Social capital can help close a wide MSME gap
Summary
- Capital allocation in India has long been suboptimal but caste-agnostic mechanisms hold promise. We need a truly national market for business credit.
In his inaugural address to the first Industrial Conference in Pune in 1890, Mahadev Govind Ranade noted that “the industry of the country is parched up for want of Capital" because after land revenue, a considerable portion of gross savings was used to hoard bullion. The lack of institutional arrangements for industrial finance meant that capital was locked up in unproductive assets and not available to India’s entrepreneurs. A century later, the German economic historian Dietmar Rothermund came to a similar conclusion. Lacking financial institutions, Indian surpluses in the second half of the 19th century went into gold and land. Meiji Japan, in contrast, was able to “gather small savings and to channel them into the mainstream of the national economy," enabling the country’s industrialization.
We can blame the British Raj for not creating financial institutions that were necessary for Indian industrialization. But it does not answer why Indians didn’t (or couldn’t) take the initiative to do so. Part of the reason why 19th century India failed to develop financial institutions, and why Indians bought up gold and land, was inadequate social capital arising from hyper-diversity. Capital stayed within caste-community groups, which zealously guarded their business interests and saw themselves in competition with each other. When there was more capital than they could invest within their own community, they put it into gold and land. Physically owning assets meant that you didn’t have to depend on governments for contract enforcement. The colonial regime, in any case, had little interest in creating trust and social capital in India.
This bit of economic history is important because the basic picture for capital allocation remains the same. Avendus Capital estimates the MSME credit gap at around $530 billion; only 14% of 64 million enterprises have access to formal credit. Over half of these are seen as un-addressable by formal financial institutions. Over 99% of the MSME sector comprises micro-enterprises, around 80% of which borrow from informal sources. A 2018 study by the International Finance Corporation found that “friends and family" constitute an important part of those informal sources. Every government of independent India has attempted to make financial capital available to entrepreneurs. Yet, almost eight decades on, its distribution remains constrained by social capital. People invest money with who they trust, and this generally means within one’s own community.
It follows that if India’s entrepreneurs are to fuel its prosperity, public policy has to make domestic capital available to domestic enterprises. Ranade’s prescription remains valid today. The question is: How do we go about it?
Whatever their other failings, public sector financial institutions have helped reduce caste bias and break caste-community barriers to capital allocation. Using data from the 2011-12 round of the India Human Development Survey, Sunil Mitra Kumar and Raghupathy Venkatachalam find that while caste-wise differences exist in application rates for farm loans, for the farmers who applied, the approval rates were almost uniform across caste groups. Indeed, for small farmers, the “caste-based differences in loan application and approval rates are largely muted." This is not perfect, but it is meaningful progress. Now compare this to MSME loans. Ashay Kadam, Prakash Singh and Jayati Chatterjee find that “while entrepreneurs from lower castes are more likely to obtain credit from the formal financial system... (those from) lower caste communities receive significantly lower loan amounts."
From these studies, we can say that banks seem to show lower caste-bias in farm lending than business loans. Now this could be because farming does not depend on business networks as much as MSMEs do, and loan officials price social capital estimates into their loan approvals. An entrepreneur from a non-dominant group will find it harder to succeed in a new business because she lacks a network. This is not to say that caste prejudice is not a factor, but that our entrepreneurs remain trapped by the limitations of social capital.
Caste-affirming identity politics will worsen things. It is likely to strengthen bonding social capital within a caste-community and weaken bridging social capital across communities. Financial capital will follow suit and remain sub-optimally allocated instead flowing into more productive investments across India. Government schemes cannot change this beyond a point. We have to change our sense of ‘us.’
Technology holds promise. I hope the Open Credit Enablement Network (OCEN) takes off the way UPI did. It can enable lending and borrowing that is agnostic to caste affiliations across the country. It’s success will be historic. For the first time ever, India will have a truly national market for business credit. It can unlock the economic potential that Ranade envisioned. However, for it to happen, OCEN will have to cross some chasms of trust: between citizen and technology, citizen and government, and ultimately citizen and citizen. Like Caesar’s proverbial wife, OCEN will have to be trustworthy and be seen as so. At least as trustworthy as a member of one’s own community.
