Thinning of credit supply to MSMEs

The Micro Small and Medium Enterprises, which accounts for 111 million job opportunities and 30 percent share in the country's GDP, faces a credit gap of Rs 20-25 trillion with the vast capital deficit limiting the sector from realizing its full potential, writes PV Rao, Director, Pennar Industries.

Hyderabad: The Micro Small and Medium Enterprises (MSME) sector has consistently contributed around 30 percent share in India’s Gross Domestic Product (GDP) generating 111 million job opportunities for skilled and semi-skilled labor. With the addressable credit demand of Rs 37 trillion and existing mainstream supply of Rs 14.5 trillion, MSMEs face a credit gap of Rs 20-25 trillion in the country.

According to investment banking firm Avendus Capital, the total credit gap in the MSME sector was $530 billion out of total addressable credit demand of $819 billion, of which only $289 billion MSME loan demand has been fulfilled through formal credit lenders such as private banks, public banks and NBFCs. Despite their prominent role in the economy, the credit gap of Micro, Small, and Medium Enterprises (MSMEs) continues to be an unaddressed challenge globally.

In India, the current business ecosystem is one that is majorly dominated by MSMEs. However, there is an astounding credit gab of INR 25 Trillion in the MSME sector. The perennial capital constraint is limiting the sector from tapping into its full potential. This report by the World Bank highlights that even with the least financial and regulatory support, MSMEs are the largest employers in most developing countries.

Given how 600 million jobs are required by 2030 to absorb the growing workforce across the globe—empowering MSMEs with formal access to credit, has become a key focus for governments worldwide. Promoting the growth of MSMEs will have a ripple effect in boosting job creation, improving income levels, reducing vulnerability, and accelerating economic growth.

The backbone of India’s economic structure, the MSME segment, is one of the primary drivers of the country’s industrial sector, accounting for 45 percent of total industrial production, 40% of total exports, and contributing about 33 percent to the nation's GDP. It’s safe to say that MSMEs have grown to have a strong foothold in both the urban and rural areas of the country.

As one of the key drivers of employment, innovation, and economic development—MSMEs have immense potential to ensure an equal distribution of wealth and curb the regional and economic imbalances in the country. Even with MSMEs playing an instrumental role in India’s economic growth, a large number of them are yet to be integrated into the formal financial ecosystem of the country.

Of the 64 million MSMEs in India, only a meager 14% have access to credit. To put it simply, the real potential of this sector lies dormant. Among the MSMEs, medium-sized enterprises are the most well-served by financial institutions considering their stable cash flow, formalized operations, and higher creditworthiness.

With nearly 80% of MSMEs outside the purview of traditional bank credit, these credit-strapped businesses end up accessing financing from private or informal sources at much higher costs. The government’s Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) which facilitates collateral-free credit to MSMEs, recorded a 52 percent spike in FY22 loan guarantees as the average loan ticket size had increased.

Though the government has introduced many timely measures and regulations to develop credit and liquidity-related policies for MSMEs, the flow of funds to the MSME segment has remained weak. Going by the 'BlinC Invest MSME Lending Report 2022', banks and NBFCs currently address less than 15% of the total credit demand of the MSME sector.

With many of these businesses heavily relying on cash-driven models, the transition to formal financial services initiatives is yet to experience a significant uptick. That said, post the pandemic, MSMEs are now more keen on adopting digital solutions. What this has done is open up more avenues for new technology companies to step in and cater to the micro-transaction needs of the rapidly expanding sector of MSMEs and in turn, bridge the widening credit gap.

The BLinC Invest report also stated that the advent of emerging lending models using advanced data and technologies such as Artificial Intelligence (AI) and Machine Learning (ML) have the potential to narrow the credit gap in the MSME sector. There has been a 2 times growth in online loan disbursements in recent months.

Backed by RBI’s recent digital lending guidelines, FinTech lenders are leveraging alternative credit scoring mechanisms and using data-backed underwriting tools along with cash flow-based assessments to offer sachet-sized loans. FinTech lenders are also meeting the MSMEs’ demand for short-term capital through POS channels.

They are now partnering with retailers, leveraging available transactional data, and integrating lending solutions at checkout points. Digital lending has ushered in a new paradigm, enabling MSMEs to access timely and affordable funding. The Reserve Bank of India’s deputy governor M. Rajeshwar Rao has called for addressing the vast opportunity to fulfill the existing credit gap in the MSME sector by banks and other financial institutions.

Addressing the 31st Annual Management Convention of Thrissur Management Association recently, Rao underscored that the “critical issue in India’s credit market has been the consistent gap between the demand and supply of credit to MSMEs,” according to his speech published on the RBI website on Monday. “This has to be seen as an area of opportunity by the banks and other financial institutions,” he said, highlighting the challenges and opportunities in driving financial inclusion in the country.

Rao pointed towards the need for financial inclusion to be redefined by developing bespoke products and services that are best suited to different strata of society depending upon their income level. This shall include innovative solutions that make it easier for people to not only access basic but also to use a variety of financial services, he said.

Among factors for driving financial inclusion in India, RBI's account aggregator framework to enable responsible use of data is expected to accelerate the development of alternative lending models such as cash flow-based lending and marketplace lending or what we popularly know as peer-to-peer lending. This, Rao said, would enable small businesses, including street vendors that may not have traditional collateral, to secure a loan.

Importantly, in the post-Covid period, credit growth to MSMEs in the industrial sector was “distinctly higher” not only on a year-on-year basis but also in comparison with credit growth to large industries, according to the central bank’s December 2022 Report on Trend and Progress of Banking in India. Credit to MSME industries grew by nearly 20 per cent in FY21 and over 35 per cent in FY22 after a negative growth of around 2 per cent in FY20, down from around 3 per cent in FY19, indicating Covid impact.

In contrast, credit growth to large industries stood at around minus 5 percent in FY21 and turned positive to around 3 per cent in FY22. Given the proportion of the problem around lack of finance, it is clear no single solution can bridge the gap, there is a need to introduce and adopt new financing models.

Alternative financing tools such as equity finance, peer to peer lending, TReDS etc, have a lot of potential to grow. TReDS is an institutional mechanism set up in order to facilitate the discounting of trade receivables of MSME’s from corporate buyers through invoice discounting by multiple financers. In spite of a plethora of policy and schemes from the Government and RBI this sector is struggling to get timely and adequate finance.

This problem persists from the side of both entrepreneurs and bankers. In the era of Digital India and Atmanirbhar Bharat, India is witnessing many small but innovative start-ups in the service sector which need assistance in the form of risk capital and timely credit. MSMEs are also making partnerships with larger firms and bringing out competitive products in the market.

In spite of the fact that a large number of enterprises are becoming sick, we cannot deny that the rate of NPA is less than the large enterprises and the Banks should consider this fact. There is also a need to ensure access to banking facilities in the remote unbanked/under-banked areas. Banks have an important role to play in addressing several problems faced by MSMEs in India.

Banks have to view themselves not merely as a credit provider but as partners in the growth of these enterprises, through a process of hand holding support of first generation entrepreneurs and startups, while they find their feet in the business. Banks should therefore, provide financial consultancy/financial management services to their MSE borrowers to give them holistic guidance and support and nurturing them.

Banks could set up special industrial and management consultancy departments to address functional inadequacies and market gaps. There might be a higher failure rate for start-up MSMEs, but despite the risk, the financing of these enterprises is a must for ensuring inclusive growth and here Credit Guarantee Scheme can play a major role.

Credit guarantee is not the sole criterion for facilitating MSME credit but we cannot deny the fact that lack of collateral is the major cause of rejection of good projects by Banks. Financial Institutions are also safe while granting loans under Credit Guarantee Scheme. Therefore, this scheme should be popularized among bankers and entrepreneurs.

Other support from governments are needed such as tender forms for bidding should be made available free of cost, exemption from payment of Earnest Money Deposit (EMD) and Security Deposit (SD) , bill discounting facility should be made available on government orders, 10% price preference i.e. where the bid of micro and small enterprises are within 10% of L1 (Least priced bid), the local micro and small enterprises will be given an offer of reasonable part of the order at L1, subsidy on interest for 5 years, subsidy on taxation for 5 years for new MSME’s etc.