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November 04, 2006

How Indian SMEs finance themselves

Knowledge@Wharton reports on an academic study "Financing Firms in India".
The study...challenges the conventional wisdom among academics and public policy experts that corruption automatically impedes economic advancement of developing countries, according to Wharton finance professor Franklin Allen, one of the authors of the study.

"Small- and medium-size Indian companies have found ways to get around [the limitations of the country's financial and legal systems]," says co-author Sankar De, clinical professor and executive director of the Center for Analytical Finance at the Indian School of Business in Hyderabad. "They depend on informal mechanisms for dispute resolution. They lend and borrow from each other. In many ways, they bypass formal financial markets and courts of law."

...The three most important financing channels for these firms during their start-up and growth periods are founders' family and friends, trade credits and loans from financial institutions, such as state-owned banks and banks specialized in lending to small- and medium-size firms. These include the Small Industry Development Bank of India and State Financial Corporations (SFCs). A "trade credit" often involves nothing more than one firm lending a hand to another by giving a customer more time to pay an invoice or by doing a special deal to help a supplier in a time of need, according to Allen. However, credit availability is not uniform across the surveyed firms, and the market for bank credit is clearly relationship-driven. Over 70% of the respondents said that their firms had to meet operating and profitability criteria to obtain their largest loans, while the median "monitoring" frequency of the banks (when bank employees contact borrowers about loans) is once per quarter.

Arun Natarajan is the Founder of Venture Intelligence, which tracks private equity and venture capital in India and Indian-founded companies worldwide. View sample issues of Venture Intelligence India newsletters and reports.