountered by small businesses are the result of a lack of advantages to scale and specialization ... These difficulties do not justify government intervention, which is only justified in the event of market failures or due to the existence of external advantages," the central bank said in the preliminary release of a chapter taken from its 2005 annual report.
"While certain large businesses with market force are known to have a negative effect on competition, frictional unemployment and economic inequality (since the market force grants them higher yield on capital), most large businesses operate in competitive markets in [Israel] and in the world," the central bank said, concluding that "handling corporations enjoying market force [advantages] should be done through the regulatory authorities and through intensifying competitiveness, not through a blanket subsidization of small businesses."
The central bank said, however, that funding is an area that could justify government intervention, since significant concentration in the banking sector and the inability of small businesses to recruit capital from other sectors gives a market advantage to the banks.
In 2004, the cost of credit for small businesses was 2.8 percentage points higher than that of the rest of the business sector.
This disparity "could indicate that the banks are exploiting their power against businesses that do not have access to foreign banks or the capital market," the central bank suggested, adding that small businesses' funding difficulties are also reflected in its survey of companies.
"The preferred way to assist small businesses is to continue steps to increase competition in the credit market, not through state-ensured credit," the Bank of Israel said, adding that liberalization of capital flows in the 1990s reduced the banks' advantage.
Banks have clear advantages on government funds in giving loans to small businesses, including larger and more varied credit portfolios, greater knowledge and experience with monitoring and supervising small businesses, and a wider geographical distribution. State-funded entrepreneurship development centers could help relieve small businesses' funding difficulties by beginning a program of rating the businesses' financial resilience, the central bank suggested.
"If this rating were to be reliable, those extending credit could count on it and save themselves the costs of checking (costs which are borne ultimately by the small business)."
Growth and increased efficiency of small businesses are important, since small business accounts for about 55% of employment in Israel and for about half of the business-sector product, the Bank of Israel noted.
"But is it appropriate to grant them special government assistance?" it asked.
Those in favor of assistance argue that small businesses are labor-heavy and supporting them will lead to improved competition and reduced unemployment and reduced economic inequality, while opponents say small businesses are characterized by low levels of productivity, a lesser ability to invest in R&D, low wages and insecure jobs. Research internationally has shown that there is no correlation between the weight of small businesses in the product and the country's rates of either economic growth or poverty, the Bank of Israel said.