Trial by fire | Outlook Business
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RA Candroo

State of the Economy 2019

Trial by fire
SME clusters across the country have shown their resilience by overcoming macro challenges, and they are now looking at the future with lot more hope

Krishna Gopalan & V Keshavdev

In a business environment that is extremely dynamic, it is only the resilience of the entrepreneur that can make the difference. At the centre of this story is disruption, which, over the last decade in particular, has threatened the survival of businesses. The rub is disruption can come in many forms, with technology being only one of them. It could be a new regulation or the intrusion of competition or even consumers just not finding your product relevant anymore.

This scenario makes for an interesting read, especially when one is speaking of smaller businesses that are forced to try things out of the ordinary. More often than not they are weighed down by the disadvantages of size — with relatively smaller production facilities — a high dependence on labour, higher vulnerability to the vagaries of government regulations and a need to keep that eagle eye on costs at all times. In short, it is that uneasy phase of an enterprise’s existence, when there could be a surprise springing up from pretty much anywhere.

None of that takes away from the contribution they make to the overall story of industrial progress. It could be that small component placed on the mirror of a three-wheeler or that piece of garment making its way into a Walmart store in the US with the Made in India tag or an active pharmaceutical ingredient entrenched deep inside that antibiotic you pop into your mouth. These capture just a microcosm of how much the micro, small and medium enterprises (more commonly called MSMEs) do without saying very much and, in many cases, their contribution drowned by the noise made by their larger counterparts.

It was this opportunity that Outlook Business spotted, which resulted in the annual State of the Economy edition. Timed to hit the stands around the Union Budget, it is the moment when small entrepreneurs take stock of how business has been thus far, before thinking aloud what the government ought to do for them. That list, of course, is often long and has hope and helplessness in equal measure.

The edition is not restricted to being just a report on what is prevailing in an industrial cluster. From visiting manufacturing units and interviewing entrepreneurs on the shop floor to meeting industry associations, we work towards understanding what makes a particular cluster tick, and what hinders its progress.

Issues confronting a cluster or its entrepreneurs are normally of two kinds – one that affects the particular industry and the other that which is unique to the cluster. A tax affecting the garments industry, for instance, would impact it regardless of location but shortage of labour could be a difficulty only in Ludhiana and not Tirupur. 

This exercise has helped our team of reporters build a relationship with entrepreneurs, which has resulted in Outlook Business hosting SME events in clusters such as Aurangabad, Pune and Coimbatore. With representatives from the government and larger players in the private sector, these gatherings provide a larger platform to discuss and highlight issues confronting the cluster in addition to picking up key insights from larger players. In all, Outlook Business has covered 50 clusters over the past 10 years, with locations such as Morbi, Jagatpur, Sanand, Butibori, Guwahati and Sikkim added over time, interviewing close to 700 SME owners across 25 industries with a turnover ranging from 50 million to 2.5 billion.

The Big Picture

In numbers, the SME story is nothing short of overwhelming. They exist across industries — 51 million of them in all — a whopping 95% of all industrial units in India. It’s just that you don’t see too many small units but choose to spot that one large company. 

They employ the most number of people (over 117 million or 40% of India’s workforce), which is second only to agriculture. Pick any sector and there is no way you can ignore the contribution of SMEs to it – be it in automobiles, pharmaceuticals, garments, iron and steel, cement, chemicals or services. Today, SMEs account for 6% of the manufacturing GDP and 25% of the service sector GDP. This does not take into consideration what they do for the local economy by way of job creation or simply in creating a town or city. Where would Coimbatore, Aurangabad, Kanpur, Nashik, Tirupur and Ankleshwar be without their SMEs?

Coimbatore, known for its engineering prowess, has SMEs units churning out electric pumps, textiles, and the likes, contributing almost 40% to the state’s GDP. But what makes Tirupur and Coimbatore stand out is that unlike other clusters in the country that leverage based on their connectivity to hubs such as Pune-Mumbai and Delhi-NCR, Tamil Nadu’s clusters have created their own robust economy.

The success story of SMEs is also suitably-demonstrated by numbers. While their contribution is significant through the number of people they employ or their share in the national GDP, it goes well beyond that. Around 40% of the SME output is exported, its contribution to overall Indian manufacturing exports is at 45%. It accounts for 16% of loans extended by banks and has an average annual growth rate of approximately 10%. Against such a backdrop, it’s not surprising that a majority of respondents that Outlook Business has spoken to, every year since 2013, have no trouble in raising bank loans
(See: Ease of money).

While size does limit their bargaining power with the government, SMEs have not let that uncomfortable reality crush them. On the contrary, they have displayed the ability to be innovative, proactive and tenacious. Their industrial associations, which bring units together, have proven to be effective in raising specific issues. The examples of this come from manufacturing hubs such as Coimbatore in setting up Codissia, Karur’s textile park, a medical devices park in Hyderabad or a special economic zone in Visakhapatnam. An association gives a zone a greater level of acceptability and seriousness, besides access to high-quality infrastructure, as opposed to an industrial zone with many units simply thrown in. These collectives also help units share lessons with each other. 

Overcoming Challenges

What SMEs certainly cannot fight now are the rising costs of labour and raw materials, which unfailingly increase each year. Since 2013, labour cost has consistently gone up for majority of the SMEs surveyed. 

In fact, respondents across clusters such as Aurangabad and Naroda in the west, Pithampur in central India, Tirupur and Coimbatore in the south said availability of skilled labour is a constant challenge. It is this perennial demand-supply gap that keeps pushing labour costs higher every year.

Even for units in distant places, the advantage of tax incentives gets nullified. Sikkim, where this benefit was given for ten years from 2007 and then extended by an equal period last year, has had to come to terms with wages being 35% more than what, on average, is paid in the rest of India – the rationale is to compensate staffers for the distant location. The fear that the tax incentive may be done away with at some point has had pharmaceutical companies in the state focus more on exports, where margins are healthier.

Clusters such as Tirupur, where garments are the bread and butter, are relatively better placed since the business has a mass production line. Not having enough people to employ remains a thorn, and that is being addressed with migrant labour or by locating the factory where labour is available. 

Just as staffing troubles hold SMEs back, government regulations do too. They also add a paralysing ambiguity to the equation. In Kanpur, environment compliance has the leather industry at the razor’s edge. By giving out more licences, the number of tanneries has more than doubled from 175 in 1992 to 700 today. Now, the decision to impose higher compliance costs threatens the survival of the 36 billion industry. Ankleshwar, a chemical industry base, has been weighed down by pollution and the tag of a “critically polluted zone”. The latter was finally dropped two years ago but nothing seems to have changed, with every expansion still needing the clearance of a lumbering bureaucracy. Exasperated entrepreneurs now have to deal with troublesome officials, for whom making a quick buck is a priority.

Similarly, 259 tanneries had to be shut down on orders from the UP Pollution Control Board. This at a critical juncture for the industry, when leather’s popularity is taking a hit with talk of vegetarianism and a growing demand for alternatives, such as synthetic. The plants are witnessing a serious drop in capacity utilisation. From being a hub for leather exports, this cluster is now looking at a very uncertain future. 

While environment rules have slowed down a few clusters, politics has brewed trouble for a few others. In a commodity business, that just compounds the problem. In Uttar Pradesh, the sugar bowl of the country, successive governments have encouraged farmers, a significant vote bank, to grow sugarcane on the back of a distorted pricing mechanism. Production has hit record highs, while domestic demand remains static. That has led to lower prices, and farmers and sugar mills finding themselves caught in quicksand. In Bijnor district of UP alone, farmers’ debt has touched 47 billion despite loan waivers. According to an Indian Sugar Mills Association estimate, mills were losing 63 per quintal of cane because of exorbitantly high cane prices fixed by the Centre.

Double Whammy

This year, our team of reporters travelled to eight industrial clusters – Chakan, Ankleshwar, Pithampur, Kanpur, Hapur, Sikkim, Coimbatore and Tirupur. By any yardstick, it has been a tough phase for all, with demonetisation and the rollout of the Goods & Services Tax (GST) clearly being the most important developments. Both have hit entrepreneurs hard and time taken to recover has been determined by how large or small the business is. In all, 77 entrepreneurs were interviewed on issues ranging from difficulties in raising money from banks and impact of GST to rising costs and the outlook for what lies ahead.

To understand the stark difference in the business situation, one needs to go back to 2013, where 65% of the respondents saw sales either decline or just about holding up. That number was at 70% the following year, with half the respondents seeing lower capacity utilisation.

The biggest disruption came in late 2016 with demonetisation and, in 2017, with the introduction of GST. The twin moves had a telling impact on the economy and sentiment, especially among small businesses. 

SMEs complained that the paperwork involved for tax filings had increased under the new regime, taking away a good amount of their time. In the auto cluster of Pithampur, business dropped sharply after GST, in some instances well over half, life is yet to return to normalcy. Since smaller units deal with suppliers who do not score much on credibility, compliance becomes a tricky issue. That leads to money not coming in on time, seriously unsettling the overall credit cycle of the SMEs.

As a consequence, the percentage of respondents who saw a decline in capacity utilisation surged from 45% in 2016 to 75% in 2018. Businesses that lacked pricing power faced the brunt of this exercise, since high transaction costs and procedural delays resulted in higher fixed costs. Compounding the disruption was that, mirroring the overall slowdown in private capex in the economy, small unit owners had put the lid on capex — 57% respondents in 2017 stating that were not going ahead with any capex for the year.

But greenshoots of a recovery are slowly becoming visible, with 58% of respondents looking to increase capex in FY19 and 60% respondents said they will invest in FY20 (See: Investing with certainty). Though teething issues with GST have eased since April 2017, it will take some years before any empirical evidence emerges to show whether indeed organised players have seen a significant jump in demand at the expense of the unorganised.

The power situation seems to be improving too. Seven years ago, it was impossible to have a conversation with an entrepreneur where the issue of power shortage did not come up. In fact, interviewing them with the generators running was the norm. The more fortunate few suffered a blackout for 3-4 hours a day, while someone in Telangana or Tamil Nadu faced at least a 12 hour shortage. This year, only four of the 77 entrepreneurs (5%) spoke of power cuts lowering their output – over time, there were no more than 4-5 clusters that are dealing with a power shortage. The story has clearly shifted to more reliable power supply, or facing the challenge of higher tariffs in a state like Maharashtra. The more enterprising, especially the ones from the South, have chosen to invest in alternate energy sources (wind and solar). It has paid off with reduced downtime, apart from creating a revenue stream, with excess power being sold to the grid.

Ahead of elections, there have been fiscal incentives too. The government has raised the exemption limit under GST from 2 million to 4 million in annual revenue. 

Self Reliance

While there is the rare relief, when SMEs turn to the government for support, it has not been forthcoming. Uncertainty is the only thing that has been certain for these smaller players. In many a case, announcements such as demonetisation hit them hard and ensured recovery time was painfully long. With experience and maturity, often drawn from a realisation that nothing much can be expected from the state, SMEs have quietly forged their own path. In these trying circumstances, many of them have not just become stronger, but more resilient.

Disruption, before anything else, is a reality that affects industry regardless of size and scale. From a rival whose core competence is scale with low costs (China being the biggest headache here for most SMEs) and a new tax structure to a technological innovation that makes an existing product irrelevant and introduction of a stringent regulation, disruptions have always landed unannounced. The real threat today is this element of unpredictability. 

However challenging these were, the units did a find a way to cushion themselves against it. Looking at a new product or idea, or scouting for new markets, or investing more in technology to remain relevant are some of the measures that they have taken. One comfort is that good entrepreneurs are getting better with time and are making their businesses more efficient, with not much support to speak of.

Tirupur was a victim of the 2008 global crisis. Back then, exports suffered, and several units recorded heavy losses. Exporters lost out to global players as garment manufacturers which didn’t have integrated facilities sent fabrics to dyeing units across India. A number of players scaled down operations and the smaller ones had no choice but to shut down. The cluster went through a period of pain from 2008-2012. Today, the cluster is weaving an impressive growth story. Almost half of Tirupur’s exports are finding their way to Europe, one-fourth to US and the remaining to the rest of the world. Exports have grown from 125 billion in FY12 to touch 240 billion in FY18. More importantly, the cluster is also changing tack by focusing on domestic sales — which has more than doubled from 60 billion in FY12 to 140 billion in the last fiscal.

The biggest achievement that the NDA government has been showcasing is the improvement in the country’s ease of doing business rank. India currently holds the 77th position globally on the Ease of Doing Business charts according to the World Bank, an improvement from 142th position in 2014. The rankings though are based on the WB’s survey in only two metros — Delhi and Mumbai. Clearly, the MSME universe, scattered across the length and breadth of the country, still have to grapple with cumbersome rules and regulation. 

With the government now increasing the exemption limit, SMEs are likely to opt for deregistering if their turnover is below 4 million and could opt for the composition scheme (if they are below 15 million) where they are not required to issue a tax invoice. Clearly, the cost and ease of compliance for SMEs continues to be a bane considering the size of their business. Not surprising that against the positive steps from the government, the sentiment among MSME owners has improved since 2014 (See: Back in business).

Maybe, there is a clear case of taking a leaf out of Germany’s book, where their SMEs or Mittelstand have managed to become stronger over time. Their domination is best explained through numbers: Germany has close to four million SMEs, which makes up for 99.5% of the total number of companies there. In Europe, an SME is defined as an entity with less than 250 employees (500 in the case of Germany) and an annual turnover of under €50 million. 

Here in India too, SMEs form the bulwark of industry but not quite like Mittelstand. While some industrial clusters like those in the south and west, especially in textiles and engineering, continue to cater to the global market, a majority of the SME units’ fortune is linked to vagaries of the domestic economy.

In fact, as part of the Decade of Innovation (2010-2020) project announced by UPA II prime minister Manmohan Singh, seven industrial and artisanal clusters were shortlisted by the National Innovation Council for a unique experiment. Instead of the usual grants and schemes announced regularly for MSMEs, the programme sought to tap into the existing pool of knowledge within the clusters and connect them to available experts within academia and research institutions. The objective — get some of India’s brightest minds to work on the challenges of India’s MSME units. But there is no clarity on what’s the status of the initiative.

Given the dearth of innovation, overseas success stories are far and few between — of the 51 million SMEs registered in the country, only 1 million, as per a World Bank report, have an exposure to the global export market. Considering that protectionism is increasingly becoming the mainstream narrative across developed markets, Indian SMEs have to really create a niche for themselves to survive and thrive. How soon this could turn into reality will depend on a supportive ecosystem.

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