Thursday, March 2, 2017

How Digital Money Transfer Impacts the SME Banking in India

Demonetization of high-value currency notes came as a huge surprise for individuals all over India. This move was an initiative adopted by Prime Minister Narendra Modi to curtail corruption and black money in the economy.

Digital Money Transfer

Demonetization has impacted money supply in two ways. Firstly, individuals who have unexplained cash holdings will be unable to deposit their money in the banks. This amount would be completely extinguished from the economy as it is irreplaceable. Secondly, the government may only release a part of the deposited currency as cash back into the system. The remaining component would in a digital form. This may result in India transitioning from a cash-based economy to a digital economy. Both these possibilities will impact the country differently in the short, medium, and long term.

Here are four implications of demonetization on the Indian economy:

1. Liquidity crunch

The demonetization announcement removed almost 86% of the currency from circulation. This has severely restricted the supply of cash in the economy resulting in tight liquidity for most Indians. As cash balances are eroded, several transactions may be eliminated because of inadequate liquidity.

2. Demand for loans

Several Small and Medium Enterprises (SMEs) would drive the demand for loans. This increase in demand for loans would primarily bridge the gap created by demonetization and ensure the smooth functioning of the SMEs. As a result, the SME banking sector is expected to get a boost in its business.

3. Disapproval of loans

With most of the cash being eliminated from the system, businesses that are cash-dependent will face difficulties in receiving approval on their loan applications. Most lenders would perceive such companies as high-risk and may disapprove loans to prevent the creation of Non-Performing Assets (NPAs).

4. Higher cost of loans

SMEs that are able to raise loans through other lenders like non-banking financial companies (NBFCs) may incur higher costs to avail of these funds.

Digital money defined as the transition from cash and cheques to instruments like debit and credit cards, non-paper based products, and stored value instruments is becoming important. Advanced payment solutions and methods are being used to overcome the liquidity crunch post-demonetization.

SME in India has emerged a highly dynamic and vibrant sector in the last five decades. These businesses provide employment to a large number of people at lower costs and also increase industrialization in the rural areas. This sector comprises nearly 36 million ventures and employs more than 80 million people across the country.

Knowing that the growth of this sector is important, let us understand what is an SME. As per the Micro, Small and Medium Enterprises Development (MSMED) Act, 2006, a manufacturing company investing between INR 25 lakh and INR 5 crores in plant and machinery is defined as a small enterprise. When this investment ranges from INR 5 crores up to INR 10 crores, it is classified as a medium enterprise. Moreover, when a service provider’s investment in equipment is between INR 10 lakh and INR 2 crores it is defined as a small enterprise. However, when the same investment is between INR 2 crores and INR 5 crores, the service provider is classified as a medium enterprise.

Digitalization in the SME banking system 

Several financial institutions have been providing SME banking services to benefit from the growing importance of this sector. Unfortunately, cash is still important among the SMEs especially in developing countries like India. However, relying on cash is not only more expensive but also risky.

An increasing number of financial institutions and companies are offering integrated payment solutions to the SME sector. Innovative solutions like enabling the businesses to collect revenues through mobile devices are being offered. Until now, such initiatives lacked large acceptance because of the greater reliance on cash. However, with demonetization, there is a surge in the acceptance of digital payments by SMEs.

Newer solutions to overcome the challenges faced by SMEs in collections are expected to continue being developed. The primary drivers for this growth include predictability, transparency, and flexibility, which are important factors for the growth of the SMEs.

Increasing digitalization and use of technologically advanced solutions would greatly benefit the SME sector in the wake of demonetization. Simpler procedures, reliable ecosystems, and more transparency through digitalization would benefit the growth of this sector.

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