SME Challenges for increasing Credit Flow to the Sector in India | Loans | Credit (Finance)


By: Amit Bhushan & Sayee Probhu

Small is beautiful but is it Powerful? Yes, say the SMEs. SMEs have been stories that happened away from the public eye, not seen and hence, not known. But can one ignore the silent march of a multitude, relentlessly servicing the behemoths. The Report Card of the SSI Sector reads thus: The growth recorded by SSI in India is 2% more than any other sector; it accounts for 40% of the country’s GDP, 35% of Direct exports, 15% of Indirect Exports (through Merchant Exporters, Trading Houses & Export Houses) and employs more than 20 million people. The SSIs needs just Rs. 60, 000 – 70, 000 to generate employment for one man, while for the same a whopping 5-6lakhs is required for other sectors. An investment of Rs.1 million in fixed assets can generate Rs.4.62 million of Goods or Services with an approximate value addition of 10%, investment of Rs. 1Lakh can provide employment to 4 people. The exports from SSI sector has ridden on the performance of garments (readymade garments, woollen garments and knitwear), leather and gems and jewellery, sports goods, plastic products, processed food units from this sector. It is also pertinent to note that the non-traditional products constitute a massive 95% of the SSI exports. The impressive performance has been inspite of the inadequacies in capital, technology and marketing. This article would however, restrict itself to the

discussion of inadequacies in capital and means to improve Credit Flows to the SSI sector. SME DEFINED If given a choice to define SMEs we would end up with over 60 of them. The common among them relate to, either Singly or the combination of, Investments in Capital or Fixed Assets and Number of people employed. UNIDO defines SMEs based on size, location and technology, being Modern, Modernizing, Intermediate Technology and Non-Modern. Others define based on location, payment determinants and type of work (Traditional/Industrial). The Industries Development And Regulation Act, 1951, defines SMEs according to limits in Investment in Plant & Machinery. The small-scale sector, in India, comprises of: Type of Units Small scale industrial undertakings , Investment / Other Criteria Upto Rs.10 Million ( Upto Rs.50 Million for certain specified Industries) Ancillary industrial undertakings Tiny enterprises Small Scale Service Related) & Upto Rs.10 Million Upto Rs.2.5 Million Business Upto Rs.1 Million Enterprises

(Industry (SSSBE)

Women Enterprises

Managed by one or more


entrepreneurs in proprietary concerns, or in which she/ they individually or

jointly have a share capital of not less than 51% as Partners/ Shareholders/ Directors of Private Limits Company/ Members of Cooperative Society. The abstractness in defining a SME presents difficulty in identifying them , formulate & implement suitable policies for them. The limit on investment in Plant & Machinery and a plethora of laws governing (58 laws in 7 different categories) them, some of the SSIs seek refuge in remaining small inspite of opportunities to grow. The small size, opacity of the firms and their lack of awareness have bred the following hindrances to their growth: 1. Under-utilization of Capacities. 2. Inadequate and Untimely Credit Flows. 3. Inability in Technology upgradation. 4. Inefficient raw material procurement. 5. Inability to Market Finished Goods. 6. Ineffective monitoring and feedback mechanism. The table below indicates the enormity of each of the hindrances to the survival of the SSI units. Reasons for Sickness/Incipient As % for Regd. SSI As % for UnRegd. SSI Sickness Lack of demand Shortage of Working Capital Marketing Problem Sector 71.6% 48% 44.5% Sector 84.1% 47.1% 41.2%

Power Shortage Non-Availability of Raw Material Equipment problem Labour problem

21.4% 15.1% 10.6% 7.4%

14.8% 15.2% 12.9% 5.1%

PROBLEMS IN LENDING TO SMES The following parameters are used in various connotations by banks/FI for their lending decisions: 1. Prospects: This refers to both the Industry and Firm analysis in terms of growth prospects, financial stability, threat perceptions and the like. 2. Purpose: The need and form of Loan. 3. Payment: The possibility of repayment. 4. Person: The will and ability of a person to repay. 5. Protection: The type of security provided to the lender, its value and ease of liquidation. Applying the same parameters, without factoring their uniqueness, has resulted in a skewed Net Bank Credit to the SSI sector: a. Of the Rs.477,899 crore Net Bank Credit ,only 11.1% was available to the SSI sector and out of the same 50.84% was available to the tiny sector. b. The Net Bank credit to the SSI sector has decreased from 15.6% at the end of March 2000 to 11.1% at the end of March 2003.

It is surprising that the measure of opacity doesn’t apply to the tiny sector. The lending, based on category of the borrowers as opposed to a fair and systematic credit appraisal system and high “Total Real Cost “ of borrowing in the formal sector has led to the longevity of the informal sector despite its atrocious lending rates and recovery mechanisms. SMEs continue to face this dilemma of choosing between the formal and informal sectors in lending. The reasons for the same can be attributed to the organizational structure of the 750,102 units in SMEs . Type Organization Proprietary Partnership Pvt. Company Co-operatives Others As percent of the Total 90.09% 6.36% 2.12% 0.31% 1.12%

The number of unregistered units is more than six times the registered units. The overwhelmingly proprietary nature and the number of unregistered units in the SME sector explain the biases in lending to them. This bias is further confirmed in assertion by Dr. Y.V.Reddy that there is only a marginal difference in NPAs arising out Priority sector lending and lending to private companies (who enjoy the facility to restructure/reschedule loans). Thus, it is clear that lending mechanisms followed for the private corporate sector with transparent and verifiable financials are as good as that for the opaque

SMEs, rooting for collaterals is also unviable given the propensity of the borrowers to take legal recourse. The question then is how can the lending institutions view the SMEs differently and enhance credit flows? AIDS IN A BLIND ALLEY For the lending pattern to be effective, clarity must be sought on the need and method of financing, risk assessment and flexibility in repayment. This calls for a dual approach in terms of: 1. Defining Small and Medium Enterprises and 2. Identifying Innovative SMEs and Non-Innovative/Traditional SMEs. The Ganguly Committee recommends defining SMEs based on TURNOVER, a. Tiny Sector -Turnover upto Rs.2 crores. b. Small Sector- Turnover above Rs.2 crore upto Rs.10 crore. c. Medium Sector- Turnover above Rs.10 crore upto RS.50 crore. This would not only make it easier for lending institutions to identify and corroborate the category to which a borrower belonged but also provide enough incentives for the units to upgrade and adopt a capital and technology intensive growth path. The Need and Method of funding necessitates further categorization as per point 2 above adopted by the units.

An OECD study indicates that Traditional SMEs adopt the Pecking Order in Financing, and Innovative SMEs follow a reverse Pecking Order. This is because the latter don’t want to and aren’t capable of the servicing the inflexibility in repayment of Debt. But as they mature they follow the Pecking Order . The sources of funding required at various stages of life-cycle of an Innovative SME is sketched below:

The valley of death spreads its shadows to other stages of the life cycle also. Growing companies, especially ones that invest in capital need not only termloans but also more working capital.

According to a study sponsored by SER Division of the Planning Commission, units that invested in technology improvement reported increase in productivity and required more working capital. Lack of it forced them to either roll back these changes or find alternative and more expensive funds for working capital needs. Sensitization of lending institution to various needs of different categories of SMEs based on the dual approach will enable better evaluation of funding options and risk assessment. Traditionally risk assessment reflected an individual’s assessment of the risks. These are time consuming and results proprietary. The following modes to evaluate risk are unbiased and available to any user:

Credit Scoring. This involves statistical analysis of large amounts of data. Two types of data on a large sample of accounts need to be collected and analyzed. These are: a. Predictive data: data that is available at the time of the decision. b. Performance data: data that is available in the period after the lending decision was made, reflecting the payment history of the accounts in the sample. Correlation between these two data types are examined and weights assigned and a score arrived at. Higher the score, the lower the credit risk associated with the applicant or account. The advantages accrue in the form of elimination of bias, focus on questionable loans and better control over risk.


Credit Bureau. These generally contain data relating to delinquency or defaults and not about the repayment history. The Ganguly Committee recommends CIBIL, set up to serve as an information exchange between banks & Financial Institutions, for the SME sector as well.


Models that assess the default risk, like ONICRA (Onida Individual Credit Rating Agency). This rates the credit worthiness of non-

corporate/Individual borrowers and will be very useful for lending institutions, given that Proprietary concerns account for 90.09% of the SME population in India. The identification of Need & Method of Financing coupled with proper risk assessment would not only enhance proper pricing of financing options but also introduce an element of flexibility in servicing these options. SUPPLY MEETS DEMAND For an effective credit flow, supply side constraints, in the form of quantum and quality of financing and the demand side constraints, in terms of effective use of finance, must be satisfied. I. Supply Side SIDBI, the primary lending agency for SMEs, has several products to cater to the financing needs of the SMEs. A broad classification of the same is as follows: 1. Direct Financing comprising of Project (1.23% of total disbursals in 200203) and Non-Project Finance (9.24%). The latter consists of Asset

Credit/Equipment financing, Short-Term Loan/Working Capital Loan and Equipment leasing. 2. Bill Financing comprises of Direct Discounting (9.39%) and Bill Rediscounting (1%). 3. Refinancing (78.64%) at Rs.5339.4 crores disbursed in 2002-03. 4. Venture Capital Financing. All these products (Except point 4- newly launched) showed a decreasing trend through1998-99 to 2002-03, with working capital a meager 2.12% of the Total Disbursals in 2002-03. SIDBI also handles the Technology Up gradation Fund (TUF), the National Equity Fund (NEF), CGTSI, is assisted by agencies like NSIC, SIDO, SISI, KVIC. The SER sponsored study mentions that SME’s lack of awareness of the financing facilities is a major cause for their Financial Constraints. Clearly, multiplicity of agencies and schemes isn’t helping.

II. Policy Policing of Demand side Affirmative action through Government policies, implementation of Committee recommendations (headed by Mr. S.P.Gupta, Mr. A.S.Ganguly) and

implementation by Banks/FI, has resulted in removing bottlenecks to credit flows.

Policies of The Goverment of India: 1. Selective enhancement in investment in Plant & Machinery from Rs.I crore to Rs. 5 Crore, in 13 items in Stationery sector & 10 items in Drugs & Pharmaceuticals sector. 2. Banks to lend to SMEs in a band of 2 % above or below the PLR. 3. Composite loan limit for SSI enhanced from RS.25 lakhs to Rs.50 Lakhs. 4. 60 clusters identified for focused development and inclusion of their credit requirements to the respective State credit plan. 5. Setting up of SME fund of Rs. 10,000 crore under SIDBI to address inadequacy of competitive financing options. 6. Credit limit enhanced to RS.10 lakhs in the Laghu Udyami Credit Card Scheme for. 7. Dispensation of collateral requirement for loans upto RS.25 lakhs for borrowers with satisfactory track record. 8. All loans upto Rs. 25 lakhs eligible for Credit Guarantee Scheme. 9. 417 SSI specialized bank branches throughout the country. 10. Dereservation of 75 items for exclusive manufacture in SSI sector. Ganguly Committee recommendations: 1. Lending to SME clusters based on 4-C approach (Customer focus, Cost control, Cross sell, Contain Risk). 2. Linking SME clusters with large corporates.

3. Financing SMEs linked to large corporates, covering suppliers, ancillary units, dealers etc. 4. Encouraging and replicating the models of successful NGOs and microcredit institutions. 5. New dispensation for the SMEs in North East India. 6. Venture Capital funding by banks and FI. 7. Banks to encourage NGOs and MFI (Micro Finance Intermediaries) in the form of NBFCs, for credit delivery. 8. Uniform priority sector lending targets for Indian and Foreign Banks. III. Recommended measures that could be introduced through a mix of educational, fiscal and monetary measures are:

Identification and facilitation of Business angel Networks (BAN). These provide not only financing but mentoring services as well. Locally oriented BANs have been found to be highly effective. These however, require government support/corporate sponsorship to operate on full cost recovery basis.


Venture Capitals (VC) need a viable exit option to be successful. The OTCEI could provide an ideal exit route through low cost IPOs. SME companies prefer the OTCEI route to the line of credit offered by SIDBI on IPO. Appropriate tax incentives could propel the growth of VCs.


With the establishment of CIBIL, a Credit Scoring Mechanism or establishment of Credit Bureaus, the time would be ripe for Mutual Funds

to step in. These would not only provide visibility to the SMEs but also bring the gains of the SME bandwagon to the Multitude.

SMEs could be allowed to issue Bonds, Convertible Debt or Preference Equity to Banks, BANs or other investing groups. These should be issuable with minimum paper work, a minimum credit score or rating and tradable at the OTCEI/ Regional Exchanges. The Limited Partnership Act is also a step in the right direction.


With the advent of TRIMS, the SME sector would be open to FDI, measures for tapping and utilizing foreign funds and prudential norms for the same should be specified.


Relationship Banking and consequently, Single Bank funding is the norm for informationally opaque firms says a World Bank study. Fiscal & Monetary Incentives could be provided to Banks that provide Universal Banking Solutions, especially active mentoring/consultancy services.


Step – Ladder financing is another option for increasing credit flows. This involves monitoring usage of funds before any fresh disbursals, a la Zero based budgeting. Any Corporate/Bank/FI that adopts SMEs in a region or Sector specific SMEs and has demonstrable results in the near term, say 3-5 years, could be provided incentives.


One stop shop financing by SIDBI would enable greater visibility; focus on utility of the products and penetration for proper credit delivery. The

dismal performance of SIDBI with its current strength of 40 branches and 65,000 PLIs throughout the country is a case in point.

Sectoral thrusts by the lending agencies, especially the SIDBI, would enhance productive disbursement of capital. This would sensitize the lenders to the varying needs for different sectors/industries and help formulate appropriate products and delivery mechanisms. These learnings will provide data for sector specific policies.

CONCLUSION The size of SMEs has put them in a catch-22 situation, easy entry but little hope of survival, because lifeblood in the form of finance is too little, too late. A World Bank study on effect of Financial & Legal constraints to firm growth concluded that: a. These constraints affected SMEs the most and any move to alleviate the same, improved the SMEs lot considerably. b. Agency problems in credit delivery affected the SMEs considerably. Policies need to be evolved to counter the same; otherwise efficient allocation of finances would remain only on paper. c. High Interest rates reduced firm growth. Though long-term capital was a constraint, short-term capital substituted for the same. This is an antithesis to the Matching Principle in Financing and endangers the viability of the SMEs.

Thus, measures to improve product options, delivery mechanisms, risk assessment and repayment flexibility for SMEs and reduction in Informational asymmetry of SMEs through better reporting and compliance, would ensure Credit flow and growth to this growth engine. The agencies involved should apply focused Fiscal, Monetary and Regulatory policies to enable SME growth and restrain the constraints on them. Reference: 1. The Management Accounting and Financial Analysis module of the ICAI. 2. Annual Report 2003-2004, Ministry of SSI. 3. Economic Survey 2003-2004. 4. Ability of Banks to lend to Informationally opaque small businesses- A study by Allen Berger,Leora Klapper and Gregory Udell- Journal of Banking and Finance. 5. Socio-economic barriers to adoption of improved technology in the SSI sector- A study sponsored by SER division of Planning Commission.


Financial and Legal Constraints to firm Growth-does size matter, A study by Thorsten Beck, Asli Demirgüç-Kunt, and Vojislav Maksimovic.


Financing Innovative SMEs in a Global economy- OECD study presented at the 2nd OECD conference for SMEs , in Istanbul, Turkey.

8. The following websites:,,,

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