Micro, small-, and medium-sized enterprises (MSMEs), which employ around 85 percent of Nepal’s labour force, are critical to Nepal’s economic development. However, these businesses face a financing gap of around $3.56 billion as they are not organised, structured or have bare-bones governance structures to suit the availability of banking and financial institutions (BFI) lending.

Nepal’s total credit portfolio is expected to exceed Rs6 billion ($46 billion) by the fiscal year 2025, accounting for well over 90 percent of Nepal’s GDP. The portfolio has recorded a remarkable 20 percent Compounded Annual Growth Rate (CAGR)—average yearly growth—over the last 15 years. Despite such expansion, the restricted flow of money to growth sectors is not primarily due to the unavailability of funds but rather due to inherent risk in high growth sectors (energy, technology), limited management bandwidth of fund providers, limited access and usage of risk management tools and/or the inability of fund providers to innovate on structures and instruments.

Role of guarantees

To mitigate such a financing gap and mobilise available credit, the Credit Guarantee Scheme (CGS) has been popular in developing countries to support MSMEs in obtaining loans. According to the World Bank, a public CGS is a government-or international organisation-backed financial mechanism that helps enterprises access credit and spur growth in selective sectors. Guarantees are not new to the investment realm. Governments and development partners use them to either crowd in investments or incentivise investment flow to riskier sectors. They catalyse investment in underdeveloped sectors by mitigating various risks (commercial, credit and political), thereby altering the risk-return profile for investors. Such schemes operate through intermediaries like banks, microfinance and non-bank financial institutions.

The Government of Nepal set up the Deposit and Credit Guarantee Scheme (DCGF) in 2010, which regarded facilitating credit guarantees as a key objective. However, over the years, instead of spurring credit growth, this profitable agency has only become a tool for BFIs to avail of provisioning discounts (lower loan loss provisions as directed by NRB) on sector-specific credit portfolios. As per the DCGF annual report for the fiscal year 2079-80, despite a large SME credit guaranteed amount (Rs13.3 billion), the collected guarantee fees were comparatively low (Rs76.6 million), highlighting that low fees should have incentivised BFIs to participate and utilise the credit guarantee service to safeguard their assets.

However, the amount paid in claims was low, Rs1.8 million, hinting at a possibility that the process to avail claims was excessively bureaucratic and excruciating. The premium rate set at 0.6 percent per annum is considered fair or modest compared to global markets. The underutilisation and ineffectiveness of the SME Credit Guarantee programme could be due to limitations in management capacity and process bureaucracy, amongst many other variables. Nonetheless, reviving this underperforming programme and bringing a paradigm shift in credit activities is never too late.

Contextual use case

Popular guarantee instruments are the First Loss Default Guarantee (FLDG)—the fund provider is guaranteed by the guarantor for the defaults that are incurred in the guaranteed portfolio—and the Portfolio Guarantees—a financial instrument that helps financial institutions manage credit risk across a portfolio of assets. These guarantees facilitate BFIs to deepen their exposure to sectors such as agriculture, women-led businesses, MSMEs, or technology-enabled businesses while transferring the burden of default to the guarantor. These sectors would remain underserved if there were no bridges or support.

Discussions with BFI personnel exhibit hesitance to lend to the agriculture sector due to the sector’s high (10 percent) non-performing asset (NPA), i.e., loan losses not being repaid. An FLDG with a 10 percent coverage would incentivise BFIs to look at the sector differently and even increase exposure while developing a specialisation in financing sub-sectors in agriculture over time. This would help BFIs develop specialised expertise within the agri-lending value chain. Through the support of guarantees, few banks could choose to develop proficiency and enhance their capacity to lend to agro-processing specifically. At the same time, some could specialise in the agricultural input vertical (seed/equipment) or other sub-verticals (crop/livestock production/horticulture), respectively.

A contextual use case is the Credit Guarantee Facility (CGF), established by the Austria-Nepal Renewable Energy Blended Finance Facility in partnership with NMB Bank Ltd. and the Alternative Energy Promotion Centre. The CGF of EUR 750,000 was allocated for Karnali Province to facilitate finance and capacity-enhancing activities for renewable energy projects while also achieving environmental, social and gender co-benefits. The fund established a 25 percent first-loss guarantee/reserve. The guarantee fund was backed by a cash deposit into the partner bank rather than a non-funded guarantee. Investors and BFIs need help to finance heavy sectors such as technology despite reports outlining their potential. Instruments such as equity guarantees are equipped to attract international commercial investors by protecting their investments/covering return gaps, i.e., if the investment doesn’t achieve the expected return, the equity guarantee will cover the difference.

Such instruments complement the existing funding offerings that Development Finance Institutions (DFIs) provide to many of the BFIs in Nepal in the form of tangible sector-directed lending mandates. Due to their intangible nature, sectors such as technology face difficulty getting regular loans. Hence, full or partial portfolio guarantee instruments facilitate and incentivise BFIs to test potentiality. For example, the Sarulla Geothermal Power Project in Indonesia leveraged a risk guarantee from the Japan Bank for International Cooperation and a 20-year business viability guarantee letter from the Indonesian government to crowd commercial funding.

Way forward

Various DFIs, Multilateral Development Banks (MDBs), aid agencies and specialised guarantee providers provide guarantees like UKaid's Sakchyam partial loan guarantee scheme for MSMEs and the Micro Hydro debt fund supported by GIZ. However, their use in Nepal has been limited and remains at the pilot stage without broader adoption. Guarantees in Nepal face multiple challenges, and complex structures require expertise that is not widely available. There needs to be more awareness about pricing these guarantees. According to a report by the Organisation for Economic Co-operation and Development (OECD), guarantees have been more effective in mobilising private finance than any other financial instrument. Given the current economic situation, characterised by Fitch's BB- sovereign rating, business stagnation and excess liquidity, there is an untapped potential for guarantees in Nepal. This suggests that guarantees could be cost-effective tools to channel the excess liquidity into productive sectors without additional financial burden on the funders.