Small and medium enterprises in developing countries routinely pay materially higher borrowing costs than comparable firms in advanced economies, yet new research argues much of that gap is not driven by how the firms perform but by how risk is measured.
Sentiment and rule‑of‑thumb charges inflate borrowing costs
The study, produced by the Institute for Economics & Peace with the University of New South Wales and the UN Development Programme (UNDP), finds lenders and investors systematically overstate both country‑level and firm‑level risk. The result: higher interest rates for creditworthy SMEs in markets where cheaper finance would support jobs and growth.
At the country level, the research examines how the market price of insuring government debt — the credit default swap (CDS) — is commonly used to price sovereign and related private‑sector risk. Using an established financial decomposition, the authors separate a CDS price into two components: the part reflecting a genuine default probability and a second part driven by global investor sentiment or “fear”.
On average, roughly 40% of a country’s CDS price is attributable to this sentiment component, not underlying default risk. Strip that element out and the estimated sovereign‑related premium shrinks substantially, which in turn reduces the country risk surcharge applied to corporate and SME loans.
Better evidence lowers firm‑level risk premiums
For individual firms the study highlights heavy reliance on crude heuristics. Where formal credit ratings and audited accounts are missing — common among smaller firms in lower‑income markets — lenders often tack on arbitrary buffers of 3–4 percentage points to interest rates to cover perceived unknowns.
Instead of guesswork, the researchers deploy empirical evidence. They draw on an International Finance Corporation (IFC) database that tracks the performance of more than 59,000 loans to private firms across 169 countries over three decades. That record shows defaults by firms in many developing markets are lower than lenders assume when using blunt surcharges.
The combined effect of refining country risk and replacing ad hoc firm buffers can materially reduce the cost of lending to SMEs — the firms that create most formal jobs in many economies.
- Country risk: Approximately 40% of CDS prices reflect sentiment rather than fundamentals.
- Firm risk: Lenders commonly add 3–4 percentage points where data are scarce; better data suggest those cushions are often excessive.
- Data source: IFC dataset covering 59,000 loans in 169 countries over 30 years.
| Measure | Reported figure |
|---|---|
| Sentiment share of CDS price | ~40% |
| Lender heuristic surcharge on small firms | 3–4 percentage points |
| IFC loan records analysed | 59,000 loans, 169 countries, 3 decades |
What this means for South African SMEs and lenders
While the study does not provide country‑by‑country prescriptions, its findings have immediate implications for South Africa. A sizeable portion of the risk premium that raises borrowing costs for local small businesses may stem from global sentiment and from lenders applying blunt penalties where richer, transaction‑level data could be used.
For household budgets and employment, the consequences matter. Lowering unjustified risk premia would reduce interest bills for entrepreneurs and could make smaller projects viable, supporting job creation and incomes. For banks and non‑bank lenders, improved risk measurement could expand safe lending opportunities and diversify portfolios away from crowded exposures.
That said, better measurement requires investment: in data collection, in credit infrastructure and in lender capacity to use empirical evidence instead of heuristics. International development partners, multilaterals and national policymakers can play a role by supporting credit registries, improving firm reporting standards and broadening access to transactional data.
The study underlines a practical point for policymakers: refining how risk is priced can be as important as injecting capital. Where measurement mistakes inflate perceived risk, correcting them can unlock private finance without extra public subsidy.
These adjustments would not eliminate all pricing differences between advanced and developing markets — real economic divergences remain — but they could narrow the gap and make finance fairer for firms that are otherwise sound borrowers.
WE NEWS does not give financial advice. The research referenced here is the work of the Institute for Economics & Peace, the University of New South Wales and the UNDP, using IFC loan records for empirical analysis.
