That apart, new regulations related to labour, environment and corporate governance alongwith technological changes being ushered in, in this century, have significantly added to costs. The worst impacted are the smaller enterprises with limited resources.

While bank advances to MSMEs have shown a growth, the overall credit gap has also expanded to about Rs 30 lakh crore, indicating severe funding strains for the sector.

One solution being touted by many experts is a specialised bank for MSMEs. Though a SIDBI  exists, its mandate is limited to development work and it is unable to hand hold the sector in the manner required in tough times of uncertainity induced by global events like the Red Sea crisis or technological obsolence, experts said.

A Crisil report in February said formal credit penetration in the sector stands a mere 20 per cent, one of the lowest in Asia implying the sector was still stuggling with high cost and risky informal credit from loan sharks and other native 'bankers'.

The credit shortage has also led to these MSMEs shying away from upgrading their technology. A  World Bank study, estimated that the gap between potential credit demand and actual flow was about $230 billion, representing 68 per cent of the total gap in the South Asia region. 

This, limited credit availability also impedes the ability of domestic MSMEs to innovate and make technological and digital upgrades. According to another World Bank report, research and development allocation of 0.6 per cent of GDP in India in 2023 was well below the global average of 2.6 per cent, underscoring an urgent need for further investments to upgrade domestic technological and digital capabilities.

Bank credit to MSMEs

Though the Reserve Bank of India’s (RBI) revised and reviewed guidelines on priority sector lending (PSL) is aimed at unlocking credit flow into MSMEs, the stringent regulatory norms pertaining to non performing assets (NPA), mandating banks to raise an early warning alarm on any delayed payment of interest or principal amount has hurt rather than help the MSME sector.  

Bank credit to the micro and small enterprises for April 2024 grew by 15.6 per cent year on year when compared to the same month in the previous financial year. Advances to medium enterprises grew 13.3 per cent year on year in April.  In May, the growth in advances for both micro and small enterprises and medium businesses was at 15.5 per cent year on year.   

Regulatory Guidelines

A red flag is raised in case of a delay in paying back loans beyond 30 days, after which an account is treated as a special mention account (SMA). In the case of small businesses, this happens quite often as payments are delayed or credit lines get extended, leading to temporary cash flow problems.

However, large formal sector monolith banks are unable to understand or live with these problems and are often caught in red tape. “Once an account figures in SMA, the account becomes a pariah both inside as well as outside the bank causing even the normal banking operations to come to a grinding halt.

"This is creating false alarms and even resulting into forced closures,” Anil Bhardwaj, secretary general, Federation of Indian Micro and Small and Medium Enterprises (FISME) said in a note.

Financing challenges for this critical sector, considered a pillar of economic growth, is growing despite several government-led schemes such as the PM Vishwakarma Scheme, Prime Minister’s Employment Generation Programme and Emergency Credit Line Guarantee Scheme among others. That apart, the Pradhan Mantri Mudra Yojna is also in place to support the non-farm micro and small businesses.

Analysts pointed out the liquidity issue coupled with inflexibility on the part of formal banking channels in dealing with small businesses means that many of them are unable to realise their potential and scale up. 

Few Indian MSMEs Make It To Big League

A recent study conducted by McKinsey Global Institute showed that in India only 11 per cent of entities categorised at MSMEs in 2000 managed to scale up to the big league. In Indonesia it was 31 per cent, in UK 18 per cent and US 17 per cent.  

“Indeed, previous MGI research found that India has a “missing middle” of mid-size companies.14 MSMEs have faced structural barriers, such as the high cost of compliance and finance, that have tended to constrain their growth,” the study said.

Also as a result - though MSMEs create enormous value for economies around the world and account for roughly half of global GDP, that share varies significantly. In Portugal, Israel, Indonesia, Italy, and Kenya (ordered by decreasing share of value added), the share is larger than 60 per cent, in India, it is less than 40 percent.

All eyes on the Union Budget

While allocation of resources to the MSME ministry has been rising, it is time for the government to take steps to boost this labour-intensive sector.

Finance Minister Nirmala Sitharaman is expected to make key announcements to support the MSMEs. Though the industry has underlined the need to set up a niche MSME bank to support lending, insiders said that there could be a reclassification of MSMEs as well. The bank, much on the lines of a commercial lender, could be supported by SIDBI with other public sector banks and government undertakings as stakeholders.

Many MSMEs fail to provide the adequate collateral while falling short of credit worthiness standards. “With these constraints, it becomes difficult for a scheduled commercial bank to extend credit as it has to maintain its own checks and balances but the lending norms of the MSME bank, if proposed will be different,” finance ministry officials said, adding that setting up of a full fledged lender will take time.

“If at all the Budget proposes setting up of an MSME bank, it will not happen immediately but with stagnating wages and rising unemployment, the need of the hour is to carve out measures urgently,” he however said.

Other measures being toyed with include strengthening SIDBI by pumping in more capital. Coming up with plans for targeted lending to address the needs of weaker borrowers and geographies were MSMEs were at greater risk and encouraging banks to move to cash-flow based lending, are also moves being considered, North Bloc top brass said.

A cash-flow lending system required that loan requirements are assessed based on information on actual revenue generation and repayment capacities rather than the usual norms of SMA red flags etc.

Until the MSME sector is given its due, touching the $5 trillion economy mark will not be easy.