Across the developing world, small businesses pay a steep and largely invisible tax on borrowed money — not because they are reckless borrowers, but because the tools used to measure their risk were never built with them in mind. Researchers from the Institute for Economics & Peace, the University of New South Wales, and the UN Development Programme have traced this overcharge to three systematic distortions in how lenders assess country risk, firm-level default, and the value of resilience — and have proposed a model that could reduce borrowing costs by more than eight percentage points witho
New Research Reveals SME Lending Risks in Developing Countries Are Routinely Overstated
Uncertainty is routinely penalised, while resilience is seldom rewarded.
Mark
Why does a Kenyan manufacturer pay so much more to borrow than a German one, if they're equally sound?
Mimi
Because lenders use a country risk premium that's actually two things mixed together—real default risk and investor fear. The fear part swings with global mood, not with Kenya's actual creditworthiness. It's like paying extra insurance because the market is nervous, not because the risk is higher.
Mark
So you're saying 40 percent of that premium is just sentiment?
Mimi
On average, yes. The researchers separated the two using financial techniques. Strip out the sentiment, and the country risk charge drops sharply. But that's just the first layer.
Mark
What's the second?
Mimi
How lenders assess the individual business. Without credit ratings or audited accounts, they just add 3 or 4 percentage points as a buffer. The data from 59,000 actual loans shows that's too cautious—firms in developing countries default less often than those assumptions suggest.
Mark
And the third layer?
Mimi
The asymmetry in what gets priced. Uncertainty gets charged as extra risk. But the same business might be creating jobs, diversifying the local economy, building supply chains, adapting to climate shocks. Those things reduce risk. They're just not reflected in the price.
Mark
So you're rewarding resilience?
Mimi
Modestly, yes. A business that strengthens its community gets a discount. It's not charity—it's honest risk measurement. When they tested it in fragile regions, seven in ten borrowers improved their creditworthiness.
Mark
What's the bottom line for a Kenyan manufacturer?
Mimi
The conventional method says 19.9 percent. The honest method says 11.7 percent. That's eight percentage points—the difference between capital flowing in or flowing past.
The Pulse
- A small business in Nairobi pays nearly triple the interest rate of an equivalent firm in Frankfurt, and new research shows a significant portion of that gap is built on measurement error, not genuine risk.
- Lenders routinely inflate country risk by folding global investor anxiety into default calculations — a distortion that accounts for roughly 40 percent of the premium charged to businesses in developing nations.
- Without credit histories or audited accounts, small firms are penalized by arbitrary safety margins, even though a 30-year dataset of 59,000+ loans shows they default far less often than assumed.
- Resilience — the jobs a business creates, the supply chains it anchors, the climate shocks it absorbs — is systematically ignored in pricing, meaning the very qualities that reduce risk go unrewarded.
- A refined model combining corrected country risk, evidence-based firm assessment, and a resilience score brings a typical Kenyan SME's cost of debt from nearly 20 percent down to under 12 percent.
- For impact investors, the implication is urgent: capital is being steered away from the places it could do the most good by numbers that confuse caution with accuracy.
Across the developing world, small businesses pay a steep and largely invisible tax on borrowed money — not because they are reckless borrowers, but because the tools used to measure their risk were never built with them in mind. Researchers from the Institute for Economics & Peace, the University of New South Wales, and the UN Development Programme have traced this overcharge to three systematic distortions in how lenders assess country risk, firm-level default, and the value of resilience — and have proposed a model that could reduce borrowing costs by more than eight percentage points without relaxing sound financial discipline. The finding asks a quiet but consequential question: how much human potential has been priced out of existence by fear mistaken for fact?
A small manufacturer in Nairobi and one in Frankfurt might run equally disciplined operations and repay their debts with equal reliability — yet face a vast difference in what they pay to borrow. Researchers at the Institute for Economics & Peace, working alongside the University of New South Wales and the UN Development Programme, have found that much of this gap stems not from how these businesses actually perform, but from how lenders measure the risk of lending to them.
The research identifies three layers of distortion. The first concerns country risk — the premium added simply because a business operates in Kenya rather than Germany. The standard method uses Credit Default Swap prices, which blend genuine default probability with a "fear premium" driven by global investor sentiment. Separating the two reveals that roughly 40 percent of the typical country risk charge reflects mood, not fundamentals.
The second distortion sits at the firm level. Because most small businesses in developing countries lack credit ratings or audited financials, lenders apply arbitrary markups as a precaution. Drawing on an International Finance Corporation database tracking more than 59,000 loans across 169 countries over three decades, the researchers found that firms in these markets default less often than assumed — and recover more when they do. Replacing guesswork with evidence reduces this charge substantially.
The third insight is perhaps the most overlooked: resilience is never priced in. Lenders penalize uncertainty but ignore the stabilizing value a small business creates through employment, supply chain integration, and climate adaptation. The researchers built a model, grounded in OECD frameworks, that scores firms across six resilience dimensions. When applied to a lending program in fragile, conflict-affected regions, seven in ten borrowers improved their creditworthiness by more than 10 percent on average.
The cumulative effect is striking. A conventional assessment places a typical Kenyan SME's cost of debt near 19.9 percent. Correcting the country and firm-level measures brings it to 15.3 percent. Adding the resilience discount lowers it further to 11.7 percent — a reduction of more than eight percentage points, achieved not by ignoring risk, but by measuring it honestly. For impact investors, the message is direct: capital that currently flows away from developing-world businesses because of inflated premiums could instead reach firms that create jobs, anchor local economies, and build resilience where it is needed most.
A small manufacturer in Nairobi and one in Frankfurt might run equally tight operations, pay their debts with equal reliability, and still face a chasm in what they pay to borrow. The Kenyan firm gets quoted 18 to 20 percent annually. The German one pays a fraction of that. Some of the difference reflects real conditions—currency risk, regulatory environment, distance from capital markets. But researchers at the Institute for Economics & Peace, working with the University of New South Wales and the UN Development Programme, have found that much of it stems not from how these businesses actually perform, but from how the people who lend to them measure the risk of lending.
For impact investors—those whose stated purpose is to deploy capital where it does the most good—that measurement gap is expensive. It means capital flows away from the places it could do the most work.
The research identifies three places where risk assessment goes wrong. The first is country risk, the premium lenders add simply because a business operates in Kenya rather than Germany. The standard method borrows from how markets price insurance against government default, using something called a Credit Default Swap. The problem is that this price conflates two separate things: the actual likelihood of default and a "fear premium" that swings with global investor sentiment, often for reasons having nothing to do with the country itself. Using established financial techniques, the researchers separated the two. On average, roughly 40 percent of a country's CDS price turns out to be mood rather than fundamentals. Remove that, and the measured default risk shrinks substantially.
The second problem lives at the firm level. Most small businesses in developing countries have no credit rating and no audited financial statements. Lenders respond by applying rules of thumb—typically adding an arbitrary 3 or 4 percentage points to the interest rate as a safety margin. The researchers replaced guesswork with evidence, drawing on a database from the International Finance Corporation that tracked how more than 59,000 loans to private firms across 169 countries actually performed over three decades. The data tells a reassuring story: firms in these markets default far less frequently than the assumptions suggest, and recover more when they do. Measured against real experience rather than caution, the firm-level charge falls as well.
The third insight addresses an imbalance in how risk gets priced. When information about a small business is scarce, lenders treat that uncertainty as additional risk and charge more for it. Yet they rarely measure or price in the risk-reducing value that the same business creates—through jobs it provides, economic diversification it enables, supply chains it strengthens, climate resilience it builds, community stability it anchors. Uncertainty gets penalized. Resilience gets ignored. The researchers built a model, grounded in OECD resilience frameworks, that assesses how much a business strengthens these foundations across six areas, weighting contributions more closely tied to lower default rates. When they evaluated a lending-and-training program in fragile, conflict-affected regions, seven in ten borrowers improved their creditworthiness, rising more than 10 percent on average. That resilience score translates into a modest discount on the loan rate.
The cumulative effect is substantial. For a typical small business in Kenya, the conventional method produces an estimated cost of debt around 19.9 percent. Applying the refined country and firm measures brings it to roughly 15.3 percent. The resilience discount trims it further to 11.7 percent. That is more than eight percentage points—not by ignoring risk, but by measuring it honestly. For impact investors, the implication is clear: capital that now flows away from developing-world SMEs because of inflated risk premiums could instead reach businesses that create jobs, strengthen local economies, and build resilience in fragile places.
Notable Quotes
Firms in developing markets default far less often, and recover far more when they do, than the assumptions suggest.— Institute for Economics & Peace research findings
When a lending-and-training programme was evaluated in fragile, conflict-affected settings, borrowers' creditworthiness improved for seven in ten participants, rising more than 10 percent on average.— Research evaluation results
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