This article was originally published in SMBStory: here.
The Indian MSME sector is the engine of growth, creating more jobs than other sectors according to the Confederation of Indian Industry.
Yet India, just like many countries, faces a credit and liquidity squeeze which disproportionately affects the MSME sector. A recent estimate is that MSMEs across the world have an unmet demand for Rs 25 trillion in credit which banks are not able to meet. Of course, perhaps a large part of that demand is wishful thinking on the part of the potential borrowers, but our experience across India is that there are real challenges growing companies are facing. In other countries, credit can be more freely available and this allows MSMEs to invest and support growing books of business with their international customers.
Inflating the economy through easy credit rarely ends well – so, in principle, the Indian approach is right. Keep the banks in check and look to build other ways to provide liquidity to growing companies that build economic value. Cash liquidity is the lifeblood of this process.
Other ways for growing MSMEs to obtain liquidity include factoring and trade finance. These techniques are very similar in terms of process but trade finance can be significantly lower cost. These products can provide a perfect financial solution which grows as a company grows, but also prevents companies from becoming over-indebted – and trade finance is the lowest cost model that a company can use to achieve this. Factoring is the purchase of invoices that a company has issued to its customers.
Provided customers are creditworthy and the MSME supplier is competent in its task of supplying goods and services, factoring can provide an elastic source of liquidity. The more the MSME sells, the more invoices it issues, and the more liquidity can be provided. Costs can be surprisingly low.
Trade finance is very similar to factoring, except that it works across borders. This means that the customer is in another country, but also may be a much better credit and so the cost can be very low.
For India, trade finance brings is a “double-win”. Trade finance companies not only help growing Indian MSMEs with cash liquidity, but they also act to ensure that foreign currency from overseas sales comes directly into the correct bank accounts inside India.
Trade finance can be very simple. The best providers offer a transactional product – that means it is finance available shipment-by-shipment and without complex legal agreements and long term commitments. This is perfect for the growing MSME – he can pick and choose with customers and supply chains should be financed, and he can duck in and out of the finance depending upon the cash flow pressures that he has. At it’s simplest, trade finance works like this: The exporter confirms that the trade finance company can give a limit on his customer – wherever that customer might be in the world.
The new breed of trade finance company can offer global underwriting. With the limit in hand, the exporter ships his goods and provides his shipping documents. Provided the shipping documents are acceptable, the trade finance company pays the exporter in cash up to 90 percent of the value of the goods. This cash is paid upfront and is not returnable if the buyer defaults later. The buyer can then enjoy 30, 60, 90, even 120 days of credit. This allows him to receive his goods and likely sell them himself before he has to pay for them. This benefit is essential for many buyers who are, themselves, cash-strapped. At the agreed later date, the buyer then pays and the trade finance company deducts a low fee (eg: 1 percent or 2 percent of the invoice value) and pays over the balance to the exporter.
As already mentioned, this simple system works shipment-by-shipment, without a myriad of fees and charges, without tie-in, and without complex legal agreements. Simple, transactional and effective – trade finance plugs a much-needed liquidity gap that MSME exporters can face. And where next? Across all financial sectors, we are seeing a growing level of innovation and segmentation between customer ownership on the one hand, and the operational activity of processing and financing on the other.
Trade finance will be very much part of this revolution. With new forms of transactional trade finance emerging, in our view, we will see new business models being developed which involve the integration of trade finance with logistics. This means that the exporter can take finance through his shipping line or freight forwarder – and not as a separate product – but integrated into the logistics services that he currently enjoys.
The importance of both trade finance and factoring cannot be underestimated in an economy that has maybe more than 30 million companies that are MSME in size. Such a large number of small companies makes a significant difference to the overall numbers, notwithstanding the huge power of the Indian economy overall. Trade finance reduces risks for this sector, providing liquidity at low cost for growing companies that are exporting – something to be encouraged and supported across all industrial sectors.