This piece of mine was published in The Economic Times on May 17th, 2017.
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%. 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.
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:
- 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 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.
- 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.
- 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 envelope with 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.
Aadhaar: Launched in 2009 but rolled out on a war footing only in 2015, Aadhaar is a unique identification number that every Indian citizen is issued. It is powered by a sophisticated technology platform that allows applications to verify the identity of any person on the basis of an Aadhaar number or biometric information such as a fingerprint or an iris scan. Aadhaar based e-KYC allows banks and other financial institutions to instantly onboard customers without cumbersome and expensive paperwork that is normally required during the onboarding process.
GST: GST is a game-changing tax regime that replaces a set of cascading taxes (e.g. excise duty, VAT, service tax), that often vary across states, with a uniform tax across the country. While this doesn’t, at first glance, seem to have anything to do with credit, it has deep implications for the credit landscape. In order for all 51 million MSMSEs in India to migrate to the GST regime, they will have to go digital. The level of digitization required for compliance with GST is very high, with businesses being required to digitally upload a tremendous amount of data ranging from input tax credits to B2B invoices. All this uploaded data valuable to lenders and can help them assess (and lend to) businesses. Thus, an important benefit of GST compliance is potential access to credit – something which most businesses don’t yet realize.
Bankruptcy Code and related laws: The Insolvency and Bankruptcy Code was adopted in 2016, creating a legal framework for liquidating insolvent businesses- something that has always been a long winded, cumbersome and expensive process that, on an average, takes 4.3 years . A plethora of laws used to cover this process, which involved courts and quasi-governmental bodies. This new framework streamlines the bankruptcy process, cutting down the time required to liquidate a business to 270 days. It has also enabled amendments to the Banking Regulation Act, that lets the government and RBI intervene to force banks to resolve NPAs.
PM Jan Dhan Yojana: PMJDY, the flagship financial inclusion scheme, enabled the opening of 285 million bank accounts for the unbanked over a period of about 3 years. These bank accounts let people build up a transaction history, access financial services and eventually credit.
Demonetization: The withdrawal of the legal tender status of specified Rs 1,000 and Rs 500 notes and the subsequent remonetisation exercise has been discussed threadbare for months. While the jury is still out on whether the stated aims around the curtailing of the black economy, disruption of terrorist financing and extinguishing of black cash were achieved, what is beyond doubt is that this exercise has led to a sustained spurt in digital transactions and altered user behaviour significantly by accelerating the adoption of UPI based applications, digital wallets, PoS machines and traditional online banking.
PM MUDRA Yojana: The MUDRA Yojana facilitates the provision much needed credit to micro and small enterprises by refinancing bank loans and MFI loans made to micro-entrepreneurs. In FY 2017 alone, Rs 1.22 lakh crore  ($187 million) worth of loans were refinanced under this scheme. This number is set to rise to Rs 2.44 lakh crore in FY 2018.
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 demonetization 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.
Ashwini Anand, CFA is the Founder of Monsoon CreditTech, a FinTech startup that enables lenders to leverage advanced artificial intelligence to make better credit decisions.