Policy changes for India to become a $5 trillion economy must include financial sector reforms that, at least, halve the cost of credit to small enterprises.
Small enterprises can be the engine of growth, local jobs and development if they get access to affordable credit.
Today, the banking sector in India allocates barely 5 per cent of its portfolio to small enterprises.
Out of the 5.1 crore small enterprises in the country, only about 50 lakh have access to bank credit. The remaining businesses borrow at prohibitively high rates of interest, ranging between 25 and 50 per cent. While the interest subvention scheme and targeted loans under Mudra were in the right direction, a system based on targets for public sector banks will not be adequate for what is needed for rapid growth.
Small businesses in India need a competitive banking sector whose core business is to lend to them. Banks need to be looking at their businesses, at their growth plans, at their credit history, and finding the best among them.
Need for reforms
The RBI panel on MSME (micro, small and medium enterprises) revival has suggested that collateral-free loans of up to Rs 20 lakh should be given by banks to make credit available to small businesses.
The share of credit to MSMEs will likely increase if this recommendation is accepted, but this will have only a limited impact. There is a need to have a multipronged approach.
First, the banking sector needs to grow in size. Then, even if the share of loans to MSMEs does not go up too much, there are more banks lending to small industries. This can be done by giving out more bank licences.
The RBI has been wary of giving new bank licences. Part of the problem is that there does not exist a mechanism to resolve private banks if they go bad.
This can be addressed by bringing back the Financial Resolution and Deposit Insurance (FRDI) Bill, which was withdrawn last year from Parliament, at least for the private sector.
A resolution corporation only for failing private financial institutions is likely more acceptable in today’s politics.
Second, the share of credit going to top borrowers like the government (under SLR or statutory liquidity ratio requirements), and to large industry, must go down.
Consider today’s situation. Large industry captures the bulk of bank credit, with 28.9 per cent of bank credit going to large industries. The share of loans to micro and small industries has been declining from 6 per cent in 2008 to less than 5 per cent in 2017-2018. The share of medium enterprises has declined to 1.35 per cent in 2017-2018.
This is abysmally low compared to international standards.
A study by the Organisation for Economic Co-operation and Development (OECD) on financing SMEs suggests that the median share of SME loans as a percentage of all outstanding business loans stood at 42.2 per cent in 2016.
However, in India, the bulk of the outstanding bank credit to industries goes to large players. Within the class of MSMEs, the share of medium industries has been consistently declining.
One important reform to address this issue would be to make the bond market more attractive so that the government and large corporates go to the bond market.
It’s not just AAA-rated bonds that should be able to get cheaper financing, even the ones with a lower rating should be able to raise money at rates lower than what they get from banks.
This requires a deep and liquid bond market. India needs to take steps to move to an integrated bond market with one regulator, one market infrastructure (exchange, clearing corporation and depository) on a par with equity markets.
It needs a public debt management agency (PDMA) that not only issues government debt, but actively works at developing the debt market. The PDMA bill and other regulatory changes proposed in the 2015 budget need to be reconsidered and brought back for debate to Parliament.
Contribution to the economy
MSMEs play a key role in economic growth, job creation and local development. The sector employs around 11.7 crore people, constituting 40 per cent of the workforce. Around 32 per cent of the total jobs are created in the manufacturing sector, 35 per cent in trade, and 33 per cent in other services.
However, MSMEs are not only important for employment, they can also be an engine of growth. The share of MSMEs in GDP was 29 per cent in 2015-16. Contribution of manufacturing MSMEs to manufacturing GVA (gross value added) is about 33 per cent.
The approach so far
Under the Priority Sector Lending (PSL) guidelines, banks allocate 40 per cent of their credit to priority sectors. The share of micro-enterprises is 7.5 per cent within the 40 per cent target.
PSL targets are fixed in terms of previous year’s adjusted net bank credit. This creates perverse incentives as banks do not scale up overall lending as it increases their overall PSL target.
PSL is very costly for banks relative to the returns that it generates for them. Returns are low on account of the interest rate ceilings imposed on these loans.
To increase credit to small enterprises, the government launched the Pradhan Mantri Mudra Yojana (PMMY) in April 2015 to provide loans of up to Rs 10 lakh to small and micro enterprises.
Under the scheme, an agency, the Mudra Bank, was set up to refinance and provide credit support to financial institutions lending to small and micro enterprises.
The objective of the scheme was to facilitate the formalisation of small and medium enterprises by providing them access to formal credit. The Mudra Bank provided an interest subvention to loans under the scheme. The number of loans increased and many enterprises were able to grow with this scheme.
The RBI panel recommendation to increase the size of loans to Rs 20 lakh is in the right direction. However, more is needed. Credit to small businesses needs to become a core activity for banks.
In addition to more banks, a bond market that can provide finance to government and large corporates at more attractive interest rates, and a competitive banking system that seeks out customers and small enterprises who they wish to lend to, additional support such as credit information systems, sharing of company information and tax filings etc that are able to reduce information asymmetries between lenders and small enterprises, can help reduce the cost of credit.
While the focus of media debates remains on RBI rate cuts of 25 or 50 basis points, these have little meaning for those who face interest rates of 25 to 50 per cent.
The author is an economist and a professor at the National Institute of Public Finance and Policy. Views are personal.
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