Modi govt’s Rs 20 lakh crore package is a missed opportunity for MSME credit reform

It is a relief that the first tranche of the Narendra Modi government’s Rs 20 lakh crore economic package to kickstart the Indian economy has a very small impact on the fiscal deficit and government borrowing this year. However, it is a missed opportunity for deeper reform of small business credit in India.

Small firms are the biggest employers in India. The present package is an attempt to give people back their jobs by reviving firms when the lockdown is being eased. It is clear that India cannot afford to keep the lockdown in place, while doing fiscal transfers to the vulnerable. The end of the three-month period, for which fiscal transfers had initially been announced, is approaching soon.

Last week the government announced an increase in its borrowing programme from Rs 7.8 lakh crore, as estimated in the budget, to Rs 12 lakh crore. The additional Rs 4.2 lakh crore were barely sufficient to make up for the first Covid-19 fiscal package, the shortfall in tax revenue this fiscal year, and the shortfall in disinvestment revenue expected this year.

With limited fiscal space, the government did not announce large fiscal transfer package for the jobless based on more borrowing. Instead, it has tried to kickstart the economy by pushing money into MSMEs.

100% guaranteed loan is effectively a fiscal transfer

The key focus of the first tranche of the package, announced by Finance Minister Nirmala Sitharaman, is to address the problem of liquidity being faced by MSMEs due to the lockdown.

However, the package misses the opportunity to address structural issues related to MSME credit. If anything, the 100 per cent sovereign guarantee for uncollateralised, automatic MSME loans will encourage both banks and borrowers to never return the money and to become defaulters. It will discourage banks from willingly lending to these MSMEs in the future.

Rs 3 lakh crore credit will be provided to MSMEs as automatic collateral-free loans. These loans will be for four years and do not have to be repaid in the first 12 months. In other words, defaults will happen in future fiscal years, by when the economy and taxes would have recovered allowing the government fiscal space to spend money for its guarantee.

With a 100 per cent government guarantee, the bank will not bother to chase the borrower. As such, this amounts to the government paying the banks after the borrower has defaulted. As the government does not have the fiscal space to pay MSMEs Rs 3 lakh crore today, it is giving money through banks, and will pay back these banks in the future. Banks are not lending much today, so they have the ability to implement this package. This poses no risks to them.

Alternatively, the government could have borrowed money and then directly given money to MSMEs through government departments. This would have meant a higher fiscal deficit and more government borrowing, and would have had administrative issues. In essence, it would be no different.

Structural issues in MSME credit

To address the structural issue of MSME credit, there need to be two key changes in the way banks lend to them. First, small businesses should be given uncollateralised loans, not just now, but also in the future. It should become a part of the way banks function. Second, they should look for good borrowers based on credit history — within their own bank, as well as with others.

In today’s situation of limited resources and limited credit availability, it is even more important that money goes to firms that are going to use it well. Banks should not want to give credit to borrowers who are expected to default. While India has focused on large wilful defaulters, it is equally important not to give loans to small defaulters — whether wilful, or even those that do not have a business plan to use money efficiently.

The first steps towards this change could have been made in the present package. First, to encourage banks to find good borrowers, the guarantee should not have been 100 per cent. Banks are risk averse today because of the fear of investigation agencies. They are not giving loans despite the liquidity being provided to them by RBI, and despite the fall in reverse repo rates that make it unprofitable for banks not to lend.

But going to 100 per cent guarantee and eliminating all incentives for banks to give loans to good borrowers is the other extreme.

Reforms needed

How should the present package be tweaked? First, by allowing banks to suffer some losses and assuring no investigations against them, incentives can be changed. The sovereign guarantee can be say, 50 per cent of the total MSME lending by the bank under this scheme. This way, banks have the incentive to give loans to better firms.

Second, the loans should be linked to the credit history of the borrower, and banks should be encouraged to give uncollateralised loans based on this credit history in the future. This way, the borrower has the incentive to repay the loan. If the borrower repays the loan, it prepares the ground for getting more loans later.

In addition to this, the problem of low MSME credit needs financial sector reforms. It requires the development of a bond market which can cater to the financing needs of larger firms. It requires a competitive banking sector in which banks chase borrowers to borrow, based on their ability to repay rather than public sector banks being mandated to give Mudra loans.

It requires a Resolution Authority which can monitor and sell off a badly managed bank before it collapses, causing pain to its depositors, borrowers and some hapless public sector bank that is forced to buy it.

Hopefully, the government will use the present adversity as an opportunity to bring these deeper structural reforms back to the table. As it is sometimes said, never let a crisis go to waste.