Financing Gap and Digitalization

Abstract

In this chapter, two issues are discussed: financing gap and digitalization. They are frequently emphasized by analysts and social planners, although from the MSMEs’ perspective, they are not keys that cause low productivity. International data show that Indonesia is one of the top 5 economies with the highest density on MSME (per 1,000 population), yet among those having the lowest lending/GDP ratio. With the exception during COVID, credit rationing as a supply-constraint contributed to the country’s unduly low credit to MSMEs, where banks’ willingness and capacity to lend played a significant role. In addition to asymmetric information, higher transactions costs were behind the rationing. The case of trade financing was even more severe. While digital usage can help reduce financing gap and provide numerous benefits for MSME productivity, it remains to be seen whether the increase during COVID is only temporary (cyclical) or permanent (structural). Overall, the digital technology adoption remains limited. One thing for sure, for certain segments of society and certain MSME businesses, leveraging digital usage and payments is likely to remain low. The difficulty in assessing the actual usage is due to the fact that merchants and consumers may claim to use and accept the digital technology but in practice they may not really use it, either because of outright opposition, rejection, or postponement.

Now that identifying the most preferred and implementable SC-compatible policies is done, we wish to discuss two issues frequently emphasized by analysts, social planners, and international organizations as very important contributors to the MSME performance: financing and digitalization. Our survey also included these two issues, although, from the MSMEs’ perspective, they were not the key, at least not as stand-alone factors, that caused the low productivity. The two, however, could affect the extent and quality of networking, that the majority of MSMEs are considered most important for productivity improvements.

We begin this chapter by delving into the issue of financing gap, one of the universally recognized impediments for MSMEs to grow. After describing the trends and extent of financing gap in Indonesia, we investigate whether the country’s low level of MSME credit was due to supply constraints or driven by a lack of demand. One form of finances that could potentially help MSME involved in international trade is “trade finance.” To the extent exporting activities can help improve the business efficiency and productivity, a large gap in trade finance faced by MSMEs is concerning. This issue is discussed in the subsequent section.

The three sections that follow are on digitalization. The relation between digitalization and financing gap is first discussed, in which the direct and indirect effect of digitalization to reduce financing gap is highlighted. This is followed by the role of “fintech” and digital payment. Like, in the case of any new technology, the introduction of “fintech” and other digitization in finance has attracted a lot of attention as a potential solution to help MSME financing needs. Theoretically, the problem of financing gap can be mitigated by adopting the digital technology. This has led social planners in many countries, including Indonesia, to intensify efforts to accelerate economic digitalization transformation. For MSMEs, however, there are a number of obstacles to achieve such a goal. Although the increasing use of digital payments and online marketing during COVID was encouraging, its sustainability remains in question. Extra efforts are needed if we expect more MSMEs going digital. Since there is always a possibility for potential users and MSMEs to oppose, reject, or postpone the use of digital technology, we discuss this issue toward the end of the section.

The organization of the chapter is depicted in Fig. 5.1. In Sects. 5.1 and 5.2, we discuss the extent and the trend of financing gap in Indonesia, followed by the analysis about the role of credit rationing and transaction costs in causing such a gap. Section 5.3 provides some brief discussions on trade finance, a type of credit critically needed for MSMEs to conduct exports-imports, yet is among those that suffer a significant gap. The direct and indirect effects of digitalization on narrowing financing gap are discussed in Sect. 5.4. The indirect channel works through the improved performance of MSMEs, where digitalization enhances the efficiency and productivity such that banks and other lenders are more willing to extend credit to them. Since improved efficiency can also be attained through exports, for which trade finance plays a vital role, there is an indirect mechanism that connects trade finance and efficiency (dotted line in Fig. 5.1). Section 5.5 covers the role and use of fintech and digital payment in affecting MSMEs’ performance, and Sect. 5.6 is devoted to the discussions on why some MSMEs are willing to use new techniques including digital technology, while others are not.

Fig. 5.1

Organization of this chapter

5.1 Extent and Trends of Financing Gap in Indonesia

Like in many countries, Indonesian MSMEs face similar challenges in accessing finance from banks and other lenders. In delving into this issue, we used secondary data and utilized a particular model to uncover the relative strength of variables that reflect the demand and supply side of credits allocated to MSMEs. Another frequently discussed issue during the last few years is the use of digitalization. With the advent of COVID-19 and the global pandemic, more and more consumers and businesses including MSMEs are converting to the digital environment. Was such a trend cyclical or structural? What are the opportunities and impediments to using digital technology for MSMEs?

Financing gap refers to the lack of funding available from the financial sector. It is a phenomenon that could have major repercussions on the development finance and performance in any country. Indeed, access to financial services has been identified as a key enabler for many of the Sustainable Development Goals (SDGs) unanimously adopted by all members of the United Nations in 2015 to end poverty, protect the planet, and ensure prosperity for all.

A lack of access continues to be one of the major problems faced by MSMEs around the world. Some MSMEs are viewed too large to be served by institutions like microfinance, but too small and high-risk to be attractive to the formal financial institutions. “Missing middle” is the popularly known term for such a condition. The sources of finance for MSMEs can be bank credit/loan, equity financing, fintech-type, and various forms of informal financing without a formal financial intermediary. The latter is prevalent in countries with less developed financial markets and intermediaries, including but not restricted to, funding from family, friends, relatives, pawnshops, community cooperatives, and trade credit. There is also a large number of self-financed MSMEs.

Financing gap in MSMEs has become a classic story everywhere. It often associates with a lack of access to finance with obstacles to growth or sales (Ayyagari et al., 2008; Banerjee & Duflo 2014). While the precise degree of financing gap and the above association varies across countries, Indonesia is among those with notable characteristics. From the multi-country information, the IFC/World Bank database shows that among 132 countries Indonesia was recorded as one of the top 5 economies with the highest density (number of MSMEs per 1,000 people), yet having the lowest lending/GDP ratio (Fig. 5.2). Although the information were based on August 2010 data and only covered the formal registered MSMEs with the usual caveats about the definition and data quality, such a relative position warrants a closer look.¹A follow-up publication by the IFC/World Bank in December 2014 covering 155 economies continued to put Indonesia among countries with highest percentage—over 60%—of SMEs unserved by credit institutions, while the density fell from the level in 2010; see Fig. 5.3 (Ariel et al., 2014).

Fig. 5.2

Source Reproduced from Kushnir et al. (2010). Note IDN = Indonesia

MSME density and lending/GDP in 2010.

Fig. 5.3

SME density and those unserved by credit institutions in 2014. Source Reproduced from Ariel et al. (2014). Note IDN = Indonesia

The data set produced by Bank Indonesia shows a slight distinction compared to the World Bank data: credit for MSME as a percentage of GDP is recorded slightly higher than what is depicted in Fig.  5.2. In 2010, the recorded number was 5.7%. It increased slightly to 7.2% during COVID but declined again to 6.9% in 2022. As a proportion to total credit, the number is hovering around 20% albeit falling since 2010 and rising only since 2018 (the right y-axis of Fig. 5.4). Looking at its distribution, the share received by micro and small enterprises increased slightly from 1.1 and 2.1% of GDP in 2011 to 2.7 and 2.4% in 2022, respectively (Fig. 5.5). Clearly, from all available information, the amount of credits allocated to MSME in Indonesia has been much lower than in most other countries, confirming the country’s position depicted in Fig.  5.2. Was the low credit due to a lack of demand or a lack of supply (lenders’ unwillingness to lend and/or credit rationing)?

Fig. 5.4

Source Department of MSME Development and Consumer Protection, Bank Indonesia

MSME credit in Indonesia.

Fig. 5.5

Source Department of MSME Development and Consumer Protection, Bank Indonesia

MSME credit by borrowers’ size.

5.2 Credit Rationing

As cited earlier, financing gap refers to the lack of funding available from the financial sector. How do we measure it? Obviously, we need to compare the estimated demand for credit and the available supply of it. Even if can assume a certain level of supply based on the past trend, the demand side is more difficult to predict as it may fluctuate depending on the economic conditions and other factors. The World Bank-IFC (2017) made such estimates, denoting it by “potential demand,” based upon which the financing gap in Indonesia was estimated at 19% of GDP or around 293% of the current level of credit. Breaking down the MSME into two groups, “micro” (the unit number of which was slightly over 1% of total MSME) and “small and medium,” and categorizing their financial access conditions into “fully constrained,” “partly constrained,” and “unconstrained,” the percentage numbers for the “micro” group were 22%, 30%, and 48%, and for the “small and medium” group were 18%, 31%, and 52%, respectively.

An alternative way of evaluating the financing gap is by comparing the estimated demand with the estimated supply of credit using a disequilibrium model. In what follows, we discuss the results of using such a model in the Indonesian case.

In a standard credit channel model, contractionary (expansionary) policy affects the economy through a decline (an increase) in banks’ supply of funds. The ups and downs of lending terms include changes in both, loan pricing and the quantities of credit available to borrowers. In its original version, such a model masks the real effect of asymmetric information that can cause a phenomenon known as “credit rationing.” The concept of credit rationing is highly relevant for the analysis of financing gap faced by MSMEs and other businesses, to the extent that it could influence the effect of the transmission of monetary policy on the economy (Blinder & Stiglitz, 1983).

In finance literature, the existence of asymmetric information between borrowers and lenders is key for understanding the phenomenon of credit rationing. It helps explain why given an interest rate there are cases where demand for credit exceeds supply.² Some borrowers are completely rationed out of the market even though they would be willing to pay an interest rate higher than that prevailing in the market. In such a setting, the interest rate failed to clear excess demand in the loan market. At the equilibrium interest rate, either every potential MSME borrower received a loan smaller than desired, or they were completely rationed out of the market. From the demand side, MSMEs within a given group are often charged the same interest rate even though banks know that they are different (with some effort banks could actually distinguish those differences). Some also argued that regulation, not just informational problems, can also distort credit markets.

Not until the 1970s when the information economics revolution began that a more complete argument on credit rationing was made. Beginning with the work on adverse selection by Akerlof (1970) and the explicit treatment of asymmetric information in general by Jaffee and Russell (1976) the notion that credit pooling could emerge was characterized by high-quality borrowers preferring a contract that entails a slightly lower interest rate with a reduced loan amount. But it was the work of Stiglitz and Weiss (1981) that dealt for the first time with the problem of equilibrium instability. They did so by endogenizing contract choices with a stable, rationing equilibrium. In their model, the lenders’ expected return is not monotonically increasing in the interest rate due to adverse selection (lenders’ payoff is concave because of limited liability upon default) or moral hazard problems (borrowers’ profit function is convex).

Two main channels are at work. First, a higher interest rate is viewed as a higher risk, causing borrowers to prefer riskier project that has a higher probability of default, while lenders prefer the safer project. Secondly, and more indirectly, rising interest rates will lower the average quality of the lenders’ applicant pool (adverse selection) and thereby lenders’ expected return, outweighing the benefits of the first effect of interest rate increase.³ As a result, lenders will not raise the interest rate beyond where the adverse selection effect dominates. If excess demand exists at that rate, credit rationing will be the choice (the equilibrium). These two channels may cause non-monotonicity of lenders’ return that eventually leads to credit rationing. Suggested implicitly by this concept is that, the condition of banks’ balance sheet and the lending channel can affect credit supply, while credit demand is affected by the firms’ balance sheet and the borrowing channel (Adrian & Shin, 2010; Bernanke et al., 1996). The point is, in analyzing credit rationing and financing gap the interest rate is not the only factor determining credit. To the extent the majority of MSMEs in most countries are bank-dependent, the concept of credit rationing is critical in the analysis.

Survey story: Rural traders in a traditional market in Magelang, Central Jawa. Even though the size of credit they need is small, the number of unit of micro business across the country is huge (more-than 98% of total MSME), and the overall sum of bank’s credit allocated to retail trade sector is not small (close to 7% of all MSME credits). On the other hand, because of their small size, lack of collateral, and viewed by lenders as risky, involving high transaction costs, getting credit approval is not easy for this type of micro business

Like in many countries, a large number of MSMEs in Indonesia are completely rationed out of the market even though they can and are willing to pay an interest rate higher than that prevailing in the market. At the time of writing, the prevailing market rate for lending is between 8 and 9%, and the well-known Kredit Usaha Rakyat (KUR) rate is 6%. Yet, given the MSME density (very high) Indonesia was ranked among the lowest in terms of SME lending/GDP. Higher lending rates not inducing higher credit is one indication of the presence of credit rationing.

Some argued that low lending for small businesses can be due to informal financing based on social networks that involve an altruistic relationship (Lee & Persson, 2016). Others argued that the recorded low lending is because of the limited coverage and a lack of reliable data. But the fact that the information were taken from multi-country data suggests that the case of Indonesia is indeed rather unique, and hence warrants a separate analysis of credit rationing. The need for such an analysis gains even more strength when there is a crisis like the COVID pandemic. It is therefore of significance to assess the credit and borrowing conditions of MSMEs before and during the pandemic. Of particular interest is the question whether the reduction in lending was caused by the demand-side or the supply-side factors. By using a disequilibrium model, we used two sets of data: macro data covering all MSME lending, and micro data comprising of sample of MSMEs in the SKLU business survey conducted by the DUPK of Bank Indonesia (Survei Laporan Keuangan UMKM, Departemen Pengembangan UMKM dan Perlindungan Konsumen). The model takes into account the existence of credit rationing, reflected in a permanent credit market disequilibrium:

$$\begin{aligned} \text {Demand}: L_t^d=\beta _1x_{1t}+u_{1t} \end{aligned}$$

$$\begin{aligned} \text {Supply}: L_t^s=\beta _2\ x_{2t}+u_{2t} \end{aligned}$$

$$\begin{aligned} L_t=\min (L_t^d,L_t^s) \end{aligned}$$

The first equation denotes credit or loan demand, the second is loan supply, and the third indicates whether the observed credit allocation to MSMEs is constrained more by loan supply or loan demand. Applying to macro data, MSMEs’ demand for loan $L_t^{d}$ is determined by a set of exogenous variables consisting of lending rate for working capital ($r_{wc}$) and real GDP (y), whereas, in the loan supply equation, the supply of loan $L_t^s$ is determined by those same variables plus two other variables, one reflecting the lenders’ lending capacity $l_{cap}$ and another is the size of non-performing loan $N\!P\!L_{SME}$. All variables are expressed in a natural logarithm.

To the extent the demand and supply of loan data are not distinguishable, only the amount of extended loan is observable. The main idea is to estimate both equations and compare the results, from which one can identify whether the estimated loan from the supply equation is greater or smaller than the estimated loan from the demand equation. It is supply-constrained if the latter is larger than the former, and vice versa. The concept of credit rationing discussed earlier is particularly relevant when it is supply-constrained. The regression results using quarterly data for the entire period and the period prior and during COVID are shown in Table 5.1.

Table 5.1 Estimated loan supply and demand to MSMEs

While the lending rate for working capital significantly caused loan demand to fall prior to and during the pandemic, the effect of GDP on demand for credit was significant and positive only before COVID. From the loan supply equation, the lending rate for working capital is not statistically significant, and so is the GDP growth. Banks’ lending capacity and non-performing loans are significant only before the COVID period.

Looking at the gap between the estimated loan from the demand and supply equations, during the entire period such a gap fluctuated. Broken down the period into prior and during COVID, however, it is clear that the loan allocation for MSMEs during the normal or prior to the COVID period was more supply-constrained. This result was consistent with the credit rationing postulates. However, immediately after the onset of the pandemic (Q1 2020), the demand-supply gap widened sharply, mostly due to a steep fall in demand, before tapering off. As a result, the demand constraint became prevalent during the pandemic, reversing the condition beforehand. Hence, with the exception during COVID credit rationing has indeed contributed to the country’s unduly low credit allocated to MSMEs, where both the interest rates and the banks’ capacity to lend play a significant role.

Table 5.2 Estimated loan supply and demand to MSMEs

Applying the same setting on micro data from SKLU Bank Indonesia with a new set of explanatory variables in both equations, the regression results based on the yearly data are shown in Table 5.2.⁴ The explanatory variables in the supply equation include: MSME annual omzet transformed into a categorical variable (omzet), the debt-to-sales ratio (dsratio), the ratio of current asset to current debt (denoted by liquidity), the value of current assets ($assets_{CUR}$), and a dummy variable indicating the age of business by using 3 years as a benchmark ($age_3$). In the demand side, we included the share of product being exported ($export_{pct}$), the value of fixed assets ($assets_{FIX}$), the stated credit need (creditneed), and the lending rate for working capital ($r_{wc}$).

This time, the role of interest rate in the demand equation has diminished (insignificant and with alternating signs), replaced by the stated need for credit (creditneed) and the size of collateral (proxied by $assets_{CUR}$). It is on the supply equation that the presence of credit rationing appears prominently. The coefficients for the size of MSME, proxied by the annual omzet, the debt-to-sales ratio, and the value of current assets are all significant with the expected signs. The effect of MSMEs’ liquidity is also significant, except in the pilot year 2017. The age of MSME, however, did not seem to matter much as its coefficient is insignificant.⁵

Similar to the national data case, prior to COVID the dominance of supply-driven constraints confirms the postulates of credit rationing hypothesis, where interest rates are not the only factor determining the amount of credit allocated to MSMEs. Lenders’ structure of balance sheet and willingness to lend matter more than the interest rates. Only after the COVID strike both supply and demand fell but the demand for loan fell more dramatically, causing the loan supply higher than the demand. As before, the credit gap is derived from the difference between the estimated credit based on supply and demand equations, the results of which are shown in the negative slope line in Fig. 5.6, where the reversal from a supply-constrained to a demand-constrained condition due to COVID was more striking than in the national data case.

Having reviewed several cases during the survey and based on some interviews we conducted, however, we suspect that asymmetric information as a standard explanation of credit rationing is not the only factor hindering banks to allocate credit to MSMEs. Another important factor is the transaction cost. As the loan size increases, unit costs decrease because transaction costs are fixed, hence driving a wedge between banks’ funding costs and the lending rate. These fixed transaction costs can take many forms and occur in different levels, from the financial system level such as regulatory costs and the costs of payment and settlement systems, to client level such as the costs of maintaining relationship over time and across different financial products, to transaction level such as the costs for assessing a loan request, all the way to financial institution level such as costs for legal services, and IT equipment.⁶ Data on these cost components, however, are not available, and hence they are not included in our disequilibrium model. All those costs are related to the smallness in transactions, banks, and market size, and they constitute an important limitation to outreach in the provision of credit, payment and savings services for MSMEs as they do not constitute profitable clientele.

Fig. 5.6

Source Own estimation

Estimated credits to MSME before and during COVID, and estimated supply-demand gap.

Under such circumstances, banks may ration at a lower-than-market equilibrium interest rate rather than raising the interest rates because the latter could lead to lower expected repayments (higher default risk). The interest rate for a popular loan for MSME in Indonesia, known as Kredit Usaha Rakyat (KUR), is also regulated and fixed by the government (set at 6%). The recorded size of KUR in 2022 was around Rp365.50 trillion, allocated to more than 7.6 million MSMEs throughout the country. The impossibility to use interest rates as screening technology entices banks to use noninterest screening devices such as collateral or other forms of assessment. Combined with the default risk, high transaction costs due to high assessment and monitoring costs not only increase the borrowing costs but also restrict MSMEs’ access to external finance.

From the perspective of borrowers, many MSMEs particularly of the microtype also had to face high transaction costs when dealing with banks and other formal lending institutions. This explains why some of them prefer to have informal transactions or exchanges with “friends and family” that have the advantage of both parties knowing each other well including their reputation. Even in cases where no written contract on interest rate and payment schedule was made, such informal transactions could be useful for the lenders to monitor and exert “pressure” at virtually no costs (Cornelisse & Thorbecke, 2010).

5.3 Trade Finance

In our previous study, we argued that some of MSMEs exporting their products also faced a financing gap of different types. We wrote in [Azis 2022, 28–29]: “Some MSMEs outside Jawa reported that after putting much effort and energy to penetrate the foreign market, they were finally able to find foreign buyers. But they complained that after delivering the products they could not get the full payment promptly despite the agreed transactions. Payments were made only after a long delay, putting pressure on the business cash flow. At the end, they had no choice but abandoning the contract all together, at the cost of no more exports and sales. Having limited network and connection, those exporting MSMEs need help from the government. Assisting them should be neither difficult nor costly, yet absolutely necessary given the weak domestic demand especially during the pandemic, and the governments’ repeated assertion to encourage MSMEs to reach beyond the domestic market.” In the current survey, we also found a number of cases showing similar problems raised by the exporting MSMEs.

Trade finance is the financing of goods or services in a trade transaction; the finance is provided directly by banks that issue letters of credit. Payment problems as part of the list of issues dealt within trade finance have been among the major challenges faced by those involved in international transactions. The main problem is a lack of access. From the perspective of improving efficiency and productivity, this problem is a serious matter. It is no secret that exporting is a way to inflict efficiency and productivity to MSMEs.

Defined as the difference between the number of applications to finance companies’ participation in international operations and the number of approvals, trade finance gap is large and growing in size. Globally, it reached almost USD2 trillion, representing 10% of global trade. Almost half of the rejected cases were MSME-related applications (compared to only 7% from multinational companies). Clearly, MSMEs are disproportionately affected by it.

Survey story: Fishermen boats in Manado, North Sulawesi. It is one of so many coastal villages throughout Indonesia where many pockets of poverty are found (the number of poor living in coastal area reached almost 18 million in 2022). While the country is ranked by the FAO as the sixth biggest fish producing nation, the living conditions of most fishermen have hardly improved. Their challenges include illegal fishing by domestic and foreign ships (and the related smuggling), rising fuel prices, poor equipment, small market scale, and the impact of climate change. In some communities, they formed a cooperative to strengthen the bargaining position. However, in some coastal areas that we visited, few big firms took advantage of government regulations by requiring the fishermen to sell their products to the firms at a lower-than market price. Many of the above problems cannot be solved by simply providing access to finance. A better network with stakeholders would have been more effective

Yet, the importance of trade finance for small business cannot be overemphasized. It is distinctive from other financing in that it is normally a high-volume and low-cost source of finance with a small risk of default. More importantly for exporting MSMEs is the lower risk of convertibility and transfer risk, for which insurance can be written to cover the risk that a buyer may make a deposit of local currency to pay for an international transaction (many MSMEs find themselves unable to convert the local currency into foreign exchange for transfer to the exporter). Bank-financed trade credits are also backed by receivables and self-liquidating, albeit short term. From this perspective, trade finance can protect small importers and exporters from counterparty risks.⁷

A standard practice in domestic and international trade is to sell or have transactions on payment terms. In international transactions, usually importers (buyers) pay the suppliers (MSMEs) cash advance for goods to be shipped, allowing them to delay the payment of the invoice. Since the shipping takes time, delayed payment is justified. On the other hand, MSMEs as exporters need this advanced payment as a security to avoid the risk of non-payment and, more importantly, to support their cash flow. But for various reasons, there are cases where MSMEs with limited knowledge and network do not receive even the cash advance. At any rate, this payment gap causes imbalances in MSMEs’ cash flow. This is where trade finance can help. Among companies of all sizes that rely on trade finance, the number of MSMEs is the largest.

A lack of local access to trade finance is also seen as a new form of financial exclusion. It was cited by the World Trade Organization (WTO) as a significant non-tariff barrier to trade, and an obstacle to economic diversification. There is a strong linkage between the availability of trade finance and trade flows. The 2008 GFC provided an important lesson on how international trade was highly sensitive to the working of trade finance. A decline in the number of correspondent banking relationships during the crisis significantly affected the ability to send and receive international payments. Those MSMEs involved in the global supply chain were among the most affected customers. Although the conditions in trade finance markets improved after the GFC, the structural difficulties in accessing trade finance of many developing and poor countries remained in place. The COVID pandemic and the repercussions of the new geopolitical configuration, especially after the war in Ukraine, worsened the situation. On top of that, the predicament of developing countries and MSMEs is also worsened by the disinclination of global financial sector to invest in developing countries where banks as trade finance suppliers tend to refocus toward their largest customers in developed countries.

In short, while exporting can impose forces for efficiency and higher productivity, MSMEs that are potentially able to penetrate foreign markets will continue to suffer from the trade finance gap. Hence, one important source of MSME productivity is wasted. Piecemeal intervention maybe helpful but not sustainable. Efforts have to be intensified to make structural changes by involving not only the government but also the private sector, multilateral financial institutions, rating agencies, and official bilateral credit agencies. Expanding the use of asset-backed securitization funding, including counter-cyclical payment structure, and a clearer risk differentiation by rating agencies and bank regulators, are examples of important structural changes that need to be considered.

5.4 Digitalization: Reducing Financing Gap and Other Advantages

The term “digitalization” is not seldom consorted with “digitization,” and is often implied in the term “digital transformation.” Digitization can be simply defined as a process to convert analog data into digital format, by which some tasks can be improved (e.g., managing MSMEs finance and cash flow) and others can be made faster and easier (e.g., payment system). Digitalization refers to the act of improving the process of digitization. More generally, it refers to firm’s operation using digital technologies to alter the business model or create new opportunities, all of which are expected to improve firm’s efficiency and productivity. Digital transformation, on the other hand, goes beyond digitizing processes. Unlike digitalization, it is a paradigm shift to restructure—in a fundamental way—how firms are organized, and to reshape the entire organizations by leveraging digital technology. The transformation may involve integration of data analytics, digital tools, automation, and cloud computing to stay competitive in the digital age. In what follows, we highlight the potential merits of using digital technology for MSMEs in general and for reducing the financing gap in particular.

Using digitalization, banks and other financial institutions could access more and better information about their existing and potential clients, including MSMEs. This prospect is conceivable if MSMEs also improve their digital footprint. They could become more noticeable to banks and other potential lenders, and their record keeping also likely improve by using the digital technology. Consequently, their credit risks can be better analyzed, allowing them to access the existing credit facilities such as KUR and other sources more easily. Given the high likelihood of credit rationing due to asymmetric information and high transaction costs discussed earlier, only MSMEs with good prospect lenders are willing to allocate credit to. More efficient MSMEs and those able to adjust to the changing market demand and consumers’ tastes have a greater chance to receive credit. In this context, digital technology can be applied to daily tasks to improve efficiency and productivity. It could also help provide new opportunities, be it new product or new process of production. When digitalization results in some automation, it can be combined with several operations to do menial and repetitive tasks that would save time and costs for the business, e.g., purchase orders for procurement, shipment tracking, invoicing, and other B2B-related activities that are critical parts of supply chain.

Digital technology could also help MSMEs to expand market potentials. By utilizing social media and other internet platforms, MSMEs can resist the limitations of their physical location, allowing them to serve far-distant markets and remote customers to enlarge the customer base. It could also help MSMEs to enter competitive export markets, for example through on-line advertisement to showcase their unique products or other features (e.g., women-run, organic, health-conscious, safeguarding environment, and sociopreneurship where the business also helps solve some social concerns). All these things are difficult to conduct if done manually. The use of digital technology can also help to diminish the risks within supply chains. Branding is also an area where digital technology can be useful for. To the extent operating in competitive markets requires good branding, digitalization can help MSMEs to create company’s name and logo, make visual identity design, and write the company’s mission and values.

Another important benefit of using digital technology is having a greater opportunity for connectivity. As discovered from the survey discussed in Chaps. 2, 3, and 4, having a good network is extremely important to enable MSMEs to improve their productivity. A process by which various forms and members of network connect is what connectivity is all about. With the ever-changing conditions and environment, connectivity with customers, employees, and other stakeholders could have a profound impact on business profitability and productivity. Using digital technology could make it easier for MSMEs owners/operators to engage more directly, frequently, and instantly, with suppliers, customers, and regulators. They can trace and evaluate customer credit, use it as a risk mitigation device (e.g., set credit limit or other conditions), and as cash flow management tool. According to a recent survey, more than 70% of MSMEs using social media in Indonesia used it as a medium for consumer interaction DSInnovate (2023). Engaging with their own employees is another important task that would improve business performance, especially for MSMEs with a relatively large number of workers. The use of digital technology can also make training for employees more seamless and effective.

In the mid of higher competition and lower purchasing power at the time our survey was conducted, we found several cases where MSME owners/operators are actively trying to develop innovations and customizations in their products to meet clients’ requests. Many of them confirmed that such efforts would have been difficult and more time-consuming had they not used digital technology or internet-based communication. Digitalization also enables MSMEs to diversify and advance their business model to navigate around direct-to-consumer (D2C), consumer-to-consumer (C2C), and business-to-business (B2B) models. New participants could also gain from acquiring better information about the challenges and opportunities experienced by incumbent MSMEs.

All the above virtues from using digital technology can essentially help improve the MSMEs’ performance, on which banks and other lenders can consider in making the decisions on credit, such that they would limit the credit rationing and extend more loans to MSMEs. This would help mitigate the problems of financing gap.

To make the potential virtues reality, however, some collaborative efforts are needed. The importance to create an enabling ecosystem is second to none. At the outset, raising the awareness about the benefits of using digital technology is a necessary step. The government is expected to collaborate with the relevant parties, e.g., phone carriers, internet providers, e-commerce companies, regulators, banks, and other potential lenders. Encouraging new innovators and startups to develop a variety of products and services that could help support MSME operations is another important part of the ecosystem. But beyond collaboration, there is also a need for coordination (often weak in most developing countries). More data on MSMEs are also needed to measure and track their progress and problems.

On the hardware side, the availability of reliable electricity and internet connectivity are necessary, yet is often lacking, especially in remote and rural areas. MSMEs also need to have sufficient tools including computer and peripheral devices. On the software side, improving the MSMEs’ digital skills and knowledge is of utmost important. Raising the digital literacy and making the users feel comfortable using it is not easy, especially among the elderly and less educated members of the community. It takes time, not an instant process. Equally important is to remove the digital barriers on the part of suppliers and customers, including MSMEs’ employees. MSMEs will not find it necessary to go online if individuals and potential customers are not online. Another important effort that needs to be made is to ensure that the fees on connectivity and the prices on hardware and devices are affordable. This could be supported by loans earmarked for purchasing devices and paying the internet fees. While digitalization makes technical things easier, the bureaucracy and procedures to obtain required documents ought to be streamlined. The government’s initiated One-Stop Service (OSS) program, intended to simplify the process of obtaining licenses and other necessary documents, is an example in the right direction. Last but certainly not least is the need to provide a protection from cyber attacks. Any operations involving digital technology always pose some security risks. To raise users’ confidence, such risks need to be mitigated.

If all the above efforts result in a wider spectrum of community able to use digital technology, not only it would help mitigate the problems of financing gap and low productivity of MSMEs but also would minimize the risk of digital divide and promote inclusion, where majority of individuals (irrespective of their gender), households, businesses and geographic areas could have similar opportunities to access information and communication technologies for a wide variety of activities. With some additional efforts, such opportunities can also be made available to informal MSMEs.

To sum up, digitalization is more than a buzzword for MSMEs. It could literally narrow the financing gap, directly through better and more instant information, and indirectly through various efficiency-enhancing channels. Since such positive virtues are not preordained, however, collaborative efforts and supporting policies are required.

5.5 Fintech and Digital Payment

Related to financing gap, digitalization or a process of moving into digital technologies is often promoted as one of the solutions to narrow the gap. Despite all the efforts, however, the adoption of digitization (making analog information digital) remains relatively low albeit growing among banks in Indonesia. The main objective of implementing digitization is cost reduction. Non-bank lending firms using digitization have been also growing but remain small. They too have a role in reducing the financing gap for MSMEs.

A combination of financial services and technology, commonly known as “fintech,” is aimed at making it easier for borrowers including MSMEs to get loan, save, or invest online. The main factor behind the potential role of fintech to narrow the financing gap is the ease of getting the funding when bank lending is difficult to access. Some arguments have been made that a greater use of fintech can help narrowing the class divide (between micro, small, and medium enterprises), the urban-rural divide, and even the gender divide. But whether that is the case, it remains to be seen. The effect of using a new approach or technology must be predicated not on an ideal case but on the real world as it is. Supporting policies and other initiatives are needed if narrowing the class divide is to be attained. Fintech alone will not do the job.

Similar to the trend of digitization use, only few banks and non-bank lending firms are familiar with—and actually use—fintech solutions. Some banks used it to reduce the cost of complying with regulatory requirements and due diligence, while others used it for credit assessment (transactions using fintech often fall under the category of peer-to-peer or P2P lending). Concrete data on the usage are still scarce, but our discussions with some bankers suggest that only few of them implemented fintech despite its potential to enable banks to “know customers” better and in a more reliable and efficient way, lower the costs, and, more importantly, reduce the incentives for credit rationing discussed earlier. From the demand side, there is an indication that only few MSMEs used fintech. They did so to diversify the source of external funding, not to substitute bank finance, as they also received loans from banks.

If fintech indeed could lower the costs, lending to MSMEs by banks using fintech should be high, mitigating the financing gap problem. Unfortunately, data and studies on the relation between the use of fintech and credit to MSMEs in Indonesia are scarce, let alone between fintech and trade credit. But studies in other countries tend to show that there is no clear correlation between the two. When asked through surveys, most lending institutions, especially smaller banks tend to report that digitalization is expected to enhance their ability to assess MSME risk, primarily through cost reduction. Yet, lending to MSMEs continues to be lower than desired, and the rejection rates for trade finance application by MSMEs remain elevated. This suggests that cost alone is not the primary reason for the small size of credits to MSME, which once again supports the postulates of credit rationing.

MSMEs’ use of digital payments follows a similar trend. Although increasing, it remains low. Unlike big companies that have established new digital networks to facilitate trade and finance by leveraging digital technologies for improved supply-chain efficiency and transparency, many MSMEs in Indonesia find it difficult to capitalize on such opportunities. During the COVID pandemic, people worried about its transmission through exchange of physical items including currency notes, thereby resorting to the use of contactless payment transactions. This provided an opportunity toward using digital modes of transactions. The transition was also pushed by the government and the monetary authority for quite some time. Indeed, initial media reports about the increased usage of digital payment modes seem to confirm this expectation.

In Asia ex-China, the growth of digital payment usage was double-digit: almost 60% of adults now have an account, and 23% of adults made digital merchant payments. The figures for China was even higher, 89% and 82%, respectively. More than half of them used digital payments after the beginning of COVID. While the gender gap involved in the transition was relatively low, however, the gap between rich and poor adults remains high, around 10 percentage points (World Bank, 2022). This raises the question over the effectiveness of the current structure of digital payment in helping to strengthen financial inclusion.

To understand better and make a more realistic conjecture about the sustainability of the transition to digital modes, one needs to look at the evidence, especially after COVID. Consider the case of digital payment made online using a smartphone camera to read a barcode with a special algorithm through Quick Response (QR) Code. In Indonesia, it is called the “Quick Response Code Indonesian Standard” (QRIS), which unifies different types of QR from various Payment System Service Providers (PJSP) using QR codes. Every QR code-based PJSP provider must use QRIS that works across various e-wallets and banking apps (unlike QRIS, however, e-wallets are deeply embedded in digital services such as GoPay for Gojek and Tokopedia). After the customers select the products and services, they then use the smartphone to scan using the QR code provided by the service providers and the switching institutions that are approved by Bank Indonesia to process QRIS transactions. The users are then asked to verify the account by entering a password. If successful, the transaction is transferred from the users to the merchant account. This is where security can be a significant factor. No matter what means of payment we are making, transactions can be carried out by scanning on QRIS (hence the motto “one QRIS for all payments”). In addition to QRIS, another digital payment transfer in Indonesia is known as the “BI Fast” which allows fund transfers from one bank to another using the recipients’ account details, mobile number, or email address.

Although QRIS offers contactless advantage, convenience of transactions, and faster payment speed, there is a potential level of risk inherent in it such as privacy issue, data theft, hackers, and others.⁸ During the COVID pandemic, QRIS became a favorable alternative since users did not need to make exchange of physical items. Other transactions based on digital payments such as mobile banking and cloud-based electronic money applications also increased in usage during that period. Is the trend structural or cyclical? Was the surge during COVID due to a desperate attempt as no alternative options for MSMEs to continue their business without it, or did it reflect a change in the mindset about moving toward digital modes? If the former applies, the trend is likely cyclical. If the latter holds, it may reflect a structural trend. Given the fact that the increase in the number of digital payment users was higher than bank accounts before COVID, however, the potential for usage growth in Indonesia is quite high.

The question of acceptance or rejection toward the use of QRIS is determined by a number of factors, including users’ performance expectations and trust. Because there is an intrinsic factor inherent in technology, namely security, trust is crucial in ensuring that the security in QRIS can be controlled and accounted for by the provider. Looking at China experience (the world’s fastest growth in mobile payment), users’ concerns could only be mitigated by clear and strong regulations on digital payments. Although holding financial institutions accountable for harmful practices is a standard practice, prevention should also include informing consumers about the risks of predatory financial practices, especially to less educated adults and other vulnerable groups who often have limited prior financial experience. These groups, including MSMEs, are often more exposed to financial abuse. After all, for any financial products, services, and the regulatory environment in which they operate, the goal should be to help people achieve financial well-being. And this can be realized not only by creating incentives for service providers to design and deliver products and services that would benefit consumers, but also by preventing and mitigating consumer risk and harm by weeding out bad practices.

Another deciding factor is cost. The usage of QRIS by customers tends to be higher when some forms of discounts are offered by merchants, and no fee is charged to either the customers or the merchants. The difficulty in assessing the actual usage of QRIS is due to among others the fact that merchants and consumers may symbolically accept it but in practice not really use it, either because of their outright opposition, rejection, or postponement. Although no concrete and reliable data for Indonesia are available, the experience of other countries going through a similar transition to mobile banking or digital payment is worth to note. In India, more than half of individuals reported that they did not make any change in their use of digital payment methods during the post-pandemic lockdown. This trend highlights the possibility that the use of digital payment methods may not have increased as much as anticipated during and after the pandemic.

It is too early to make a conjecture about whether the increase in the usage during COVID is only temporary or more likely permanent. It remains to be seen whether after COVID people will return to their pre-pandemic transaction behavior by reverting to using currency notes for transactions, or the increased adoption will continue and become more permanent. The pandemic had clearly catalyzed digital payment, but there are limits in leveraging digital payments for certain segments of the society and for certain types of businesses including MSMEs that rely on suppliers who are willing to receive only cash payments. Even at the beginning of COVID, it was not easy for elderly residents, MSMEs, and less educated groups in many countries, developed and developing alike, to make a switch from using cash to digital channels for various reasons. Some pointed to their lack of digital skills and a lifetime of reliance on cash, others highlighted the low digital access especially for those living in remote areas.

It is therefore safe to argue that until a longer series of data of post-COVID are available, it is difficult to conclude whether the increased use of digital payment during COVID was cyclical or structural. In the meantime, some theoretical concepts on why a certain group of people are accepting while others are rejecting the use of a new technology is useful to explore. It helps us understand better about the circumstances behind the limitation of usage of the digital technology or any new change for that matter.

5.6 Rejection and Acceptance

Two types of people are identified: those who prefer order and precision and to work within established patterns of rules, hence likely resisting a change, and those who tend to explore new things and even challenge the existing rules and break away from established procedures. While most of the concepts on resistance toward using new technology point to a range of factors, from market-related, psychological, product features, and cultural (individual characteristics), we need to understand them better from the point of view of these two types of people. Among several concepts, the one based on the theory of “adaptive-innovative cognitive style” introduced by Kirton (1976, 1994) has been used extensively in the analysis of consumer innovativeness. Rather than people’s cognitive level, ability, or complexity, the concept describes how people’s mode of intellectual activity in processing information, making decisions and problem-solving determines their reaction and approach to a new alternative technology.

Psychological barrier, such as communicability barrier, is one of the cited reasons for resistance. One needs to be aware, however, that such a barrier can also reflect a perceived—not real—ineffectiveness when used to describe the benefits or shortcomings of using digitalization or any innovation (Talke & Heidenreich, 2013, 6). Product feature is another commonly cited reason, referring to the perceived difficulties of trying to use or introduce the digital technology to other merchants. It partly reflects the shortcomings of both the hardware and software aspects of digitalization. On the hardware, the non-existence or unreliable internet connection is a factor. On the software, a lack of internet or digital information literacy especially among the older adults is the significant impediment. For some MSMEs residing in rural areas, going digital is not a matter of choice but of availability and affordability. Resistance is also attributed in no small part to the cultural factors. Some perceive that the new technology conflicted with their values and traditions and the benefit of learning and using it is no longer worth the time and money spent given so many hurdles they have to go through.

There are several types of dismissal: opposition, rejection, and postponement. The most extreme form is objection, and this could lead to rejection. Take the case of digital payment or online marketing designed to help MSMEs. Even when there are no obstacles related to the internet access, some MSMEs may object to the use of the digital-based modes. The reasons for opposing it can be related to cognitive style, situational factors, or simply because it is perceived as not offering them a differential advantage or even giving them a relative disadvantage.⁹ Such an objection may come early before trying. When there is a mass rejection of this type, social planners should think of an alternative strategy and approach. Once such a strategy is implemented, the digital payments or online marketing may be accepted, may still be rejected, or it may be postponed. With or without social planners’ efforts to persuade MSMEs, there is also a possibility that MSMEs may proactively search themselves for further information, which in turn may lead to either final acceptance or persistent rejection.

Fig. 5.7

Source Survey data

Increased use of digital technology by MSMEs.

During our survey, we also made an effort to find out if the increased use of digitalization during COVID, particularly the digital payments, the e-commerce such as Tokopedia, the messaging platforms such as WhatsApp, and the social network platform such as Instagram and Meta (formerly Facebook) is expected to continue, tapering off, or will decline once COVID ends.¹⁰ What we have learned from our interviews on the subject is that, during COVID they shifted to digital or online technology out of necessity in order to stabilize their sales. As shown in Fig. 5.7, the increase was not too dramatic, lower than in other countries during the pandemic. The reported impact in terms of sales volume was also not too significant. By the time our interviews were conducted (end of 2022), some of them had ceased using the digital technology

But another benefit from using the digital technology emerged. Most of our respondents cited an increase in their network, albeit mainly with their customers (existing and new ones). A recent study by Estiko (2023) looked at a particular case of how halal label could increase visibility to customers. Having such a label makes MSME products permissible or acceptable in accordance with Islamic law (in the case of food products, for example, they are guaranteed to use acceptable sources such as a cow or chicken that are slaughtered according to the law). It is argued that its effectiveness to help increase the sales could be enhanced by using e-commerce platforms. In the current format, however, the study found that there is no significant impact of halal labels on sales. This could be due to a number of factors, such as label’s subtle visibility on the platform being overshadowed by other product details and seller’s rating, and consumer purchasing behaviors that might not prioritize the halal certification. To make the efforts more effective, it is suggested that the government should encourage the e-commerce platforms to promote and enhance the visibility of such labels to ensure that they are not overshadowed by other product details.

While overall the digital usage by MSMEs during COVID was on the rise, it tapered off afterward. It was unclear why this occurred. Some reported because they fell ill and unable to continue the networking, others said that some of the counter-parties were no longer contactable. Interestingly, only those MSMEs receiving support and guidance from BI managed to maintain and even expand the number of network. To the extent other MSMEs also utilized the digital technology during COVID, many also reported that they were facing more competition as other MSMEs had become their business rivals.