Credit guarantee: Getting it right on MSME lending

By Mohammad Mustafa
Covid-19 has expectedly taken a huge toll on the economy. The compounding effect of multiple jolts has been the protracted uncertainty around demand recovery in key impacted sectors. We are likely to face an uphill battle in the coming months.

Fitch Ratings predicts that India’s economy will contract by 10.5% in FY21. Although the agency forecasts that it will rebound strongly to 11% growth in FY22 and 6% in FY23, the truth, however, is that until the MSME sector is back on its feet, we will continue to see tepid economic recovery. However, MSMEs are facing a sombre future with bruised balance sheets. Considering their economic significance, reviving the MSME sector has to be our top priority.

Resultantly, the financial measures for MSMEs have been a key constituent of India’s economic relief package, primarily the Rs 3 lakh crore Emergency Credit Line Guarantee Scheme (ECLGS) announced by the government in May. As of September 21, a total of Rs 1.5 lakh crore has been disbursed under the 100% guarantee scheme.
However, data from RBI suggests that results are not encouraging from a credit growth standpoint.

The first five months (April-August) of FY21 have seen a sharp 7.1% decline in the non-priority sector portion of micro and small enterprise loan outstanding. Also, the credit-deposit ratio of the banking sector has come down from 76% in March 2020 to around 72% in September 2020. Certainly, the economic impact of the crisis would have been worse without the policy support of the government. The data also brings two things in perspective—one, the role of credit guarantee schemes and, two, the risk-averse nature of the banking sector.

Credit guarantee schemes are a common form of government intervention to unlock finance for underpenetrated segments. There are many guarantee schemes operational in India. The Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), one of the largest schemes, sanctioned about Rs 45,000 crore of fresh guarantees in FY20. The National Credit Guarantee Trustee Company Ltd (NCGTC) also runs operations of five guarantee schemes set up by the government of India, prominent among these being the scheme for micro units (the Credit Guarantee Fund for Micro Units) and education loans (the Credit Guarantee Fund Scheme for Education Loans).

As of March 2019, outstanding live guarantees under these two schemes were Rs 50,848 crore and Rs 6,000 crore, respectively. Similarly, there is export credit guarantee scheme as well.

In my published research, entitled ‘Impact of credit guarantee on the output gap: A panel data analysis of Asian sovereigns’, I have attempted to gauge the significance of the credit guarantee scheme as a macroeconomic determinant in emerging economies like India, Indonesia, Republic of Korea, Malaysia and Thailand, which are effectively peers by way of GDP size.

The research shows that there is a high probability of actual output gap remaining below its potential level whenever the credit guarantee to offtake ratio falls and vice-versa. Therefore, from a policy perspective, in order to maintain actual output close to its potential level, guarantee schemes are an important policy instrument.

But the ‘economic additionality’ of these schemes must be seen in conjunction with their overall size. A 2015 data from 12 eurozone economies suggests that outstanding volume of credit guarantee was close to 1% of their GDP, with only Italy (2.1%) and Portugal (1.8%) higher than the 1% benchmark, while the remaining ten economies were much lower. In the face of the pandemic, policymakers across the globe, including in Spain, Israel, France, South Korea, etc, have resorted to substantially increasing the total funding for these schemes, depending on their fiscal wiggle-room. The ECLGS in India also already amounts to more than 1.5% of the GDP, even without taking into consideration other operational guarantee schemes.

Although there are arguments in favour of these guarantee schemes, a tight policy space means that their impact and outreach will be limited given the constraint on their overall size relative to the GDP. Therefore, guarantee schemes may encourage lending in adverse situations, but they are certainly not a replacement for direct lending by financial institutions. The banking sector is the most critical tool available with the government and is definitely far better equipped to fight the crisis than it would have been in the past few years due to its stronger capital position.

However, the focus and success of credit guarantee programmes highlight a conservative approach by banks. Furthermore, the positive effects of guarantee schemes may be offset by the increased moral hazard as banks may have less incentive to screen borrowers, since the risk is partially or fully transferred to the government.

Banks play an important economic role when they channel funds from savers to borrowers by suitably underwriting the credit risk. This is the core function of banks and they cannot shy away from underwriting and appropriately pricing the risk, and therefore lending to the perceived riskier segments.

This does not mean that banks need to be reckless in their lending approach. What banks must do is to look beyond the conventional sources of data typically used in credit-risk assessments and use advanced analytics to enable effective credit decision-making for the MSME segment. This will help banks to contain the resultant non-performing loans.

The economy is now open as most lockdown restrictions have been lifted. The recovery trajectory of different sectors may follow different speeds depending on post-Covid-19 demand behaviour. Resilient MSMEs need to be supported as their inability to access bank financing will have a large negative impact on economic recovery.

The complexity of these challenges entails a multifaceted policy and regulatory response. Banks need to step up and further share the burden as credit growth remains untenably muted. Banks are entrusted with the task of underwriting risk and determining the viability of a business proposal—they must not abdicate this, we hear many such stories.

The author, an IAS, was most recently the CMD of SIDBI