Introduction
In today’s rapidly changing financial landscape, it's quite evident that Small and Medium-sized Enterprises (SMEs) act as a key catalyst in an economy’s growth. They not only contribute to employment generation but also play a significant role in a country’s GDP.
However, despite all the significance they hold, SMEs often grapple with a daunting challenge: The Finance Gap. The finance gap primarily refers to the difficulty SMEs face in securing funding from Banks and Non-Banking Financial Institutions(NBFI) in order to expand and sustain their businesses. In this blog we’ll delve into the intricacies of this financial discrepancy and explore potential solutions..
What are SMEs & Why are They So Relevant?
Before getting into the complexities, let’s understand the basics first. Small and Medium-sized Enterprises, often abbreviated as SMEs represent a diverse array of businesses which fall within a certain size range, typically defined by factors like capital invested, annual turnover etc. These businesses are smaller in comparison to large corporations but are characterized as per the following criterias:
Small Enterprise
Investment < Rs. 10 crore (US$ 3.1 million), Turnover < Rs. 50 crore (US$ 6.8 million)
Medium Enterprise
Investment < Rs. 50 crore (US$ 6.8 million), Turnover < Rs. 250 crore (US$ 34 million)
Source: Ministry of Micro, Small and Medium Enterprises
SMEs are global economic pillars, representing about 90% of businesses & 50% of employment worldwide (World Bank, 2020). In India, the SME sector with over 63 million enterprises, accounts for approximately 30% of the nation’s GDP in recent years & plays a crucial role in rural industrialisation at minimal capital cost (Agarwal 2023). In emerging markets, SMEs create 7 out of 10 formal jobs while also contributing to nearly 40% of India’s total exports (World Bank, 2020). This signifies that SMEs not only are pivotal in shaping the local economy but also address the pressing global demand. On the global avenue, SMEs are poised to generate the majority of the 600 million jobs needed by 2030 to absorb the growing global workforce (Weerakkody 2021).
As we examine the relevance of SMEs, it is clear that they are more than small businesses; they are the lifeblood of the economies, serving as engines of growth, prosperity & innovation.
Understanding the Finance Gap
Now that we understand the significance of SMEs for an economy, let’s address the key issue they face - The Finance Gap. The finance gap in SMEs is much more than just lack of funds; it is more complex with far-reaching implications.
By describing it as “more than just lack of funds”, it highlights that this problem encompasses various interconnected factors including economic, regulatory & structural elements. Finance gap or Credit gap at its core is the difference between the total addressable demand for external credit compared to the overall supply of finance from the formal sources.
Quantifying the Gap
In India, the formidable financial crisis is quite evident. An thought paper by an investment banking company Avendus Capital has shone light on the staggering credit gap of around $530 billion. What’s even more concerning is the fact that this gap has inflated over the past 5 years.
To put this in perspective, according to the latest data from 2023, India’s GDP is $3.75 trillion, with government spending of approxipatly $630 billion dollars equivalent to Rs 419 lakh crore. The $530 billion signifies the tremendous unmet demand for financial resources. Jun Zhang, Country Head-India at IFC, underscores the enormity of the issue, emphasizing that only a mere 16% of Indian SMEs receive financial support from the formal banking system. This means that over 80% of SMEs in India remain excluded from the formal financial system.
Across developing nations, SMEs face varying degrees of financial constraints. On average, 30% of SMEs in these regions grapple with access to financial resources. Sub-Saharan Africa has the highest proportion of financially constrained SMEs, at 54%, followed by South Asia at 50%. In contrast, Europe and Central Asia lead with 69% of unconstrained SMEs, while Latin America and the Caribbean follow closely with 68%. (World Bank, n.d.).
Factors Contributing to the Finance Gap
Understanding the root causes are essential inorder to provide effective solutions. SMEs find themselves ensnared by several challenges, making access to finance a formidable task. Banks often consider these businesses as high-risk customers due to limited collateral & financial history. This wariness translates into higher interest rates & more stringent lending criterias, discouraging SMEs to seek loans from the formal sector.
Additionally, the administrative processes & associated expenses for small loans for SMEs mirror those required for larger-scale enterprises, discouraging banks from catering to them. The hesitance of traditional financial institutions to serve these smaller enterprises has further exuberated the humongous gap.
Bridging the Finance Gap
Efforts to bridge the gap encompasses various strategies, like government initiatives or direct intervention from the government. Policy makers should consider market-oriented actions like improving credit information availability, implementing movable collateral laws, reforming insolvency regimes, strengthening legal & regulatory framework for factoring & leasing and fostering innovation-friendly environments for SMEs to flourish.
Fintech innovations and strategic partnership between traditional banks & fintech firms can also assist with financial inclusion of SMEs.
Role of Traditional Banks
In the recent changing landscapes, banks have stepped in to embrace collaborative efforts with non-banking financial institutions(NBFI). These alliances, often in conjunction with fin-techs, help in expanding access to finance for SMEs, streamlining the lending process & often cutting down the operational expenses.
Models such as co-lending, on-lending and securitization further simplifies the SME lending process. With integration of financial technology, the loan processes are streamlined, resulting in quicker approvals, reduced operational costs and competitive interest rates.
Moreover, banks are crucial in advancing SME growth by offering specialized collateral-free loans, with competitive rates, swift processing & flexible repayment options.
At Mintoak, we fully acknowledge the importance of this grave issue, & our efforts in addressing it are evident through our active collaborations with the banks. Through these initiatives, we are resolute in our mission to empower SMEs & help them flourish in this competitive ecosystem.
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