December 2008 · Number 140 A regular series of notes highlighting recent lessons emerging from the operational and analytical program of the World Bank`s Latin America and Caribbean Region. Microleasing 47530 Overcoming Equipment Financing Barriers Mike Goldberg As their businesses grow, many microbusiness owners the financial lease and the operational lease. In a finan- would like to purchase new machinery from a microfi- cial lease, the client pays the full price of the equipment, nance institution (MFI), since such equipment can hold plus interest, through the lease period. At the end of the the key to increasing production. However, MFIs are of- lease period, the client may purchase the equipment out- ten not able or willing to lend for longer periods of time, right for a nominal amount (usually the depreciated asset with grace periods that long term lending for machinery value). A financial lease can only be cancelled by mutual requires. Long term financing from other sources is agreement. In an operational lease, the client rents the usually not feasible, since banks and leasing companies equipment for a specified period, at the end of which the require collateral, a well-documented credit history and client returns the equipment, buys it outright, or renews financial statements. For many the agreement. The client may cancel the agreement microbusinesses, leasing could and return the equipment before the end of the lease provide an effective alternative period. to taking on more debt. This note reviews financial and opera- Both leasing types have some risks for the MFI tional leasing, describes two mi- and the client. The most important is the possibility croleasing experiences in Latin that the client will fail to make the regularly sched- America, identifies risks, and uled payments. In that case, provides recommendations for the MFI, as the equipment launching a micro-leasing pro- owner, can more easily seize gram. It is based on a distance the equipment than under the learning dialogue with South terms of a defaulted loan. American microfinance networks Indeed, this stronger legal and presentations by Glenn Westley of the Inter Ameri- position is the best argument can Development Bank (IADB) and Eduardo Gutiérrez, for leasing. For the client, this Executive Director of the National Ecumenical Devel- requirement means that even opment Association (Asociación Nacional Ecuménica in an economic downturn, the de Desarrollo; ANED). The authors included additional business must continue mak- research. ing the monthly payment. Under the operational lease, the residual value of the as- The Basics of Leasing set after the end of the lease period may be difficult to There are two types of equipment leasing arrangements: predict. If the asset's resale value at the end of the lease The work described in this note was supported by the UK Government's Department of International Development (DFID) through the Markets and Governance for Poverty Reduction Fund (MGPR) Trust Fund. The views expressed in this document are not necessarily those of the UK Department for International Development' period is less than what is owed, the MFI loses the client for the service. They also make regular visits to difference. Another risk for operational leases is dam- confirm that the client is using the equipment properly. age to the leased equipment. Damages will reduce the Some MFIs also turn to insurance policies to cover re- residual value and increase maintenance costs. Because lated risks, such as theft, injuries to workers, and life in- the operational lease has no lease-to-buy provision, the surance for deaths related to the use of leased equipment. client has fewer incentives to maintain the equipment Finally, the MFI may offer to sell the equipment to the or to avoid damaging it during the life of the lease. The client at a low price at the end of the lease period. This MFI also faces the risk of warehousing expenses for last option assumes that the lease has covered the initial storage of repossessed equipment, as well as security cost of the equipment, plus interest. costs and equipment removal costs. On balance, the financial lease is the better product To reduce damage risks and costs, the MFI may charge for an MFI, because it serves as an alternative for an a damage deposit at the beginning of the lease period, equipment loan--and the MFI can avoid the added re- but this is not a perfect solution. The amount may sponsibility of entering the secondary market when the not be sufficient to cover the costs of maintaining the original lease contract ends. Table 1 below describes equipment or fixing the damage. Moreover, the client the advantages and disadvantages of financial leasing. may not be able or willing to pay to fix the equipment If a client fails to make the regular payment (for at the end of the lease period. Some MFIs address whatever reason), financial leasing gives the MFI a damage risk by making arrangements to maintain the stronger legal position then a loan for repossession of equipment during the lease period, and billing the the asset. The equipment serves as the collateral, and can easily be repossessed. This is a routine legal pro- cess; it takes less than two months Table 1: Financial leasing advantages and disadvantages in Ecuador and Colombia, compared to one or two years for a defaulted Factors Advantages of Financial Disadvantages of Financial Lease Lease loan. It is fairly inexpensive--be- tween one and two percent of the Legal Firm legal position to repos- Greater potential for misun- lease cost. In Chile, Colombia, El enforcement sess and sell equipment if derstanding and legal disputes Salvador, Honduras, and Mexico, the client does no pay the the laws and procedures are similar lease. for the recovery of leased equip- Product The MFI can offer financ- May not create a credit his- ment. Leasing companies often design ing with smaller initial pay- tory for the client limit their exposure to standardized ments, fewer external guar- goods that can easily be resold lo- antees, and longer terms cally. Easy for clients to plan cash flow Assessing the tax advantages of financial leasing is complicated by Costs Lower enforcement costs High set-up costs a country's tax codes. Examples of High operational costs taxes include a stamp tax on equip- ment over US$27,000 (Colombia), Regulatory Often there is no cap on in- Banking regulations some- an asset tax (Mexico), and a tax on aspects terest rates for leasing times prohibit financial leas- imported equipment (Rumania). ing or limit it to a special For informal businesses, tax con- subsidiary siderations favor loan financing of new equipment. For formal clients Tax issues Taxes could be advanta- No tax advantage from leas- (who pay taxes), the local tax code geous for formal businesses ing for informal firms determines whether leasing makes that pay the value-added tax sense. Often, the MFI can reduce its (VAT) and utilities taxes. tax burden by deducting the depreci- 2 · March 2008 · Number 119 ated value of the rented equipment. Sometimes taxes are to qualify potential clients. Leasing offers a secure form charged on principal and interest, and in other cases the of lending to clients who have already shown an ability client can deduct principal and interest from taxable in- to manage short term working capital loans. It also helps come. The value-added tax (VAT) is sometimes applied to diversify the loan portfolio. In some countries, equip- against the lease charge, but not a loan. ment leasing is exempted from the interest rate ceilings imposed on lending. In addition, as discussed below, Advantages of Leasing for Microbusinesses and MFIs there are cost-effective means of limiting the risks of Leasing provides a number of advantages for the cli- damage to the equipment and the costs of recovering the ent, both in financial and operational terms. In financial asset in the event of non-payment. terms, collateral is far less of a constraint, since the title of the equipment remains with the lender until the end Two Latin American experiences: ANED and Finarca of the lease contract. In that way, collateral is built into The International Finance Corporation (IFC) has been the arrangement. It offers fixed rate financing, making instrumental in promoting leasing in Latin America. leasing "inflation friendly.. The IFC has worked with a number of financial institu- As other costs go up, the cli- tions in Peru, Bolivia, and Nicaragua, among others. ent pays the same amount Despite this support, leasing has remained fairly small, each month through the compared to the loan portfolios of the region's MFIs. lease period. There is also Some institutions considered equipment leasing pro- less upfront cash outlay. In grams, but government policies other words, the client does discouraged them from moving not need to make a large forward. In Bolivia, a new law re- cash payment to acquire the equipment, since quired the creation of a subsidiary the lease usually covers 100 percent of the for leasing programs. As a result, asset purchase cost. This means that the busi- Banco Procredit Los Andes, for ness can use its own funds for working capital example, discontinued its leasing needs. Leasing payments can be structured to program--and two other MFIs, match a business's cashflow--whether through FADES and Pro Mujer, never balloon payments, step-up or step-down payments, de- advanced beyond expressions of ferred payments or even seasonal payments. Leasing interest. As General Manager Hugo Paguaga Baca of does not affect the solvency of the firm, since it is not Finarca put it, "it is always good to have a regulatory reflected in the liabilities of the balance sheet. Finally, framework in place, but it shouldn't be a noose that is depending on the country's tax code, leasing can also going to strangle the industry." represent a significant tax saving for a formally regis- tered firm, especially if accelerated depreciation is per- That said, the experiences of ANED (www.aned.org), mitted for the equipment. in Bolivia and Finarca (www.finarca.com) in Nicara- gua, show how leasing programs can respond to de- The client also benefits in operational ways. The client mand by their microbusiness clients for better ways can choose the supplier and the equipment without inter- to acquire productive assets. Both institutions began vention or limitations placed on the choice by the MFI. In their programs in 1997. In 2004, ANED's program addition, leasing is efficient, because the client acquires was redesigned with support from the Inter-Ameri- the equipment only for the time it is needed. The client can Development Bank. Finarca was the first leasing can also upgrade more easily, as new technology or im- company licensed by the Superintendency of Banks provements become available, by leasing more modern, and Other Financial Institutions. In 2000, the Super- more productive equipment. Finally, leasing also offers intendency permitted it to offer a broader range of easy to understand lending terms and does not require a financial services--working capital loans, consumer large amount of documentation. Since the lease covers loans, housing finance, and letters of credit. The company evolved quickly and, three years later, was The microfinance institution (MFI), acting as the leasing acquired by Scotia Bank of Canada. company, can use more flexible financial requirements March 2008 · Number 119 · ANED's leasing program is dedicated to meeting the ing a clear legal definition of financial leasing and treat- needs of the micro business sector by improving the ing leasing and lending equally under the tax codes will conditions for access to medium and long-term financ- avoid the market distortions of a tax system that dis- ing. Equipment and machinery include farm implements, tinguishes between the two arrangements. MFIs should machinery for carpentry shops, bottling plants, energy, also understand and implement effective risk mitigation and small industry, among other things. Based on its ex- strategies to limit their exposure and provide incentives periences to date, ANED is expanding leasing to include for prompt repayment by clients holding leases. livestock. Bibliography Finarca has grown in two directions: expanding the Banking with the Poor Network. "Microleasing in range of leases and finding new clients in the country- Livelihood Restoration following a Natural Disaster," side. Finarca recently launched a new program to lease B.W.T.P Brief 5, n.d. equipment to at least 300 micro and small enterprises. Eligible projects and products for leasing include indus- Dowla, Asif Ud. "Microleasing: The Grameen Bank trial machinery, warehouse equipment, vehicles, hotel Experience" Journal of Microfinance, Volume 6, Number and restaurant equipment, agricultural machinery, and 2, office equipment, among others. As of June, 2008, Finarca had a portfolio of Finarca Nicaragua. www.finarca.com US$18.8 million, representing 85 per- cent of its total assets. Gutierrez, Eduardo. Asociación Nacional Ecuménica de Desarrollo (Bolivia). "Micro ANED's and Finarca's leasing pro- Leasing de ANED: Equipamos tu esfuerzo". grams resolve the problem of inad- October 17, 2007 presentation. La Paz, Bolivia. equate or no guarantees. They incorpo- rate productive technology and support Moncada, Mario José. A Push for Leasing. La and strengthen the credit products Prensa (Nicaragua), February 2, 2006. Managua. already offered. They also strengthen the relationship between the small Westley, Glenn. Arrendamiento y préstamo producers and the farmers. The leasing para equipo: Guía para el microfinanciamiento. Inter- programs have improved the supply of machinery and American Development Bank, 2003. Washington, DC. equipment and have led to the establishment of strategic alliances among providers. Westley, Glenn. "Microleasing: The Unexplored Financing Instrument." Microenterprise Development Recommendations for Establishing a Microleasing Program Review, 6:1. July 2003 Microfinance institutions considering long term lending for equipment should consider leasing as an alternative Westley, Glenn. "Prestamos y arrendamiento para to credit. Given the right market and legal and regulatory equipo: Guia para las Microfinanzas", October 17, 2007 conditions, MFIs will benefit by adding leasing to the list presentation. Washington, D.C. of financial products they offer their clients. As the expe- riences of ANED and Finarca demonstrate, the rewards Graphics from FINARCA and ANED websites of a leasing program for the institution and its clients can outweigh the initial costs of design and set-up. To that end, MFIs and government authorities should About the Authors seek to create the appropriate environment for a suc- Mike Goldberg is a Senior Private Sector Specialist with cessful leasing program. They should begin with a stan- the Poverty Reduction and Economic Management dard definition of financial leasing to replace the vari- Department of the Latin America and the Caribbean ous definitions currently found in the tax laws. Adopt- Region of the the World Bank. "en breve" is produced by the Knowledge and Learning Team of the Operations Services Department of the Latin America and the Caribbean Region of the World Bank - http://www.worldbank.org/lac 4 · March 2008 · Number 119