Can SMEs drive India’s growth?

Over the past decade, the Indian economy has demonstrated both remarkable acceleration in growth and employment and equally sharp deceleration. The high growth recorded during 2003-09 was based mainly on a sharp increase in the investment rate permitted by significant improvements in the savings of the public sector, particularly government, and by the private sector.

High growth during 2003-09 was driven by investment

The recovery of the economy from the industrial slowdown, which stretched from 1997 until 2002, was led by large improvements in the efficiency of the Indian corporate sector. The virtuous cycle unleashed by this increase in efficiency led to increased saving and investments by the corporates, which amounted to nearly 8 percentage points of the gross domestic product (GDP). At about the same time, the government, prompted by the enactment of the Fiscal Responsibility and Budget Management Act (FRBM) and supported by rising revenues from increased corporate profits, reduced its dis-savings sharply and turned them into a small surplus during the latter part of the period. This allowed public investments, particularly in infrastructure, to be scaled up substantially, which gave further impetus to the positive growth dynamics. It also enabled the government to reduce its draft on household savings and thereby released resources for investment by the small and medium scale enterprises (SMEs).

The aftermath of the 2008 global crisis

The situation today is very different. As things stand, India cannot hope to achieve even 8% growth relying entirely, or even largely, on increase in investment. The global crisis of 2008 led to a situation where the government had to prop up the economy through fiscal expansion, which led to a sharp reduction in public savings. Despite the recovery of growth, neither government revenues nor the savings of the corporate sector managed to recover from the shock. Since 2012, the sharp deceleration of the economy has made matters considerably worse.

During the corporate-led growth process of 2003-09, the increased revenues of the government permitted expansion of both public infrastructure investments as well as SME investments. However, when the global crisis occurred, the corporate sector in India cut back sharply on its investment activities. Conversely, the SME sector actually further expanded its investments as a share of GDP quite significantly. Thus, the resilience of the Indian economy in the first two years after the crisis owed almost as much to the small and medium entrepreneurs in the country as it did to the government’s fiscal expansion. It appears that the corporate sector is much more sensitive to global developments than the SME sector, which seems to be more attuned to the dynamics of the domestic economy.

Can we expect corporate investment recovering in the immediate future?

In the immediate future there are two possible scenarios that could play out. The first is a steady recovery of the global economy and the return of confidence in the international financial markets. In such a scenario, there is a strong likelihood of a return of the growth dynamics of the 2004-09 period spurred by a sustained recovery of corporate investments. However, there are some important problems which could compromise this possibility.

The first and the foremost is that not only are Indian firms suffering from a loss of confidence, a number of them are seriously over-leveraged and have liquidity issues. This is particularly true in the infrastructure space, where neither demand nor technical capacity are constraints, but financial access is. In such a situation, the public-private partnership (PPP) model for infrastructure development that had been followed with some success in recent years may be adversely affected. In this case, the pattern of infrastructure investment may have to be reconsidered since a significant part of the 12th Five-Year Plan (2012-17) target for infrastructure investment of $1 trillion was to be met by the private sector. Even with optimistic assumptions, this figure will have to be scaled down to around $800 billion. While this is not an issue in itself, it does require a complete reworking of the priorities for infrastructure development since the limited public resources will have to be redeployed to meet the core requirements in areas originally planned for private investment.

Second, the uncertainties created by policy, particularly with regard to retrospective taxes, land acquisition, environmental clearances and fuel linkages, are not going to be resolved soon. The prevailing mood is that most of these changes will have to await the forthcoming general elections and assumption of charge by a new government. Even so, the fear psychosis among the bureaucracy engendered by a spate of corruption charges and vigilance cases in recent years is unlikely to abate simply by a change of government. Consequently, most corporations have put all major new projects on hold. Revival of such projects can take at least two to three years.

The SME alternative

The alternative, and the more likely, scenario is that the recovery process of the developed world will be at best slow and weak. The financial markets too will be jittery and display significant volatility. In such a situation, corporate sentiments in India may not be positive enough to be able to lead the growth process.

However, an alternative process which can raise the growth rate significantly and hopefully trigger a revival in corporate confidence exists based on the dynamism of the SME sector. There is, of course, a need to start the process by increasing the overall savings in the economy as rapidly as possible. The current account deficit, running at over 4% at present indicates that even with the relatively subdued investment activity in the country, there is yet a substantial gap between investments and savings. Inflation too is high and sustained for an extended period. Demand is therefore not an immediate concern.

The increase in savings initially can only come from the government through steady correction of its fiscal balances. If the past is any indication, a reduction in the fiscal deficit, which is a measure of the public draft on household savings, leads to an immediate increase in the investments of the SME sector. Although the SME sector tends to have lower marginal savings rates than the corporation, nevertheless a positive cycle can be generated. If the government was also able to lower its revenue deficit, the pace of infrastructure development, which has lately slowed, can be revived without crowding out the private sector. This would contribute to increasing the overall efficiency of the economy and, therefore, support the growth process.

India is fortunate that it is richly endowed in entrepreneurial talent. The economic censuses demonstrate the huge size and growth of entrepreneurial activity in India. At a rough estimate, the net increase in the number of non-agricultural establishments in the country is about 8 million every 10 years. While admittedly many of these enterprises reflect basic survival strategies, many do not. The past decade has shown the dynamism that is possible in this sector under the right circumstances and with the proper policies. Many of the leading corporate houses existing today belonged to the SME category at the turn of the century.

SME-led growth would require more investment but also generate more jobs

In so far as efficiency of capital use is concerned, there is mixed evidence on whether the SME sector is inherently more efficient than the corporate. Although it is certainly true that SMEs tend to have lower capital to labour ratios, it is also true that the value added per unit of capital may actually be lower. In the aggregate, the probability is that an SME-led growth process would require a higher investment rate to achieve a particular growth rate than a corporate-led strategy. This, taken with the lower marginal savings rate of the SMEs, implies that the burden for generating the requisite savings would fall more heavily on the government. On the other hand, there is no doubt at all that SME-led growth would generate far higher employment growth than the corporate-led. This would in itself reduce the need to support aggregate demand through fiscal action since the private consumption arising from such incomes will be higher.

There is, however, cause to believe that the capital efficiency of the SME sector can be increased significantly with proper policy since much of the measured inefficiency arises from a variety of constraints within which the SME sector has to operate. The most important of these are: (a) the quality of labour that is available to the SME sector (b) the lack of support to entrepreneurship in general, and to innovation and risk-taking in particular, and (c) the operation of the financial sector.

Skill development efforts should focus on catering to SME sector needs

In the absence of an adequate skill development system in the country, the SME sector invariably recruits untrained workers who are then trained on the job. Quite often once the workers reach a certain level of skill they are absorbed by the corporate sector. Consequently, the SME sector is in a constant process of training raw hands and being unable to retain skilled workers. The efforts that are being made at present to improve the skill development infrastructure in the country need to focus on abilities which are needed by the SME sector. If this can be carried out effectively, we should expect to see a significant improvement in the efficiency of SME production and, thereby, an increase in their value added per unit of capital.

Moreover, SMEs are the primary source of employment opportunities for new entrants to the labour force. This is certainly true of India, but is probably true in most countries of the world, including the developed countries. One of the reasons possibly why India has one of the lowest incidences of youth unemployment is because it has one of the highest shares of SMEs in its GDP. Thus, if youth unemployment is a concern for policy, focusing on entrepreneurship is a better strategy than supporting existing corporate enterprises.

Need to encourage innovations in the SME sector

Another source of possible efficiency increases comes from the higher levels of innovation, both product and organisational, which are possible in the SME sector. We do not as yet have systems which encourage and nurture such innovations. There are some efforts that are being made through incubation centres and early venture capital activities. These have, however, yet to reach scales where their impact is economy wide. Encouraging such activities should become a core activity in the coming years. This is not merely for attaining the desired growth rate over this Plan period, but as an important component of the inclusive growth strategy for the longer term as well.

There is a distinction between supporting entrepreneurship and supporting enterprises: a common confusion in policymaking. Clearly there are commonalities: ease of doing business, improving infrastructure, better governance, and so on. However, there are differences which arise from the size and age of the two categories. For instance, in cases of public procurement or PPP projects, the conditions almost always work against new companies. How this bias can be corrected without compromising on quality and time depends upon circumstances. Two successful cases in India have been the rural roads programme and the early years of the National Highway Development Programme.

Ensuring access to finance for the SME sector

The other major constraint is finance. Anecdotal evidence suggests that informal credit arrangements play a significant, if not dominant, role in a wide range of informal sectors, especially agriculture, SMEs, trade, transport and real estate. Although there is no rigorous measure of this, an indication can be obtained from the national accounts data which suggests that financial intermediation services indirectly measured (FISIM), which is a euphemism for such transactions, could be larger than 40% of formal financial intermediation services.

Although India has implemented a number of measures to improve the flow of formal finance to the SME sector, especially through directed bank lending to small enterprises though priority sector lending targets, the experience is not entirely positive. It is felt that entrepreneurship support cannot be achieved by such policies when banks (and other formal financial sector entities) continue to follow traditional methods of lending. A possible solution would be to change banking rules in a manner that for certain categories of lending, banks shift from a project appraisal approach to an actuarial approach. This is not a new idea at all, but banks simply do not have the capacity to adopt this model in most cases. In the period while banks develop the technical capacity to adopt this approach for building their loan portfolios, two methods can be adopted. The first is to permit insurance companies to issue credit default swaps (CDS) against bank loans to SMEs, and the other is for banks to partner insurance companies in determining joint customers. The important point, however, is that innovations in finance are essential, and should not be eschewed simply because of the recent global experience.

It is equally important that the role of informal credit providers be recognized, and not merely denigrated, since they perform useful functions which cannot necessarily be taken over by the formal institutions. Contrary to popular opinion, these informal institutions are not just credit providers, but also mobilize savings in a manner which is more suited to the needs of the poorer segments of the population. Moreover, the interest rates charged by many of the institutions do not compare unfavourably with those charged by microfinance agencies. If a SME-led growth process is to be considered seriously, then ways will have to be found to integrate them into the larger policy framework.

It may, therefore, be possible to achieve and maintain growth rates of above 7% per annum without any significant improvement in the global economy, relying mostly on the dynamism of the Indian entrepreneur and the creation of financial space through government fiscal correction. Taking this up to the 8% plus level, however, would require either favourable developments in the global economy or additional policy action to improve both the efficiency as well as the sentiments within the domestic economy.

The column is based on a talk by the author at the 5th Annual International Conference on Issues of Concern for G-20 Countries in New Delhi organized by the Indian Council for Research on International Economic Relations (Icrier).

Pronab Sen is chairman, National Statistics Commission.

Published with permission from Ideas for India (www.ideasforindia.in), a public policy portal.