Equity route the best for scaling up in MSMEs

Trust equity to transform MSMEs

Along with its good oversight, equity brings greater financial discipline right from the start

By Author

TelanganaToday

B Yerram Raju  |   Published: 7th Oct 2019  12:05 am Updated: 6th Oct 2019  10:17 pm

It is well known that the micro, small and medium enterprises (MSMEs) live in debt markets in India unlike in many other parts of the world where they access equity and debt in reasonably good proportion. In India, 93% of MSME credit is flowing to just 13 States. This skewed distribution requires correction.

Of late, genuinely worried about the continual decline in credit to MSMEs, the government of India introduced MUDRA to comfort these enterprises with Shishu, Kishore and Tarun products. But not even 10% of the total 17 million estimated enterprises was in the manufacturing sector. Then the government introduced 59Minute loan window. Both these efforts have not improved grassroots lending to the sector.

Driven to the wall, the Finance Minister pushed the panic button asking banks to do aggressive canvassing of loans for MSMEs and retail in 400 district-level shamiana meetings. The FM must be aware of both adverse selection of beneficiaries and moral hazard consequences. She expects the banks to tackle them effectively.

Convenient Option

But are there no other means of meeting the financial requirements of MSMEs? Why is equity not being explored as a convenient option? Is it because of the unorganised nature of the sector or because of the undependable clients in the sector? Or both?

Debt has been the most convenient option driven by perverse incentives right from 1950 when the Industrial Policy was announced. Debt, apart from being less costly, takes less than 30 days to deliver while equity takes at least nine months, if not more, where the promoters are assessed through a rigid due diligence process and corporate governance and board rules are put in place before filing the IPO. This process can be shortened if the enterprise has credible historical data for the pre-launch and good governance structure.

Movement from micro to small and small to medium is more governed by greater stake of the promoters through equity infusion. Therefore, such a transition is also extremely slow.

Enabling Ecosystem

District Industrial Centres, introduced in 1980-81 when George Fernandes was the Union Minister for Industries, have been engaged by the State governments to dispense the incentives, raw material like coal, iron, and help in realisation of unrealised debtors through the MSE Facilitation Councils since 2006. The Facilitation Councils, however, did not succeed to resolve the problem of delayed payments to MSMEs.

Manufacturers are the worst hit. Hence, the FM came out with a strict mandate to the PSUs and Central government departments to pay up all their bills by October 15, 2019, and confirm. Hope this would provide a lot of liquidity to the beleaguered MSMEs.

For the transformation from debt to equity access, the ecosystem, capacities and capabilities of firms and the perceptions of entrepreneurs play an important role. Several entrepreneurs are knowledge-insulated and mostly unwilling to unlearn in their growth journey.

Successful Model

Equity firms can participate with the MSMEs over a seven-year period with a gestation period of 1-2 years. Revenue sharing is the model on which it operates and is assessed after sectoral analysis and exits at an appropriate time. The participating equity firm also keeps enhancing skills and scouts for market opportunities of the partner firm. The model is a success in the US.

This equity comes at a cost of 5% more than the market price of debt. But it brings along with it good oversight and greater financial discipline right from day one. Structuring finances and structuring enterprise during the growth is a seamless process.

Scaling them up requires a different level of investments to wean away the entrepreneurs from the protective environment to self-dependence. The biggest problem they invariably come across is the choice of directors for governance. While the Institute of Directors has got on its platform thousands of trained directors, accessing them at affordable levels and verification and validation of their credentials pose problems.

Incentivise Transition

With the economy targeted for $5 trillion by 2022, MSMEs as growth engines and seedbeds of innovation have a significant role to play. Such a role requires that they seamlessly migrate to a higher level of operations during the growth stage.

Fiscal incentives can help such a transition. Having eased the rules for FDI participation and amended the corporate tax structure, it is time to look at what best can be done to make MSMEs go for greater aggregation and contribute significantly to the growing economy.

We have the potential to overtake China if we trust our MSME sector more than now and provide more long-lasting solutions than kneejerk reactions.

Risk Management in Indian Banks and FIs need Improvement

The scale of frauds across the Banks in India, from cooperative banks to commercial banks crossing half a trillion rupees, ballooning NPAs, slow and untimely resolve of bankruptcy cases have exacerbated the credit and operational risks. Finance specialists add to them the impending climate risks.

The PMC Urban Bank is just the tip of the iceberg viewing from regulatory perspective. Lack of oversight is clearly visible. Appointment of Directors failed to honor the ‘fit and proper criteria’. IL&FS and DHL in NBFC space shook up the shadow banking as well. This situation raises more questions than answers and require a firm resolve to warding off financial risks sooner than later, much before they translate into macro-economic risks.

Post-recession (2008), when the regulators hurried to drive risk management and governance of risks relied on Basel Committee. The industry’s new-found focus on risk management was ‘driven largely by a survival mentality and regulatory requirements’, as pointed out by Clifford Rossi and not by internalizing the risk assessment processes and governance improvements.

Rating institutions gave exemplary ratings and yet there was collapse of corporate credit. Risk management committees were set up and Chief Risk Officers were appointed and yet the risk mitigation did not take place. Both the government – the owner of the largest banking space and the Banks do not speak of risk management as a factor that led to the recent surge in frauds. Every product and process in these institutions is put for risk assessment.

New schemes and new programs do not get assessed for all the risks. Institutional failure to unlearn from the past and complacence on the part of Banks and FIs would appear to be the main reason for the current imbroglio. Time is not unripe for a 360⁰ thinking on the subject to put in place a mechanism for risk management and governance.  Noticeably, it is the absence of risk culture that is to blame for the absence of risk governance, process, analytics and expertise.

Banks sit on a mountain of data and claim AI and MML are receiving their immediate attention. The questions that come to my mind are: why then the Banks and FIs are unable to put in place a risk-based pricing system for all their loan products? How is it they fund start ups in manufacturing and services at the same level of interest rates? Again, why an owner-driven or proprietary or partnership micro and small enterprise and a medium enterprise driven by a Board with competent directors are also charged the same price? Why the Banks that claim latest technologies in place failed to transmit the rate cuts of the regulator to the clients requiring a mandatory compliance to pare the rates of interest with the Repo rate?

First and foremost for correction, is the tacit acceptance of failure of governance unabashedly and move to a thorough clean up. The four regulatory institutions – RBI, SEBI, IRDA, PFRDA should sit together and review the rating processes of all the Rating institutions they approved. Rating should not lead to a regulatory arbitrage. A simple uncompiled directive like the corporate institutions should reflect the dues beyond Rs.2lakh per vendor MSMEs did not reduce the rating of many a corporate. Had this been done, many MSMEs would not have become NPAs. There would not have been any need for the FM to give specific mandates to clear the dues to MSMEs before October 15, 2019.

Institutions that are adept at rating corporates have a myopic view of MSMEs and such thinking is largely driven by false risk perception driven by the lenders! Watch out the data – micro and small enterprises constitute around 8% of the credit to them as NPAs and every NPA is not unrecoverable. Rating is also influenced by the collateral rather than the enterprise, entrepreneur and environment over which the Banks have data but with no required behavioral analytics.

I agree with Clifford Ross, the leading risk professional when he says: “Risk professionals need to use disruptive technologies and perhaps find other tools to more effectively assess non-financial risks (e.g., cyber and operational), which have grown substantially over the past five years.

For both financial and non-financial risks, the continued development of risk expertise is vital. A great risk professional possesses the following qualities: (1) a balanced and logical temperament; (2) experience, over-the-cycle; (3) critical thinking; (4) analytical leanings; and (5) an action-driven mindset. What's more, on-the-job training is essential, because we are all at least accidental risk managers.”

*The author of ‘Risk Management – The New Accelerator’, economist and risk management specialist. Can be reached through www.yerramraju1.com

Revival of economy requires swallowing bitter pill

The US Fed rate cut last month signalled that the world economies linked to the US dollar are under stress. Also, the  International Monetary Fund (IMF) cut global gross domestic product (GDP) expectation from 3.2% to 3.1% while India’s GDP slowed down to 5% in the second quarter this fiscal. The debate and discussion in the media has been on: are we heading for a recession or has the economy hit a slowdown as a natural phenomenon of the business cycle?

Growth rate of the Indian economy is linked more to the agriculture and services sectors than to others. But the precipitous fall in business confidence and consumer confidence indices, slowdown in savings and investment rates, and in capital  formation signal the necessity of corrections on different fronts. 

A fall in the growth of real estate, automobiles, and core sectors warranted policy corrections. It is, however, doubtful whether a stimulus is required. Moody’s expect the growth of the economy to be at 6% current fiscal. A 6% GDP growth in an overall depressing scenario in the rest of the world, should be seen as encouraging but that does not leave any room for complacence. 

The IFO World Economic Survey, released every quarter, says in its recent statement: “In the emerging and developing Asia, the climate indicator fell, from +2.1 to –12.1 balance points. This figure mainly reflects the negative developments in China and India. 

The ASEAN-5 countries (comprising Indonesia, Malaysia, the Philippines, Thailand, and Vietnam) saw a renewed downturn in their economic climate, from 34.6 to 21.3 balance points. The present economic situation continued to deteriorate but remained at a satisfactory level. The best economic climate is reported for Malaysia and the Philippines.” Malaysian Ringgit, it says, is undervalued vis-à-vis US$.

INFLATION RATE 

Retail inflation in India fell to 3.15% year-on-year as of July 2019, less than the RBI inflation target of 4%. A growing economy should be having a healthy inflation index. High growth rates in the past were achieved against high inflation rates. 

An alarming rise in inflation to 12.17% in 2013 provoked the RBI to take stiff measures to bring it down to the inflation expectation target. Deflationary trend will send negative signals for growth. A comparison between India and China in terms of Inflation rates indicates peaks and turfs but do not cause the economy to shrink to lows, bringing it close to recession. 

On the retail price front, inflation accelerated to a nine-month high, though remained moderate and below its long-run average. If we can maintain at the RBI an expectation at 4%, that is a rise of 0.75 in the inflation rate, the economy will bounce back to a growth level of average 7%. 

GDP Per capita 

Comparing with US dollar, per capita GDP in India was 2104.20 in 2018, which is equivalent to 17% of the world’s average and it was at a record low of $330.20 in 1960. 

Poverty index also fell to a low of less than 20%, going by the Niti Aayog data. Bourgeoning middle class and conspicuous consumption would not disappoint the retail markets, particularly the fast moving consumer goods (FMCG) sector. This would mean that the slowdown would be a temporary phenomenon.

Consumer Confidence Index:

Consumer confidence in India fallen to 95.70 index points in the third quarter of 2019 from 97.30 in the second quarter of 2019. It is way below the average of 103.10 for the period from 2010 until 2019. It has been falling since demonetisation but started rising till the second quarter of 2018. Thereafter, the fall has been precipitous. Reversing this requires more than pep talk. 

The goods and services tax (GST) has a sagging effect not merely on micro and small enterprises but also on consumers. While it has brought about the much needed business discipline and tax compliance, input credit delivery suffered gradually eroding the confidence in the system. This needs reversal sooner rather than later. 

Bank mergers contributed to the erosion in consumer confidence. Mergers led to distancing the reach of banking to the people, notwithstanding the new initiatives like the small finance banks, postal bank, small payments bank, Rupay card and Micro Units Development and Refinance Agency Ltd. (MUDRA). 

The speed of service through technology is different from the reach. Caring for customers has vastly eroded in the banks. Apps may be attractive but difficult to access for the semi-literate rural clients. If growth of the services sector is declining, financial services has a major contribution to this failure. This needs quick reversal.

BUSINESS CONFIDENCE INDEX

The business expectations index (BEI) fell to 112.8 in the second quarter of 2019-20 fiscal year from 113.5 in the previous three-month period. The index in India averaged 117.74 from 2000 until 2019, reaching an all-time high of 127.50 Index in the second quarter of 2007 and a record low of 96.40 Index in the second quarter of 2009.

Ups and downs are part of business cycles. Several states indulge in make believe efforts when it comes to projecting ease of doing business. Still, several departments and public sector companies indulge in the procedural rigmarole for paying the bills and releasing the promised incentives. 

It is necessary that all states should revisit their industrial incentives as to what they can easily deliver and what they cannot, and whether the incentives are delivering the intended benefits at the right time. Giving rise to undeliverable expectations brings down the business confidence index. This needs correction.

MANUFACTURING NEEDS A BIG PUSH

The IHS Markit India manufacturing PMI (purchasing managers’ index) dropped to 51.4 in August 2019 from 52.5 in the previous month and below the market expectations of 52.2. The latest reading pointed to the weakest pace of expansion in the manufacturing sector since May 2018.

Output rose the least in a year and new order growth slowed to a 15-month low, with overseas sales increasing at the softest rate since April 2018. Backlog of works and project delays continued. Employment levels continue to cause concern with not so good results seen even against the huge investments made in skill development. 

Source: https://tradingeconomics.com/india/manufacturing-pmi

Technology and markets are growing at a rapid pace, throwing up new opportunities. More than 75% of global growth in output and consumption is in the emerging markets. High tech advancements like the industrial internet of things, machine learning (ML), artificial intelligence  (AI), though have become buzz words in the Industry, they are yet to catch up in all the segments of manufacturing. 

Some of the announcements like relaxations in foreign direct investment (FDI) policy touching retail and media, government junking old vehicles and replacing them with new ones will trigger a demand in auto sector only marginally. Cost-cutting across the supply chain remains a major priority. 

Addressing the workforce skill gap remains a challenging priority. Manufacturers can address the skills shortage by forming partnerships with schools, associates and even competitors to train and recruit talent at an early stage.  But there exists a gap in the confidence of industry to partner with educational institutions, irrespective of the emphasis that Modi and several state governments like Telangana have laid on it. 

Though labour code has been introduced with the consolidation and rationalisation of 12 labour laws, the increased burden of social security and minimum wages requires re-engineering of business processes and restructuring of organisations and this may require some more time. 

In order that the industry develops its own push-pull measures, tax breaks can be planned by the government for research and development. Corporate social responsibility (CSR) targets can also be dovetailed for a soft touch to the markets. When the morale is sagging, demand generation is hard to come by. Every measure from the government addresses just one or the other key component of manufacturing investment. It needs to be a facilitator and catalyst rather than pumping money into the economy. 

The areas where it should pump money are public investments in infrastructure and fast delivery of contract payments. Quick credit of input tax on payment of GST will also help. But unless state governments also come on board, avoid wasteful expenditure, monitor all their investments for quick results on an on-going basis and review the situation periodically through accredited third-party agencies, it will be difficult to reverse the slow growth.