Will atmanirbhar call damage India’s small entrepreneurs?

December 5, 2020 5:00 AM

The beneficial linkages between formal and informal enterprises become stronger with trade liberalisation, not protectionism.

India is no exception to these global trends. Even in highly industrialised states, like Gujarat, jobs have expanded in the informal sector.India is no exception to these global trends. Even in highly industrialised states, like Gujarat, jobs have expanded in the informal sector.

By Ejaz Ghani

the slow growth of India’s manufacturing sector has been a long-standing concern for policymakers. India’s manufacturing sector generates less than 20% of the national output, and it has been overshadowed by China. The recent policy initiative—Aatmanirbhar Bharat—is aimed at addressing this deficiency. More restrictive trade will enable entrepreneurs to tap into India’s large domestic market rather than relying just on exports. The shift towards the domestic market has been fueled by the size of the domestic market, the rise of the middle-class, and India’s young demographics. Will this shift in the trade regime help or hinder Indian entrepreneurs and promote or retard job creation?

The conventional wisdom suggests that a more restrictive trade regime should help domestic entrepreneurs. Unfortunately, this is not backed by evidence from three decades of India’s trade liberalisation. India’s expansion in the manufacturing sector came primarily from the expansion of small entrepreneurs, who account for 99% of establishments and create 80% of jobs in the manufacturing sector. Small entrepreneurs expanded in the tradable sector but contracted in the non-tradable sector (tradable industries defined at a three-digit industry level using high export and import ratios to gross output levels, see bit.ly/36BRGA1).

The shift towards a more restrictive trade regime may benefit a few large conglomerates, but it will harm small entrepreneurs, and slow down the pace of job creation. The entire net job growth in the manufacturing sector during the last three decades came primarily from small enterprises in the tradable sector. One-person enterprises more than tripled, from 6% of the informal sector workforce in the early 1990s to more than 20% in recent years, thanks to trade liberalisation.

This trend in the expansion of jobs and small enterprises in the manufacturing sector was not observed in the non-tradable sector. The expansion of small entrepreneurs in the tradable sector and contraction in the non-tradable sector shows that India’s trade liberalisation has primarily benefitted small entrepreneurs, who became an integral part of the global supply chains.

What explains the rise of small entrepreneurs in the tradable sector? Trade liberalisation played a key role in enabling small enterprises to become an integral part of the global supply chains. Another factor is the close timing of trends in trade liberalisation and urbanisation. Essentially, all of the net employment growth in Indian manufacturing over the last three decades has occurred in urban areas. The urban share of SMEs in the tradable sector employment rose from under one-third in the early 1990s to over 60% in recent years.

This connects strongly with the broader trend for the informal sector to be moving into the tradable sector in urban areas. There are features particular to more dense urban areas that provide the infrastructure and facilitate stronger networking amongst micro-enterprises. Trade liberalisation and the rapid pace of urbanisation boosted India’s size of the informal tradable sector.

Beyond trade liberalisation and urbanisation, did other factors help the rise of SMEs in the tradable sector? The expansion of female business ownership, the increased pace of subcontracting, and “push” entrepreneurship, where entrepreneurs start businesses out of necessity rather than growth desires, did play a role. However, the evidence suggests that these factors were not the key drivers. The rise of SMEs and one-person establishments relates to the tradable nature of the work, which is not a proxy for other industrial traits, like financial dependency or materials intensity.

Small entrepreneurs account for up to half of the economic activity in the developing world. Contrary to conventional wisdom, their importance has not declined but increased over the last several decades. The rise of the informal sector has gone hand in hand with a faster pace of trade liberalisation and structural transformation. The informal tradable sector has absorbed the reallocation of labour from low-productivity agricultural activities in rural areas to higher-productivity non-agricultural activities in urban areas. Investments in physical and human infrastructure, and agglomeration economies generated by the rapid pace of urbanisation, have enabled SMEs to thrive.

Young entrepreneurs in the informal sector have created more jobs compared to the large established conglomerates in the formal sector. The informal sector has remained the key driver of poverty reduction, compared to publicly funded poverty programmes. India is no exception to these global trends. Even in highly industrialised states, like Gujarat, jobs have expanded in the informal sector.

Small entrepreneurs conform much more closely to the overall contours of India’s economic geography than large conglomerates. Not all jobs in the informal economy yield paltry incomes. Many self-employed earn more than unskilled or low-skilled workers in the formal economy. A diverse and large number of entrepreneurs in the garment industry in New York made it much more competitive compared to Pittsburgh with one large and vertically integrated steel factory, which has now become a ghost town.

India’s young demographics, and limited employment generated by large industrial conglomerates, has increased the importance of a friendly trade regime for small entrepreneurs who create a majority of jobs in India. Trade flexibility and global integration has enabled millions of more women to find jobs, and better manage work-life balance.

Despite its huge size and importance, the role of small enterprises in export growth and economic development has not attracted attention from the policymakers. Some continue to view the informal sector as an enemy of the formal sector, and as parasites competing unfairly with law-abiding formal firms. This is not backed by evidence which shows that formal and informal firms are friends and not enemies, and they cater to different markets.

There are huge horizontal and vertical linkages between large and small firms. Small firms are an important supplier of inputs to large firms. Employment and output have increased in the formal sector in those states in India that also have a greater presence of informal firms. Conversely, informal employment and output are greater in those states that have a greater presence of formal buyers of inputs.

Formal enterprises are more competitive in the presence of informal firms, as they change their product mix, adapt to new technology, and outsource more labour-intensive tasks to informal firms. The input-output linkages between formal and informal firms are very strong and become stronger with trade liberalisation.

It is unlikely that the current reversal in the trade regime will lead to the demise of the small entrepreneurs in India. Remaining small is a rational response to high urban density, young demographics, and India’s entrepreneurial spirit. Technological changes too have enabled small entrepreneurs to operate more efficiently, and benefit much more from knowledge spillovers, networking and agglomeration economies, which are much stronger amongst small entrepreneurs.

However, the reversal in the trade regime may break the friendship that currently exists between large and small enterprises and informal and formal sectors. Any trade and industrial policy should not be targeted just to benefit large industrial conglomerates. It should also promote greater entrepreneurship, entry of new firms, and job creation. Policymakers should strengthen friendships and linkages between small and large enterprises, and not kill small entrepreneurs.

Former lead economist at the World Bank, and lecturer in Economics at the Oxford University. Views are personal

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