India is now a country of over 100 million micro, small and medium enterprises (MSMEs) following the inclusion of retail and wholesale trading in the MSME category by the government last year. This means the fortunes of over 25 per cent of the households are linked to any policy changes related to MSMEs.

Over 47 per cent of micro enterprises and 53 per cent of SMEs have adopted digital sales platforms according to a CRISIL report. Another report assessed that over 65 per cent MSMEs have incorporated WhatsApp and video conferencing like digital tools into their daily business operations.

Use of digital mediums for payment collections, online sales by MSMEs, GST transactions have seen between 50-100 per cent growth over the last few years. Despite all this, the fact is that over 90 per cent MSMEs in India are Micro in nature (turnover of less than ₹5 crore), don’t have enough turnover to fall under the GST or other taxation ambit and don’t maintain formal record keeping of their finances. They still rely on savings, friends, family and money lenders for meeting seasonal exigencies for working capital or growth capital and fall short of requirements most of the time.

As per a Global Findex report, only 8 per cent of India’s population borrowed money from formal sources and this may not be a result of choice, given that informal funding is costly and at times considered embarrassing.

Over the last five to six years, digital lending has gained significant prominence, bolstered by the success of strong government payments infrastructure, burgeoning e-commerce sales and customer base and thus, more than 50 per cent of the new Bank accounts opened in the last five years, have been by Fintechs.

The RBI has promoted multiple sandboxes to propel innovation in the MSME space. Further, NITI Aayog’s recommendation on digital banking for businesses are examples of policy level thinking for the betterment of the MSME sector.

The digital lenders have truly brought inclusion and formalisation of credit to the fore by providing widespread access to information, availability, transparency and hassle free experience. They use data backed surrogate underwriting tools and cash flow based assessments to sachetise the lending size and use cases.

MSMEs can now access loans based on their purchase and sales, discount their invoices, borrow against their machinery or even pledge bullion digitally. Data suggests that digital lending is one of the fastest-growing fintech segments in India and it grew exponentially from a volume of $9 billion in 2012 to $110 billion in 2019 and is expected to grow to $350 billion by 2023.

According to the Global Findex report 2021, distance to financial institutions, lack of trust, and lack of need were the most commonly cited reasons for formal banking account inactivity in India. Adequacy and timeliness of funds are equally prominent reasons.

India’s private debt to GDP ratio is amongst the lowest in the world and needs to really expand to contribute to the GDP per capita. Digital lending has both the potential to solve most of the challenges mentioned in the aforementioned report due to the ability to use the new age ML and AI architecture to disseminate credit efficiently, minimising frauds and errors.

Embedded finance and ONDC

Embedded finance, as a category, now enables merchants to take real time loans during the purchase and sale journeys. It is becoming a boon to many small outlets that can stock more, sell and pay to the lenders once sale is done versus requirement of upfront cash in the past.

Payment collections in industries like Textiles and Chemicals have significant challenges and invoice backed financing propositions by the Trade Receivables Discounting System (TREDS) ecosystem and digital lenders are bringing discipline and unlocking significant cash flows stuck in the working capital.

The recently announced Open Network for Digital Commerce (ONDC) is a promising framework that can take MSME credit and their effectiveness to the next level. The RBI is taking measured steps in both encouraging digitisation of the lending processes and at the same time checking on the data and customer centricity components to ensure sustainable growth of the ecosystem.

That said, the penetration of formal credit for MSMEs has fallen significantly short of potential. The MSME credit culture in the country has a history of higher delinquencies that have further precipitated with demonetisation, GST, IL&FS crisis and the continuing Covid pandemic, breaking the backbone of this segment.

Cost of funding for the digital lenders remain elevated as banks and NBFCs are charging significantly high rates for such onlending, making low cost funding to MSMEs difficult. The availability of consent based digital data like GST, banking information, transaction data is still in its nascent stages, making it difficult to underwrite thin files, even with surrogate data. The Business KYC process is still a high friction process versus the consumer KYC and is an area that needs attention to viably expand small size credit to MSMEs. The prospects for MSMEs getting affordable access to finance are bright due to continued governmental focus on making these enterprises competitive, digitisation of trade records like GST and digital payments, and schemes like Mudra and CGTMSE by SIDBI.

Fintech players are now tapping low cost funds via the co-lending mechanism and this can be the game changer in the near future for MSMEs. A lot more support is required from the government and the stakeholders in encouraging digital lenders and digital lending on the lines of priority sector lending and initiatives like UPI.

Digital lending can unlock a very strong culture of formalisation in the economy that has far reaching benefits.

The industry needs to focus on MSME education relating to benefits of formal finance, better litigation mechanisms for managing wilful defaulters and early warning signals, stronger banking-fintech partnerships to provide inclusive finance as enablers for the digital credit revolution for MSMEs. This is very important for propelling the country towards the goal of becoming a $5 trillion dollar economy and beyond.

The author is Co-Founder of FlexiLoans.com