Journal of Governance and Regulation / Volume 4, Issue 1, 2015, Continued - 1 94 INFORMAL FINANCE AS ALTERNATIVE ROUTE TO SME ACCESS TO FINANCE: EVIDENCE FROM ETHIOPIA Ashenafi Beyene Fanta * Abstract The problem of SME financing has received attention of policy makers and academics in recent years owing to the role of the sector in reducing unemployment, narrowing income gap and alleviating poverty. Alternative financing schemes were suggested but their success depends to a large extent on the development of legal, informational, and institutional frameworks. Existing body of literature grossly undermines SME ability in reacting towards financial restraint and generally assumes they are passive participants in the credit market. Through a survey of 102 randomly selected firms across 10 industrial sectors in the manufacturing sector, we examined how the Ethiopian manufacturing SMEs reacted to acute shortage of formal credit. We found that SME owners actively react towards financial restraint by resorting to alternative schemes such as iqqub(variant of rotating saving and credit association), customer advances, and trade credit. Although the alternative financing schemes are not the best but they are useful in evading the impact of credit restraint on their operation and growth. Keywords: Trade Credit, Smes, Iqqub, Informal Finance, Ethiopia, Customer Advances * Department of Finance, Risk Management, and Banking; College of Economic and Management Sciences, University of South Africa 1. Introduction Literature shows that underdevelopment of the financial market coupled with imperfections are the prime causes of SME financing problems (see (Beck, Demirguc-Kunt 2006). Cross country studies reveal that whilst financial underdevelopment prevails in most of the developing and emerging economies, imperfections exist even in advanced economies, implying pervasiveness of SME financing problem. Although financing constraints also exist in advanced economies where financial markets are more developed, the extent of SME financial exclusion is by far less severe in developed economies owing to the fact that they have a better informational, legal, and financial framework. Various SME friendly schemes were suggested (Beck and Demirguc-Kunt 2006; Berger et al. 2005; Frame and Woosley 2004; Klapper 2006) but their efficacy hinges on the existence of legal and financial institutions-the inexistence or inefficiency of which is the primary cause of SME financing problems in most developing countries. Besides, disparity in the level of economic development, the financial intermediary system, and characteristics of the SME sector, often renders a scheme effective in one country barely useful in others. This calls for both better understanding the each country’s financial system including the informal financial market, and also the ways in which SMEs manage to shred off the financial obstacles. Most of the existing literature assumes the SME sector as passive that does not react towards hostile financing environment. Hence, studies that shed light on SME reaction to financial restraint are very scant. Only few studies have ventured into the issue (Lin and Sun, 2006; Vandenberg 2003), and it was reported that SMEs do react in many ways ranging from bootstrapping to active participation in the informal credit market. However, country case studies show that the way they react differs from country to country owing to the difference in each country’s social, economic, and business setting. Understanding the alternative financing schemes used in each country’s SME sector paves the avenue for determining the economic soundness of the schemes, for setting up workable models that can enhance their efficiency, and also in standardizing them such that they are applicable elsewhere too. We argue that a closer study and analysis of these schemes helps in averting the severity of the credit market against small firms and can provide at least a short-term solution to their financing problems. We also contend that a critical look at the informal credit market helps in forging a link with the formal credit market. Such a scholarly engagement will foster transformation of the informal markets from their rudimentary level to essential elements in the credit market in developing countries. Through a survey of 102 randomly selected firms across 10 industries in the manufacturing sector, we examined how the Ethiopian manufacturing SMEs coped with acute shortage of formal credit. We found that the SMEs use various