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Pradeep Gaur/Mint
Pradeep Gaur/Mint

Opinion | The problem of low investment in MSMEs and what we can do

The low rate of greenfield investment could reflect poor demand for credit and supply-side problems among NBFCs

The Economic Survey (ES) in three volumes this year covers a large range of structural reform issues. Some of the chapters quite understandably are self-congratulatory in terms of past achievements. The Swachh Bharat scheme, for instance, has led to visible improvement in urban areas, but surveys show that decline in open defecation in villages has been vastly overstated. Getting people to use an indoor toilet in place of open defecation is not quite a matter of nudge. People can live in close proximity to a toilet only where water is available. Where water is scarce, community dry toilets are the only solution, at some remove from dwellings and spaced out over the habitation.

Other chapters in the survey do focus on future directions for reform. Of these, chapter 3 on medium, small and micro enterprises (MSMEs) is relevant in the present situation where, as admitted by the Reserve Bank of India governor, investment in MSME is sluggish. What ails small enterprises?


Chapter 3 of the ES is more about the structural problems retarding growth in pre-existing MSMEs rather than the immediate problem, which is the lack of fresh investment (on which more below). The ES stresses the growth-stifling impact of the size threshold (100 workers) above which stringent restrictions on employee downsizing kick in. The chapter provides evidence that firms in India, whether they start out above or below the 100 worker line, do not grow as much over time as they do elsewhere because of these restrictions, and shows the growth benefits in Rajasthan of having lifted the threshold to 300 workers.

The evidence for lifting the ceiling is compelling, but labour hire-and-fire remains a political hot potato in India, something that external observers find hard to understand. The Rajasthan government, which raised the threshold in 2014, lost its majority in the next elections. One of the many reasons why the generalized fear of being laid off from a job is particularly intense in India is because, until recently, pensions under the Employees’ Provident Fund Organisation (EPFO) often died with the job, since the EPFO number was not portable. This has fortunately been hugely reformed over the last few years, under a dynamic administrator. If EPFO number portability is true de facto and not just de jure, and is possible even across changes in job location and intervals of unemployment when nothing is paid in, we can begin to erase the fear of being employed without security of tenure. But it will be a slow process. There are many other problems faced by a worker having to relocate. The school system does not facilitate free movement of children, and the impossibly splintered market for rental housing does not help either.

An age-related sunset clause to downsizing flexibility (as recommended by the ES) could switch off investment in MSMEs altogether. A start below the downsizing threshold, despite the scale economies of being bigger, could be because of high downside risk to demand projections, which would vary by sector. Then there is also a spatial dimension to the issue. Investment within agglomerations is less risky than stand-alone units in a provincial location. The overall data may show more employment growth in young firms starting out above the line, but smaller enterprises that are more spatially dispersed may be what we need, especially since our housing and sanitation infrastructure do not support agglomerations beyond a point. Provincial MSME startups may be especially sensitive to an age-related sunset to downsizing flexibility.

Other privileges to MSME classification are a function of asset value (as set out in the MSME Development Act of 2006), so there are multiple thresholds that a small, young firm may not wish to cross. The goods and services tax (GST) has added another threshold, defined in terms of turnover, below which compliance is less burdensome. All these thresholds would have to carry age-related sunset clauses for the incentive to work, but the most likely impact would be to discourage MSME startups altogether. The ES acknowledges that an age-related sunset may merely result in firm mortality at the age ceiling, and rebirth as a new firm, and recommends use of the Aadhaar of the promoter to prevent that.

Coming to the present situation, the low rate of greenfield investment in MSMEs could reflect both poor demand for credit, and supply-side problems among non-banking financial companies (NBFCs). On poor credit demand, one possible reason could be the GST Council’s announcement at its June meeting that the submission forms will change over October-December 2019. Although the new system retains quarterly filing for enterprises below the GST threshold, the new forms are more burdensome and mark a return to invoice matching (see also my Mint column, 5 July 2019). This change could well lead to a fresh round of mortality among existing MSMEs, aside from the discouraging impact it will have on new startups. My plea to the GST Council would be to stay with the present system of interim filing for at least another five years.

On the supply of credit, since banks have to now move in where NBFCs fear to tread, there could be process delays resulting from difficulties in due diligence, especially for locations spatially removed from major urban centres. Jack Ma has started a MYbank in China, which boasts a process time of three minutes, based on a risk model and big data updated in real time. That is more razzle-dazzle than what we presently have in hand, but perhaps a new financial startup could work towards it.

Indira Rajaraman is an economist

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