In the run-up to the general election next year, the Centre has announced an important credit stimulus package for micro, small, and medium enterprises (MSMEs). Among the many sops doled out under the new scheme, Prime Minister Narendra Modi has promised the sanction of business loans of up to ₹1 crore within a time frame of 59 minutes, in order to encourage faster credit flow to MSMEs. These companies will also receive an interest subvention of 2% under the scheme and support from public sector units, which will now be mandated to make at least 25% of their overall purchases from MSMEs. It is worth noting that MSMEs, which account for 30% of India’s gross domestic product (GDP), were hit hard by the twin shocks of demonetisation and the implementation of the Goods and Services Tax over the last couple of years. Further, in the aftermath of the IL&FS crisis, which has affected the amount of lending done by non-banking financial companies to the MSME sector, the government would be looking at the scheme as a tool to improve credit flow and the pace of job creation in the economy. A study by officials of the Reserve Bank of India in August 2018, however, showed that growth in credit flow to MSMEs had recovered to pre-demonetisation levels by the April-June quarter, just before the liquidity crisis.
The scheme has signs of state-led economic planning written all over it. The biggest risk of a credit stimulus is the misallocation of productive economic resources. Pumping extra credit into MSMEs now may well lead to a temporary boom and enable a feel-good atmosphere in the run-up to elections, but it can lead to a painful bust when the stimulus ends some day. Another unintended consequence is the likely deterioration in credit standards as financial institutions are pushed to lend aggressively to MSMEs. Efforts to expedite business loan approvals may be welcome from the point of view of growth and job creation, but they rarely end well when motivated by political reasons. Conceptually, the Prime Minister’s latest credit scheme is no different from the MUDRA loan scheme, which has been troubled by soaring bad loans. In September, former RBI Governor Raghuram Rajan had warned that loans extended under the MUDRA scheme could turn out to be the source of the next financial crisis. Care needs to be taken to see that the new MSME loan scheme does not pose a similar risk in the future. Also, the demand that PSUs must procure a quarter of their inputs from MSMEs could breed further inefficiency in the economy. In all, the MSME loan scheme is yet another example of how bad economics can make for good politics.