Easier bank lending critical for India to grab the manufacturing moment

“We work for the banks.” Talk to an entrepreneur in manufacturing long enough and the chances are that they will say this. Manufacturing entrepreneurs lament a lot of things but they reserve a special place in their heart for bankers. They believe that bank loans are very expensive and come with onerous conditions and that bankers are very slow. This is already an issue for growth of manufacturing in India but will become even more critical as opportunities in diverse supply chains as drones, aircrafts, air conditioners and ships open up. The availability of cheap and quickly available capital- especially debt capital — for manufacturing companies, is perhaps the biggest structural challenge that India faces in ramping up its manufacturing capabilities. At the heart of this challenge is the fact that the interests of entrepreneurs, bankers and the regulators are not aligned. What’s worse is that there is no ‘perfect’ solution to this problem.

This is how ChatGPT ‘imagines’ India entrepreneurs, bankers and regulator

Let’s begin with the entrepreneur’s point of view.

Entrepreneur’s lament

Imagine you are the founder of a company that specializes in injection molding. It is late 2010s and the Government of India has announced a move from Bharat IV to Bharat VI pollution norms. You know that automobiles will have to use Fuel Injectors instead of carburettors because of this change. This could be a huge opportunity for you as you can make parts for fuel injectors. When you meet your clients — some of the best automobile manufacturing companies in the country- they are almost frantic. They want to be assured that you can meet their new requirements. They in turn assure you that they would definitely buy from you. You are very optimistic about the future. Until…. Until you go and meet your bank.

When you present your bank with a proposal for an investment that would allow you to perhaps double your revenues without much risk, you meet blank faces. Bankers cannot understand your talk about the difference between BS IV and BS VI and between a carburettor and a fuel injection system. They tell you that their norms don’t allow them to lend you more than a small fraction of your requirements. You know that even that small fraction will not come quickly and will come with many onerous conditions.

Not only will the banker take a lot of time to process your loans, but also you will have to pledge your Plant and Machinery and factory land as security. But that is not all. You would need to collateralize all of your privately held property. If that property is not enough, you will need to approach well off relatives who can mortgage their property or provide other guarantees on your behalf. You will also be required to give a personal guarantee. Most important of all, the interest rate that the bank charges will be nearly the highest possible. Your lower profits because of the high interest rate would further reduce your capacity for growth.

You shake your head. ‘Make in India’ indeed!

But before we condemn the ‘ossified, scared banker’ who is ‘holding the country back’, let us look at things from his point of view.

Banker’s dilemma

You are the newly appointed branch manager of a bank in Pune. An entrepreneur comes to you with a proposal. He has a good record with your bank. But, he is looking for a very large loan. He believes that changes in pollution laws would create a huge opportunity for him. You struggle to understand his proposal.

Your first difficulty is that you don’t understand the automobile industry very well. You have no idea about pollution laws or carburetors or Fuel Injectors. You are not in any position to judge the techno commercial soundness of the project. Additionally, you know that manufacturing is learned by doing. You know from experience that even when complete plants are imported, it takes time for operations to stabilize. Would the entrepreneur overcome the likely difficulties? The loan proposal includes letters of interest from the buyers but you know that if there is a delay in implementation of the pollution norms,the buyers would delay purchase of the components and the new equipment would sit around doing nothing. Nothing except, accrue interest on your loan that the promoter would struggle to service.

The fact that you have security on the Plant and Machinery would mean very little. First of all, a significant part of the value of the factory would be civil works which would have no resale value. Secondly, the machinery would start losing value as soon as it is bought. Anyway, you have no way of knowing whether the quoted price of the machinery is correct if it is anything unusual. Thirdly, in case of default, your bank might have to fight the entrepreneur in courts and that could take time. Finally, the loan would be a large part of the portfolio of your branch. Which means that in case of the loan going bad, there could be an enquiry and you would be hard pressed to defend your decision.

You glance at another file in front of you. It is a set of mortgage loan applications. You wish you were dealing with them instead.

Even though you are new there, you have a fairly good idea of apartment prices across the city. Secondly, you know that you would have good quality documentation on the income and wealth of the applicant. You also have clear lending norms from your bank and the lent amount would be a fraction of the value of the flat. The clear norms also mean that you would personally not get into trouble if the loan became bad. Additionally, you would be able to quickly repossess the flat in case of a default by the borrower. It is extremely likely that the value of the flat would have only increased. Finally, each loan would be a small amount and you would have the protection of portfolio diversity. You would clear the bunch of applications very quickly.

In dealing with the entrepreneurs’ proposal, you would not show ‘undue haste’. If possible, you will push the decision to committees above you. Your bank would make sure that the amount lent is as per norms, you have all the possible security and you charge nearly the highest interest rate possible. You know that if you don’t do this and if the loan goes bad, you would be in trouble.

The dire telling of Banker’s point of view can make us think that no lending to manufacturing happens in India. That is not true.

The reality of Bank lending to manufacturing

The gross bank credit to industry has increased from Rs. 25.2 Lakh Crore in 2013–14 to 36.53 Lakh Crore in 2023–24.

On the face of it, the growth in loans to ‘Medium’ and ‘Micro and small’ has been much more. In ten years, both these categories have seen more than 100% growth. But it should be noted that the absolute quantum of increase for large companies is still more than for the other two categories combined.

Then there is the all important question of the cost of this loan. Here is a chart from a recent report published by Blume.

My conversations with small and medium sized manufacturing firms and banks reveal that:

• It is easier for larger established companies to get loans than for small and medium sized companies.
• A small company that is the subsidiary of an established MultiNational Company (MNC) will find it easier to get a loan than a similar sized independent Indian company.
• It is more difficult to get a loan for new projects than for financing of working capital. The difficulty only increases when the requirement is large compared to the size of existing operations.

Hence, independent Indian companies with a short track record will find it very difficult to grab opportunities that come up. Grabbing such opportunities is critical for Make in India. To understand this, we need to understand that manufacturing ‘happens in the middle.’

Manufacturing happens in the middle

Most complex products have a long chain that processes raw material into the final products. Take automobiles for example. Steel is a big part of a car. Many different kinds of steel are used. There are parts with very different shapes and load bearing capabilities. For example, the frame, the chassis, wheel rims and exhaust pipe may use steel of very different characteristics. The many bushings, bearings, screws, etc also would be of very different types.

At one end of the automobile supply chain would be the steel manufacturer. At the other end would be the car assembler (like Mahindra and Mahindra) and in between there would be multiple manufacturers. For example, a manufacturer may take steel sheets and shape them in the form of exhaust pipes and ship them to the final OEM.This manufacturer himself may use another company that just cuts the steel sheets in the sizes required by him. Exhaust pipes are relatively simple. Other more complex parts may have multiple processes carried out by many small companies. The machines being used in all these processes themselves are being made by other manufacturers.

We have taken a very brief look at one product and one material — automobiles and steel. Automobiles use materials other than steel. And there are many different products being manufactured in a complex economy. For example, relatively simple products such as detergents or complex ones like molecules used to treat cancer may start as simple Petrochemicals and / or salts. The transformation may use 100s of catalysts being manufactured by specialist companies. Or take semiconductor chips…or rather, don’t take semiconductor chips. The point is there are hundreds and thousands of companies involved in the transformation of raw material into the finished products we use.

Typically, these hundreds and thousands of companies in the middle find niches for themselves. Ruthless competition forces these companies to become very efficient. The efficiency in making and in logistics typically comes from the doing and not application of theory. Some of these manufacturers may be skilled and lucky enough to become big. A select few of these would be risk taking, skilled and lucky enough to figure out how to become makers of the final products. It is very unlikely that all this would happen without support of cheap and patient capital. If there is support, entrepreneurs can spot opportunities.

The entrepreneur at the beginning of our article spotted an opportunity because of a change in pollution laws. There are other possibilities. Electronics assembly has taken off in India. Production nearly doubled from USD 48 billion in FY17 to USD 101 billion in FY23, driven primarily by mobile phones. However, according to the government Press Release the domestic Value Addition is only 15% to 18%. That is, we are importing most of the parts that go into the phone. Maybe our entrepreneur thinks he can make one or more of these parts?

I believe that India has a unique opportunity to get into manufacturing right now. President Trump’s policies could mean a big reset for global trade which would mean a lot of opportunities. Increasing tensions with Pakistan will definitely lead to opportunities in defence. Even without these large events, government policies are creating more and more reasons to make in India . For example, there is an increased demand in making of parts for Air Conditioners as a combination of Production Linked Incentives (PLI) and other measures (such as imposing strict quality norms on imports) is pushing production to India. Take another example. India recently awarded a contract for C 295 military aircraft to Airbus. One critical condition for this contract was that a significant part of manufacturing had to happen in India. This is a great opportunity for manufacturers. As a last example, take the fact that the Government of India is strongly encouraging ship building in the country. Again, an industry that provides opportunity to many manufacturers.There isn’t a lack of opportunities for entrepreneurs ‘in the middle’.

PLI could help set up many factories which put together the final product. Usually big names such as Tatas set up these factories and they would not have the challenge of banking support. Increasing Value Addition in any of these value chains would mean a requirement of a lot of support for the entrepreneurs in the middle.

Why can’t the policy makers direct banks to lend to the Entrepreneurs in the Middle? Don’t they know the factories that these entrepreneurs put up would generate a lot of desperately needed jobs? Don’t they know that national security requires a very strong manufacturing base?

Policy maker’s conundrum

If it is difficult for a banker to understand manufacturing, it is more difficult for a regulator to understand the lending of bankers to manufacturing. It is even more difficult for a politician to understand a regulator’s performance in regulating a bank that lends to manufacturers.

An honest and capable politician would know that banks lending to manufacturing companies is good for society. However, the politician would also know that if and when the loans go bad and the banks needed a bailout from the taxpayers money, people would not like it. They would suspect that there was corruption in the lending decisions of the bank. Corruption in which the politician also participated. The problem for society is compounded because there aren’t that many honest and capable politicians as one would wish.

The job of a policy maker becomes even more tough when manufacturing companies have to be supported through tough times. Manufacturing is cyclical. Opportunities come up and attracted by these opportunities, many entrepreneurs put up capacities. If this capacity is more than than the demand, prices for the product fall and many entrepreneurs get into trouble. This is not necessarily a bad thing for society as this can weed out inefficient players. However, sometimes it can weed out all the players if the debt capital supporting the entrepreneurs is not supportive and discerning. The banks might have to be supported, in face of the bad loans, to support some manufacturers in dire times. However, the public does not like it when governments pour taxpayers money into ‘corrupt banks’ that are supporting ‘reckless and dishonest’ businessmen. Regulators know this and hence they make sure that there are very strict conditions for bank lending to manufacturing.

This in short is the trilema. Entrepreneurs need help from debt capital to grow. Banks are not capable of judging the risk well and they find lending to individuals easier and less risky. Policy makers know that they need to support manufacturing but are wary of the inevitable political cost of supporting banks that have lent badly.

But surely, these challenges are not unique to India? How did other countries who have become successful manufacturers do it? How did they resolve the trilemma? For an answer, we can turn to How Asia Works from Joe Studwell. A mild warning here: the answer is not satisfying to minds that don’t appreciate tradeoffs.

Experience of the East Asian Manufacturing giants

In this book, Joe Studwell called financing for manufacturing as one of the three fundamental challenges of development. His reasoning is as follows.

• To develop and to provide productive employment, countries have to increase the share of manufacturing.
• Manufacturing is learned by doing and many mistakes are made while learning.
• Successful countries have provided their manufacturers with patient and cheap capital.
• This patient and cheap capital has come at a cost to bank depositors.

Joe Studwell believes that the cheap and patient capital is available to manufacturers only when

• Banks are restricted from lending to individuals.
• Banks are ‘encouraged’ to lend to manufacturing companies even when it results in bad loans. And consequently,
• A generation of depositors accepts a low rate of return on their deposits.

This happened in Japan. This happened in South Korea and most recently it happened in China.

China’s leadership has repeatedly pushed its banks to lend to manufacturing (and infrastructure building). Sometimes even recklessly. In 1998, the bad loans in the ‘Big Four’ banks had reached a staggering 1/3rd of GDP according to Arthur Kroeber. Kroeber believes that the bailout of the banks was the reason for low deposit rates for savers. He estimates that in 2004–2013, the average real deposit rate was a negative 0.3 percent! A generation of depositors accepted this rate and manufacturing in the country benefited.

As I write this note, there is talk about the overcapacity in manufacturing (and real estate) in China. It is very likely that Chinese banks would need to take another huge write off sooner rather than later. The costs of ‘reckless’ lending to manufacturing to society are very real.

However, if costs are real, so are the benefits. China is today the manufacturing superpower. Many books have been written about this and it would be foolish for me to detail all the way in which China dominates manufacturing. However, I will share two facts. As this article says, it is a matter of time before China becomes the biggest exporter of automobiles in the world. It is also the leading exporter of garments. In 2022, its share of exports was 10 times that of India. China dominates both simple and complex manufacturing.

I think that the cost of bank lending to manufacturing companies has been more than compensated in Chinese society. Of course, the people who gained from the manufacturing boom and the people who lost from the financial repressions are different.

What can an honest policy maker in India do to get similar outcomes?

Can India seize the moment?

It seems we are at an inflection point. Events across the world including in India means that we have a good chance of onshoring many complex supply chains. I have mentioned a few but there are many others. How can India do that?

The short answer — open the taps, at least a little. Encourage banks to lend to manufacturing entrepreneurs. Especially those in the middle.

What would that mean in practice?

• Urge state owned banks to increase their lending to manufacturing for a period of five years.
• Urge banks to improve their turn around times for project loans.
• Provide interest support to manufacturers, especially those working in supply chains that India is trying to attract.
• Perhaps create specialized funding agencies for new and complex industries like shipping.
• Stay the course. That is, do not lose your determination for increasing manufacturing at the first instance of corruption or stupid lending.

I make these recommendations knowing fully well that it would result in a NPA build up in a few years later. And that some bankers and politicians and entrepreneurs will use the ‘opening up of the taps’ for corruption. And that there will be stupid lending and not just corruption. But what is the alternative?

It must be remembered that the big manufacturers of today’s India benefited in the past from cheap and patient capital from institutions like ICICI and IDBI*. Not only that, they also benefited from multiple rounds of restructuring. There are many examples but you could look up JSW steel which is now the biggest steel manufacturer in India.

Once again missing an opportunity to become a competent manufacturing nation is not an option.

_____

A huge thanks to all the manufacturers who have spent hours talking to me. Another huge thanks for them to be in the thankless task of manufacturing.

Thanks to Vasant, Anirudha and Girish for the their extensive comments.

* The benefits and costs of the ICICI and IDBI initiatives haven’t been studied comprehensively till now.

This post is part of a series on Make in India. The story How did China become a manufacturing superpower in this series has got a lot of attention.

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