No economist would disagree with the statement that credit is a key fuel for economic growth, without which, normal economic activity would be virtually impossible. What is equally indisputable is that the Indian economy in general and Indian small businesses (MSMEs) in particular, have been credit-starved for decades.
Case in point - India's credit to GDP ratio stands at a modest 60%, compared to China's 209.5%, UK's 164.3%. and USA's 152.3% says BIS. This implies that individuals and businesses are struggling to get credit- a fact underscored by India's low household (12.9% of GDP) and corporate (56% of GDP) debt levels. Further, India's small businesses stared at a credit-gap of 56% of demand in 2014, as an estimated 92% of them lacking access to formal credit, says an EFL study.
The Problem: Why India is credit-starved
While inadequate capitalization of banks, excessive regulatory oversight and issues around the rule of law are often cited as reasons for bankers being unwilling to lend liberally and take risks, I believe that the following framework is useful for analysing the problem:
1. Bad-debt laden books: Banks in India have a very high rate of stressed assets (12.3% of advances according to RBI data). This requires them to set aside 100% of value of the unsecured portion and between 25% to 100% of the secured portion of the value of these stressed assets as provisions, thus impairing their ability to lend. Further, it is very hard for a bank to get rid of a bad loan since Asset Asset Reconstruction Companies that buy out these bad loans are few and far between. The legal framework consisting of the Banking Regulation Act and the SARAFESI Act has traditionally limited the capability of banks to resolve stressed assets, thus dampening their ability to take risks and bring more people under the credit umbrella.
2. Lack of high-quality borrowers with adequate credit/transaction history: Bankers lack high-quality data on the basis of which they can lend to a person. Just 21.4% of all Indians, according to the World Bank, had credit histories (in 2014) and a mere 52.8% of Indian adults had bank accounts. Therefore, the overwhelming majority of Indians have been outside the formal credit system and had to rely on small money lenders (who charged exorbitant interest rates) and microfinance companies for credit.
3. Identity and documentation linked issues: In the absence of a robust identity verification mechanism, onboarding new borrowers and ensuring that their documentation is genuine, has been a major challenge. A variety of documents ranging from PAN cards, ration cards and driver's licenses are used in the onboarding process. This makes de-duplication and fraud detection a tremendous challenge, thus restricting the ability of the financial system to push the respect to financial inclusion.
However, all this is set to change in the medium term as a result of an unlikely convergence of a series of seemingly unrelated policy initiatives.
Government Policy Initiatives
Unified Payments Interface (UPI): UPI is a technology platform, that is built on the IMPS framework, that enables any entity to instantly and securely transfer money to another via their mobile phone. This platform can be leveraged via any payments application or via the BHIM app that was developed by NPCI (the organization behind UPI). Aadhar Pay, that uses the Aadhar database and infrastructure to allow merchants to instantly accept money from customers via a finger-tap, completes the set of UPIs based payment channels that enable instant payments.
Impact of these policies on the credit economy & MSMEs
While the Jan Dhan Yojana ensured that virtually every Indian has access to a bank account, the demonetisation exercise ensured that almost everyone with a bank account used it to deposit/withdraw money. UPI, along with the BHIM app, makes it easy for people to transact using their bank accounts and mobile phones, thus creating a tremendous amount of digital exhaust.
Aadhaar ensures that banks can easily verify the identity of a person and onboard him without all the associated paperwork, thus cutting down the risk of fraud and minimizing the friction associated with the process. The result is that, over the next few years, virtually every adult Indian will have a reliable data-trail on the basis of which, his creditworthiness can be assessed.
Migration to the GST platform will ensure that every MSME goes digital. This will open up a treasure trove of verifiable data, which will allow banks and NBFCs to leverage. Machine learning and data science can be applied on this data to enable the identification of creditworthy borrowers for banks to lend to.
The MUDRA Yojana is providing banks and NBFCs, through refinancing, the capital required to lend to the MSMEs while the new legal framework will soon make it possible for lenders to resolve NPAs in an efficient and time-bound manner. As soon as it becomes apparent that this new set of MSME and retail borrowers are creditworthy, foreign and domestic private capital will pour in, flushing out any supply side bottlenecks.
This unlikely convergence of policies has opened up and will, over the course of the next 2-5 years, continue to open up virtually unlimited opportunities, particularly for MSMEs, that will likely fuel a sustained credit boom, thus transforming the face of, not just the credit economy, but the overall economy.