As mainstream household microfinance has matured in India over the past thirty years, focus has turned to the country’s underserved Micro, Small, and Medium Enterprises (MSMEs). The MSME sector is a pinnacle of the Indian economy, made up of 48.8 million units that contribute 11% of India’s GDP (IFC, 2010). With India’s young working-age population to peak by 2020, the government has taken measures to give impetus to MSMEs’ potential to scale and generate further job creation.
MSMEs operate in an environment that makes it difficult for them to formalize and scale however. Challenges that have chronically constrained the growth of the sector include poor infrastructure and insufficient market linkages, but the most cited challenge to growth is a lack of adequate and timely access to finance. As microfinance prioritized the financial inclusion of households over that of enterprises, credit has become more accessible to self-help groups than to entrepreneurs with a larger need for it (Joshi, 2017). Financial inclusion advocates have adopted the term “missing middle” to categorize MSMEs that fall into a debt gap, being too small to access bank loans, yet too large for microfinance loans (CGAP, 2015). According to an IFC estimate, the sector suffers from a debt gap of over INR 2.9 trillion ($ billion), which, despite the advances made in the last decade to expand financial services to MSMEs, cannot bridged by the current composite of government schemes, financial institutions, and individual enterprises.
The MSME sector in India is classified into Micro, Small and Medium based on the size of the initial investment made to start the enterprise. This classification however provides limited visibility into the sector’s finance needs, more so a function of an enterprise’s size and area of operation, type of industry, customer segment, and stage of development. Honing in on the distinctions between manufacturing and service-oriented enterprises provides an example of the sector’s heterogeneity in terms of credit needs and the challenges in accessing formal credit channels.
The service sector accounts for 71% of MSMEs and is dominated by retail trade, eateries, and small transport operators. The addressable debt gap in this sector amounts to INR 0.9 trillion ($ 18 billion). The primary reason for this shortfall is a lack of understanding of the business models and financing benchmarks at play in a sector that almost entirely operates in the informal economy. A second reason is that service sector operations are intangible and entrepreneurs do not have the primary security or immovable collateral banks require to hedge the risk of default.
Although the manufacturing sector accounts for a smaller share of enterprises, its contribution to GDP is greater and its debt gap twice that of the service sector at INR 2 trillion ($40 billion). Manufacturing is more capital-intensive and has longer working capital cycles, especially as payments from buyers are realized with the significant delay of 100 days on average. Since suppliers’ credit remains limited, the working capital demand of enterprises tends to exceed the short-term credit limits offered by financial institutions, resulting in a large financing gap.
To mitigate these challenges and address the financial requisites of service-oriented and manufacturing MSMEs, boiled down respectively to start-up capital working capital, the Government of India has accelerated reforms to facilitate banking the underserved. The first wave of reforms ensured that every registered MSME has a bank account linked to the Udyog Aadhar. This was followed by the operationalization of an equity fund for the MSME sector and the inauguration of development banks and “small finance banks” to cater specifically to the missing middle. In parallel, India’s central bank expanded coverage of credit guarantee schemes that require banks to allocate 40 percent of their credit portfolio to “priority sectors” including MSMEs, and also reassure banks that, in the event of default, the government will make good the loss incurred by the lender up to 85 per cent of the credit facility (RBI, 2016).
Supported by these initiatives, it was expected to see more players and capital flow into the debt gap, resulting in greater volume of credit to MSMEs. The government’s impetus however did not glaze over the banking sector’s perception of small businesses as a high-risk and commercially unviable proposition to lend to, mainly due to the high transaction cost and high risk associated with these businesses. As a result, Indian banks are not inclined to ﬁnance MSMEs, especially micro and small enterprises, which predominantly translate to subsistence enterprises in the service sector.
First, the transaction costs associated with sourcing and evaluating MSMEs are high. Banks have limited manpower to scope out small businesses, and the transaction costs of sourcing being constant regardless of loan size, there is a natural incentive for bank agents to fish for sizeable producers in need of larger loans as opposed to corner stores with smaller ticket sizes. Assessing credit worthiness is also more expensive due to the informational opacity of MSMEs. Enterprise promoters are for the most part not financially literate and do not maintain formal accounts or differentiate between business and household finances. In the absence of standard capital benchmarks and credit scores, bank agents are left to base loan needs on cash flows, a time consuming and approximate process.
In addition, promoters lack collateral to secure their loans. Or rather, they lack the right collateral. This may seem paradoxical, given the recent finding that 95% Indian households’ wealth is held in physical assets, but these assets primarily consist of gold and land that are difficult to mortgage in the event of default. While the trend of collateral-free debt is growing gradually, in part thanks to the aforementioned schemes, financial institutions insist 95%-98% of bank loans be secured with immovable collateral, especially in light of the sector’s historically high levels of non-performing assets (RBI, 2017).
So it is that of the overall finance demand of INR 32.5 trillion ($650 billion), 78 percent is either self-financed or comes from informal sources. The banking industry’s reluctance to work with this sector is far from being the singular cause for the debt gap, as MSMEs are almost equally reluctant to avail formal financing. Starting with the human perspective, promoters’ fear of seeing their costly bank applications rejected and the belief that their projects are not worthy of formal investment keeps them from approaching banks. One might wonder how this is given the plethora of credit schemes tailored to them, but according to a recent survey of 85 MSMEs in India, over 50% of promoters were not aware of a single financial scheme, and only 12% had ever resorted to one to obtain financial support (Singh, 2016).
Were MSMEs aware of these schemes, there might also be an economic reason for not availing them. Informal finance currently fuels the sector, and while institutional channels, comprising trade credit, chit funds, and moneylenders, tend to be expensive, non-institutional sources such as family, friends, employers, and joint family businesses represent 95% of informal credit, and float it at minimal or no interest. Granted, these loans come with other strings attached and are limited in capacity, but overhauling quick, cheap money in favour of security and interest-laden loans will require more than preferential policies. When considering the registration, tax, and compliance requirements necessary for MSMEs to be eligible for credit schemes, the benefits of formal financing hardly seem to outweigh the costs of formalization.
In 1992, Dr. Prabhu Ghate, an independent researcher interested in the interaction of formal and informal credit markets, noted that “The expansion of formal credit at the expense of informal is often mistakenly assumed to be an end in itself, and the success of such policies is often discussed in terms of changing relative shares. Their true rationale, however, should be to ‘compete’ the terms of informal credit down by providing an alternative.” Although written over two decades ago, his words hold true, as the priority remains to study MSMEs’ current pathways to growth, and their sources and uses of informal credit, in order for the formal financial sector to put forth better adapted financial products, and for the government to more easily accessible credit facilitation.