Remarks by George Deikun, USAID Mission Director at the MSME Credit Guarantee Consultative Conference at Trident Hotel, Mumbai.

July 08, 2008

USAID Mission Director George Deikun speaking at the MSME Credit Guarantee Consultative Conference at Trident Hotel, Mumbai on July 8, 2008. Photo Credit: IBA

It is a pleasure to be here this morning to open this conference. First, I would like to thank Small Industries Development Bank of India, the Indian Banks’ Association, GTZ, IFC and the World Bank for partnering with USAID to organize this event. On behalf of USAID, I extend a warm welcome to you all.

India’s Economy has been growing spectacularly in recent years. Despite this growth over two-thirds of India’s workforce continues to be employed in agriculture sector whose contribution to India’s GDP is less than 20%. Unlike other rapidly growing Asian economies, a substantial shift in the deployment of labor force to manufacturing and services sectors is yet to happen. Continued sustainable high growth rate of the Indian economy will depend to a large extent on India’s ability to create new enterprises and generate employment in non-agricultural sectors. In other words, it will depend on the ease with which Small and Medium Enterprises or SMEs can be started and financed, given their large contribution to the economy.

SMEs are the dominant form of business in all countries worldwide. All of us have heard of Microsoft and Dell Computers. The stories of these large international businesses are as well known as their products. What we forget or don’t realize is that they started on a very small scale with not much more than an entrepreneur’s vision. These erstwhile SMEs have grown into global companies in the process creating jobs, generating income and thus making a contribution to economic growth in the countries in which they operate.

SMEs make up for over 99% of all enterprises in U.S., U.K. China, Japan, Brazil, South Korea and many other countries including in India. They account for over 50% of employment and over 40% of total value-added in these countries. Micro-businesses (those with fewer than 10 employees) dominate employment in countries such as Italy (47%) and Poland (41%), whilst the share of large enterprises in total employment in the United Kingdom is just 46%. In fact, small businesses are the real giants of many developed economies.

What is it that contributes to SMEs growth in some economies? One can think of three major factors – rich entrepreneurial resources, an inclusive financial system and a conducive legal and regulatory environment.

India is fortunate to have been endowed with strong entrepreneurial activity. According to a report by Global Entrepreneurship Monitor, India’s economy is experiencing an exceptionally high rate of 18% (defined as the percentage of the adult population currently setting up a business/managing business) second only to Thailand (19%) among 37 countries.

India’s legal system is reasonable robust, the legal and regulatory burden on business is high though. According to a World Bank report it takes on an average 11 procedures, 89 days and 49% of the income per capita to start a business in India. In comparison, it takes 6 procedures, 27 days and 85 of income per capita to start business in OECD countries.

But it is the access to credit that is the greatest obstacle faced by SMEs in many countries including in India. Instead of relying on the bank, SMEs tend to rely on informal sources of funds such as family, friends, supplier credit and customer advances. Commercial banks prefer governments and large enterprises, thus crowding out SMEs. The World Development Report 2005 indicates that small firms obtain only 19 percent of their financing from external sources while large firms meet up to 44 percent of their financing needs through external sources. This is largely due to higher costs of collecting and analyzing information for relatively small loan sizes, unreliable financial and accounting related information, and absence of credit information bureau exacerbated by policy-induced distortions.

In order to provide low cost credit to SMEs, governments are sometimes tempted to mandate below-market interest rates for SMEs, but this usually causes more problems than it solves. Low rates make lenders less willing to lend to SMEs due to their intrinsically risky nature. The removal of interest rate controls in Indonesia in 1983 allowed banks to experiment with new financial products, which enabled them to expand their outreach and meet the demand of many SME clients.

In addition to high transaction costs and poor quality of available financial information about SMEs, banks are not comfortable lending to this segment due to lack of collateral, low level of technical and management skills and high percentage of SME business failures.

It is not hard to see why banks behave the way do while lending to SMEs. Banks are in business, like anyone else, to make profits for their shareholders. But they also have a duty to their depositors and thus are quite naturally averse to taking undue risks.

Ideally, a bank would expect its small business customer to have well-established systems for gathering information and forecasting and keep it informed of enterprise’s financial position and prospects. However, the vast majority of small enterprises are unable or unwilling to provide such information and, therefore, a bank is obliged to deal with them as it finds them.

In order to expand SMEs’ access to finance on larger scale, it is necessary to develop market-based approaches. India’s reasonable well-developed financial system comprising of a vast network of banks and capital markets could provide some market-based solutions which are commercially viable to mobilize private sector investment into the SME sector.

The mechanisms of loan guarantee, credit enhancement and securitization offer some really good options. Of these, the loan guarantee programs are most widely used mechanism in many jurisdictions to ease SMEs access to finance. There are a variety of reasons why countries establish loan guarantee programs. They range from the "lenders of last resort" rationale to support failing small businesses to programs that augment the financing that is already available. The countries that have used loan guarantee and risk sharing programs primarily to augment the financing available to small business include Canada, France and the United Kingdom. The loan guarantee programs in these countries are administered almost exclusively through financial institutions. In Canada, the loan guarantee administration is not involved in reviewing of loan applications. The administration gets involved when a claim for the loss is submitted.

The federal loan guarantee systems of the U.S. and state-run programs such as the one in California are based on "lenders of last resort" rationale. In order to avail the facility under the program an applicant is required to have been officially "turned down" for financing by commercial financial institutions. In contrast to Canada, the Small Business Administration (SBA) in the U.S. reviews individual loan applications.

Other countries primarily seek to provide funding to small businesses that would otherwise fail. An example of such a program is Japan's Credit Supplementation System. The primary objective of the Japanese guarantee program is to prevent bankruptcy of SMEs because the banking system would shy away from making loans to a failing enterprise. Two public sector institutions, the Japan Development Bank and the Japan Finance Corporation, administer the guarantee program. The Japanese government also provides the ultimate guarantee through the Small Business Credit Insurance Corp. Italy and Poland use mutual guarantee mechanism to provided access to credit to particularly small and micro-enterprises.

The structure of loan guarantee scheme in a jurisdiction also responds to the structure of the financial system and the local needs. For example, in Japan, banks provide most, if not all, of the available financing. In the U.K., four large banks provide more than 80 per cent of the financing for SMEs. This is quite different from Canada; where banks contribute provide around half of the available SME debt financing. India should develop its guarantee program keeping in view the strengths and weaknesses of its financial system and the needs of SMEs.

USAID has a global loan guarantee program called the “Development Credit Authority or called DCA”. USAID missions in developing countries use DCA to mitigate the perceived risks of lending to underserved clients. The guarantee program covers up to 50% of a private lender’s risk in providing financing. In the eight years since the program became operational, USAID missions around the world have used the DCA to structure almost 200 partial credit guarantees in 54 countries to enhance access to finance by nearly $1.3 billion in sectors as diverse as SMEs, microfinance, water and sanitation, health, energy efficiency, agriculture and housing. USAID program has mobilized nearly $400 million of private sector financing for SMEs.

The guarantees are very often in conjunction with a mission’s technical assistance (TA). The TA is intended to help transfer knowledge to the lending institution to support them in learning to analyze loan requests from new sectors and for new borrower activities.

In India, USAID in partnership with the Financial Services Volunteer Corps (FSVC) and the Chennai-based Institute of Financial management and Research has been working with several banks to help expand loans to SMEs. The USAID supported program provides targeted technical assistance and short-term training in global best practices to Indian bankers. Under the program senior level officials from international banks and regulatory institutions deliver specialized workshops and seminars and provide tailored consultations with select commercial banks focused on the practical use of credit scoring models for SME credit evaluation, credit risk measurement and small business lending.

I hope the issue of what works and what does not work in SME loan guarantee programs will be discussed in greater detail over the course of today’s agenda. I hope the conference will provide an opportunity for banks, financial institutions, the regulators and the policy makers in the government to think, discuss and understand the issues better. Several institutional ingredients that are needed for a successful SME loan guarantee program already exist—high level of entrepreneurial activity, a robust banking system, a vibrant capital market, and a functional legal system. I hope today’s event will help build from here forward.

Thanks You