Elaborate Notes
MSMEs
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Data and Facts on MSMEs in India:
- Contribution to Exports: Micro, Small, and Medium Enterprises (MSMEs) are a vital part of India’s export basket, contributing approximately 40% of total exports. This figure, often cited by the Ministry of Commerce and Industry and the Ministry of MSME, highlights their role in earning foreign exchange. For instance, products like textiles, leather goods, auto components, and gems and jewellery from MSME clusters are major export items.
- Formalization Challenge: An estimated 86% of MSMEs operate outside the formal registration framework. This means they are not registered on portals like the Udyam portal, nor are they necessarily part of the Goods and Services Tax Network (GSTN). This “informality” leads to a lack of access to formal credit, government schemes, and social security for their workers, a point highlighted in numerous reports by the International Labour Organization (ILO).
- Women’s Participation: Women own approximately 20% of all MSMEs in India. This statistic underscores the sector’s role in promoting female entrepreneurship. Schemes like the ‘Stand-Up India’ and the ‘Mahila Coir Yojana’ are specifically designed to bolster this trend. The NITI Aayog’s reports on women’s empowerment have consistently emphasized the need to increase this share through targeted interventions.
- Rural Dominance: About 60% of all MSMEs are based in rural India. This demonstrates their critical role in diversifying the rural economy beyond agriculture and preventing distress migration to urban centers. Khadi and Village Industries Commission (KVIC) is a prime example of an institution that supports rural MSMEs.
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Significance of MSMEs:
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A) Economic Significance:
- Employment Transition: MSMEs are crucial for facilitating the structural transformation of the economy, a concept theorized by economists like Sir Arthur Lewis (1954) in his dual-sector model. They absorb surplus labour from the low-productivity agricultural sector into higher-productivity manufacturing and service sectors, driving economic development.
- Inclusive Growth: The sector is inherently inclusive. With 20% ownership by women, a significant presence of traditional artisans from Scheduled Castes and Scheduled Tribes, and a 60% rural base, it ensures that the benefits of economic growth are more widely distributed across society.
- Export Potential & Forex: Their 40% contribution to exports is critical for managing India’s Current Account Deficit (CAD) and maintaining stable foreign exchange (forex) reserves. In the fiscal year 2022-23, MSME-related products accounted for over 45% of India’s total exports.
- Rural Employment: After agriculture, the MSME sector is the largest employer in rural India. It provides non-farm employment opportunities, which helps in augmenting rural incomes and reducing disguised unemployment in agriculture.
- Building Brand India: By participating in global value chains, Indian MSMEs enhance the country’s reputation for quality and innovation. Government initiatives like ‘One District One Product’ (ODOP) aim to identify and promote unique products from each district, thereby creating global brands from India. For example, promoting Chikankari from Lucknow or Kanchipuram sarees on a global scale.
- Indigenous Growth (Atmanirbhar Bharat): MSMEs are at the heart of the ‘Self-Reliant India’ mission. They strengthen domestic manufacturing capabilities, leading to import substitution for a wide range of goods, from simple components to sophisticated machinery parts.
- Supply Chain Integration: They function as ancillary units for large-scale industries, supplying raw materials, components, and services. This integration creates a robust and resilient domestic supply chain, as seen in the automotive industry where numerous MSMEs supply parts to large car manufacturers.
- Value Addition: MSMEs are increasingly moving towards value-added products and services, catering to niche market demands that larger corporations might overlook. For example, organic food processing units or bespoke software development firms.
- Reducing Import Bills: By manufacturing components and finished goods domestically, MSMEs directly contribute to a reduction in the import bill, saving precious foreign exchange.
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B) Social Significance:
- Social Justice: The sector provides economic opportunities to marginalized and vulnerable groups, including women, SC/STs, and minorities, thereby empowering them and promoting social equity. For instance, tribal handicraft clusters in states like Odisha and Jharkhand generate sustainable livelihoods.
- Balanced Regional Development: The widespread geographical distribution of MSMEs across the country helps in countering the trend of economic activity being concentrated in a few large urban centers. This promotes more balanced regional growth and development.
- Curbing Work-based Migration: By creating employment opportunities in rural and semi-urban areas, MSMEs help reduce the compulsion for people to migrate to overcrowded cities in search of work, thereby easing pressure on urban infrastructure.
- Tribal Development: There is a growing global and domestic market for tribal products like handicrafts, textiles (e.g., Dongria Kondh shawls), and forest produce. Organizations like TRIFED (Tribal Cooperative Marketing Development Federation of India) promote these products, ensuring economic benefits flow directly to tribal communities.
- Reducing Income Inequality: By fostering entrepreneurship at the grassroots level and creating a large number of jobs, the MSME sector contributes to a more equitable distribution of income, thereby addressing the issue of rising income inequality.
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Challenges of the MSMEs:
- Poor Insolvency Process: While the Insolvency and Bankruptcy Code (IBC), 2016, was a landmark reform, its framework was initially complex and costly for smaller firms. The World Bank’s ‘Doing Business’ Report (prior to its discontinuation in 2021) often highlighted the long time taken for insolvency resolution in India, which was cited as 7.9 years in the summary, although recent data after IBC implementation showed improvements. A pre-packaged insolvency resolution process for MSMEs was introduced in 2021 to address this.
- Informality: The summary notes that around 90% of MSMEs operate in the unorganized sector (a more accurate term than organized). This leads to a lack of social security benefits (pension, health insurance) for workers, difficulty in accessing institutional finance, low economies of scale, and vulnerability to market shocks.
- Regulatory Hurdles: Despite efforts towards improving the ease of doing business, MSMEs still face numerous compliance requirements, from environmental clearances to labour law regulations, which can be overwhelming for small entrepreneurs. This is often termed ‘Inspector Raj’.
- Low Production Capacity & Technology: Many MSMEs use outdated technology, which results in low productivity and poor quality of products, making it difficult for them to compete globally.
- Access to Credit: Lack of access to timely and affordable institutional credit remains a perennial problem. Banks are often hesitant to lend to MSMEs due to a lack of collateral, poor credit history, and perceived high risk.
- International Competition: With the opening of the economy, MSMEs face stiff competition from cheaper imports, particularly from countries like China.
- Infrastructural Deficiencies: Poor infrastructure, including unreliable power supply, inadequate roads, and poor connectivity, increases the operational costs for MSMEs, especially in rural and semi-urban areas.
- Skill Gap: There is a significant mismatch between the skills required by the industry and the skills possessed by the available workforce.
- Poor Digital Presence: In the age of e-commerce, a weak digital footprint limits the market reach of many MSMEs.
- The “Dwarf” Phenomenon: The Economic Survey of India 2018-19 extensively discussed the issue of MSMEs remaining “dwarfs” (old but small) instead of growing into “gazelles” (young and large). These firms remain small to avoid regulatory compliances and labour laws, and thus never achieve economies of scale, remaining low on productivity.
- Automation and AI (Industry 4.0): The advent of automation and artificial intelligence poses both an opportunity and a threat. It threatens to displace labour in traditional MSMEs if they fail to adapt and re-skill their workforce.
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Government Initiatives:
- Increased Budgetary Allocation: The government has consistently increased budgetary support for the MSME sector through various schemes.
- Stand-Up India Scheme (2016): Aims to facilitate bank loans between ₹10 lakh and ₹1 crore to at least one Scheduled Caste (SC) or Scheduled Tribe (ST) borrower and at least one woman borrower per bank branch for setting up a greenfield enterprise.
- Udyog Aadhar Memorandum (UAM): Introduced in 2015, it was a one-page online registration system to simplify the process. This has since been replaced by the Udyam Registration Portal (2020), which is fully online, paperless, and based on self-declaration.
- Labour Reforms: The Shram Suvidha Portal was launched to provide a single platform for reporting and compliance with various labour laws, reducing complexity for employers. The recent consolidation of 29 central labour laws into four codes also aims to simplify compliance.
- Credit Linked Capital Subsidy Scheme (CLCSS): This scheme facilitates technology upgradation in MSMEs by providing a 15% upfront capital subsidy on institutional finance.
- Skill Development: Programs like the Entrepreneurship Skill Development Programme (ESDP) are conducted to nurture the talent of youth by enlightening them on various aspects of industrial activity required for setting up MSMEs.
- U.K. Sinha Committee Recommendations (2019): This expert committee made several key recommendations, including the creation of a ₹10,000 crore government-sponsored ‘Fund of Funds’ to support venture capital and private equity firms investing in MSMEs, promoting collateral-free loans, and easing regulatory burdens.
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Way Forward:
- Cluster Manufacturing: Developing industrial clusters (e.g., the Tiruppur textile cluster or the Ludhiana hosiery cluster) allows MSMEs to benefit from shared infrastructure, technology, and a skilled labour pool, enhancing their collective competitiveness.
- E-commerce Integration: Leveraging e-commerce platforms like Amazon, Flipkart, and the Government e-Marketplace (GeM) can provide MSMEs with direct access to wider domestic and international markets.
- Promoting Innovation: Fostering a culture of research and development (R&D) and innovation is crucial for MSMEs to move up the value chain and create unique products.
- Leveraging Industrialization 4.0: Instead of viewing it as a threat, MSMEs should be supported to adopt automation, IoT, and AI to improve efficiency, quality control, and competitiveness.
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New Classification of MSMEs (effective from July 1, 2020): This new classification removed the distinction between manufacturing and services sectors and introduced a composite criterion of investment and annual turnover.
| Types | Micro | Small | Medium |
|---|---|---|---|
| Manufacturing & Services | Investment in Plant & Machinery or Equipment ≤ ₹1 crore AND Annual Turnover ≤ ₹5 crore | Investment in Plant & Machinery or Equipment ≤ ₹10 crore AND Annual Turnover ≤ ₹50 crore | Investment in Plant & Machinery or Equipment ≤ ₹50 crore AND Annual Turnover ≤ ₹250 crore |
Banking and Money Supply
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Issues Faced by the Banking System in India:
- Declining Interest Margins: Increased competition from Non-Banking Financial Companies (NBFCs), small finance banks, and fintech companies, along with regulatory pressure to link lending rates to external benchmarks, has squeezed the Net Interest Margin (NIM) of banks.
- Asset-Liability Mismatch (ALM): This is a critical risk, especially for banks funding long-gestation infrastructure projects. Banks typically raise funds through short-term deposits (liabilities) but lend them out for long-term projects (assets). If depositors withdraw their money prematurely, the bank can face a liquidity crisis. This was a key factor in the IL&FS crisis of 2018.
- Double Financial Repression: This term describes a situation where a bank’s balance sheet is constrained on both sides.
- Asset Side Repression: High Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) requirements force banks to hold a significant portion of their assets in low-yield government securities, limiting their ability to lend to more profitable sectors.
- Liability Side Repression: Historically, this involved administered interest rates on deposits set by the RBI, which were often below the market rate. While deposit rates are now largely deregulated, informal government pressure can still exist.
- Twin Balance Sheet (TBS) Problem: This term was prominently used in the Economic Survey 2016-17 by then-Chief Economic Adviser Arvind Subramanian. It refers to the stressed balance sheets of both the public sector banks (overburdened with NPAs) and the large corporate sector (over-leveraged with debt they could not service). This created a vicious cycle where corporates couldn’t invest and banks couldn’t lend, stalling economic growth between 2011 and 2016.
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Non-Performing Assets (NPAs):
- Definition: An NPA is a loan or advance for which the principal or interest payment has remained overdue for a period of 90 days. In essence, it is an asset that has stopped generating income for the bank.
- Classification of NPAs (as per RBI norms):
- Substandard Asset: An asset which has remained an NPA for a period less than or equal to 12 months.
- Doubtful Asset: An asset that has remained in the substandard category for a period of 12 months. The probability of recovery is very low.
- Loss Asset: An asset is considered a loss asset when it is identified as uncollectible by the bank, its internal or external auditors, or the RBI inspection, but the amount has not been written off entirely.
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Impact of NPAs:
- Economic Growth: High NPAs erode the profitability of banks. To compensate, banks may increase their lending rates and become more risk-averse, leading to a credit crunch that stifles private investment and slows down economic growth.
- Inflation: The relationship is complex. A severe credit crunch due to NPAs can be deflationary. However, if the government recapitalizes banks by printing more money or through excessive borrowing (fiscal deficit), it can lead to inflationary pressures in the long run.
- Credit to Priority Sectors: When banks’ balance sheets are weak, they tend to reduce their exposure to riskier sectors, which often includes small-scale industries, agriculture, and other parts of the Priority Sector Lending (PSL) portfolio.
- Impact on Inclusiveness: A higher cost of borrowing and reduced credit availability disproportionately affects small borrowers and marginalized communities who rely on formal banking channels, thus hindering financial inclusion.
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BASEL Norms:
- Introduction: The Basel Norms are a set of international banking regulations issued by the Basel Committee on Banking Supervision (BCBS). The BCBS is headquartered at the Bank for International Settlements (BIS) in Basel, Switzerland. The overarching goal is to enhance financial stability by improving the quality and quantity of regulatory capital in banks, thereby strengthening their ability to absorb shocks.
- India’s Stance: India is a member of the BCBS and has accepted the Basel Accords. The Reserve Bank of India (RBI) has implemented these norms, often with more stringent requirements (e.g., prescribing a higher minimum capital ratio than the international standard).
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A) BASEL-I (1988):
- Focus: The first Basel Accord was primarily focused on credit risk—the risk that a borrower will default on their debt.
- Capital Adequacy Ratio (CAR): It introduced the concept of a minimum CAR, also known as the Capital to Risk-Weighted Assets Ratio (CRAR). The formula is: CAR = (Total Capital) / (Risk-Weighted Assets)
- Risk-Weighted Assets (RWA): This framework assigned risk weights to different asset classes. For example, a loan to the government (cash, government bonds) might have a 0% risk weight, while an unsecured personal loan would have a 100% or higher risk weight. This ensured that banks holding riskier assets were required to maintain more capital.
- Components of Capital:
- Tier-1 Capital (Core Capital): This is the most stable and loss-absorbing form of capital. It comprises shareholders’ equity (common stock) and disclosed reserves (retained earnings). It represents the highest quality capital.
- Tier-2 Capital (Supplementary Capital): This is a secondary component of capital. It includes items like undisclosed reserves, revaluation reserves, preference shares, and subordinated debt (debt that is paid off only after all senior debt holders are paid in the event of liquidation).
- Adoption in India: India officially adopted the Basel-I guidelines in 1999. The RBI mandated a minimum CAR of 9%, which was higher than the BCBS’s prescribed 8%.
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B) BASEL-II (2004):
- Refinement: Basel II was a more comprehensive and risk-sensitive framework designed to address the shortcomings of Basel I. It was structured around three pillars.
- The Three Pillars of Basel II:
- Minimum Capital Adequacy Requirement: This pillar expanded the definition of risk. Banks were now required to maintain a minimum CAR of 8% against not only credit risk but also operational risk (risk of loss from failed internal processes, people, and systems) and market risk (risk of loss from movements in market prices, such as interest rates or exchange rates).
- Supervisory Review Process (SRP): This pillar empowered bank supervisors (like the RBI) to review and evaluate a bank’s internal capital adequacy assessment process and risk management systems. If supervisors found these to be inadequate, they could require the bank to hold capital in excess of the regulatory minimum.
- Market Discipline: This pillar aimed to complement the first two by promoting greater transparency through enhanced disclosure requirements. Banks were required to disclose details of their risk exposures, capital adequacy, and risk assessment methodologies to the public. The idea was that well-informed investors and market analysts would exert a form of discipline on banks, rewarding prudent risk management and penalizing excessive risk-taking.
Prelims Pointers
- MSMEs contribute around 40% to India’s total exports.
- An estimated 86% of MSMEs in India are unregistered.
- Women own about 20% of all MSMEs in India.
- Approximately 60% of Indian MSMEs are located in rural areas.
- The U.K. Sinha Committee was constituted to suggest measures for the economic and financial sustainability of the MSME sector.
- Shram Suvidha Portal is a government initiative to simplify compliance with labour laws.
- New MSME Classification (from July 1, 2020):
- Micro: Investment ≤ ₹1 crore AND Turnover ≤ ₹5 crore.
- Small: Investment ≤ ₹10 crore AND Turnover ≤ ₹50 crore.
- Medium: Investment ≤ ₹50 crore AND Turnover ≤ ₹250 crore.
- A Non-Performing Asset (NPA) is a loan where principal or interest payments are overdue for more than 90 days.
- Classification of NPAs:
- Substandard: NPA for ≤ 12 months.
- Doubtful: Substandard for > 12 months.
- Loss Asset: Identified as uncollectible but not yet written off.
- The “Twin Balance Sheet Problem” refers to the stressed balance sheets of public sector banks and large corporations.
- The Basel Committee on Banking Supervision (BCBS) issues the Basel Norms.
- The BCBS is headquartered at the Bank for International Settlements (BIS) in Basel, Switzerland.
- India adopted Basel-I norms in 1999.
- Basel-I was primarily focused on credit risk.
- Tier-1 Capital is the core capital of a bank (e.g., equity, disclosed reserves).
- Tier-2 Capital is supplementary capital (e.g., undisclosed reserves, subordinated debt).
- Basel-II (2004) is based on three pillars: Minimum Capital Requirement, Supervisory Review, and Market Discipline.
- Basel-II expanded risk coverage to include credit risk, operational risk, and market risk.
Mains Insights
MSMEs
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Engine of Growth vs. Structural Weakness:
- Argument: While MSMEs are lauded as the “backbone of the economy” due to their contribution to employment, exports, and inclusive growth, they are plagued by deep structural weaknesses.
- Cause-Effect Analysis: The challenge of “dwarfism” (as highlighted in the Economic Survey 2018-19) is a prime example. MSMEs intentionally stay small to avoid regulatory scrutiny (e.g., labour laws), which prevents them from achieving economies of scale. This, in turn, hampers their productivity, ability to invest in new technology, and global competitiveness, thus limiting their potential contribution to the economy.
- Debate: The policy debate has shifted from protectionism (e.g., reservation of products for SSI, a policy dismantled in the 2000s) to promoting competitiveness. However, there is an ongoing discussion on whether government support should focus on helping all MSMEs or selectively on identifying and nurturing “infant” firms that have the potential to grow large and create more jobs.
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Formalization: A Double-Edged Sword?
- Perspective 1 (Pro-Formalization): Formalization (through Udyam registration, GSTN) brings MSMEs into the mainstream, giving them access to formal credit, government tenders, and export incentives. It also provides social security to workers.
- Perspective 2 (Challenges of Formalization): For micro-enterprises, the costs and complexities of compliance (filing GST returns, maintaining accounts) can be prohibitive. A sudden push for formalization without adequate hand-holding and simplification can increase their operational burden and potentially render many unviable. The policy approach must be gradual and incentive-based rather than coercive.
Banking and NPAs
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The Cyclical Nature of the NPA Crisis:
- Cause: The Indian NPA crisis that peaked around 2015-16 was not a sudden event. Its roots can be traced to the exuberant lending during the economic boom of 2004-2008, followed by project delays due to the 2008 Global Financial Crisis, domestic policy paralysis (e.g., environmental clearances), and corporate malfeasance.
- Effect: This led to the “Twin Balance Sheet” problem, creating a vicious cycle: Stressed corporates defaulted on loans → bank balance sheets weakened → banks stopped lending → corporate investment collapsed → economic growth slowed down. This demonstrates the critical link between banking sector health and macroeconomic stability.
- Policy Response: The government and RBI responded with the 4R Strategy: Recognizing NPAs transparently (through Asset Quality Review), Resolution (through the IBC, 2016), Recapitalizing public sector banks, and Reforms in the banking sector.
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Basel Norms: Global Standards vs. National Realities:
- Debate: Are the sophisticated, one-size-fits-all Basel norms appropriate for a developing country like India?
- Argument for Adoption: Adopting global standards enhances the credibility of the Indian banking system, facilitates its integration with the global financial system, and attracts foreign investment. It imposes a necessary discipline on banks, preventing excessive risk-taking.
- Counter-Argument: Critics argue that these norms can be pro-cyclical. During a downturn, as risks increase, the norms require banks to hold more capital, which can force them to curtail lending precisely when the economy needs it the most, thus deepening the recession. The complex risk-modelling requirements may also be better suited for large, sophisticated banks in developed economies than for smaller banks in India. A tailored, context-specific approach may be more effective. This is why the RBI often prescribes a “Basel plus” framework, adapting the norms to Indian conditions.