By Ashvin Parekh
If there has been a fundamental problem facing the government, economy, and the financial system for the past eight decades, it is the funding of micro, small, and medium enterprises (MSMEs). The credit gap available to MSMEs has only been increasing. Whether it has to do with some structural issues confronting our system, such as emphasis on secured or asset-backed lending instead of cashflow-backed lending, or a lack of formalisation is a matter of interesting evaluation.
This article attempts to examine the issue and discuss the size of the problem, some structural reforms undertaken in the past few years, and their efficacy in addressing the problem at hand.
Let us examine the size of the challenge confronting the system. We now have a platform set up by the ministry of MSMEs to register the units who qualify as such. The total registration so far (as of March 2025) is more than 6 crore, providing employment to nearly 26 crore people. It constitutes more than 30% of the gross value added in India’s GDP, and accounts for over 40% of the total exports of the nation.
Now let us turn to the financial need of the sector, credit available from the formal channels, and the credit gap. We also examine the rate at which the gap increases despite measures undertaken by policymakers, banking regulator, and trade bodies to address it. This will give us a correct assessment of the size of the problem and the rate at which it is growing.
Around five years ago, the report of the expert committee on MSMEs constituted by the Reserve Bank of India (RBI) estimated the credit gap to be Rs 20-25 lakh crore. Now let us look at the latest numbers reported by the Small Industries Development Bank of India as of February 2024 under their platform, MSME Pulse. It has data from the banking companies alone and not from non-banking finance corporations (NBFCs) and other lenders. The platform estimates the total credit demand to be around Rs 70 lakh crore and current credit available from formal channels at only around Rs 20 lakh crore. One can see the growth of the gap — it was Rs 20-25 lakh crore and is now Rs 50 lakh crore. It is increasing briskly and has more than doubled in five years.
The rapid increase in the credit gap may be attributed to various factors. One major factor that could possibly have played a significant part in the increase in credit gap is the shift of asset choice of the household and institutional savings. The choice of savers has gradually shifted away from the banking system by way of deposits to the security markets. This shift has led to a fundamental change in the extent of intermediation from the banking system, leading to a decline of credit. Large enterprises now turn to the capital markets to meet their funding requirements. The credit flow to MSMEs keeps on reducing and will be unable to meet the credit gap. The Mudra loans from public sector banks (PSBs), which are expected to participate in the Pradhan Mantri Mudra Yojana (PMMY), shows that as of October 2024, PSBs and regional rural banks have achieved just 42% of their FY25 target. Against a goal of Rs 2.3 lakh crore in loans, only around Rs 90,000 crore has been disbursed.
For the first time since the pandemic, PMMY loan disbursals have shown a noticeable decline, raising concerns about the programme’s efficacy. The RBI narratives and directives, including the changes in the risk weightages in November 2023, may perhaps have added to the issue. However, taking a holistic view, the regulations’ concern about unsecured and small loans looks well-justified. When economic growth shows signs of gradual decline and the liquidity in the banking system is hardened to address inflation and exchange parity concerns, non-performing loans will rise. In fact, there is growing evidence to suggest the rise of non-performing assets in the microfinance sector as well as small and medium enterprises. The recent monetary policy has reduced the repo rate by 25 basis points and thereafter the RBI has reduced risk weightages. This is a bold effort to improve the credit flow to the MSME sector. This reduction will assist both the banking system as well as the NBFCs to expand the credit flow.
Now let us examine the recent initiatives by the policymakers and the RBI to prioritise the inclusion of MSMEs in the formal financial system through a range of targeted measures. One of the key initiatives is the priority sector lending (PSL) guidelines, mandating that a sub-target of 7.5% banks adjust new bank credit for micro enterprises, while all loans to MSMEs qualify under PSL. The RBI has also promoted collateral-free lending by requiring banks not to insist on collateral for loans up to Rs 10 lakh for micro and small enterprises (MSEs), and encouraging financial institutions to lend under the credit guarantee MSE scheme which carries zero risk weight for guaranteed portions of loans.
The Trade Receivables Discounting System (TReDS) addresses the delayed payment to MSMEs. The TReDS scheme will be very useful when, due to liquidity pressures, large enterprises delay payments to ancillaries and suppliers. There are several other measures by the RBI and the government to improve credit flow to MSMEs. These, however, look like incremental measures and are certainly not enough to bridge the credit gap, but the effort is commendable.
On the part of MSMEs, there is a dire need to formalise. Many MSMEs operate informally, making it difficult for the system to evaluate their creditworthiness. They should adopt formal payment systems and have adequate repayment records for good credit ratings. They must have a good order of governance and records to demonstrate their capability and intent to repay.
The MSME credit gap has been a vexing problem for a long time and calls for continuous effort on the part of all stakeholders. The hitherto practice of secured lending needs to be re-examined. At the same time, the abuse of credit and loan waivers by political interventions needs to be seriously checked. It may not be wrong to observe that there has been more effort on the part of the policymakers and the regulator to formalise the demand component of credit requirement of MSMEs as compared to their effort to augment the supply of credit.
The writer is managing partner, Ashvin Parekh Advisory Services LLP.
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