Financing MSMEs: The continuing challenge

Access to finance is a critical requirement for economic development, especially at micro-entrepreneurial levels. India is yet to evolve a dependable mechanism for providing credit to the needy, forcing many to approach moneylenders. A 2018 IFC study reports that formal sources of finance cater to only 16% of the total MSME debt financing — the rest is either self-financed or availed from informal sources — down from 22% in 2012.

Moneylenders target mainly, small and marginal farmers, daily wage-earners, self-employed and unorganised sector entrepreneurs, urban slum dwellers, and migrants etc. Poor households often find themselves dependent on informal credit for their needs for investment or consumption. Small-scale entrepreneurs often fall back on moneylenders for working capital, borrowing on a daily or weekly basis at exorbitant interest rates. They suffer frequent shocks to their income forcing them to borrow to maintain their precarious livelihood. With limited resources for plying their trade, they need access to credit, but given the informal nature of their activity, a loan from the banking sector is hard to come by.

Coexistence of formal and informal financial system in a market is characteristic of economies with weak legal institutions and low levels of income. A study by Banerjee and Duflo showed that almost 95% of borrowers living below the poverty line in Hyderabad accessed informal sources even when the banks were present in their localities. In Udaipur, nearly two-thirds of the poor had a loan outstanding, and only 6% had sourced it from a formal source.

When it comes to credit for poor rural households, access is cited as the most important criteria by far. Although low-cost formal credit is available, banks generally accord the least priority to it. They also avoid giving out loans for consumption as it is considered unproductive. Besides, after being made to pass through multiple hoops, a borrower must deal with stringent requirements of collateral security or mismatches in credit needs with credit disbursement.

When you are thirsty, you don’t drink salt water as it only aggravates the problem. A desperate borrower, however, quickly gets into bigger trouble by borrowing from moneylenders. In taking on a loan with a high-interest burden, he sinks deeper into unsustainable debt, which inevitably leads to more borrowings at even higher costs. This is the classic debt-trap, and it invariably ends badly. Money lenders are known to lend at exorbitant interest rates.The interest may exceed the capital even before the year is over. In Tamil Nadu, “Vaara Vatti”— a weekly loan usually taken by agricultural and construction labourers— can attract an interest rate of 25% for just one week. “Meter Vatti”- a daily loan usually taken by small entrepreneurs such as vegetable vendors who may borrow ₹1,000 in the morning and pay back ₹1,100 by evening, which amounts to 10% interest per day.

Data from the All-India Debt and Investment Survey (AIDIS, 2003) conducted by NSSO show that moneylenders have a share of over 9% while non-institutional lenders commanded a share of over 36%. The same survey in 2012 found that nearly 48% of farmers across the country had taken loans from informal sources, rising from 36% in 1991, and 43% in 2001. Among farmers who owned land parcels smaller than 1/10th of a hectare, 85% had pending loans from informal sources of credit.

The performance of banks in rural and MSME lending has been inadequate even after the considerable expansion of the scope of priority-sector loans. Moneylenders continue to exercise a stranglehold over rural and semi-urban credit, accounting for as much as 70 percent. The NABARD All India Rural Financial Inclusion Survey (NAFIS) 2016-17 confirms this, indicating that while 43.5% of agricultural households borrowed money, nearly 40% of them borrowed from informal sources.

At the same time, financial inclusion is not an issue as nearly 90% of households reported having a bank account with 33% having more than one savings account. The problem, then, is that even as most rural households have acquired bank accounts, they still do not get their share of credit from formal sources and informal lenders continue to account for over 30% of lending in rural households. A disturbing trend is that the hold of moneylenders has strengthened since 1991 with the share of informal credit going up substantially after 2012, as a comparison of AIDIS 2013 with NAFIS 2017 reveals.It begs the question,how do we reduce the dependence on informal credit?Bear in mind that most of these people are daily wage earners, small shopkeepers, marginal farmers etc. who typically lack documentary proof about their assets and regular income as required by formal lending institutions.

One feasible option has been around in plain sight for quite some time. Gold loans are a viable alternative source of formal finance which can be made available either through an NBFC or through a bank. After all, gold jewellery may be the only asset low-income families have. Also, a gold loan is perhaps the only channel of formal credit which does not make the borrower scurry around for documentation and collateral requirements. Unfortunately, India’s policymakers appear to have overlooked the contributions made by gold jewellery loans in weaning marginal households away from moneylenders and bringing them into the formal institutional credit framework.

We know that since 2012 the share of informal lending has increased. Incidentally, this was the year when RBI first imposed a cap on the maximum loan to value (LTV) ratio for gold loans. (Initially prescribed at 60 percent, later revised upwards to 75%.) The cap on LTV effectively restricts how much credit the poor can get by monetising their meagre holdings of gold jewellery. Easy availability of credit for poor households is the key to breaking the back of the informal moneylenders. A loan against the security of gold jewellery is as easy as it can get. Importantly, it is fully secured and can go ahead even if the borrower lacks documentary proof of income or property.

At a time when banks are struggling with high NPA levels (mostly on account of large borrowers), small and marginal borrowers are unable to raise credit even for their fully monetisable assets. It is almost as if we have decided that India’s rapacious moneylenders should continue to be in business. Loans against gold jewellery not only provide liquidity to the poor to weather income shocks, but it also keeps them away from the clutches of moneylenders. It is therefore time that we consider easing the restrictions on gold loans (such as removing the cap on LTV) to extend the reach of formal credit. To keep a check on the excessive risk-taking that may arise, regulators should put in place well thought-out credit risk capital requirements. For example, the RBI can consider prescribing NIL risk-weight for gold loans with LTV of less than 75% and 100% risk weight for LTV between 75-90%. Anything over this, and we may even consider 150% risk weight so that an adequate capital cushion always backs aggressive lending.

A chronic ailment cannot be cured all at once. However, if a remedy to ease the pain is readily available, we should accept it even as we continue efforts for a permanent cure. Gold loans are not a panacea, but it surely can make things easier for some of the most vulnerable sections of society.

Views are personal.

The author is MD & CEO of Manappuram Finance.