Micro, small and medium enterprises are perpetually starved of credit. A recent report suggests that the gap between demand of MSMEs for loans and what the financial sector is willing to supply is around Rs 25 trillion. Since MSMEs are considered to be important for growth and employment, we need to understand the causes of this gap before increasing our reliance on policy interventions that channelise credit toward this sector.
The Indian government’s response to the credit gap has been two-fold. The first is policy-directed credit where banks are required to lend 40 per cent of their net credit to what is termed as “priority sectors” including MSMEs. The second is a credit guarantee programme where the government guarantees bank loans to MSMEs. These have been around for a long time—from credit guarantee schemes administered by CGTMSE to the Emergency Credit Line Guarantee Scheme (ECLGS) run by the National Credit Guarantee Trustee Company (NCGTC) Ltd during Covid-19. The Budget 2023 announced an infusion of Rs 9,000 crore toward credit guarantees. This has enabled additional collateral-free guaranteed credit of Rs 2 lakh crore to MSMEs. The government also said that the cost of credit will be reduced by 1 per cent. A pertinent question to ask here is if these interventions solve the problem that afflicts the credit market for MSMEs.
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Root cause of credit gaps
If there is an adequate supply of capital, why are some able to get more of it than others? Lenders typically need information on two parameters before extending credit.
First, the likelihood of getting the total money back. This requires understanding the creditworthiness of the borrower and the business toward which the credit will be deployed. Second, if the borrower defaults, then how much will the lender get back, if anything.
In modern economies, good information systems including credit scores help evaluate the former. A robust mechanism for collection, sometimes in the form of bankruptcy law, helps toward the latter. Both these systems help the lender decide which projects to finance.
In India, these frameworks are still evolving. This has meant large corporate houses, or those with “relationships”, were able to access credit. The difficulties in recovery meant that creditors required the borrower to post collateral. Unsecured credit never really took off.
Some of these bottlenecks have been reduced through the setting up of credit information companies and collection laws such as the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act 2002 and the Insolvency and Bankruptcy Code (IBC) 2016. But MSMEs are often more vulnerable on both these fronts—they may not have a credit history, and the bankruptcy law does not apply to them.
Cost of interventions
Directed credit does not solve the problem of information asymmetry or bankruptcy. It only forces banks to channel credit to certain sectors. While the benefits of such credit appear large at least to beneficiary firms, the costs remain hidden.
Credit guarantees, too, do not solve the problem of information asymmetry. However, from the banks’ perspective, they solve the problem of collection—if an MSME defaults on a loan, the bank doesn’t lose money as the government pays it the guaranteed amount. Banks can, therefore, take a chance on an MSME, which they may have been reluctant to do earlier. In effect, the government’s guarantee replaces the need for collateral. Credit guarantees protect depositors’ money since the nonperforming assets (NPAs) generated on account of MSMEs are already paid for. This creates a moral hazard. Banks could potentially reduce due diligence on loans. Also, since the guarantee is funded by the government, the taxpayer bears the cost. Society also bears a cost when credit gets allocated to unproductive firms.
Our experience with the Emergency Credit Line Guarantee Scheme (ECLGS) suggests that the concerns described above may well be playing out in reality. One in six loans under ECGLS had turned NPA. The share of micro enterprises in the NPAs was at 93.5 per cent in comparison to 3.2 per cent share of other business enterprises, 2.8 per cent of small enterprises, and 0.5 per cent of medium units. It is possible that these numbers reflect the distress caused during Covid-19. It is equally possible that some of the recipients of the guarantee schemes did not have robust business models. Their inability to source funds without government intervention reflected that the credit market was actually working.
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The design of the policy interventions becomes important. While progress has been made on developing and sourcing better information on borrowers, we need to think about ways to improve it further. One mechanism to incentivise banks to continue doing due diligence is to introduce a price for the credit guarantee. For every guaranteed loan, the bank pays a premium to the government. If the NPA rate rises, then the premium charged to the bank should also increase. Better systems are required to track the performance of these guarantees, and the impact that changing fee structures may have on banks’ performance.
Directed credit and credit guarantee schemes, therefore, should not become the only tools for closing the credit gap. It is more important to focus on solving the underlying problems of information asymmetry and bankruptcy.
Renuka Sane is research director at Trustbridge, which works on improving the rule of law for better economic outcomes for India. Views are personal.
(Edited by Ratan Priya)