India is a nation of small enterprises with big problems. An overwhelming number of them are unregistered, operating out of homes or small units. Banks are typically cautious to lend to such firms, as these are considered high risk and expensive to service. Large creditors place small firms at the end of the payments chain, exacerbating their financial woes. Timely loan repayments are a problem.
To make matters worse, the recent years have not been kind to small firms. The demonetisation of 86% of the currency notes by value in 2016 had a disproportionate impact on unorganized smaller firms which largely transact in cash. Then came the economic fallout from covid-19. Thanks to sluggish rural demand and high interest rates, many small firms are struggling today.
The missing middle
The numbers are not insignificant. Micro, small and medium enterprises (MSMEs) make up 29% of GDP, according to the Reserve Bank of India, and employ 110 million people. The average economic establishment has 2.24 employees, according to India’s census. Just one in every 50 enterprises hires more than 10 employees. In contrast, most workers in China are employed by firms with 51-2,000 people.
If it is to create 100 million paying jobs by 2030, India will need to grow its small firms quickly. That’s why India is hoping to use fintech and data to help Indian small firms get better and faster access to formal credit. Just like the unified payments interface (UPI) transformed the payments space, the government is betting that fintechs armed with data will spark a revolution in allowing access to credit to small firms.
Just how will the digital pieces come together? What are the issues that could affect this ambitious plan? And, most importantly, are small enterprises ready to take the great leap?
Digital divide
At the heart of the government’s plan is the Open Credit Enablement Network (OCEN), which connects borrowers and lenders. By relying on the cash-flow lending mechanism, OCEN allows borrowers to share data real time that helps it get access to finance. This data capture allows for constant monitoring of small firms, which will help in loan disbursements and repayments. Many small firms have moved online after the pandemic — they feel underserved in terms of credit and customer service.
The government has also grown its goods and service tax network (GSTN). Data collected from it can now be added to the account aggregator network to enable information sharing. A Trade Receivables Discounting System (TReDS) platform has been launched to facilitate financing of trade receivables of small enterprises from corporates. More such digital platforms are in the works, including one from the Reserve Bank of India.
This data push rests on three pivots. One, MSMEs are being told they need to formalise or perish. By significantly increasing the definitions of MSMEs in 2020, the government has signaled that it wants its smaller firms to grow — without the fear of losing privileges. A firm with an investment of ₹10 million (£95,550) in plant, machinery or equipment is now defined as a micro enterprise; an investment of up to ₹100 million (£955,500) would define a ‘small’ firm; up to ₹500 million (£4.77 million) would be a ‘medium’ enterprise.
Secondly, by stitching together loan-service providers, account aggregators, underwriters, lenders and borrowers, OCEN is promising end-to-end processes for digital lending to MSMEs. This should lead to creativity across India’s booming fintech ecosystem and reduce transaction costs. Co-lending — where banks and non-banks enter into arrangements for joint contribution of credit — is one area that is expected to grow. Neo banking platforms targeted at MSMEs will compete with traditional banks in this space.
Finally, this formalization has a flip side too. While there has been a big rise in digital payments, the underlying banking infrastructure is lagging behind. Most small firms still prefer to deal in cash, and getting them to feel comfortable on a digital platform will take time. Some of the apprehensions around formalization arise from MSMEs’ fears about taxation or control. As MSMEs get more access to credit, this could also put them under more stress, particularly those on the margins of formalisation. They will need to be sensitively shepherded into formal banking.
The potential
In April 2022, a Parliamentary committee on finance said MSMEs face a huge credit gap of ₹ 20-25 trillion (c. £190-£238 billion). The banks are profitable and have significant headroom for expansion into new territories. According to McKinsey data, commercial banks continue to lend largely to corporates and retail. Loans to MSMEs constituted 12% of the total loan book of commercial banks in 2022-23. On this small base, credit growth to MSMEs is 10% CAGR for 2018-23.
The government and the financial services ecosystem sees lending to MSMEs as the Holy Grail of banking. That’s said it’s going to be a long journey to bridge the “information asymmetry” that hinders small firms.
Sunit Arora is an independent journalist and editor based in Delhi. His twitter handle is @sunitarora