Going beyond the credit requirements of MSMEs

The announcement of support to micro, small and medium enterprises (MSME) by Prime Minister Narendra Modi last week had both economic and political rationales behind it. Politically, the government would like to be seen as supporting MSMEs, given that people engaged in the sector are considered a core constituency of the ruling Bharatiya Janata Party. Economically, any improvement in the sector’s operating environment will help the Indian economy. The share of MSMEs in the country’s gross value added is estimated to be about 32%. It also contributes about 40% to total exports and 45% to manufacturing output.

Apart from improving ease of doing business, the most important announcements were regarding access and cost of credit. MSMEs can now get in-principle approval for loans of up to ₹1 crore in 59 minutes. Additionally, goods and services tax (GST)-registered MSMEs will get an interest subvention on fresh or incremental loans. Interest rate rebates have also been announced for exporters. While an increase in the flow of credit will benefit the sector, banks and financial institutions would do well to not dilute their credit appraisal criteria.

Availability of credit from formal sources has been a problem for the sector. MSME credit is also one of the reasons behind the ongoing rift between the government and the Reserve Bank of India (RBI). In terms of financing, the share of non-banking financial companies (NBFCs) has gone up in recent years, given that banks saddled with high non-performing assets (NPAs) are reluctant to lend. But since NBFCs are now facing a liquidity crunch, it is likely that the flow of credit would have been affected. A Mint Street Memo, published by the RBI in August, mapped the flow of credit to the sector. While about 90% of credit from formal sources comes from banks, loans extended by NBFCs to MSMEs have increased in recent years. Credit flow was affected in the aftermath of demonetization, though it subsequently recovered from February 2017. Nevertheless, the share of credit to MSMEs has declined as a proportion of overall bank credit in recent years.

Although government intervention will help the sector, the actual impact for a large number of small firms will remain limited. The problem is that, as researchers highlighted in the above-mentioned note, more than 90% of MSMEs operate in the informal sector. These firms largely depend on informal sources of credit at higher interest rates. It is difficult for these firms to get loans from banks because they do not maintain proper documents and records.

At a broader level, since most firms are very small, besides non-availability of formal finance, they are also not in a position to adopt technology to improve productivity. Further, most firms in the informal sector are unlikely to attract skilled labour. The sixth economic census, for example, showed that enterprises on an average employed only 2.24 people. This illustrates that the problem is much bigger than the availability of credit.

India has a large number of tiny firms that work in the informal sector and do not scale up. This has not only affected growth and output, particularly in the manufacturing sector, but also employment generation. It is likely that with increasing digitization and the implementation of the GST, more firms will join the formal sector. However, a large informal sector raises important policy questions: Why do most firms operate in this sector? Does the regulatory environment disincentivize firms to formalize and increase their scale of operations?

Coming back to credit, as mentioned above, it is important to note that the while incentivizing credit flow will help improve activity in the sector, government intervention and directed lending can affect proper credit appraisal. This could not only result in higher NPAs, but also affect the flow of credit in the future. In this context, former RBI governor Raghuram Rajan, in his note to a Parliamentary committee, recently cautioned: “Both MUDRA loans as well as the Kisan Credit Card, while popular, have to be examined more closely for potential credit risk. The Credit Guarantee Scheme for MSME (CGTMSE) run by SIDBI is a growing contingent liability and needs to be examined with urgency.”

Public sector banks already have significant NPAs in the MSME sector and a push by the government can increase the risk. Thus, what is needed is a simplification of processes so that more firms can access formal finance. Also, banks should improve their credit appraisal capability to work with firms that are perhaps dealing with a financial institution for the first time. Meanwhile, the government should work to improve the overall regulatory architecture that would incentivize smaller firms to scale up.