Prime Minister Narendra Modi’s Diwali package for micro, small and medium enterprises (MSMEs) may be late in the day, but it’s nevertheless a boon, particularly the interest subvention and the measures to see that bills are paid on time.

Why the need to boost lending to the MSME sector? Simply put, non-banking financial companies (NBFCs) have increased their share of financing MSMEs in recent years and the current lack of lending to NBFCs threatens to cut off credit to a substantial number of MSMEs too.

The data shows bank lending to micro and small-scale industrial units fell from 3.1% of gross domestic product (GDP) in 2013-14 to 2.22% in 2017-18. Over the same period, bank lending to medium-scale industrial units fell from 1.1% of GDP to 0.62%. But this decline is part and parcel of the credit cycle and indeed lending to large industrial units as a percentage of GDP saw a larger decline, doubtless because of the Reserve Bank of India’s (RBI’s) asset quality review.

Interestingly, RBI data shows that in the priority sector, bank credit to SMEs in the manufacturing sector as at end-September 2018 contracted by 1.4% from a year ago. In sharp contrast, bank credit to SMEs in the services sector grew at a good 17%. This mirrors the overall weakness in manufacturing and the buoyant conditions in the services sector.

While bank lending to MSMEs was tepid, NBFCs stepped in. The share of NBFCs in total finance to MSMEs went up from 7.9% in December 2015 to 9.6% as on June 2017 and then spurted to 11.3% by June 2018. This was aided by bank lending to NBFCs, which grew by 26.9% in 2017-18. Now that NBFCs are suffering from a lack of liquidity caused by contagion from the Infrastructure Leasing and Financial Services Ltd’s debacle, the government is attempting to ensure that credit channels to MSMEs remain open.

One reason why public sector banks are reluctant to lend to MSMEs is that a substantial proportion of these loans go bad. According to the MSME Pulse report, for public sector banks, the level of non-performing assets (NPAs) among MSMEs went up from 13% in June 2016 to 15.2% in June 2018. Public sector banks accounted for half the total credit given to MSMEs. The credit quality of MSMEs availing loans from private sector banks and NBFCs is significantly better and as of June 2018, their NPA levels on account of MSME loans were 3.9% and 5%, respectively.

This suggests that the loss of market share by public sector banks in MSME financing (see chart) is good for the Indian economy, as private sector banks and NBFCs seem to be far better at managing bad debts. That is why the system whereby banks lent to NBFCs and they on-lent to MSMEs was a win-win for all.

The trend is therefore likely to continue, once confidence in NBFCs is restored. More lending to MSMEs is all very well, but public sector banks need to ensure better credit assessment so that higher lending now doesn’t translate into NPAs later.