Innovations can plug the growth capital gap of MSMEs

India has over 7.9 million micro, small and medium enterprises (MSMEs), as of 27 March 2022, as reported by the MSME Ministry. They face a financing gap which could prove to be their Achilles heel. The sector is heterogeneous, with most MSMEs (over 7.5 million) being micro-enterprises, about 350,000 being small enterprises, and 35,773 being medium businesses. The UK Sinha Committee report (bit.ly/3A8N9UP) of 2019 had placed the overall credit gap in the MSME sector at $20-25 trillion.

Scheduled commercial banks (SCBs), which extend credit to MSMEs primarily in the form of loans, overdraft facilities and credit lines, are not the natural go-to institutions for MSMEs. This is because bank credit is based on principles that include the borrower’s creditworthiness and an assessment of expected future cash flows as the basis for primary repayment. On both these criteria, MSMEs fall short. Information asymmetries and inherent principal-agent conflicts challenge bank lending to small businesses. Entrepreneurs have better access to business information than the financier/bank, which they may share only partially. Small business owners, as agents, may use the funds in ways other than what a bank, as the principal, intended them to use. Money may be used for risky projects better aligned with the borrower’s own risk-return calculations.

The credit gap translates into a ‘growth capital gap’, especially for innovative and high-growth MSMEs seeking a radical pivot in their business models or overseas expansion. One needs to only look at MSME credit data from SCBs to understand the magnitude of the financing challenge. MSME accounts with banks were a minuscule 14% of the overall loan accounts with Indian SCBs in 2020-21, while the sector accounted for just 16% of the overall credit flow outstanding 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. This was meant to serve as an electronic platform to bring together MSME sellers, buyers (including corporate, public sector enterprises and government departments), and banks and non-bank financial corporations (NBFCs) as financiers. The goal was to facilitate the financing/discounting of MSME trade receivables drawn on their buyers through a competitive auction mechanism. The low interest rates of 4-6% that such a platform guaranteed, together with multiple financiers and the resultant low-interest short-term credit for MSMEs, held the promise of making both MSMEs and their large customers highly competitive. The TReDS also promised speed of settlements, with the settlement process between financiers and MSMEs to be completed on a T+2 day basis.

However, in reality, the picture hasn’t been quite so rosy. Despite the government’s mandate to make all companies with a turnover of ₹500 crore and above, besides central PSEs and government departments to join the TReDS platform, there has been considerable lethargy in adopting it on the part of buyers and sellers. Thus, the Receivables Exchange of India Ltd (RXIL), the largest of the three TReDS platforms allowed to operate by RBI, in its annual report of 2020-21 reported a total of only 5,300 MSME sellers as having registered on its platform. On the buyers’ side, while the proportion of qualifying firms registered on the TReDs is an uninspiring 35.2%, most large companies are doing so only to fulfil compliance norms. Moreover, they have not even started transactions, as attested by the chief executive of RXIL (bit.ly/3HXq9u5). Neither have all central PSEs been onboarded.

While RBI will need to make it mandatory for all MSMEs and large corporate buyers to register and actively trade on the TReDS platform, other innovative ways could mitigate the credit concerns of MSMEs. Two such novel routes are credit crowdfunding or peer-to-peer (P2P) lending, and equity or investment-based crowdfunding. These devices may suit MSMEs especially well, as they differ institutionally from large corporates and could rely on trust-based or other relational systems, rather than the predominantly transactional mechanisms of traditional finance.

In both, surplus and deficit MSMEs can participate, borrowing and lending money among one another directly by means of unsecured personal loans without a financial intermediary. Medium-sized enterprises with surplus funds may lend to small and micro enterprises and startups. Platforms for such activities may be provided by advocacy and interest groups. The successful use of such novel financing mechanisms would, however, rest on such platforms preparing both lenders and borrowers for the modalities involved in non-collateral-based finance. Borrowers, in particular, would need to be provided additional advisory and mentoring support, including for branding, marketing and general capability building, besides networking opportunities, which could increase the credibility of their borrowing needs. These platforms would also need to educate lenders on the impact of such crowdfunding mechanisms on the entire ecosystem. There may even be non-monetary motivations for lenders and investors to get into the act. At the same time, the quantum of funds committed to many small ventures may allow them to spread their risks cost-effectively.

The use of such innovative mechanisms could supplement the efforts of India’s central bank and government to help MSMEs armour their Achilles heel.

These are the author’s personal views.

Tulsi Jayakumar is professor of economics and executive director, Centre for Family Business & Entrepreneurship, Bhavan’s SPJIMR