Rising Borrowing Costs and Credit Mispricing: Implications for Small and Mid-Sized Indian Firms

India's Micro, Small, and Medium Enterprises (MSMEs) have long been the backbone of its economy, contributing nearly 30% of GDP and employing over 120 million people. However, in a tightening credit environment marked by rising borrowing costs and persistent credit mispricing, vulnerabilities within the sector are becoming increasingly pronounced. As of March 2025, MSME credit exposure has surged to ₹35.2 lakh crore, reflecting a 13% year-on-year (YoY) growth. Yet, beneath this headline figure lies a complex landscape of sector-specific risks and untapped opportunities for defensive investors.

Sector-Specific Vulnerabilities: A Closer Look

The MSME sector's resilience has been tested by structural challenges, particularly in industries with elongated working capital cycles. Ready-made garments, grocery retail, and food processing firms, for instance, often operate on cash flow timelines exceeding the 90-day non-performing asset (NPA) classification threshold set by the Reserve Bank of India (RBI). This mismatch forces businesses to divert working capital to service loan installments, exacerbating effective borrowing costs.

According to the Small Industries Development Bank of India (SIDBI), the sector faces a staggering credit gap of ₹30 lakh crore. Service-oriented businesses and women-owned enterprises are disproportionately affected, with 12% of micro-enterprise funding still reliant on informal lenders. Meanwhile, the Federation of Indian Chambers of Commerce and Industry (FICCI) notes that 85.4% of SMEs depend on bank loans, yet only 18% have adopted digital lending solutions—a gap that leaves many exposed to mispricing and liquidity shocks.

The data also reveals uneven asset quality. While the overall portfolio at risk (PAR) for MSMEs has stabilized, segments with credit exposure under ₹10 lakh show deteriorating delinquency rates, rising to 5.8% in March 2025. This fragility is compounded by the sector's reliance on collateral-based lending, which excludes many small businesses from formal credit channels.

Defensive Investment Opportunities in a Tightening Environment

Despite these challenges, the MSME sector offers compelling defensive opportunities for investors willing to navigate the complexities of credit mispricing. Key areas of focus include:

1. Collateral-Free Lending Platforms:
   The Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) has emerged as a critical lifeline. By providing 90% guarantee cover for women-owned enterprises, it has enabled collateral-free loans to 27 lakh MSEs. Investors can target fintechs and NBFCs like Credit Wise Capital, which raised ₹120 crore in 2025 to expand credit access in Tier 2-4 cities.

2. Digital Lending and UPI Integration:
   Digital adoption is reshaping the MSME credit landscape. With 72% of transactions now conducted digitally and UPI processing over 16 billion transactions in January 2024, platforms leveraging data analytics and alternative credit scoring are gaining traction. Aditya Birla Capital's Udyog Plus portal, offering online loans up to ₹10 lakh, exemplifies this trend.

3. Government-Backed Schemes and Funds:
   The Union Budget 2025–26 has introduced several initiatives to mitigate borrowing costs. The Pradhan Mantri Mudra Yojana (PMMY) expanded loan limits to ₹20 lakh for repaid borrowers, while the Self-Reliant India (SRI) Fund has allocated ₹50,000 crore to support innovation-driven MSMEs in agriculture, pharma, and auto sectors.

4. Sector-Specific Reforms:
   Policy interventions such as extending NPA classification timelines to 180 days and promoting cash flow-based lending models could unlock liquidity for vulnerable industries. The Raising and Accelerating MSME Performance (RAMP) scheme, which has already benefited 4 lakh enterprises, offers a blueprint for targeted regional investments.

Strategic Recommendations for Investors

For investors, the key lies in balancing risk mitigation with growth potential. Defensive strategies should prioritize:
- Exposure to CGTMSE-backed lenders and fintechs with strong digital infrastructure.
- Diversification across sectors with shorter working capital cycles, such as IT/ITeS and manufacturing.
- Support for women-owned and SC/ST MSEs, which are prioritized under government schemes and offer untapped growth.

While rising borrowing costs and credit mispricing pose headwinds, the MSME sector's adaptability—driven by digital innovation and policy reforms—presents a unique opportunity for those who can navigate its complexities. By focusing on collateral-free lending, digital transformation, and sector-specific interventions, investors can position themselves to capitalize on India's most dynamic economic engine.

In a landscape where resilience meets innovation, the MSME sector remains a cornerstone of India's economic vision. For investors, the challenge is not just to survive the tightening credit environment but to thrive within it.