Financing SMEs: An Industry Perspective
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09 Mar,2012 05:58 IST

Financing SMEs: An Industry Perspective

Despite their economic significance, SMEs face a number of bottlenecks that; low credit penetration and accessing desired finance are primary

R. Seshasayee

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Small and Medium Enterprises (SMEs) are critical to the nation's economy: they contribute approximately 40 per cent of India's domestic production, almost 50 per cent of total exports and 45  per cent of industrial employment. More importantly, they are the second largest employers of manpower, after agriculture. SMEs in India operate mostly in the unorganised sector and are the source of livelihood for millions of people.

The social contribution made by SMEs is even more significant than its economic contribution. Within the SME sector, the small sector serves as a seed-bed for nurturing entrepreneurial talent and originating units to eventually grow into medium and large enterprises. The promotion of SMEs, therefore, becomes a major area for policy focus. The regeneration of SMEs must receive public support particularly for village, cottage and micro level enterprises. Despite their economic significance, SMEs face a number of bottlenecks that prevent them from achieving their full potential. Some of the major obstacles in the path of business development for SMEs relate to a wide range of issues:

Financing: Lack of access to finance and timely credit as well as escalating cost are cited as the primary reasons for under-utilisation of the manufacturing capabilities of SMEs.

Infrastructure: The infrastructural facilities in India have not reached to the desired level. This restricts private initiatives in this sector. Therefore, creation of better infrastructural facilities for SMEs must receive greater priority.

Taxes And Regulations: A multiplicity of regulating agencies lead to harassment and inspections with greater impact on operations of SMEs than on larger units.

Marketing: With growing access to modern means of communication, particularly revolution in the information technology, the sheltered market for the SMEs product is no longer so. SMEs should join hands globally to create a global commodity chain. In this regard, SME mother units in marketing, similar to mother units in production, may be promoted.

Technology: It becomes difficult for SMEs to access cutting-edge technology due to the high initial costs, thus leaving them behind in the race for competitiveness. A major impediment in SME development is their inability to access timely and adequate finance.

There are several reasons for low SME credit penetration, key among them being insufficient credit information on SMEs, low market credibility of SMEs (despite their intrinsic strengths) and constraints in analysis. This leads to sub-optimal delivery of credit and services to the sector. As the access of SMEs to capital markets is very limited, they largely depend on borrowed funds from banks and financial institutions. While investment credit to SMEs is provided by financial institutions, commercial banks extend working capital. In the recent past, with growing demand for universal banking services, term loans and working capital are becoming available from the same source. Besides the traditional needs of finance for asset creation and working capital, the changing global environment has generated demand for introduction of new financial and support services by SMEs. There is an urgent need to regenerate SME financing.

As SMEs have been the green-field for nurturing entrepreneurial talent, first generation entrepreneurs should be facilitated in accessing desired finance through the creation of guarantee funds. Finance should not only be timely but also cost effective. Among instruments of SME Financing, SIBDI, is the principal financial institution for the promotion, financing and development of industry in the SME sector in the country. SIDBI also provides appropriate support in the form of promotional and developmental services. In order to improve the credit flow to the SME sector, it has tied-up with eight public sector banks in the country. With these tie-ups, it has covered 150 SME clusters, out of the total 388 clusters identified across the country. In spite of the various initiatives taken by the government, banks and financial institutions, SMEs face certain challenges which are universal in nature. These problems relate to the issue of collaterals, cost of loans, delay in receivables, obsolete technology, marketing, etc. In order to address the above problems in the Indian context, some innovative instruments of financing have been introduced and institutional set ups have been created. Some of the major initiatives include:

Credit Guarantee Fund Trust for Small Industries: Government of India, in association with SIDBI, has set up a Credit Guarantee Fund Trust for Small Industries (CGTSI) to implement the guarantee scheme.

Risk Sharing Facility: While the CGTSI extends guarantee cover for the loans up to Rs.2.5 million, there is a need for offering guarantees for loans extended by banks beyond the above limit. Under a World Bank led Project on Financing and Development of SMEs, a possibility of introducing a risk sharing facility for the SME sector is being examined, wherein the risk in lending by banks to SMEs could be shared on pari passu basis between the originating banks and the suggested entity.

Venture Capital Funding: With regard to,  many countries are considering liberalising the rules regarding venture capital investments. In India also, various measures have been taken in this direction. SIDBI, along with some other institutions, has taken a lead in promoting venture capital funding in the country.

Micro Credit: Realising the potential of micro finance in stimulating economic growth, SIDBI, has laid emphasis on increasing the capacity of the sector to handle credit and growth in the disbursements of micro finance. SIDBI Foundation for Micro Credit has been established.

Small and Medium Enterprises Fund: The most important amongst the sectoral initiatives taken by the GoI and SIDBI is an SME Fund, with a view to giving impetus to the fund flow to the SME sector. Under the Fund, assistance is being provided to SMEs at an interest rate of 200 basis points below the Bank's PLR. Direct assistance is being extended to SMEs through SIDBI's own offices at 9.5 per cent rate of interest as also by way of providing refinance  to  the primary lending institutions.

Refinance to SFCs is available in the interest rate band of 7.5 per cent to 8 per cent. The SME Fund provides for routing of assistance, besides SFCs, through commercial banks as well. The Fund, besides upscaling the flow of assistance to SMEs, addresses the issue of cross sector parity in the cost of loans. Setting up of a dedicated credit rating agency for SMEs can play an important role in addressing some of these concerns. In this context, SMERA is wholly committed to facilitating the overall growth and development of Indian SMEs. The agency's primary objective is to provide SME ratings that are comprehensive, transparent and reliable. All facilities to SMEs should be in the form of a level playing field. Boundary-less markets of today   can sweep aside which are not globally competitive. At the same time, businesses which enjoy comparative advantages are forward looking and can attune themselves to the changing environment, will have tremendous opportunities. SMEs need to rediscover and regenerate themselves to integrate with the world markets.

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In the backdrop of emerging needs, new financial services need to address the challenges of technology up gradation and modernisation, marketing, finance, infrastructural facilities, venture capital, micro finance and factoring assistance. In the non-financial services, information dissemination, technical assistance, early warning, human resources development, environment management   and quality consciousness are required more urgently than ever before. Globalisation of SMEs and their competitiveness in the global markets is a priority. Though Indian SMEs have achieved a measure of success, especially in sectors such as, garments, leather and leather products and gems and jewellery, among others, further heights can only be achieved by fostering international linkages between SME sectors of different countries. A concerted effort on the global scale is required to bring SMEs to the mainstream from the periphery and integrate them with the organised sector.

Under the WTO regime new opportunities are being created for linkages between SMEs across the globe. It is critical for SMEs to be international in their outlook, competitiveness and costs. Models for clusters are developed to help them integrate with global supply chain. Based on the strengths and diversity of the vibrant SME sector in India, there exists enormous potential for participation and partnership for further development. The crucial role of the Confederation of Indian Industry (CII) has been involved with the promotion of SME sector since inception. CII strongly believes that employment will be best served by promotion of the small sector. 

The Promotion of the SME sector addresses other larger problems of regional equity, income distribution and strain on urban infrastructure. Thus, approximately 80 per cent of CII's members are from the SME sector.  CII has been deeply involved in their development   and modernisation,   introducing concepts of quality management, energy conservation, globalisation and technology up-gradation to its member-companies. It also undertakes dedicated measures for marketing linkages and access to export markets for SME units. This is done through the following initiatives:

An SME division analyses the challenges facing the sector and suggests interventions to the government for improving their efficiency. CII's inputs have been considered while drafting the SME Development Bill. A unique cluster activity of shared learning has been developed in consultation with leading Japanese experts for assisting units in quality management and globalization at affordable cost.

CII sets up special exhibition platforms at all its leading high-profile trade fairs such as International Engineering and Technology Fair, DefExpo for defence industry, Auto Expo for the automobile and components industry and many others throughout the year.

  • A conference on globalisation of SMEs is held annually in partnership with the Ministry of Small Scale Industries, bringing to one venue ideas as well as networking opportunities for SME entrepreneurs.
  •  CII regularly conducts Enterprise India shows in many countries during the year, where overseas investors and markets are able to view the latest developments in SMEs.
  • Realising the importance of credit ratings in getting finance, CII has partnered with ICRA, the premier credit rating institution, to provide ratings to small enterprises.
  • CII has also set up the Subcontracting and Partnership Exchange with UNIDO to disseminate information about opportunities in these avenues.

    CII's principle of partnerships and cooperation is especially relevant to small and medium enterprises and its activities, to sustain and grow the sector, are bound to increase as industry expands and funding becomes easier for these units.

There are a number of issues in lending to the SME sector, which banks generally face. The key issues among them are outlined below:

Information Asymmetry: Accurate information about the borrower is a critical input for decision-making by banks in the lending process. Where information asymmetry (a situation where business owners or managers know more about the prospects for, and risks facing their business than their lenders) exists, lenders may respond by increasing lending margins to levels in excess of that which the inherent risks would require. However, the sheer ticket size of SME lending makes it inviable for  banks to invest in development of information systems about  SME borrowers. In such situations, banks may also curtail the extent of lending even when SMEs are willing to pay a fair risk adjusted cost of capital. The implication of raising interest rates and/or curtailing lending is that banks will not be able to finance as many projects as otherwise would have been the case.

Granularity: This refers to a situation where the risk grading system at banks does not have the requisite capability to discriminate between good and bad risks. The consequence is tightening of credit terms, or an increase in prices, or both. From the borrower's perspective, this leads to an outcome where the bank is over-pricing good risks and under-pricing bad risks. The fact that most banks in India have not developed adequate expertise in SME lending risk assessment exercises leads to the problem of granularity when it comes to SME lending.

Pecking Order Theory: Pecking order theory shows from the above two issues, which makes SME lending highly difficult for banks. Under this hypothesis, SMEs, which face a cost of lending that is above the true risk-adjusted cost, will have incentives to seek out alternative sources of funding. Evidence suggests that in such situations, SMEs prefer to utilise retained earnings instead  of raising loans from banks.

Moral Hazard: Even when loans are made to SMEs, it may so happen that the owners of these SMEs take higher risks than they otherwise would without  lending support from the banks. One reason  for this situation is that the owner of the ? rm benefi ts fully from any additional returns but does not suffer disproportionately if the firm is liquidated. This is referred to as the moral hazard problem, which can be viewed as creating a situation of over-investment. The moral hazard problem may, thus, result in SME lending turning bad in a short period of time, a situation that all banks would like to avoid.

Switching Costs: SMEs may find it harder to switch banks, when countered with any issue. It is a known fact that the smaller the business, the more significant the switching costs are likely to be and, therefore, it is less likely that the benefi ts of switching outweigh the costs involved. This situation results in SME lending becoming a seller's market, which may not be attractive to SME borrowers. Steps for Smooth SME Lending In order to ensure that the Small and Medium Enterprises (SMEs) play a very significant role in the economy in terms of balanced and sustainable growth, employment generation, development of entrepreneurial skills and contribution to export earnings. However, despite their importance to the economy, most SMEs are not able to stand up to the challenges of globalisation, mainly because of difficulties in the area of financing. With the opening up of the Indian economy, it has become necessary to consider measures for smoothening the flow of credit to this sector. The article provides a cross country perspective in this regard and highlights the Indian scenario with reference to SME lending.

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