India has created ‘perverse incentives’ for firms to stay small. Here’s how to fix it – The Economic Times

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SynopsisIncentives meant to help Indian SMEs have an unintended and undesirable result. Most small businesses start small and stay small throughout their life. They do not want to grow.

For small businesses in India, growth pangs are more draining than birth pains. In fact, most of them often remain in the size they were born, as entrepreneurs have often found it difficult to balance their aspirations and expansion needs.

Chief Economist of Dun and Bradstreet Arun Singh says for every 100 companies, 95 are micro, 4 are small and medium and only 1 is large. “Whereas, in most of the developed countries, 50-55 entities out of 100 are micro and 40 are small and medium firms.”

Low competitiveness, arduous compliance norms as well as skill and capital deficits, among others, keep MSMEs — and the domestic economy — from achieving their true potential. Given that MSMEs’ play a pivotal role in economic development — they contribute about 30% to GDP, 40% to exports and employ about 120 million — it is time to inspect how small businesses in India can become globally competitive in a post-Covid world.

Globally Competitive
Small businesses need to understand that competitiveness isn’t some vague concept that is limited to the boardrooms. A 2019 report by the Confederation of Indian Industry defines competitiveness as the “ability of a firm or a nation to offer products and services that meet the quality standards of the local and world markets at prices that are viable and provide adequate returns on the resources employed or consumed in producing them”. While MSMEs have been able to adapt and show resilience, says the report, many domestic factors hinder their competitiveness index.

Higher efficiency, superior value proposition to customers, product innovation, strong partnerships and alliances can all add to the competitive advantage of a company, says Singh. “The concept of global competitiveness applies not only to companies that serve international customers but also to companies that serve domestic customers. Since we live in an open economy, domestic companies need to be competitive to be shielded from competitive imports,” says the expert analyst.

One of the primary reasons holding back MSMEs’ growth is the high compliance and regulatory costs. In fact, industry observers claim, most MSMEs don’t want to grow. They like to stay smaller — sometimes even shrink — to avoid being the target of impractical regulatory policy.

Last year, Finance Minister Nirmala Sitharaman revised the definition of an MSME by raising the investment limit. An additional criterion of turnover was introduced and it also eliminated the distinction between manufacturing and service sector.

Falling under the purview of the definition of an MSME is important for scores of firms. A small business qualifies for priority sector lending, exemptions under labour regulations, comes under the purview of the Credit Guarantee Fund Scheme, finds a place in the purchase preference policy, price preference policy, get benefit in tendering, eligible for marketing assistance scheme among other policies.


Source: Economic SurveyIf the threshold to qualify as an MSME is kept low, we incentivize firms to remain small in order to reap the benefit of the schemes and policies. According to the Economic Survey of 2018-19 policies often create a “perverse” incentive for firms to remain small. “As economies of scale stem primarily from firm size, these firms are unable to enjoy such benefits and therefore remain unproductive,” said the Survey.

In a chapter devoted to MSME, the Survey said job creation in India suffers from policies that foster dwarfs. “These dwarfs, i.e., firms with less than 100 workers despite being over ten years old, account for more than half of all organized firms in manufacturing by number, their contribution to employment is only 14 per cent and to productivity is a mere 8 per cent. In contrast, large firms (more than 100 employees) account for three-quarters of such employment and close to 90 per cent of productivity despite accounting for about 15 per cent by number.”

“We have seen this tendency among many companies. They break ownership structures into parts to avoid compliance costs as they become bigger,” explains Singh. Some rules treat large companies with thousands of workers as equal as a smaller one with 10 or so employees equally. “This can be detrimental.”

Besides, an entity can set up plants anywhere in the country, but it will have to procure multiple clearances and licences. In the absence of a streamlined and centralised system, MSMEs sometimes have to spend a lot of resources to navigate this labyrinth.

Amit Bansal, CEO of Standard Chartered-backed Solv, says of the 65 million MSMEs in India, 90-95% are sole proprietorships with turnover of under Rs 10 crore. “Their businesses are very small and they are very fragmented in their geographic location as well. Therefore, policies have to be tailored accordingly,” says the CEO of the e-commerce marketplace.

Some classifications have to become more flexible if the small businesses have to thrive.

Singh cites the government’s decision to increase the tax audit threshold to Rs 10 crore turnover from Rs 5 crore — announced in the latest Union Budget — as an example of easing compliance norms for SMEs. More such reforms will infuse confidence to take risks and grow in the sector, he says.

‘Show Me the Money’
Poor access to low-cost capital has been a major issue for small businesses. In a survey by Dun and Bradstreet, one in three MSMEs claimed getting finance was one of the top challenges in scaling up their operations. The primary reason was they had a low or bad credit score, or poor loan history because of reliance on traditional lending. Most MSMEs deal in the cash economy, so formal lending systems won’t have adequate data about them.


A recent report by the Association of Chartered Certified Accountants states that around 50.7 million enterprises do not have access to formal lending channels. This means 80% of the 63.4 million Indian MSMEs cannot get low-cost capital.

Finance institutions such as banks classify loan aspirants based on their earning power, says Ram Iyer, founder and CEO of financial intermediary Vayana Network. But SMEs don’t form a cohort easily. Each one has its own demands, and each one has a varied set of problems. “One could say that with GST, e-invoicing and a bunch of other things that we are doing right now, more data is available. That is true. But also remember that a lot of these enterprises don’t even have Rs 5 crore in revenue, so they don’t even really need to file GST (goods and services tax) returns,” he says. These documents can help MSMEs get loans.

A consultative approach in each case can be a solution, points out Iyer. But it will make the business costlier for banks as they will have to hire an account manager or relationship manager for each SME. A more practical way of giving access to finance for these entities is to recognise the fact that they are part of some supply chain.

“If you are a kirana store, you obviously are buying from some distributor of, say, Nestle or Colgate. Therefore, those guys could provide legit information about the purchases by the kirana store. This info can be used to give the shopkeeper some credit. We need to use a lot of supply chain information to provide financing to these guys. Lending institutions can then design and create loans for these entities, and see how to do it at scale,” says the CEO of the financial intermediary.

Going Online
One good news for MSMEs is that digitalisation has changed the way business is done, especially after the pandemic started. After big companies embraced virtual ways of life, the focus has turned to digitalising the numerous small businesses. Many entities such as ShopifyShopmatic and ANS Commerce have emerged to help SMEs befriend technology. Even the big companies are looking at this as a strategic move. “A lot of tech-enabled large companies have realised the importance of partnering with smaller businesses. A big company may be able to attract top-notch talent. But it cannot get the entrepreneurial zeal a small business operator brings to the table,” says Bansal of Solv.


iStockGoing digital can be one way for small businesses to scale.SMEs have also realised the various benefits of the internet, especially when a lockdown stops normal activities. “Around a decade back, SMEs were getting used to the idea of the internet being a potential medium to do business. Now, SMBs think about using it as a medium to grow their business,” says Sampad Swain, CEO of Instamojo, which helps small businesses move on to the web.

Speaking on similar lines, Jiten Arora, Member, SC Ventures, says that making technology accessible to SMEs through India’s vibrant startup ecosystem will go a long way. “This will result in easing critical bottle necks and having a multiplier effect on creation of MSME entrepreneurs in the ecosystem, helping India transition to a hyper-growth mode. What we do with this sector now will pave way for its growth in the next couple of decades,” he adds.

Digital Learning
This shift has helped small companies scale up faster and become more competitive. “They are starting their own direct-to-customer lines and leveraging the power of simpler and affordable software, which can also give them better pricing options and better insights. SMEs are no longer afraid of competition. This raises hope that they can be extremely competent in an international platform as well,” Swain says.

The pandemic gets the credit for bringing in this change in mindset among even traditional SMEs. Before the pandemic, says Singh of Dun and Bradstreet, various studies suggested that just 2% of the MSMEs in the country were actively using the internet for business. “Digital adoption has been accelerated by 7-10 years during the pandemic, which means if we eliminate the pandemic, the digital adoption rate that we have achieved today would have been achieved after 10 years.”

Along with digitalisation, MSMEs should also look at new-age payment platforms. These can help small businesses open a virtual account and process any payment almost immediately. The cost and time taken for such transactions would be negligible when compared to traditional methods.

Rohit Kulkarni, Vice-President at cross-border payments platform Payoneer, says SMEs use archaic payment methods even today. They depend on Letters of Credit, bank guarantees and other expensive and cumbersome methods. Processing these can take days. “They are also collateralised, which means the promoter has to mortgage his home, office or other assets to make banks clear these payments. But with a new-age payment platform, SMEs can start accepting payments in rupees for a foreign transaction at the click of a button,” he says.

Digital transactions can help SMEs stay on the grid, become more transparent and also help improve their credit history. Staying connected also means getting quick information and clarifications about various government schemes. A large portion of SMEs are informal players and so not linked to networks that can educate them about eligible schemes. This lack of knowledge also keeps them from venturing into new and potentially lucrative markets.

Fixing it
There are plenty of low-hanging fruits that can fix some issues. Every incentive that a firm receives should not be for perpetuity, but linked to the age of the firm. Where the promoter shuts one unit and starts another to reap the benefits from incentives, the Economic Survey points out that linking Aadhaar to a business may effectively nix the issue. When it comes to the banking sector, there is a need to re-orient the Priority Sector Lending (PSL) scheme and take a sectoral view. Sectors that show high growth and potential to create employment should be targeted.


iStockFocus on service sectors with high spillover effects such as tourism.Beyond policy issues, four out of 10 MSMEs in India consider access to market as one of the top challenges in scaling up their business, according to the Dun & Bradstreet report. Singh says export promotion agencies and export promotion councils can help MSMEs become familiar with business information portals. “This will reduce the sunk cost of entering a new market. We also need to improve our trade openness. Unfortunately, India is ranked 131 out of 141 economies under trade openness in the World Economic Forum’s Global Competitiveness Report 2019. We are almost at the bottom 10. One reason behind this is increasing trade tariffs. Between 2017 and 2019, tariffs have increased on 45% of the product categories, while tariffs have decreased on 1% of product categories, and remained constant on the rest,” says the chief economist of the data and analytics company.

Vayana’s Iyer cites the example of China and how it created an enabling public infrastructure for SMEs by working on improving their operations. The SMEs Promotion Law 2003 uplifted the status of SMEs in Beijing’s national economic order. With such support, China’s SMEs could aggressively compete globally.

Over 98% of all firms in China are small businesses employing 300 or fewer employees. They contribute over 60% to the country’s GDP, 68% to exports and 75% to job creation, according to a 2019 report by the Organisation for Economic Co-operation and Development. India’s over 63 million MSMEs contribute 30% to the country’s GDP and 49% to exports.

At an operational level, says Singh of Dun & Bradstreet, SMEs need not compete with their massive peers to grow. Small businesses can earn an enviable reputation by becoming an indelible part of a global value chain. “Global giants are coming here to set up plants. They are looking for local vendors.” This can also help small businesses diversify their product mix and customer base and grab more growth opportunities, he adds.

MSMEs have to decide if they want to be a relic of a bygone era or the stars in a new economic galaxy.

(Editing by Ram Mohan)

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