There are over 7.9 million Micro, Small and Medium Enterprises (MSMEs) in India as of 27 March 2022, as reported by the Ministry of MSME. They face a financing gap that could prove to be their Achilles heel. The sector is heterogeneous, with most MSMEs (over 7.5 million) being micro-enterprises, around 350,000 are small enterprises, and 35,773 are medium businesses. The UK Sinha Committee report of 2019 (bit.ly/3A8N9UP) put the total credit gap in the MSME sector at $20-25 trillion.
Scheduled Commercial Banks (SCBs), which primarily extend loans to MSMEs in the form of loans, overdraft facilities and lines of credit, are not the naturally go-to institutions for MSMEs. This is because bank loans are based on principles that include the creditworthiness of the borrower and the estimation of expected future cash flows as the basis for primary repayment. MSMEs lag behind on both these parameters. Information asymmetries and inherent principal-agent conflicts make bank lending to small businesses a challenge. Entrepreneurs have better access to business information than a financier/bank, which they can share only partially. Small business owners, as agents, can access the funds in other ways that a bank, as principal, intends to use them. The funds can be used for riskier projects that better align with the borrower’s own risk-return calculations.
The credit gap translates into a ‘growth capital gap’, especially for innovative and high-growth MSMEs who are looking for a revolutionary pivot in their business model or overseas expansion. One only needs to look at the MSME credit data of the SCBs to understand the magnitude of the financing challenge. MSME accounts with banks accounted for less than 14% of total loan accounts with Indian SCBs in 2020-21, while the sector accounted for only 16% of total credit flow from these lenders (bit.ly/2O4fX5w).
To address this challenge, the Reserve Bank of India (RBI) launched the Trade Receivables Discounting System (TReDS) in 2017. It was intended to serve as an electronic platform to bring together MSME sellers, buyers (including corporate, public sector enterprises and government). department), and as bank and non-bank financial corporation (NBFC) financiers. It was aimed at facilitating financing/discounting of MSME trade receivables drawn on their buyers through competitive auction mechanism. Such platforms hold the promise of making both MSMEs and their large customers highly competitive, with guaranteed low interest rates of 4-6%, with resultant low-interest short-term loans to multiple financiers and MSMEs. TReDS also promised speed of settlement, with the settlement process between financiers and MSMEs completed on a T+2 day basis.
However, in reality, the picture has not been that rosy. Despite the mandate of the government to create all companies with a turnover of 500 crore and above, apart from Central PSUs and Government Departments joining the TReDS platform, there has been considerable slowdown in adoption on the part of buyers and sellers. Thus, the Receivables Exchange of India Limited (RXIL), the largest of the three TReDS platforms operated by RBI, in its 2020-21 annual report, reported a total of 5,300 MSME sellers to be registered on its platform. On the buyers side, while the proportion of eligible firms registered on TReDs stands at 35.2%, most large firms are doing so only to meet compliance norms. Furthermore, they have not even initiated the transaction, as evidenced by the Chief Executive of RXIL (bit.ly/3HXq9u5). Nor have all Central Public Sector Undertakings been included.
While RBI will need to make it mandatory for all MSMEs and large corporate buyers to register and actively do business on the TReDS platform, other innovative methods can ease the credit concerns of MSMEs. Two such new avenues are credit crowdfunding or peer-to-peer (P2P) lending, and equity or investment-based crowdfunding. These instruments may be particularly suitable for MSMEs, as they differ institutionally from large corporates and may rely on trust-based or other relational systems rather than the predominantly transactional mechanisms of traditional finance.
In both surplus and deficit, MSMEs can borrow and lend money directly between each other through unsecured personal loans without a financial intermediary. Medium sized enterprises with surplus funds can lend to small and micro enterprises and startups. Forum support for such activities and may be provided by interest groups. However, the successful use of such novel financing mechanisms will depend on such platforms preparing both lenders and borrowers for the modalities involved in non-collateral-based finance. Borrowers, in particular, will be required to provide additional advisory and mentoring support, including branding, marketing and general capacity building, in addition to networking opportunities, which can increase the credibility of their borrowing needs. These platforms will also need to educate lenders on the impact of such crowdfunding mechanisms on the entire ecosystem. There may also be non-monetary motivations for lenders and investors to get into the act. Also, the amount of money many small enterprises commit can allow them to spread their risk cost-effectively.
The use of such innovative mechanisms can complement the efforts of India’s central bank and government to help MSMEs strengthen their heels.
These are personal views of the author.
Tulsi Jayakumar is Professor of Economics and Executive Director, Center for Family Business and Entrepreneurship, SPJIMR of Bhavan