1. Column: Levelling the playing field

Column: Levelling the playing field

The key to Make-in-India lies in creating a modern system of small-business finance in the country

Published: January 8, 2015 12:37 AM

The New Year begins for India with a sense of optimism on the economic front, with growth finally picking up, inflation seemingly tamed, and an increased clarity of vision from the political leadership with regard to moving the economy forward. Of the many new initiatives, Make-in-India is perhaps vital for generating employment along with overall growth. This initiative has to be complemented by a serious effort to provide India’s youth with the requisite education and skills. It is also well-recognised that the physical and institutional infrastructure for business success has to improve for Make-in-India to succeed. In this column, I would like to suggest there is one more important piece of the puzzle that needs to be put in place.

The key to Make-in-India may lie in creating a modern system of entrepreneurial and small-business finance in the country. There is evidence that India is not generating enough new firms. For instance, a few years ago, Laura Alfaro and Anusha Chari examined data for Indian firms from 1988 to 2005. They found that incumbents, including state-owned and private firms, continued to dominate the economic landscape over that period. A partial exception was in services, with new private firms in business and IT services, communications services and media, and health showing substantial gains. But not in manufacturing. On the other hand, Ejaz Ghani, William Kerr and Stephen O’Connell have shown that it is new business creation that leads to employment growth (see my column, “Entrepreneurship and jobs”, goo.gl/GdXxZe).

In October 2011, the then-Deputy Chairman of the now-defunct Planning Commission constituted a Committee on Angel Investment and Early Stage Venture Capital, which submitted its report in June 2012. The report was more expansive than the committee’s name, being titled “Creating a Vibrant Entrepreneurial Ecosystem in India”. That broad objective includes addressing the supply of potential entrepreneurs and overall barriers to doing business, but finance remains the core issue, in my view.

The committee report suggested a National Entrepreneurship Mission, which naturally was the focus of headlines, but perhaps the true need is more in the nature of the “hundred small steps” approach of the earlier Rajan Committee report on financial sector reform. The report also gave considerable attention to “impact investing,” related to social entrepreneurship, but the core focus has to be conventional profit-making businesses.

What were some of the steps recommended by the report? In my view, the starting point has to be improving credit models and their coverage. The report notes the progress made by the SME Rating Agency (SMERA), which was started in 2005, but that there is “still a lack of comprehensive credit rating coverage for small businesses”. Given the importance of asymmetric information in credit markets, scaling up SMERA’s efforts would potentially have a high pay-off. Second, the report emphasises the many changes that are needed in the regulatory framework for small businesses in general, and start-ups in particular. Given the higher risks involved for these firms, the recommendations include measures such as more favourable tax treatment, and credit guarantee mechanisms to mitigate or partially insure these risks. Small firms and start-ups also suffer disproportionately from fixed costs of starting up associated with current laws and regulations, and streamlining these for this category of firms would help to level the playing field. Using the model of Software Technology Parks of India (STPIs), the report makes an important recommendation for “entrepreneurial hubs” for early stage ventures—although it does not address the issue of how and when such ventures would graduate out of such clusters. Perhaps they would not need to, instead leading the way to a universal streamlining of doing business in India.

Finally, the report has important recommendations on how to bring down barriers to angel and early stage venture capital investing, including removing restrictions on high net-worth individuals, and foreign entities. It also examines the role of the Small Industries Development Bank of India (SIDBI). Like many government efforts, SIDBI has a very wide range of responsibilities, and is stretched thin. The committee report discusses how SIDBI can work with banks, and on its own, to increase debt and equity financing for start-ups. Each of these recommendations includes multiple specific changes in how money is channelled to small businesses that can really benefit from it. Although not mentioned in the report, it is well-known that large firms in India mercilessly squeeze their smaller suppliers in receivables, leaving the latter with more stringent financial conditions than even their small size would impose. The recommendations in this report would help to break this unlevel equilibrium.

Financial inclusion policy and rhetoric has mostly focused on unbanked households, and that is important in its own right. But growth and employment creation at the scale India requires will come from accelerating new venture creation. The committee report on financing new ventures quantifies the needs in terms of business creation and start-up investment—in either case, the increase has to be by a factor of well over ten times the current rates. Focusing on the committee’s key recommendations will have a high pay-off.

Nirvikar Singh

The author is Professor of Economics, University of California, Santa Cruz

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