Small and medium enterprises—SMEs in India, Mittelstand in Germany, Zhongxiao qi ye in China—constitute the lifeblood of most economies around the world. While this is widely recognized and studied, policies and consequent economic and societal outcomes are widely variant across countries. In India, we add the word “micro" to the classification: MSMEs make up a substantial segment (over 95%) of the nearly 60 million enterprises in India.

The role of mid-sized firms evolved along different paths in industrializing Europe (particularly Germany), newly independent US and pre-war Japan during the 19th century. Newly federal Germany, after World War II, provided a dramatic fillip to its Mittelstand through its provinces (landes).

Regional governments and banks backed local champions and these firms adopted a method of continuous innovation to stay ahead—using retained earnings, rather than debt, to fuel growth. Competitive pressures from the export market led to relentless innovation and elevated many Mittelstand companies into becoming world-class specialists in specific products and categories.

In Japan, the evolution of SMEs can be traced back even further to medieval industrial clusters. Manufacturing clusters like Nakajima were developed during the pre-war industrial period and dramatically expanded in the 1960s and 1970s.

Japanese SMEs form part of an elaborate subcontracting framework for world-class automobile, electronics and machine firms. Many of these SMEs make up a loose conglomerate, called the keiretsu, which replaced the old family-style zaibatsu (family-controlled) structures that were nationalized during the war.

Nearly 25 million SMEs form the backbone of the US economy, with nearly two-thirds contribution to net new jobs in recent decades. SMEs in the US evolved from homesteading farmers during the 19th century. In the early part of the 20th century, large corporations became more important than small ones in the US, but with appropriate legal, tax and finance policies, SMEs have steadily regained influence and impact over the last 100 years.

The definition of SMEs varies around the world—most accept between 250 and 500 employees as the upper limit. Similarly, micro enterprises range with a cap of up to 10-50 employees. In addition to the number of employees, other factors, such as whether they are manufacturing or services enterprises, which subcategory they come from, what their assets are, etc., are also often used.

India’s definition slots them as micro, small and medium by investment size, and also sector: manufacturing or services. This results in six buckets for MSMEs. The principal regulation that governs the industry in India is the MSME Development Act of 2006.

In Germany, Japan and elsewhere, the common elements of success have been three: (1) clustering, (2) access to finance and (3) specialization and export competitiveness.

Since India’s development appears to have skipped the normal transition from agriculture to manufacturing to services, and gone straight from agriculture to services, the evolution of manufacturing-related SMEs has been suboptimal.

Furthermore, given the general non-competitiveness of our manufacturing industry in the global context, the SMEs we have are not punching at global class. The implication of this is that, in an open economy, even a domestically-oriented SME has to compete with imported products in many segments —from toys to shoes to apparel.

Given their global competitiveness, the quality and landed costs of these imported products are more than adequately competitive with local products.

This is gradually changing in some subsectors; for instance, in the two-wheeler supply chain, a range of consumer products, and for certain steel and aluminium products.

The opportunity that MSMEs present for India’s employment and economic growth is tremendous.

However, the challenges are immense. In contrast to many other countries, even at a comparable stage in development, Indian enterprises have to deal with and solve a greater range of problems in the entire vertical supply chain.

The bedrock of MSME policy should be to develop reliable infrastructure—roads, electricity, water and telecommunications—and to actually ease the conduct of business with simpler rules and easier compliance. The inadequate infrastructure and the thicket of compliance requirements deters all but the most perseverant and resourceful of entrepreneurs from scaling. Beyond this, the best contribution that policy can make is to ease access to finance and develop the benefits of clustering.

The latest budget correctly targets startups as a source of employment growth, but needs to be a lot bolder. Research from around the world unequivocally agrees that new MSMEs demonstrably produce net new job creation in all economies.

Policy would do well to address the access of domestic equity funds to startups by pushing for a comprehensive pension system (we cannot solely rely on external capital for equity funding) and by easing access to working capital finance from banks.

PS: “There is no passion to be found playing small—in settling for a life less than the one you are capable of living," said Nelson Mandela.

Narayan Ramachandran is chairman, Inklude Apps. Read Narayan’s columns at www.livemint/com/avisiblehand

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