Executive Summary

The Small and Medium scale Enterprise (SME) working as the engines of economic
growth. Promotion of SME includes their relatively high labor intensity, dependence on
indigenous skills and technology, contributions to entrepreneurship development and
innovativeness and growth of industrial linkages. The growing economic significance of
the SMEs as sources of new business creation and employment generation. There are
certain problems in financing SME which should be removed as the SME sector has a
huge prospect.

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1.1 Small and Medium Enterprises (SMEs) — Defined
There is no universally accepted definition of SMEs, in fact it is not possible.
Because it depends not only on investment level and number of workers but also
on technologies and technical complexities of production, degrees of skills
demanded from workers and managers, end use of products and so on, which
varies from country to country. For example, the EU members state Germany
defines SME as an enterprise with a limit of 500 employees, while in Belgium it is
only 100. There is no standard definition for a small business in the United States
also. Generally it is determined by the industry in which it competes, where income
and number of employees will determine whether a company is a small business or
not.

2.1 Problems of Small and Medium Enterprises (SMEs)

Historically, every followed a development strategy in which private investment was

controlled through a host of regulations involving investment sanctioning, credit
disbursement, import licensing, foreign exchange allocation, etc. While these
regulatory barriers dissatisfied private investment in general, the impact fell unevenly
on SMEs. This was because of the relative inability of the SMEs to cope with the
regulations compared to their large-scale counterparts. Thus, the policy regime was
largely biased against the SMEs although, illogically, promoting SME development
was a stated objective of successive governments.

2.1.1 Policy Level Problems

 Public Development Outlay:

Although successive year long plan documents have mentioned development

of small, medium and cottage enterprises as priority area, public development
expenditure in this sector has not been adequate with this declared policy. In
the current Fifth Five-Year Plan, the share of the sector in total public
development expenditure has gone down even further. If the sector has to make
much headway, there is need for substantial increase in public investment in

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 the sector particularly in the area of training, extension, research, market
promotion, etc. A collaborative effort of the government with business
associations, nongovernmental organizations NGOs and other development
partners is recommended in such public outlays.

 Trade Policy:

During the past decade, extensive reforms have been carried out in the external
trade regime worldwide. The import procedure has been greatly eased and
deregulated. Import tariffs have been lowered and quantitative restrictions virtually
eliminated. All these have facilitated greater access of domestic producers to
imported raw materials. This has particularly benefited SMEs as they were
affected more adversely by the regulated trade regime.

However, import liberalization has also exposed domestic producers to

competition from foreign goods.

2.1.2 Legal, Regulatory, and Administrative Problems

 Trade License

Investors are required to procure trade license from local government bodies by
paying statutory fees. The process involves unnecessary delays, harassment
and side payments. The procedure needs to be simplified and the issuance of
the license made automatic subject to payment of requisite fees and
declaration by the investor that the proposed investment is in conformity with
the rules and regulations and zoning restrictions of the local government
authority.

 Clearance from the Department of Environment

All industries are also required to obtain a certificate from the Department of
Environment in respect of proper arrangement for anti-pollution and safety
measures. Here again, the requirements should be clearly stated for the type and
size categories of industry and the investor should be allowed to go ahead with

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 investment on the basis of the undertaking that the requirements will be complied
with.

 Registration with Sponsoring Agency

Registration with sponsoring agencies is voluntary unless an enterprise wants to

avail itself of government incentives. To keep track of private investment in various
sub-sectors, it would be useful to make registration with the sponsoring agency
mandatory. However, to relieve the investors of possible hassles, registration
procedure should be simplified requiring minimum information to be provided by
the investor, and registration should not be held up until the proof of investment
has been produced as the current practice appears to be.

 Contract Enforcement and Resolution

This is a constraint, which is faced by both large and small firms. Inadequacy in
the system for contract enforcement and resolution arises from archaic legal
system where procedure of adjudication is long drawn out and cumbersome and
the system is corrupt. As a result it is not difficult to delay a scheduled date for
hearing. SMEs with low sustaining power often lose out in the long drawn out court
battle.

2.1.3 Financial Problems

 Access to Finance

SMEs encounter great difficulties while raising fixed and working capital because
of the reluctance of banks to provide loans to SMEs. Banks are shy to lend to
SMEs because of high processing and monitoring costs of loans to SMEs. The
loan application forms for investment financing from banks are long, tedious, and
redundant. Since the removal of the interest rate subsidy without the removal of
interest band, financial institutions find little incentive to lend to SMEs. SMEs find it
difficult to use non real estate assets as collateral to obtain loans from the banks.

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  Project Preparation and Evaluation

The first problem entrepreneur’s face in seeking institutional finance is with regard
to preparation of the project proposal. In spite of directives from the central bank to
follow standardized procedure, the loan application process has still remained
lengthy and cumbersome. The entrepreneur often lacks the ability to formulate a
proper project proposal. Even when he prepares the proposal drawing on outside
expert services, there is no guarantee that the proposal will be evaluated properly
as the financial institutions themselves lack adequate capability for proper project
evaluation.

 Collateral Requirements

One of the main factors that have hampered flow of institutional finance into SMEs
is banks' pre-occupation with collateral based lending. Traditionally banks have
used fixed asset ownership, particularly land ownership as the basis for judging
credit-worthiness. This puts SMEs at a relative disadvantage, as large
entrepreneurs are often able to get around the problem because of their influence
and contacts by putting up collateral of dubious valuation. The solution to this
problem lies in banks seeking deposit relationship with owners of SMEs and using
cash flow rather than asset ownership as the criterion for credit-worthiness. An
expanded credit guarantee scheme will have to play a vital role in this regard.

3.1 Prospects of Small and Medium Enterprises (SMEs)

SME financing is a high risk service with low profit, discouraging the
banking sector to extend loans to this sector. However, banks cannot ignore
an emerging sector like SMEs. That is why, banks are continuously
endeavoring to evolve appropriate model(s) of financing SMEs. Generally,
banks provide both working and other than working capital financing to large
and medium as well as small industries. Unfortunately, information
regarding financial contribution by banks to this sector is not segregated. It is
clear that both working capital and other than working capital financing is

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 higher in large and medium industries than that of small industries.
Recently, working capital financing has been increased in large and
medium as well as in small industries. We have shown that in terms of
contribution to SCIs, nationalized commercial banks (NCBs) come first
followed by private commercial banks (PCBs) and specialized banks
(SBs).The reason behind the upward contribution of PCBs. The growth rate
of PCBs declined thereof. Moreover, only the NCBs have extended credit
to priority sectors in response to government directives that at least 5%
of a bank’s loan portfolio be set aside for SCIs financing, although this is
not sufficient. The contribution of PCBs in developing this sector is very
meager. It seems that they even do not care for the government directives.

Today there is a widespread perception that most of the laws under which the
microfinance institutions are operating seem to have fallen short in dealing with
their institutional and operational aspects. Microfinance institutions, which are
basically NGOs providing financial services, do not fall under the government
regulations that are applied to banks and other non-bank financial intermediaries.
Actually, they are in need of appropriate regulatory frameworks. The absence of a
single registering, monitoring and supervising organization appropriate for the
microfinance institutions has made it difficult to decide if they have been targeting
the right people and for the right purpose. If a SME institution is to maintain its
capacity holdings, it must generate sufficient revenue to meet its operating costs,
including the cost of administering loans, mobilizing and training groups, mobilizing
funds for on-lending and covering bad debts.

4.1 Conclusion

A vibrant SME sector is considered as one of the principal driving forces in the
development of a market economy. They encourage private ownership and
entrepreneurial skills, and are flexible and can adapt quickly to changing market
demand and supply situations, generate employment, help diversify economic
activity, and make a significant contribution to exports and trade. Even in the
developed market economies SMEs account for a large share in output and
employment.

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