Bridging the gap: Financing MSMEs

– This article was originally published by Bidhyalaxmi Maharjan in the Himalayan Times on September 01, 2019.

Micro, small and medium enterprises (MSMEs) are often the creation of enterprising individuals, who offer innovative services and products to the people.  They make optimum use of locally available resources and skills to provide much-needed solutions to the market. In developing economies like Nepal, MSMEs play an important role in poverty alleviation, employment generation, and economic growth acceleration. According to the International Finance Corporation (IFC) estimate, MSMEs offer employment to 1.75 million people in Nepal and account for 22% of the country’s GDP. Despite such valuable contributions to the economy, lack of access to finance has crippled the growth of MSMEs in Nepal.

Any business needs capital to roll out their services and products in the market, to expand its operations and additional capital injection to scale up. The need for financing never ceases. Thus, MSMEs turn to financial service providers, such as banks and financial institutions (BFIs), for loans. However, a large number of MSMEs face challenges in accessing such credits from formal lenders. The conventional lending practice in Nepal is based on securing immovable assets, primarily land and buildings as collateral. Since many MSMEs do not have property sufficient to obtain credit, their access to formal credit is limited.

In Nepal, a 2018 survey estimates that there is a deficit US $3.9 billion in the credit supply compared to the demand from MSMEs. The significant gap in MSME financing is tied to several challenges on both demand and supply side. The lack of collateral and poor financial documentation among MSMEs are some of the challenges on the demand side, whereas the supply side is hindered by inappropriate MSME lending models and credit appraisal.  As a result, MSMEs are directed towards informal lenders, such as family and friends or use their own funds. They end up paying higher interest rates with shorter repayment periods than with formal credit. This not only leads to stagnation of business growth but BFIs also lose out on revenue opportunities.

The growth of MSMEs is linked to the growth of the economy of the country. The government has introduced various interventions to increase MSMEs’ access to finance through BFIs. Nepal Rastra Bank has mandated BFIs ranked A, B, and C to assign five percent of their credit portfolio to women, Dalit, Janajati, rural farmers, etc. under deprived sector lending.  Many BFIs practice wholesale lending, whereby they provide loans to a microfinance institution that lends to the targeted group. Similarly, BFIs of class A, B, and C are required to lend, 25, 15 and 10 percent of loan portfolio respectively, to Priority Sector, which also includes small and medium enterprises. Despite these policies by NRB, the credit gap in MSMEs has not reduced. So instead,  the government could implement the following market-oriented policies and programs aimed at improving MSMEs’ access to finance:

Entrepreneurs can obtain credit against movable assets, such as machinery, equipment, vehicles, livestock, agricultural produce or receivables with the inception of Secured Transaction Registry Office (STRO). The Secured Transaction Act 2006 has finally come into effect with the introduction of Secured Transaction Regulation 2017 and the establishment of STRO with the Credit Information Bureau.   According to the annual report of Credit Information Bureau 2018, the majority of the users of the collateral registration service were commercial banks, with more than 95% of the total registrations. The report states that some commercial banks have started aggressive lending against movable assets. However, the limited use of collateral registry service by MSMEs indicates a lack of information on the availability of such service.   Thus, the government should promote the service amongst MSMEs and individuals so that they can leverage their movable property to acquire loans.

Although the unmet demand for finance is a business opportunity, many BFIs are reluctant to lend to MSMEs due to the perceived high risks. Thus, one of the interventions can be initiating a credit assessment of MSMEs to evaluate their creditworthiness. As the credit rating market is in its nascent stage in Nepal, with only two private firms, the government could establish a credit assessment institution as a private-public partnership. Such an assessment can offer an accurate picture of risks involved in lending to a particular MSME and provide much-needed assurance to lenders. The institution could be later registered as an independent company.

Unless MSMEs across the country have easier access to finance in different phases of their business, touting them as “the engine of economic growth” will only prove to be a gimmick. Thus, it is worth looking at alternative solutions to meet their financing needs, other than direct interventions on the capital market.