The role of credit rating agencies in addressing gaps in micro and small enterprise financing: The case of India

Shankar, Savita Working Paper The role of credit rating agencies in addressing gaps in micro and small enterprise financing: The case of India ADBI Working Paper Series, No. 931 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Shankar, Savita (2019) : The role of credit rating agencies in addressing gaps in micro and small enterprise financing: The case of India, ADBI Working Paper Series, No. 931, Asian Development Bank Institute (ADBI), Tokyo This Version is available at: https://hdl.handle.net/10419/222698 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/igo/ ADBI Working Paper Series THE ROLE OF CREDIT RATING AGENCIES IN ADDRESSING GAPS IN MICRO AND SMALL ENTERPRISE FINANCING: THE CASE OF INDIA Savita Shankar No. 931 March 2019 Asian Development Bank Institute The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI’s working papers reflect initial ideas on a topic and are posted online for discussion. Some working papers may develop into other forms of publication. In this publication, “$” refers to United States dollars. Suggested citation: Shankar, S. 2019. The Role of Credit Rating Agencies in Addressing Gaps in Micro and Small Enterprise Financing: The Case of India. ADBI Working Paper 931. Tokyo: Asian Development Bank Institute. Available: https://www.adb.org/publications/role-credit-rating-agenciesaddressing-gaps-micro-small-enterprise-financing-india Please contact the authors for information about this paper. Email: savita.shank[email protected] Savita Shankar is an associate professor at the Keio Business School of Keio University in Yokohama, Japan. The views expressed in this paper are the views of the author and do not necessarily reflect the views or policies of ADBI, ADB, its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms. Working papers are subject to formal revision and correction before they are finalized and considered published. Asian Development Bank Institute Kasumigaseki Building, 8th Floor 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: [email protected] © 2019 Asian Development Bank Institute ADBI Working Paper 931 Shankar Abstract This paper describes the common financing challenges faced by micro, small, and mediumsized enterprises (MSMEs) in India and some important measures taken to address them, with a focus on the credit rating scheme implemented in 2000. It examines the usefulness as well as the limitations of the scheme, drawing on interviews with rating agencies and MSMEs. The analysis indicates that with credit rating being an expensive exercise, the availability of government subsidies under the scheme has been an important factor in encouraging MSMEs to get themselves rated, thereby reducing information asymmetry with banks and enabling access to credit. Given the large number of unbanked MSMEs in the country, leveraging the data generated by MSME lending and credit rating in the country through the creation of a credit risk database is necessary. Lenders will then be able to tap into the collective data generated in order to make more informed credit decisions with regard to MSMEs without relying on subsidies. Keywords: micro, small, and medium-sized enterprises, India, credit rating JEL Classification: G21, G28, G38 ADBI Working Paper 931 Shankar Contents 1. INTRODUCTION ......................................................................................................... 1 2. MSME SECTOR IN INDIA AND ITS PLACE IN THE ECONOMY .............................. 1 3. CHALLENGES IN ACCESS TO FINANCE FOR MSMES IN INDIA ........................... 3 4. DEVELOPMENTS WITH REGARD TO CREDIT RATING FOR MSMES ................... 5 4.1 Specialized Credit Rating Agency ................................................................... 5 4.2 Performance and Credit Rating Scheme ......................................................... 5 5. BENEFITS OF CREDIT RATING OF MSMES ............................................................ 7 6. OTHER POLICY INITIATIVES TO HELP MSMES ACCESS FINANCE ..................... 8 6.1 Credit Guarantee Scheme ............................................................................... 8 6.2 MUDRA Bank Initiative .................................................................................... 8 6.3 Start-Up India .................................................................................................. 9 6.4 Stand-Up India ................................................................................................ 9 6.5 Other New Sources of Loans for Micro and Small Enterprises ..................... 10 6.6 Initiatives to Reduce Information Asymmetry regarding MSMEs .................. 10 7. CONCLUSIONS AND POLICY RECOMMENDATIONS ........................................... 11 REFERENCES ..................................................................................................................... 13 ADBI Working Paper 931 Shankar 1 1. INTRODUCTION The Indian micro, small, and medium-sized enterprise (MSME) sector is estimated to comprise 63.38 million enterprises, employing an aggregate of around 111 million people (Ministry of MSMEs 2017–18). As MSMEs tend to be labor-intensive, this sector is especially important in India where the creation of job opportunities for the large workforce is an important policy objective. However, studies have shown that MSMEs in India face various constraints, the primary one being that of a lack of timely and adequate finance. The inadequate financing of MSMEs is often attributed to the paucity of information regarding these entities. Many MSMEs lack financial records, credit histories, and collateral, the bases on which lenders make credit assessments. In their absence, lenders are unable to progress with their credit appraisals. Credit rating is one way to address these information asymmetries prevalent in the sector. In India, some policy initiatives have tried to encourage credit rating agencies to offer MSME ratings. This paper analyzes the policy initiatives taken and examines the potential for using credit ratings to help address the gaps in financing micro and small enterprises in India, drawing on interviews with rating agencies and MSMEs. The paper is organized as follows: The second section will provide background on the Indian MSME sector and its importance for the Indian economy; the third section describes the challenges that MSMEs face in accessing finance; the fourth section examines the developments with regard to the credit rating of MSMEs in India; the fifth section discusses the benefits and challenges of credit rating for MSMEs; the sixth section discusses the other policies being implemented to improve MSMEs’ access to finance; and the final section develops policy recommendations. 2. MSME SECTOR IN INDIA AND ITS PLACE IN THE ECONOMY In India, enterprises are classified as belonging to the MSME sector based on their investment in plant and machinery. In the manufacturing sector, enterprises with investment in plant and machinery of up to Rs 2.5 million (approximately $3,5001) are categorized as micro, those with Rs 2.5 million up to Rs 50 million ($0.7 million) as small, and those with Rs 50 million to Rs 100 million ($1.4 million) as medium-sized enterprises, respectively. In the services sector, the corresponding limits for investment in plant and machinery for micro, small, and medium-sized enterprises are up to Rs 1 million ($14,286), Rs 1 million up to Rs 20 million ($0.29 million), and Rs 20 million to Rs 50 million ($0.7 million). The reason for using investment as a benchmark to define MSMEs is that given the lack of records and documents prevalent among these enterprises, investment is relatively easier to measure and verify. These definitions were given in the MSME Act, 2006. A bill had been introduced in 2015, seeking to amend the Act and raise the investment limits for each of the categories to update the definitions after a decade to adjust for inflation during the period. While the bill was still pending in Parliament, in February 2018, the Indian cabinet approved a proposal to revise the definition of MSMEs to one based on annual revenue rather than on investment. The logic for this revision is 1 An approximate exchange rate of Rs 70 to $1 has been assumed throughout the paper. The exchange rate has varied between Rs 65 and Rs 72 over the last 12 months, with the rate as of 23 September 2018 being Rs 72.70. ADBI Working Paper 931 Shankar 2 that in July 2017, the country had replaced multiple indirect taxes in the country with a single unified tax called the “Goods and Services Tax” (GST). The implementation of the GST required the creation of an information technology (IT) platform that could serve as an interface with taxpayers that could be shared by the central government and various state governments. This infrastructure was set up by the GST Network, a not-for-profit company in which the central government, state governments, and financial institutions hold stakes. Because of this IT infrastructure, the government is now able to ascertain the annual turnover of registered entities, making it possible to have a turnover-based definition. The MSME Act 2006 will now need to be amended to make the new definition effective. According to the new definition, enterprises with a sales turnover of up to Rs 50 million ($0.7 million) would be categorized as micro enterprises, while those with a turnover of between Rs 50 million and Rs 750 million ($10.7 million) would be called small enterprises, and those with a turnover of between Rs 750 million and Rs 2.5 billion ($35.7 million) would be considered medium-sized enterprises. The new definition is expected to make classification of enterprises into these categories more transparent and will eliminate the need for unnecessary inspections to this end (Prasad 2018). While state governments are primarily responsible for the promotion and development of MSMEs, at the national level, the Ministry of MSMEs is responsible for overseeing the growth of MSMEs through initiatives designed to help them become competitive and to assist them in scaling up. The Ministry was formed after the enactment of the MSME Development Act in 2006. Under the Ministry, the National Small Industries Corporation (NSIC) specifically focuses on assisting micro and small enterprises by providing integrated support services such as marketing, technology, finance, and other services. A single-member committee, comprising Prabhat Kumar, former Cabinet Secretary, was set up to help formulate a national MSME policy. The committee submitted its report in January 2017 and is said to have recommended setting up a national authority to coordinate policies relating to MSMEs. The number of MSMEs in the country was estimated to be 63.38 million according to the last census conducted by the MSME ministry in 2006–07, of which only 6% were registered enterprises and the remaining 94% were unregistered. Registered enterprises file business information such as investment, the number of employees, and the nature of operations with District Industries Centers of the state or union territory that they are in, while unregistered enterprises do not do so. This shows that even basic information regarding the majority of MSMEs in the country was missing. Another important aspect of the MSME group is that 95% of the enterprises fell into the “micro” category while 4.8% fell into the “small” category and the remaining 0.2% were classified as “medium.” This shows that MSMEs in India are predominantly very small in scale. MSMEs are however, spread across rural and urban areas with 52% in rural areas as per the last census. With respect to sector of operation, 71% of MSMEs were in the services sector, with the rest being in the manufacturing sector. Among registered MSMEs, the main areas of operation were wearing apparel; grain mill products, starches, and prepared animal feeds; repair of personal and household goods; metal products; and furniture. Among unregistered MSMEs, the main areas of operation were retail sale of food, beverages, and tobacco, and retail trade and manufacture of wearing apparel and tobacco. Not surprisingly, nearly 95% of MSMEs were organized as proprietorships. The MSME sector has an important place in the Indian economy. According to the Ministry of MSME’s 2017–18 report, it employed 111 million people, which is approximately 21% (KPMG 2016) of the overall employment in the country. Over 20% of the enterprises were female owned and according to the last census in 2006–07, 18% of employees in this sector were female. The sector also contributed 28.8% to the ADBI Working Paper 931 Shankar 3 country’s GDP (Ministry of MSMEs 2017–18 annual report). The estimated contribution of the sector to the country’s exports was 45% (ibid.). According to the census conducted in 2006–07, the sector’s share in the services sector GDP was 24.6% and its share in the manufacturing output of the country was 33.4%. The contribution of the sector to GDP is low when compared to the average in a number of other countries in Asia. In the ADB’s Asia SME Finance Monitor 2014, the average contribution of the sector to GDP for the countries studied was 42%. In addition to the above factors, MSMEs are important because they have the potential to promote employment in rural areas, thereby reducing the need for urban migration. Moreover, many MSMEs focus on traditional skills and the use of local resources. 3. CHALLENGES IN ACCESS TO FINANCE FOR MSMES IN INDIA A unique feature of MSMEs in India is that almost 93% do not access any outside funding while a little more than 5% use institutional finance and 2% use noninstitutional finance. Even among registered MSMEs, only 11% access institutional finance (Ministry of MSMEs 2009). The main problem faced by MSMEs in accessing institutional finance is their lack of collateral, which makes it hard for them to offer any security for bank loans (IFC 2012). Another significant problem is that often they do not have credit histories either. This makes lending to them a risky proposition for banks. A very detailed loan appraisal of an MSME could reduce the risk of lending but could lead to very high transaction costs. Given the small unit value of typical MSME loans, such a high transaction cost could make lending to MSMEs unviable. Credit scoring models have been routinely used in developed countries to reduce the time and cost of lending to small businesses. However, such models need to be specifically developed in the Indian context using historical data on lending to MSMEs. In the absence of collateral and credit histories, past data could be used to obtain credit insights that could help evaluate loan requests made by MSMEs. Using such models could be a good way to ensure speedy appraisal of loan requests from MSMEs at a reasonable cost. However, developing reliable and robust models would require access to a large volume of historical data. As MSME financing has been a neglected area for a long time, such vast amounts of historical data on MSMEs in India are not currently available on a consolidated basis. Some banks in India have developed their own models based on the available data (Joshi 2014). A major hurdle for MSME financing is the information opacity prevalent in the sector as many of the units do not have complete accounting records, audited financial statements, or well-articulated business plans. This makes credit assessment by potential lenders very difficult. Lenders may need to help the enterprises put together these documents, which may again increase transaction costs, especially relative to the small ticket nature of such loans. Even when accounting records and financial statements are available, MSMEs sometimes have trouble accessing institutional finance. This is because volatility and risk levels are considered to be higher in the MSME sector than among large corporates as often MSMEs are dependent on very few partners and contracts, especially as suppliers ADBI Working Paper 931 Shankar 4 to larger companies. For instance, when there was a crisis at Maruti Suzuki India Ltd.,2 the company itself did not default but several MSMEs that were dependent on its business defaulted on their bank payments due to liquidity problems. These MSMEs therefore were classified as NPLs by their banks, though later they paid back their dues (Singh 2017). NPL rates among MSME loans have been on the rise. For the micro sector3, the rate has gone up from 7.9% in March 2016 to 8.8% in 2018 while for the SME sector4 it has gone up from 9.8% to 11.2% during the same period (TransUnion CIBIL 2017; TransUnion CIBIL-SIDBI 2018. This is reflective in some ways of the trend of increasing overall NPL levels experienced by banks in India with levels increasing from 7.6% in March 2016 to 11.6% in March 2018 (RBI Financial Stability reports 2016, 2017, 2018). As already seen, the NPL rates in the MSME sector have typically been higher than overall NPL levels in the past, though more recently we see that the levels in the SME sector are comparable to the overall rates because of the spike in NPL levels among large corporate borrowers. In the case of the micro sector, the NPL rates are at present lower than the overall NPL rate. It is also found that even when MSMEs do access loans, the interest rates on these loans are frequently higher than those on loans availed by larger corporates. This is because when lending norms and models applied to large enterprises are applied to MSMEs, the ratings obtained by MSMEs are lower, resulting in higher interest rates being applied to loans availed by them. Besides their lack of collateral, MSMEs face other disadvantages that reduce their rating. For instance, MSMEs often lack bargaining power with suppliers and customers, resulting in their having unfavorable working capital terms that are a strain on their liquidity. A 2012 study on MSMEs in India by the International Finance Corporation (IFC) estimated the overall demand for finance by MSMEs to be around Rs 32.5 trillion ($0.5 trillion), comprising a debt demand of Rs 26 trillion and an equity demand of Rs 6.5 trillion. After excluding enterprises that are in difficult situations, enterprises that have been operating for less than a year, enterprises that have been rejected by financial institutions, and enterprises that prefer informal sources of finance, the study estimates the viable debt demand in the sector to be Rs 9.9 trillion. Of the financing available to MSMEs, only 22% is catered to by formal sources of finance, with the balance coming from self-finance or informal finance. A proportion of 85% of formal financing comes from banks. Informal sources of finance include friends, family, moneylenders, and rotating savings and credit associations (ROSCAs or “chit funds” as they are locally known). The viable equity demand is estimated to be Rs 0.67 trillion by excluding entrepreneurs’ equity contributions and equity demand from proprietorships and partnerships, as these legal forms do not allow outside capital to be accepted. Considering the available supply, the study estimates the gap between the demand and supply of funding for MSMEs to be around Rs 3.57 trillion, affecting around 11.3 million enterprises. A proportion of 97% of the viable debt gap comes from micro and small enterprises. 2 One of India’s leading passenger vehicle companies, Maruti Suzuki India Limited is a subsidiary of Suzuki Motor Corporation of Japan. Until 2007, it was known as Maruti Udyog Limited and was a joint venture between Suzuki, Japan, and the Government of India. 3 In the case of lending by commercial banks, the micro sector refers to loans below Rs 10 million. 4 In the case of lending by commercial banks, the SME sector refers to loans between Rs 10 million and Rs 250 million. ADBI Working Paper 931 Shankar 11 In 2017, TransUnion CIBIL introduced a credit risk ranking for MSMEs that ranks MSMEs on the chances of their defaulting over the next 12 months. Using algorithms based on the data that banks enter into their systems, a rank between 1 and 10 is assigned to MSMEs, with 1 representing the rank for the least risky MSME. 7. CONCLUSIONS AND POLICY RECOMMENDATIONS There are three aspects that need to be addressed with regard to MSME financing. The first relates to the supply of funds to the sector. Several steps have been taken by the government to make more funding available to the sector. The setting up of MUDRA Bank makes more funds available to the last mile providers. The number of last mile providers has also increased with the setting up of new banks, including small finance banks, which have a special focus on the sector. Moreover, market-led sources of funding such as specialized NBFCs and digital lending platforms have also emerged. However, availability of funds does not guarantee that loans will be made to the MSME sector. As lenders need to be able to make sound assessments of borrowers, there is a need to reduce the information asymmetry in the sector. This is the second important aspect of MSME lending. It is here that credit rating plays an important role. However, since credit rating is an expensive exercise, government subsidies have been used to encourage its use in India. The availability of budgetary funds tends to vary depending on other pressures, and as a result, usage of credit ratings by MSMEs tends to be volatile too. As many MSMEs that are getting rated for the first time have no idea about the kind of rating they are likely to obtain, they are reluctant to go in for credit ratings in the absence of a subsidy. Given the large number of unbanked MSMEs in the country, funding for the PCRS needs to be sustained. As in the past the funding for the scheme has t been sporadic, the role of credit rating in terms of access to funds for MSMEs is limited and is likely to remain so. Besides the credit rating scheme, the growth of services providing credit information on individuals and attempts to provide MSME ranks based on credit history are also useful. Most importantly, the availability of GST data, TReDs data, and transaction data is likely to be very useful to potential lenders for verifying and cross-checking details provided by MSME owners. The third aspect that is important for MSME finance is reducing the cost of loans to these entities. Reasonably priced loans support the viability of MSMEs. While increasing the supply of funds and reducing information asymmetry could be useful, schemes such as the Credit Guarantee Scheme could also help in reducing the risk levels and costs of financing. On a long-term basis, to get the benefit of the government-supported credit rating and credit guarantee schemes, the information generated should be utilized to build a large credit risk data set that could enable the use of credit scoring models that have a lower unit cost. Currently, some banks have their own in-house models developed with the data available to them. Building up a credit risk database focused on the MSME sector to which lenders submit financial statements as well as default data could be extremely useful for developing statistical credit scoring models. Such a model based on data from all MSME lenders is likely to be much more robust than individual bank models. Availability of such a model could greatly reduce the appraisal time and cost for MSME loans as well as reducing risk levels. Moreover, the models used will improve with time as more and more data are added. A similar database with SME data being shared by members in an anonymous form has been found to be useful in Japan (Kuwahara et al. 2016). The database was set up specifically to ADBI Working Paper 931 Shankar 12 encourage bank lending to SMEs. The costs of setting up the model need to be borne by potential users and subscribers. This initiative would be distinct from the MSME databank initiative that the government is pursuing. The latter is useful in developing a census of MSMEs; however, building up a credit risk database would be useful in helping lenders make risk assessments. MSMEs are a heterogeneous and large group, so such a database can help in understanding the various subsegments in the group. The database should utilize data generated by the implementation of the Goods and Services Tax, data available at credit bureaus, and data available with banks and credit rating agencies. Mandatory reporting as required in the case of credit bureaus will help in building up the database. The use of analytics will help in developing scoring models for MSME lending specific to each subsegment. The database could also help in developing differential pricing for credit guarantees. While availability and cost of financing of MSME loans is very important, financial literacy of MSME owners is important to enable them to make informed financial decisions. Only 24% of adults are financially literate in India according to the Global Financial Literacy Survey (Standard & Poor 2005). The government of India and the RBI need to design and implement a financial literacy strategy that will target adults and MSMEs, helping them make informed decisions. This could include a wide array of measures, such as financial education in national education curricula, dedicated training and workshops for MSMEs, and the launch of applications and a website to promote financial education (with videos, calculators, and games) based on the model of the Australian website MoneySmart (OECD 2012). There have been several positive developments that augur well for MSME financing in recent times. The development of an MSME-focused credit risk database that will help in developing credit scoring models and widespread and systematic promotion of financial literacy efforts for MSME owners are the next steps that will greatly help the MSME sector to take full advantage of these positive developments. ADBI Working Paper 931 Shankar 13 REFERENCES Asian Development Bank. 2014. Asia SME Finance Monitor 2014. https://www.adb.org/ publications/asia-sme-finance-monitor-2014. International Finance Corporation (IFC). 2012. 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