Credit guarantees to MSMEs: What are they and how will they help

Finance Minister Nirmala Sitharaman addresses the press in New Delhi on Wednesday. (Express Photo: Anil Sharma)

Finance Minister Nirmala Sitharaman announced some details of the Atmanirbhar Bharat Abhiyan economic package on Wednesday. This is the second tranche of the package that includes past actions by the Reserve Bank of India as well as the first Covid-19 relief package announced during March and April.

The main thrust of Wednesday’s announcements was a relief to Medium, Small and Micro Enterprises (MSMEs) in the form of a massive increase in credit guarantees to them. There was, however, very little actual fiscal outgo that was announced. (Read highlights from Sitharaman’s press conference)

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In other words, instead of directly infusing money into the economy or giving it directly to MSMEs in terms of a bailout package, the government has resorted to taking over the credit risk of MSMEs should they want to remain in business. These credit guarantees should help the formal banking system meet the credit demand of the MSME sector (see Chart 2).

What are credit guarantees?

Loans to MSMEs are mostly given against property (as collateral) because often there isn’t a robust cash flow analysis available. But in times of crisis, like the one currently playing out, property prices fall and this inhibits the ability of MSMEs to seek loans. It also means that banks are less willing to extend loans.

A credit guarantee by the government helps as it assures the bank that its loan will be repaid by the government in case the MSME falters. For instance, if the government provides say a 100% credit guarantee up to an amount of Rs 1 crore to a firm, it means that a bank can lend Rs 1 crore to that firm; in case the firm fails to pay back, the government will make good all of Rs 1 crore. If this guarantee was for the first 20% of the loan, then the government would guarantee to pay back only Rs 20 lakh.

Why credit guarantees?

Even before the Covid-19 crisis, Indian government finances were in poor health. This pandemic has meant that government revenues will come under further pressure. For instance, experts are already talking of a GDP contraction of 5% to 10% in the current financial year. That will result in a revenue loss of anywhere between Rs 5 to 7 lakh crore. And yet, this is also the year when employees and firms want the government to help them out financially.

Efforts to pump liquidity via the banks have been a non-starter because banks simply do not want to lend any new money. Banks, quite justifiably, suspect that any new loans will only add to their growing mountain of non-performing assets (NPAs).

So the government was facing an odd problem: Banks had the money but were not willing to lend to the credit-starved sections of the economy, while the government itself did not have enough money to directly help the economy.

The solution — credit guarantees — finally chosen by the government is not a new one, because this fiscal conundrum is not a new one either (Chart 3).

So, what is the quantum of credit guarantee provided to MSMEs?

There are three proposals but the main one is for standard MSMEs — that is, those MSMEs which were running fine until the Covid-19-induced lockdown disrupted their work.

For these, the government has provided a credit guarantee of Rs 3 lakh crore. This is like an emergency credit line, said the Finance Minister, and it is for MSMEs that have an already outstanding loan of Rs 25 crore or those with a turnover less than Rs 100 crore. The loans will have a tenure of 4 years and they will have a moratorium of 12 months (that is, the payback starts only after 12 months). The loan should be taken before October 31, 2020.

According to Hetal Gandhi, Director, CRISIL, “if there is an MSME which had a loan (up to Rs 25 crore) with any bank or NBFC and if, as a result of the Covid-19 crisis, this MSME needs more funds then it can take more loans, without the need for any collateral, because the government will guarantee such loans fully.”

Why Rs 3 lakh crore?

Gandhi said the total outstanding loan to MSMEs by the banking and NBFC sector would be around Rs 16 to 18 lakh crore. Assuming that 80% of these loans are working capital loans where there would be a 20% incremental funding needs, that gives an amount of approximately Rs 3 lakh crore. So the government is hoping that this credit guarantee will help those MSMEs take out another loan and recover: The hope is that since these MSMEs were able to pay back before the crisis, there is no reason why they cannot after the crisis, provided they are given some extra money to survive this period.

The main thrust of Finance Minister Union Sitharaman’s announcements has been the massive increase in credit guarantees to the MSMEs. (Express Photo: Anil Sharma)

What are the other measures?

There is a subordinate debt scheme, worth Rs 20,000 crore, which will allow loans to MSMEs that were already categorised as “stressed”, or struggling to pay back. In this case, the government’s guarantee is not full, but partial.

The third measure is the creation of a fund with a corpus of Rs 50,000 crore to infuse equity into “viable” MSMEs, thus helping them to expand and grow. The government intends to put in Rs 10,000 crore and get others, possibly institutions like LIC and SBI, to fund the remaining amount.

Then there is a change in the definition of an MSME that was pending for long. Now MSMEs will be judged on turnover and there will be no difference between a manufacturing MSME and a services MSME.

How far will these measures help?

The Rs 3 lakh crore credit guarantee is the most substantive announcement as it will most likely have a significant impact in helping MSMEs pay salaries and keep their heads above the water even as the economy slows down.

According to the Finance Minister, this measure will help as many as 45 lakh MSMEs. While this is a minuscule proportion of the overall number of MSMEs, these are likely to be the medium and small enterprises, which employ almost 40% of all employees — although these enterprises themselves are very few in number (just about 0.5% of all MSMEs).

The change in definition of MSMEs will also help because “turnover” is the more efficient way to identify an MSME and it also allows a lot of firms, especially in the services sector like mid-sized hospitals, hotels and diagnostic centres to be eligible for benefits as an MSME.

The other two steps are unlikely to make a huge dent in the overall scheme of things.

Are there any downsides to resorting to credit guarantees?

There are, especially if it is a 100% credit guarantee. That’s because such a guarantee leaves no incentive for either borrower to pay back — he has nothing to lose — or for the lender — the banker is assured of payback from the government so why should he bother to check if the borrower is deserving or not.

A more prudent option would have been a split (say an 80%-20%) wherein the government assures to pay back only 80% of the new loan. This circumvents the problem of a moral hazard.

As a result, it is quite likely that the government will have to start shelling out money in the next financial year when MSME NPAs rise once the moratorium is over.

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