Access to working capital is a major problem for smaller firms, and they habitually get squeezed by their big-company customers.
My recent columns have been about India’s Coastal Economic Zone (CEZ) policy, including comparisons with, and possible lessons from China. If we step back and consider India’s recent export performance, the need for, and limits of, CEZ policy become even clearer. Recent news reports highlight the country’s sluggish export performance in recent years. The problems began earlier, but demonetisation, a less-than-optimal rollout of the Goods and Services Tax (GST), and the mess in the banking sector—with new cases of fraud piled on a legacy of distressed assets—have prolonged the pain.
Although export growth has picked up, labour-intensive sectors such as textiles, jewellery, and leather have continued to lag. Anaemic exports in general can contribute to macroeconomic vulnerabilities, especially when oil prices remain high, but the big issue is really the need to create more good jobs, and labour-intensive exports have to be part of the strategy of meeting that need. In my last column, I noted that China is emphasising innovation, finance, and talent for its major CEZs, in ways that India has not. In India’s case, even the supply of workers with basic skills suitable for a range of labour-intensive production is relatively small. CEZ policy has to address this in ways that China did even before it began pursuing a more capitalist route: in short, India still needs to improve the basic health, nutrition and literacy of much of its population. This seems like a tall order for CEZs, but one can think of historical examples of employers, enlightened or just pragmatic, who found that it made sense to invest in their workers and the workers’ families to increase productivity. So, it is not outside the realms of possibility.
Essentially, just like the concept of CEZs themselves, the driver of wider involvement in education and skilling is the poor state of governance in India, and the continued failure of the government to deliver on basic human needs such as health and primary education. Of course, the private sector is not guaranteed to provide them either, but CEZs can provide laboratories for trying new approaches. The key idea is that institutions for imparting skills have to be part of the ecosystem.
Financing presents a different sort of challenge. India’s banking mess is just one part of the sad state of the financial sector. Aside from a well-functioning stock market, which helps only a very small fraction of India’s firms, the rest of India’s financial sector is severely stunted. Access to working capital is a major problem for smaller firms, and they habitually get squeezed by their big-company customers, through delayed payments, or sometimes no payment at all. The lack of a well-functioning court system in India means that small firms typically do not have effective legal recourse either, when financial contracts are reneged on.
As finance flows across the economy, this is one area where simply focusing on the needs of CEZs will not be enough. It is likely that a successful CEZ will draw on a supply chain that extends beyond its borders. Larger firms in a CEZ would still be able to exert market power on their smaller suppliers. For small firms, finance is inherently challenging because of the moral hazard and other asymmetric information problems in financial contracting (of course these have been exploited by large firms in India, as we have seen). Digital technology provides an important new method for overcoming some of the barriers to small firm finance. Technology also means that scaling up is both feasible and desirable. The relative advantages of personal relationships and local knowledge become less important. In short, financing does not have to be local, and should not be. Financing innovations for smaller firms can transcend CEZs.
The government has created its own electronic exchange for small firm finance, the Trade Receivables Discounting System (TReDS), but much more is needed. Luckily, it seems that new firms are entering this space with a range of business models and approaches to filling some of the gaps in the financing ecosystem, including matching borrowers and lenders, and setting prices. Even without significant infusions of outside capital, these firms have the potential to remove some of the frictions that plague small firm financing. An analysis of what these firms offer will require a separate column, but one can note examples such as C2FO, Capital Float, Indifi Technologies, LendingKart, and NeoGrowth, among many others.
The government has touted the benefits of sticks such as demonetisation and the GST for bringing smaller firms into the formal sector. A better approach will be to encourage the entry and growth of financial firms that improve the workings of supply chain finance. Anything involving finance requires regulation, but the key to policy here will be to ensure that regulation is light handed but effective. Of course, banking regulation in India has failed in significant ways, but the Securities and Exchange Board of India (SEBI) provides a more positive example of financial regulation. Ultimately, better mechanisms for smaller firm financing will transform the economy, and support job growth, in CEZs, and elsewhere in the economy.