Supply chain financing can help solve small business challenges

DEVEX
Himanshu Chandra

Workers at a seafood processing factory in Can Tho, Vietnam. Micro, small and medium enterprises, also known as MSMEs, are the largest employers across the world. Photo by: International Labor Organization / CC BY-NC-ND

According to the World Bank, 600 million jobs are needed in the next 15 years to absorb a growing global workforce. Most jobs in emerging markets, specifically in Asia and sub-Saharan Africa, are created by small and growing businesses. These businesses, also known as MSMEs, are the largest employers across the world, with some estimates showing that 90 percent of businesses worldwide are small and medium enterprises.

MSMEs significantly contribute to the training of the unskilled and semiskilled workforce, providing many of the 71 million unemployed youth worldwide with jobs. These MSMEs not only play a critical role in reaching the underserved consumers and employees, but are also necessary for the stability and sustainable growth of the global economy.

In emerging markets, MSMEs are even more crucial for continued economic growth. In India alone, MSMEs employ 69 million people, while also playing a critical role in reaching underserved populations and offering essential goods and services to the most marginalized individuals. According to India’s Ministry of MSME, there are nearly 30 million MSMEs in India that are responsible for 45 percent of Indian industrial output and 40 percent of its exports.

Yet the majority of MSMEs in India, and worldwide, struggle to gain access to capital from the formal financial sector, thus limiting their potential to grow and scale. At the same time MSMEs find themselves trapped by a system where large trading powers hold the control. When those large companies delay payments, which occurs constantly, MSMEs have little recourse and find themselves under even greater financial strain.

MSMEs lack access to the formal financial sector in India because they lack collateral, have limited track records, and are perceived to be high-risk investments. Even though the government and stakeholders are working towards creating an enabling financing environment, the current system often fails to mitigate existing challenges. Given the size, scope, and the economic growth potential of the MSME market, a new approach is needed for the formal financial sector to play a role in expanding their reach to the unemployed and underserved, thus driving sustainable global development.

Currently commercial banks, impact funds, and boutique financing institutions are using the traditional credit evaluation methods to make lending decisions, which is making it tough for these institutions to provide credit to MSMEs. The current system is not designed to allow MSMEs to access funding that would encourage them to scale up.

Many small businesses are interconnected as suppliers or buyers to large enterprises that have strong borrowing credentials. Those small businesses are often in need of working capital to meet their commitments to these large companies and therein may lay a potential solution to some of MSME financing challenges.

Supply chain financing, which allows financiers to lend to smaller borrowers against the creditworthiness of their larger, more fiscally secure partners, is a budding asset class. Adopting that type of financing could provide steady, reliable funds to MSMEs linked to established enterprises. Through the mechanism, a financial institution uses the reach, due diligence and internal controls of a trusted corporate to extend working capital financing, in most cases taking financial and moral commitment from the corporate as a proxy collateral.

A few established financial institutions are already doing so. For example, Dupont’s crop protection division in India is utilizing this approach to create financing options and close the funding gaps for its smaller buyers. On the basis of Dupont India’s strong relationship with its MSME buyers in rural parts of the country a leading financial institution extended working capital credit to support the farming supply chain during the critical sowing and harvesting cycle. This led to an increase in the sale of crop protection products, improved yields and, as a result, farmers’ incomes.

Credit scoring by measuring the strength and durability of a supply chain of a large company can potentially open up financing to even microenterprises that currently access credit through informal sources at exorbitantly high cost and social risk.

In order to capitalize on supply chain financing, there is a need for large companies to support their ecosystem of MSME buyers and suppliers. This new approach to risk assessment can reduce the risk of lending and the cost of borrowing. But it can only move the needle once a large number of financial institutions adopt such a risk assessment framework to identify, score, and underwrite credit to small companies who lack a formal credit history. Leveraging the strength of business linkages can more than compensate for an inherent weakness in the balance sheets of individual MSMEs. This is the new system needed to invigorate MSME financing, and kick-start the growth curve of this hugely important sector yet underfinanced sector.