Opinion | Quick MSME loans can bear fruit, but interest rate subsidy is a bad idea

Some people are ecstatic after Prime Minister Narendra Modi announced a package for micro, small and medium enterprises (MSME) in India. Modi has promised them loan clearances in 59 minutes flat, disbursal within 10 days and concessional interest rates on borrowings. It was a great idea, but a flawed decision.

First, the caveats. There is no denying that MSMEs are the backbone of the Indian economy. They employ over 90 percent of the organised sector work force and account for over 90 percent of the total number of units.

Just look at the numbers. The Ministry of Micro, Small and Medium Enterprises' annual report for 2017-18 points out that this sector accounted for Rs 39 lakh crore of gross value added (GVA), or about 31.6 percent of the country’s GVA. Their importance is also underscored by the jobs they provide.

There are around 6.33 crore MSMEs, which account for 11 crore jobs. About five crore of these jobs are in rural areas. Obviously, MSMEs cater to a crucial sector of votes, especially in states like Uttar Pradesh, which accounts for 14 percent of all MSMEs.

The only dark cloud is that the rate at which they have been growing has been declining consistently. They grew by 15 percent in 2012-13, 12.3 percent in each of the two following years, and only 7.62 percent in 2015-16. Clearly, they needed incentives and a bit of prodding to accelerate their growth rate. Demonetisation had hit them very hard and so did the Goods & Services Tax (GST). The latter has increased their need for working capital because GST must be paid at the time of invoicing, even before the money comes into their kitty.

Still, there is no denying that many MSMEs have been weighing down the list of non-performing assets (NPAs) in India. They have become riskier for banks to lend money. Worse, the risk is growing each month. And that is why the idea of giving them loans at subsidised rates of interest is terribly bad.

People often forget that interest rate is a reflection of the risk that the borrower poses. The riskier the borrower becomes (either because of the industry, markets, or personal downturn in fortunes) the more will the interest rate climb. This is the market’s way to ensure that money is used carefully and all prudential lending is based on this principle. Violate this norm and you will end up creating a mess in the financial sector.

Just go back to the times before the 1990s when long term lending carried a lower interest rate and vice-versa. Any college student would have told you this was insane. Long term borrowing poses more risks than short term lending. I can predict I will go somewhere tomorrow as most appointments are fixed on this assumption of predictability. But I cannot say for certain that I will meet an appointment fixed for a particular day five years hence.

In the pre-1990 era, the interest rate structure was such that businessmen often borrowed for long term projects and then diverted the money for short term use. Banking was turned on its head. This was rampant and hurt banks terribly. Mercifully, this practice was ended.

Risk is the reason why, with other things being equal, long term borrowing always carries a higher rate of interest than short term. That is also why riskier loans command a higher interest rate than less riskier loans. Hence, interest rates for MSMEs should be determined by the risk they pose to the lender.

The trouble with interest concessions is that many businesses will spawn MSMEs, borrow money against them and divert money to non-MSME uses. It will be difficult for banks to monitor end-use because the numbers of MSMEs are huge. The constraints of bankers are many. As a result, such practices could lead to major problems for banks and for the rest of the economy.

So, how does one help out MSMEs? Two ways.

First, give them a tax break. Reduction of GST rates would be one good way. The government did toy with this idea in August, but gave it up because nobody could decide on the amount that should be borne by the state and how much by the Centre.

But that was an academic issue. Eventually, this is paid for by common taxpayers like you and me. But there is one difference. Since GST is paid on the basis of production of goods and services, there can be no diversion of funds. Lower interest charges actually encourage people to cheat. Hence, the reduced GST pinches taxpayers less severely than concessional interest rates.

A second way would be to encourage MSMEs to go in for credit ratings. This way they learn how to reduce their risk profile. They become eligible for lower interest rates – not as a favour from the government but because they deserve it.

Together, both reduce the financial burden on MSMEs and contribute to the health of the economy.

Banks are already weakened by bad loans. Concessional interest rates and forcing them to increase their allocation of funds to MSMEs from the existing 20-25 percent is not a wise way of strengthening the banking sector.

The author is Consulting Editor with Moneycontrol.com