Top Challenges in MSME Financing in India

The Indian MSME (micro, small and medium enterprises) market has undoubtedly been one of the country’s growth drivers and a source of pride over the last several decades. The sector employs millions of people from low-income regions and contributes significantly to the country’s exports and GDP. It strengthens the entrepreneurial spirit at the grass-root level and opens up countless opportunities to Indians.

Despite the good tidings, several financing challenges prevent the sector from reaching its full potential. There is a massive $240 billion credit gap in the sector, and the formal financial system reaches a mere 16 per cent of Indian MSMEs. This shortfall leaves many small-time entrepreneurs striving to access working capital and struggling to pay off debts.

New policies and the rise of the startup sector offer optimism. But what’s needed is a deep-dive into issues that plague the sector, along with long-term strategies to bridge the credit gap and improve financial literacy.

Here are five financing challenges faced by MSMEs in India:

Lack of financial literacy

The diversity of India’s MSMEs is a crucial strength. The sector comprises Indians from poverty-hit and education-deprived regions who have the entrepreneurial spirit for starting a small business. But this often means that MSMEs are run by individuals who don’t have the necessary financial literacy and exposure to make the most pragmatic business decisions. This inexperience causes them to make unfeasible financial decisions, leading to imbalanced working capital ratios. For instance, they may end up with low credit scores, high interest rates and the inability to leverage digital technologies or alternative funding channels.

What’s needed is a grassroots-level financial literacy program that teaches entrepreneurs how to better source, invest and expand financing.

Lack of trust by traditional banks

Banks and traditional financial service providers often feel hesitant to provide MSMEs with the financial support they demand. They view MSMEs as less attractive customers due to small loan disbursal amounts. They also don’t believe that all MSMEs have repayment capabilities, so they apply stricter regulations on smaller entrepreneurs. Moreover, the returns obtained from MSMEs are often not proportionate to the high transaction costs, and this acts as a further deterrent. MSMEs represent a high-risk sector for banks due to their low, or no, credit rating. This perception makes banks sceptical of an MSME’s loan repayment capability, and the outcome is an acute lack of working capital.

Lack of options for borrowers

Since MSMEs often prefer traditional banking channels and loans, they are left at the mercy of outdated and prolonged risk assessment processes. These channels take a long time to assess and release loans, robbing MSMEs of the chance to capitalise on real-time business opportunities. Lending institutions insist on high credit scores and security collaterals, which many small-time borrowers don’t have. Without the knowledge of digital lending channels, MSMEs end up spending resources to meet complex eligibility factors and fill long paper trails. These cause further delays in financing and liquidity.

Lack of liquidity for expanding operations

MSMEs routinely work under the limitations of high inventory costs and no minimum order guarantees. This compels them to divert all finances towards day-to-day operations, which leaves them cash-strapped. They thus look for the simplest and quickest funding sources and don’t have resources left for long-term investments that can expand the business. Since MSMEs are always racing from one solution to another, they don’t get the opportunity to achieve economies of scale. They are left short-changed and underfunded.

This lack of liquidity can be enhanced with better financial literacy, and also with schemes that encourage high-return investments.

Lack of modernised financing regulations

Another factor that works against MSMEs is the impact of long-standing regulatory practices that have been around for decades. Acquiring business licenses, insurance and certifications, and conducting tax assessments are unduly complicated for MSMEs. Despite government schemes and the rise of the FinTech industry, most regulations persist, especially in rural regions. Operating with outdated technologies and lacking access to skilled labour further prevents MSMEs from presenting convincing cases to source financing. As long as inefficiencies and inequalities in the system exist, regulation reforms will be unable to benefit their intended MSME targets.

The significance of MSMEs in the Indian economy has never been under any doubt. The sector contributes 28 per cent of GDP after all. However, inclusive and sustainable growth has been a long-standing challenge. Until the massive credit financing gap in the sector is filled, Indian entrepreneurs from the hinterland will be immobilised with high debt, rising interest rates and debtors. Restructuring the country’s financing mechanism is essential, and there remains plenty that must be done to fill the credit gap.