INDIA'S LABOR INTENSIVE SMALL BUSINESS SECTOR STRUGGLING IN

UNCLAS SECTION 01 OF 04 MUMBAI 000056 SENSITIVE SIPDIS PASS TO EX-IM BANK:JESSICA FARMER AND RAY ELLIS PASS TO USTR: ADINA ADLER E.O. 12958: N/A TAGS: EFIN ECIN ECON IN SUBJECT: INDIA'S LABOR INTENSIVE SMALL BUSINESS SECTOR STRUGGLING IN WAKE OF GLOBAL SLOWDOWN MUMBAI 00000056 001.2 OF 004 ¶1. (U) Summary: During a discussion with Consul General, stakeholders from the Micro, Small and Medium Enterprises (MSMEs) noted that shrinking global demand, and not lack of bank credit, is hurting the sustainability of MSME business operations. They pointed out that most MSMEs could not get bank credit even before the economic meltdown, and they had little faith that the government's recent financial stimulus package would ease their financing woes. MSMEs, constrained by lack of personnel or lack of adequate data, cannot manage what they view as excessive and duplicative loan documentation needed to qualify for bank loans. Our interlocutors also maintained that their other challenges are similar to those faced by large corporations like restrictive labor laws, multiple and duplicative taxes, excessive regulation and compliance mechanisms. They also admitted that changing the mind-set of these mostly family-owned businesses to empower them to "think big" was the main inhibitor to the growth and sustainability of the MSME sector. The panelists recommended U.S.-India MSME collaboration as a key enabler for the development of the Indian MSME sector. End Summary. India's MSME Sector -------------- ¶2. (U) Like most other countries across the world, the micro, small and medium enterprise (MSME) sector is a vital component of the industrial sector in India. As per the Ministry of Micro, Small and Medium Enterprise's estimates, micro and small enterprises account for about 39 percent of the manufacturing output and around 33 percent of the total exports, in terms of value. According to the ministry, the sector employs about 31 million people spread over 12.8 million businesses. The Indian MSME Ministry classifies micro, small, medium enterprises in manufacturing as companies with investments in productive plant and machinery of up to Rs. 2.5 million ($52,000),between Rs. 2.5-50 million ($52,000-1 million) and between Rs.50-100 million ($1-2 million),respectively. Similarly, service-oriented micro, small and medium enterprises are companies with investment in productive equipment of up to Rs. one million ($ 20,000),between Rs. one-20 million ($20,000-400,000) and between Rs.20-50 million ($400,000-1 million),respectively. However, MSME stakeholders pointed out that trade associations use different variables to classify MSMEs, and that MSMEs in India are relatively much smaller compared to MSMEs in the U.S. ¶3. (U) The MSME sector receives government concessions -- in the form of financial and tax incentives, and the provision of infrastructural facilities -- as part of the government's strategy to achieve inclusive growth. MSME financing is part of the Priority Sector Lending policy of banks. (Note: Along with MSMEs, banks are required to lend proportionally to the agriculture, education, housing, export credit, and other sectors. End note). For public and private sector banks, 40 percent of the net bank credit (NBC) is earmarked for priority lending. However, no specific percentage is assigned solely for the MSME sector for public sector and Indian private banks, and they are free to use their discretion to decide loan allocation to MSMEs. In contrast, foreign banks are required to allocate 10 percent of the NBC specifically for MSME loans. Government Steps in to Ease MSME Financing Woes -------------- ¶4. (U) In December 2008, following negative export growth in India as a result of the global economic slowdown , the Government of India (GoI) and Reserve Bank of India (RBI) announced several measures to support the MSME industry. The RBI announced a refinance facility of Rs. 70 billion ($1.5 billion) for the Small Industries Development Bank of India (SIDBI),to be disbursed directly to MSMEs or indirectly via banks, non-banking finance companies (NBFCs) and State Finance Corporations. The government also doubled the guarantee cover under the Credit Guarantee Scheme on loans to micro enterprises from Rs. 5 million ($100,000) to Rs. 10 million ($200,000) with an 85 percent guarantee cover for credit facility up to Rs. 0.5 million ($10,000). (Note: In 2000, with the aim of lowering the "risk-perception" of MSME financing, the GoI in collaboration with SIDBI, had set up the Credit Guarantee Fund Trust to MUMBAI 00000056 002.2 OF 004 provide a counter guarantee for loans extended to the MSME sector. End Note). The lock-in period for such collateral-free loans was also reduced from 24 to 18 months. But MSMEs Complain that Access to Credit Still Problematic -------------- ¶5. (U) Despite these remedial measures to facilitate easy credit for MSMEs, our interlocutors complained that banks are still reluctant to lend to them. Deepak Doshi, the President of the Indian Small Scale Paint Association and the Director of a medium-sized paint company, said that banks required lengthy, cumbersome and duplicative loan applications, making it difficult for MSMEs -- with limited personnel and less robust record keeping -- to access loans at the prime lending rate. Banks cite most often a lack of transparency and insufficient information in denying a loan, he added. ¶6. (U) Yogesh Dixit, the Head of SME Ratings for CRISIL, agreed with Doshi, and noted that "information asymmetry" between the MSMEs and the banking sector was one of the major challenges for the industry. MSMEs need timely and adequate funds, but banks require complete information and documentation which the smaller industry players may not be in a position to provide, he admitted. He recommended that an information sharing platform be created to enable transparency and compliance to ensure that banks can provide timely and adequate credit to MSMEs. Doshi suggested that MSMEs get "smart cards" with embedded financial information about their business, which they can use to access loans up to a pre-sanctioned limit. Another alternative, Dixit suggested, is for MSME trade associations to collect funds from their members which could be used as bank collateral to avail credit for the member MSME. ¶7. (U) Doshi believes that only those MSMEs who were already getting credit from banks would benefit from the government's stimulus package. He dismissed the perception that MSMEs that are rated by a third-party would qualify for easy bank credit. The bank would itself rate the MSME and take a loan decision based on its internal rating, he opined; banks view MSMEs as unreliable and lacking creditworthiness, he claimed, and no outside rating system can overcome this bias. Delayed Order Payments More Worrisome than Lack of Bank Credit -------------- ¶8. (U) Despite problems accessing credit, all interlocutors agreed that the MSME industry was hit more by shrinking global and domestic demand following the economic meltdown. Rajendra Gandhi, the Managing Director of Gujarat Rubber Reclaim and a Managing Committee member of the All India Rubber Industries Association, explained that globalization caused several inefficient and non-competitive MSMEs, who previously depended on government support for their survival, to shut operations. Driven by the demand of larger companies that they serviced, the remaining MSMEs became more competitive, efficient, and technology savvy. They made significant investments to become the "preferred supplier" of large companies. Currently, Gandhi said, these "efficient" MSMEs are "at the mercy" of their larger customers who -- hit by the economic slowdown and global financial crisis -- have reduced demand from the MSME vendors. Doshi claimed that the large companies are demanding longer credit periods and delaying payments to their MSME suppliers. In a way, the MSME sector is "refinancing" larger companies, he argued. ¶9. (U) K. R. Sharma, Director of the MSME Development Institute which is under the Ministry of MSME, explained that the MSME industry can broadly be classified into family-owned MSMEs which cater directly to the domestic market, the ancillary units or vendor MSMEs who sell to larger companies, and export-oriented MSMEs. The economic meltdown has impacted the ancillary vendors and exporters the most, he admitted. These units have made large capital investments and accumulated inventories which they now cannot sell due to shrinking global demand, he continued. Doshi noted that the MSME industry could not even gain from the crash in commodity and raw material prices. He explained that when prices rose, the MSEMs were not able to pass on these price increases to the customers, and now MUMBAI 00000056 003.2 OF 004 when prices have fallen, their clients expect them to reduce prices proportionately. Gandhi claimed that China, which experienced a slowdown in the last quarter, is dumping a lot of low-cost goods in India which is hurting the competitiveness and sustainability of MSMEs. "Usual" Challenges to Doing Business in India Cited as Industry Challenges -------------- ¶10. (SBU) Raj Nair, the Chairman of the MSME wing of the Indian Merchant's Chamber, emphasized that India's restrictive labor laws constrain the growth of the MSME sector. It is difficult for any company, including an MSME, to hire contract labor for an extended period of time. The inflexible labor laws do not allow MSMEs to adjust their labor demand to market requirements. Moreover, MSMEs would like the ability to hire during an economic boom and fire during a downturn. This would allow MSMEs to finetune their ability to service orders at a particular point in time. The existing employment in the MSME sector could double if Indian labor laws are relaxed, he argued. ¶11. (SBU) Doshi emphasized the need for less regulation; he believes that MSMEs have to comply with multiple authorities and government agencies. (Comment: This is a common complaint of Indian businesses and is not unique to the MSME industry. End Comment). Nair said that the government should tackle the issue of multiple and duplicative taxes as a priority. The MSME Ministry's Sharma accepted this argument and said that the government was planning a scheme of collecting taxes at one source and then distributing it to different agencies. Gandhi noted that multiple taxes and excessive regulation harbors corruption. MSMEs Struggling to Upgrade -------------- ¶12. (U) Nair said that some MSMEs are diversifying into new product lines and new markets to cope with the current economic crisis. Nevertheless, he admitted that the majority of MSMEs are "waiting and watching" to see how the market situation plays out. Most MSMEs are long-term suppliers to larger companies and believe that their fate is tied to the fate of the larger players. According to Nair, they believe that the government will not let large companies fail and will either bail out distressed companies or empower them with liquidity. Therefore, they believe that the recovery of the MSME sector is tied to the recovery of larger companies, he said. ¶13. (U) Gandhi pointed out that many MSMEs "choose" to remain small to qualify for fiscal concessions. Nair concurred, and admitted that the biggest challenge is to change the mind-set of these players and teach them to "think big." (Note: In order to promote small scale industries (SSI),the Government of India reserved the production of some industrial and tradition items - ranging from socks and industrial goods to handwoven items - for production by small enterprises. In recent years, many of these restrictions have been removed. Companies protected by SSI rules now find themselves facing greater competition, or opportunities to expand. End Note.) Some MSMEs try to manufacture a wide product range rather than specialize, which hurts their export competitiveness, he added. Gandhi argued that MSMEs need a "professionalization" of family-owned businesses to separate the owners from the management to ensure sustainability. ¶14. (U) Doshi pointed out that U.S. and Indian MSMEs are "natural partners." He emphasized the need for more U.S.-India joint ventures where the U.S. partner can bring in technology and the Indian partner can provide the cheap labor and the huge market base. Dixit suggested that building institutional linkages between U.S. and India will provide a good information sharing platform for MSMEs of both countries to exchange their experiences and share lessons learned. Nair believes that a trade association would be a better mechanism to link U.S. and Indian MSMEs. Gandhi suggested that U.S. MSMEs adopt industrial clusters. (Note: In a separate discussion with SIDBI, we heard that the government is promoting industrial clusters to provide MUMBAI 00000056 004.2 OF 004 backward and forward linkages to MSMEs and to create common infrastructural facilities. End Note). ¶15. Comment: (U) Recognizing that the MSME sector is a contributor to the India growth story and to the vision of "inclusive growth", the Government of India has undertaken numerous reforms for the development of the sector. The need of the hour is to streamline these efforts and ensure that it reaches the most deserving MSME. However, sustainability of the MSME industry also depends on the ability of the MSME to scale up efficiency using technology, research and development. All the participants unanimously agreed that the MSME sector had tremendous opportunities to grow, but admitted that changing the mind-set of these mostly family-owned businesses to empower them to "think big" was the main inhibitor to their growth and sustainability. End Comment. FOLMSBEE