From struggling to thriving: How Credit Guarantees can bridge the credit gap faced by MSMEs

In India, the share of credit disbursed to the MSMEs as a % of GDP is very low as compared to other emerging nations. Countries such as China, South Korea, and even Bangladesh have had massive industrial growth, mainly led by MSMEs, on the back of high leverage. Increased credit to MSMEs leads to higher investment in productive assets, thereby driving economic growth and job creation.

Indian MSMEs find it difficult to get finance due to weak creditor and property rights, informal economy, lack of appropriate accounting records, and information asymmetry. Furthermore, the administrative cost of lending to MSMEs is relatively higher because of their smaller loan sizes. Collecting information on MSME’s creditworthiness requires more resources as a percentage of the underlying loan. Therefore, lending institutions may not always find it economically rational to lend to MSMEs.

Therefore, banks’ lending decisions are generally dependent on collateral. However, many first-generation MSMEs, who may be having huge potential (and many ingenious ideas!), may not have the capability to fulfill the collateral requirements of banks. Therefore, because of a lack of funds, many individuals and MSEs with enormous potential cannot start or scale up their businesses. Due to credit rationing, profitable projects of micro and small enterprises may not see the light of the day, resulting in suboptimal investment and employment in the economy.

In order to turn today’s worker into tomorrow’s MSME; and today’s microenterprise into tomorrow’s medium enterprise, it is necessary to plug the financing gap faced by them. As per RBI, credit outstanding to the MSME Sector as on 30.09.2022 is Rs 20.7 lakh crores. The report of the Expert Committee on MSMEs headed by U.K.Sinha had estimated the credit gap in the MSME sector in 2019 to be as much as Rs. 20-25 lakh crore. This means there is a need for more than doubling the rate of disbursal of credit to the MSME sector.

Providing credit guarantees to lending institutions can play an increasingly important role in bridging this credit gap and facilitating the growth of credit to the MSME sector. By providing guarantees to the lending institutions and covering part of the default risk, credit guarantee institutions lower the lender’s risk as guarantees secure repayment of all or part of the loan in case of default.

Credit Guarantee not only enables micro and small businesses without collateral to obtain loans but also leads to overall credit enhancement in the economy as many of the MSMEs without collateral would not have otherwise got credit from the lending institutions. Credit guarantee also encourages lending institutions to save on capital provisioning as the provision of guarantees reduces the capital adequacy ratio.

By providing a guarantee for a percentage of a financial institution’s loan portfolio, the capital adequacy requirements against the portion of the portfolio that is guaranteed are correspondingly lower, which further leads to credit enhancement in the economy.Furthermore, since the entire risk of default is not borne by lending institutions after the provision of credit guarantees, lending institutions need not to charge a higher interest rate to take care of the risk associated with lending to SMEs. Thus, providing credit guarantees at nominal guarantee fees also allows lending institutions to extend loans at a cheaper rate to MSMEs.

It is important to note that funding credit guarantee institution leads to 2x or 3x more disbursal of credit than directed credit or loan subsidies. Public credit guarantee scheme requires relatively small cash outlays, at least initially before credit losses materialize, and can guarantee a large volume of loans with a comparatively small capital base. Empirical evidence also suggests that risk management instruments can maximize public capital use, compared to equity or loan capital. Therefore, funding credit guarantee institutions can lead to better and optimum utilization of government funds. Infusion of funds in the guarantee scheme can lead to a credit revolution for the micro units in the MSME sector which will provide a massive boost for employment.

In India by way of extending loan guarantees to lenders and thereby instilling confidence and risk aversion amongst the lenders, Credit Guarantee Trust for MSMEs (CGTMSE) has played an increasingly important role in facilitating the growth of credit to MSME sector. CGTMSE provides credit guarantees for a loan up to a limit of Rs. 200 lakhs with a guarantee coverage ranging from 50% to 85% for various categories of loans. As per the latest available data, the year-wise guarantee cover provided by CGTMSE has been increasing substantially since FY18 (Rs 19,066 crore) to Rs 45,851 crore in FY20 and Rs 56,172 crore in FY22.

Fully understanding the importance of guarantee institutions in improving access to credit for MSMEs, in Budget 2023-24, an additional infusion of Rs. 9,000 crores has been announced in the CGTMSE corpus. Hon’ble FM announced in the parliament that this financial boost to the CGTMSE scheme would enable additional collateral-free guaranteed credit of Rs. 2 lakh crore and reduce the cost of the credit by about 1 percent.

However, some more tweaks in the CGTMSE scheme can also be undertaken to improve the efficacy of the scheme further. The signup for the Guarantee cover amongst member lending institutions is still very low. Guarantee fee charged by CGTMSE from member lending institutions is believed to be high by many banks. Therefore, rationalising fee for claiming guarantee cover will go a long way in covering a bigger share of MSEs loans under the guarantee scheme. The Recent SBI report also suggests reducing the annual guarantee fees to 0.50% of the loan amount across all the slabs and making CGTMSE coverage mandatory for all SME loans up to Rs 2 crore. Moreover, the report also suggests increasing the limit for non-collateralized loans under CGTMSE to INR 20 lakh from the current INR 10 lakh for micro and small units for all activities under the manufacturing, services, and trade sector.

Furthermore, by encouraging State Financial Corporation (SFC) to provide first and/or second loss guarantee to lending institutions instead of directly financing MSMEs out of their balance sheet, there can be multiple times disbursal of credit with the same amount of outlay incurred by them. At present, besides providing guarantees, the SFCs also provide financial assistance to MSMEs in various forms, such as directly providing term loans, direct subscription to the debentures or the equity, and seed capital. Sincere efforts need to be put into increasing the share of guarantees provided by SFCs to lending institutions out of the total expenditure incurred by them. Moreover, setting up a state-level credit guarantee trust for MSMEs on the lines of CGTMSE, which is at the national level, can also fulfill state-specific requirements, and provide MSMEs with easy access to funds, & banks with higher reliability.

(Rajib Sen is Senior Adviser and Monika Mangla is Research Officer in NITI Aayog. Opinions expressed are personal and do not represent the views of, NITI Aayog or the government of India.)

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