INSTITUTIONAL FRAMEWORK & MSME Financing
The importance of MSMEs is recognised in the 12th five year plan for 'faster, sustainable and more
inclusive Growth (Planning Commission, 2011). It is understood that MSMEs provide a vehicle to
build more inclusive growth, with higher disbursement compared to larger scale enterprises. With
MSMEs, comes the opportunity for unrestricted creativity and innovation driven by individual of
entrepreneurship. Backed by Hon'ble Prime Minister Shri Modi's ambitious 'Make in India'
campaign, there are number of growth advantages that MSMEs can benefit from. They have
significantly higher labour to capital ratios and as such offer significant opportunities for job
production, as well as growth through rural urbanisation which comes as a result of a strong
degree of operational flexibility. The MSME sector remains one of the most cost-effective
employment creation resources. A number of capital resources can be mobilised by the increased
spread of entrepreneurship that would otherwise have been left immobile. Similarly, with
increased MSME job production comes the opportunity to utilise the nation's skills that may have
been left unutilised were over skilled workers to remain in unskilled jobs.
A vibrant MSME sector could create heterogeneous market that cuts across Technology,
Manufacturing and Pharmaceuticals sectors. This vibrancy manifests itselfin a variety of
enterprise sizes, varying levels of capital investments, varying outputs and ultimately highly
differentiated products that satisfy domestic demand and help the enterprises register an
increasingly strong global presence. As the strength of the MSME sector grows, India grows,
setting trends towards import substitution and development of indigenous technology. Presently,
the MSME entrepreneurs are fuelling a wave of socio-economic development across the country
through an increased sense of self-determination while shedding employee status. With MSMEs
increasingly being able to emerge close to both resources and markets, they are tending to come
together and exist inclusters. This presents the opportunity for them to benefit from certain
characteristics that give them a competitive advantage over other disparate MSME units and
sometimes even large enterprises. Whether it is a technology cluster that locates close to a
college to take advantage of skilled graduates or a manufacturing cluster that relies on local
resources, MSMEs can profit from grouping together into high concentration. The existence of
clusters often attracts the benefit of abundance of customers or company buyers where the
industry has a preference for cluster production.
Interestingly, the rapid growth in the MSME sector complements the growth in the larger
industries. The variety in scale of production gives alternative supply chain possibilities such as
an opportunity for outsourcing to smaller enterprises. Such a possibility emerges due to rapid
technological advances that enable small enterprises to compete. As such, growth has not
necessarily come at the expense of other enterprises. And here exists for the lenders an exciting
possibility of dovetailing large enterprise financing to the MSME financing and the vice versa.
Globally and historically, MSMEs often find themselves unable to access the finance required to
grow their businesses. This is exacerbated by very limited access to the capital market, so
financing usually relies on non-bank borrowing and/ or borrowing from outside the financial
system. The issue can be looked at from two sides of the table. For the banker, the issues pertain
to the inherent riskiness of providing the loans, as they look at the proposals through conventional
risk assessment lenses. For the MSMEs, the issue is the inability to meet the requirements of the
banks due to the limited information they could generate and provide to the banks. Loan
applications for such enterprises involve meeting a series of stringent requirements that banks
implement to assess and mitigate risks.Large number of MSME enterprises lack of experience to
effectively and meaningfully communicate with the bankers and even when they are able to
communicate they fail to offerusual types of mitigants like tangible collaterals. As such, some of
the requirements may not be satisfied, and loans may be refused, even if they represent a strong
investment choice. Even if these are met, there are extensive delays in sanctioning and
disbursement, which leads to cash flow issues, limiting technological investment and stifling innovation.
Information Asymmetries
For many MSMEs, the existence of information asymmetry between the lender and the borrower
is the cause for lack of finance. This is due to the lack of reliable financial and legal information
such as patents or financial statements. Accounting standard may not be followed and records of
payment behaviour will often be extremely limited. Thus, the banks do not find themselves in a
strong position to take an informed decision regarding the suitability of the company. This
manifests itself in increased transaction costs as risk is overestimated.
Lack of collateral
In the banking sector, use of collateral for guarantee of loans often provides a safety net against
the possibility of the loan becoming an NPA. The issue for MSMEs is that they may not possess
the necessary collateral that potentially guarantees their loans. This limits the ability of the
banks to provide them with the required finance to grow their business. If for example, the
enterprise sought finance to invest in new machinery to speed up the packaging of a particular
drug, the risk of using the machine as collateral is that it is extremely specialised, and would
struggle to regain anywhere near the original value should it need to be seized to repay the
loan. As such, these loans will often be either refused, or provided at exorbitant rates, imposing
a further cost on the enterprise.
Inadequate supply of raw materials
The requirement of raw materials for the production of goods is often reflected in the location of
MSMEs. Due to their small size, they cannot purchase in bulk and therefore do not benefit from
economies of scale. Furthermore, they may need to buy on credit, leading to further costs and
thus often they choose to purchase locally. In addition, a survey of 200 manufacturing SMEs
found that 91% cited raw material sourcing as the second biggest challenge after access to
finance, showing that procurement of inputs can be as problematic as the purchasing process.
The inconsistencies in the supply of high quality domestic raw materials can lead to enterprises
looking to imports, which come at a cost. The process of establishing and maintaining an efficient
procurement route is key to continued growth and development of MSMEs. In particular, with
MSMEs losing certain elements of protection such as the reservation of drugs for the production
in the MSME sector, they will need to ensure that they are able to compete on other factors such
as price or quality. This rests heavily on the ability of the enterprise to efficiently source the
materials required.
Infrastructure
Sufficient capacity in every area of infrastructure proves a major stumbling block for MSME
growth. Obsolescent technology in the manufacturing of goods and lack of provision of transport
infrastructure can lead to low quality, high cost products. In both respects, there are modern
technology requirements.
The reality for many MSMEs is the lack of capital to meet these demands. In each example, the
initial investment required puts much of this technology out of the reach of small enterprises who
ultimately struggle to raise finance. This can result in MSMEs employing more labour intensive
practices which, due to low relative cost of labour, keep initial costs low, but stifles innovation,
development and progression. Thus due to a high labour to capital ratio, the marginal
productivity of labour is low on account of diminishing marginal returns. Inversely, the marginal
productivity of capital is high. There is therefore, a higher opportunity cost of using funds to
employ labour, as the returns from technological investment would be higher, representing
foregone revenue and growth possibilities.
Furthermore, infrastructure difficulties exist outside the manufacturing and development process
for MSMEs. Insufficient capacity in transportation network causes logistical difficulties and
imparts unnecessary costs. These problems include road conditions, lack of capacity in airports
and docks, poor intercity connectivity and a lack of the development in alternative inland
methods of transportation. Moreover, the infrastructure that is in place is not sufficient to
manage the capacity in the system, thus leading to bottlenecks which impart time delays and
higher costs. Considering that the logistics sector is equally fragmented, many of the firms are
not in position to take advantage of economies of scale, pushing costs higher and restricting the
possibility for established logistics networks that ensure consistency in service.
Inadequate Knowledge and Access to Markets
Success in a particular industry relies on a working knowledge of what the consumer wants, how
best to deliver, and where the market is going. This requires a level of managerial and
technological competence and the ability to conduct market research. These possibilities are
limited by the enterprises' resources, in terms of both skilled labour availability and the capacity
to allocate resources towards R&D. Many MSMEs also remain unaware of the benefits and
consistency of using online advertising to promote products, services and the brand as a whole.
In addition, due to the make-up of the small scale industries, many generate most revenue from
the local market and as such look towards narrow field advertising such as print and electronic
media to reach customer.
The importance of MSMEs is recognised in the 12th five year plan for 'faster, sustainable and more
inclusive Growth (Planning Commission, 2011). It is understood that MSMEs provide a vehicle to
build more inclusive growth, with higher disbursement compared to larger scale enterprises. With
MSMEs, comes the opportunity for unrestricted creativity and innovation driven by individual of
entrepreneurship. Backed by Hon'ble Prime Minister Shri Modi's ambitious 'Make in India'
campaign, there are number of growth advantages that MSMEs can benefit from. They have
significantly higher labour to capital ratios and as such offer significant opportunities for job
production, as well as growth through rural urbanisation which comes as a result of a strong
degree of operational flexibility. The MSME sector remains one of the most cost-effective
employment creation resources. A number of capital resources can be mobilised by the increased
spread of entrepreneurship that would otherwise have been left immobile. Similarly, with
increased MSME job production comes the opportunity to utilise the nation's skills that may have
been left unutilised were over skilled workers to remain in unskilled jobs.
A vibrant MSME sector could create heterogeneous market that cuts across Technology,
Manufacturing and Pharmaceuticals sectors. This vibrancy manifests itselfin a variety of
enterprise sizes, varying levels of capital investments, varying outputs and ultimately highly
differentiated products that satisfy domestic demand and help the enterprises register an
increasingly strong global presence. As the strength of the MSME sector grows, India grows,
setting trends towards import substitution and development of indigenous technology. Presently,
the MSME entrepreneurs are fuelling a wave of socio-economic development across the country
through an increased sense of self-determination while shedding employee status. With MSMEs
increasingly being able to emerge close to both resources and markets, they are tending to come
together and exist inclusters. This presents the opportunity for them to benefit from certain
characteristics that give them a competitive advantage over other disparate MSME units and
sometimes even large enterprises. Whether it is a technology cluster that locates close to a
college to take advantage of skilled graduates or a manufacturing cluster that relies on local
resources, MSMEs can profit from grouping together into high concentration. The existence of
clusters often attracts the benefit of abundance of customers or company buyers where the
industry has a preference for cluster production.
Interestingly, the rapid growth in the MSME sector complements the growth in the larger
industries. The variety in scale of production gives alternative supply chain possibilities such as
an opportunity for outsourcing to smaller enterprises. Such a possibility emerges due to rapid
technological advances that enable small enterprises to compete. As such, growth has not
necessarily come at the expense of other enterprises. And here exists for the lenders an exciting
possibility of dovetailing large enterprise financing to the MSME financing and the vice versa.
Globally and historically, MSMEs often find themselves unable to access the finance required to
grow their businesses. This is exacerbated by very limited access to the capital market, so
financing usually relies on non-bank borrowing and/ or borrowing from outside the financial
system. The issue can be looked at from two sides of the table. For the banker, the issues pertain
to the inherent riskiness of providing the loans, as they look at the proposals through conventional
risk assessment lenses. For the MSMEs, the issue is the inability to meet the requirements of the
banks due to the limited information they could generate and provide to the banks. Loan
applications for such enterprises involve meeting a series of stringent requirements that banks
implement to assess and mitigate risks.Large number of MSME enterprises lack of experience to
effectively and meaningfully communicate with the bankers and even when they are able to
communicate they fail to offerusual types of mitigants like tangible collaterals. As such, some of
the requirements may not be satisfied, and loans may be refused, even if they represent a strong
investment choice. Even if these are met, there are extensive delays in sanctioning and
disbursement, which leads to cash flow issues, limiting technological investment and stifling innovation.
Information Asymmetries
For many MSMEs, the existence of information asymmetry between the lender and the borrower
is the cause for lack of finance. This is due to the lack of reliable financial and legal information
such as patents or financial statements. Accounting standard may not be followed and records of
payment behaviour will often be extremely limited. Thus, the banks do not find themselves in a
strong position to take an informed decision regarding the suitability of the company. This
manifests itself in increased transaction costs as risk is overestimated.
Lack of collateral
In the banking sector, use of collateral for guarantee of loans often provides a safety net against
the possibility of the loan becoming an NPA. The issue for MSMEs is that they may not possess
the necessary collateral that potentially guarantees their loans. This limits the ability of the
banks to provide them with the required finance to grow their business. If for example, the
enterprise sought finance to invest in new machinery to speed up the packaging of a particular
drug, the risk of using the machine as collateral is that it is extremely specialised, and would
struggle to regain anywhere near the original value should it need to be seized to repay the
loan. As such, these loans will often be either refused, or provided at exorbitant rates, imposing
a further cost on the enterprise.
Inadequate supply of raw materials
The requirement of raw materials for the production of goods is often reflected in the location of
MSMEs. Due to their small size, they cannot purchase in bulk and therefore do not benefit from
economies of scale. Furthermore, they may need to buy on credit, leading to further costs and
thus often they choose to purchase locally. In addition, a survey of 200 manufacturing SMEs
found that 91% cited raw material sourcing as the second biggest challenge after access to
finance, showing that procurement of inputs can be as problematic as the purchasing process.
The inconsistencies in the supply of high quality domestic raw materials can lead to enterprises
looking to imports, which come at a cost. The process of establishing and maintaining an efficient
procurement route is key to continued growth and development of MSMEs. In particular, with
MSMEs losing certain elements of protection such as the reservation of drugs for the production
in the MSME sector, they will need to ensure that they are able to compete on other factors such
as price or quality. This rests heavily on the ability of the enterprise to efficiently source the
materials required.
Infrastructure
Sufficient capacity in every area of infrastructure proves a major stumbling block for MSME
growth. Obsolescent technology in the manufacturing of goods and lack of provision of transport
infrastructure can lead to low quality, high cost products. In both respects, there are modern
technology requirements.
The reality for many MSMEs is the lack of capital to meet these demands. In each example, the
initial investment required puts much of this technology out of the reach of small enterprises who
ultimately struggle to raise finance. This can result in MSMEs employing more labour intensive
practices which, due to low relative cost of labour, keep initial costs low, but stifles innovation,
development and progression. Thus due to a high labour to capital ratio, the marginal
productivity of labour is low on account of diminishing marginal returns. Inversely, the marginal
productivity of capital is high. There is therefore, a higher opportunity cost of using funds to
employ labour, as the returns from technological investment would be higher, representing
foregone revenue and growth possibilities.
Furthermore, infrastructure difficulties exist outside the manufacturing and development process
for MSMEs. Insufficient capacity in transportation network causes logistical difficulties and
imparts unnecessary costs. These problems include road conditions, lack of capacity in airports
and docks, poor intercity connectivity and a lack of the development in alternative inland
methods of transportation. Moreover, the infrastructure that is in place is not sufficient to
manage the capacity in the system, thus leading to bottlenecks which impart time delays and
higher costs. Considering that the logistics sector is equally fragmented, many of the firms are
not in position to take advantage of economies of scale, pushing costs higher and restricting the
possibility for established logistics networks that ensure consistency in service.
Inadequate Knowledge and Access to Markets
Success in a particular industry relies on a working knowledge of what the consumer wants, how
best to deliver, and where the market is going. This requires a level of managerial and
technological competence and the ability to conduct market research. These possibilities are
limited by the enterprises' resources, in terms of both skilled labour availability and the capacity
to allocate resources towards R&D. Many MSMEs also remain unaware of the benefits and
consistency of using online advertising to promote products, services and the brand as a whole.
In addition, due to the make-up of the small scale industries, many generate most revenue from
the local market and as such look towards narrow field advertising such as print and electronic
media to reach customer.
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