India’s central bank is under pressure to cut interest rates. Borrowing costs, say critics of its anti-inflation policy, are now so high that investment demand — crucial to creating much-needed productive capacity in the fast growing economy — may just collapse.
While that may be right in theory, lowering rates now will only spur consumer lending; it won’t help India’s small businesses, for whom a bigger constraint on investment is deficient access to credit, rather than its high cost.
Although the Reserve Bank of India in August prohibited external commercial borrowings of more than $20 million (Rs79 crore) for domestic spending, the large ompanies in the country still have good access to global capital markets.
And with US interest rates declining, their expansion plans aren’t likely to be derailed for want of funds even if India’s central bank keeps its policy rate at 7.75%, the highest in almost six years.
It’s the small business owner in India pressed by the credit drought. Tiny enterprises, whose average loan requirement may be as low as Rs20 lakh, are unable to obtain credit. The state-owned banks that dominate India’s financial landscape find them too risky.
So underserved is this segment, and so acute is its hunger for credit, that at least one finance company is able to charge annual interest rates of 20% or more while restricting the loan amount to a third of the value of the collateral.
To begin with, a small business in India has very little collateral that is acceptable to its financiers. When only a third of that is free to be used to create new capital for growth, the speed at which such a company can expand and create new jobs is limited.
Talk to a major corporation in India and chances are you’ll hear it grumble about the slow response of the small- and medium-size enterprises, or SMEs, that act as its vendors. These suppliers seem incapable of keeping pace with their customers’ expanding global ambitions.
But the fault is hardly theirs; credit availability remains a big hurdle for India’s SMEs. They can spot the many opportunities for growth in the economy but can’t take them because there just isn’t enough money around.
The banking system has surplus cash, but when it comes to lending, bankers can’t be bothered to look beyond the publicly traded companies and the consuming middle class.
Now that almost all who could afford to take a loan to buy a motorcycle—and many who couldn’t—have been inducted into the buy-now-pay-later club, banks are becoming more discerning about who they lend to, especially in a default-inducing, high interest rate environment.
If Reserve Bank of India pares the policy rate now, loans to individuals will get a boost once again.
But a quarter percentage-point cut in the small business owner’s annual 20% interest bill will hardly be a big spur to investment.
“The small-and-medium enterprises sector in India is marked by a severe shortage of financing,” University of Pennsylvania finance professor Franklin Allen and other economists said in a 2006 study, citing a government survey showing that 93% of these businesses had no loans on their books from any bank or financial institution.
Reducing the policy rate won’t significantly improve the small business owner’s access to debt capital. Only a more competitive banking system, coupled with better credit information bureaus and collateral registries, can unclog the blocked channels. Only then will credit flow to where it’s needed.
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