India - Small Scale Industry : Performance, Evaluation and Agenda for Reform (Vol. 1 of 2)

CONFIDENTIAL MICROFICHE COPY Report No. 10390-in CONF1ENTIAL Report No. 10390-IN Type: (SEC) ZAGHA, R. / X80348 // 1)1009/ SA2'CI INDIA SMALL SCALE INDUSTRY PERFORMANCE, EVALUATION AND AGENDA FOR REFORM VOLUME I June 24, 1992 Average Exchange Rates (Rs/US$1) 1970 7.50 1975 8.38 1980 7.86 1981 8.66 1982 9.46 1983 10.10 1984 11.36 1985 12.37 1986 12.61 1987 12.96 1988 13.92 1989 16.23 1990 17.50 1991 21.50 List of Abbreviations ASI - Annual Survey of Industries CAG - Comptroller and Auditor General of India CBs - Commercial Banks CTTC - Central Tool Room and Testing Centers DCSSI - Development Commissioner Small Scale Industries DFI - Development Finance Institute DI - Directorate of Industries (State level) DICs - District Industries Centers DSCRs EDIIs - Entrepreneurship Development Institute of India EDPs - Entrepreneurship Development Programs FICCI - Federation of Indian Chambers for Commerce and Industry GOI - Government of India ICICI - Industrial Credit and Investment Corporation of India IDBI - Industrial Development Bank of India IEP - Industrial Estates Program IES - Industrial Extension Services IFCI * Industrial Finance Corporation of India MITCOM - Maharashtra Industrial and Technical Consultancy Organization MOI - Ministry of Industry MRTP - Monopolies and Restrictive Trade Practices Act MODVAT - Modified Value Added Tax NGOs - Non-government Organization NIC - National Industry Classification NIESBUD - National Institute of Entrepreneurship and'Small Business Development NIMID - National Institute for Motivation and Institutional Development NISIET - National Institute of Small Industry Extension Training NSIC - National Small Industries Corporation NSTEDB - National Science and Technology Entrepreneurship Development Board PDTCs - Prototype Development and Testing Centers PPDC - Product and Process Development Centers RBI - Reserve Bank of India REER - Real Effective Exchange Rate R&D - Research and Development RTCs - Regional Testing Centers SBI - State Bank of India SFCs - State Financial Corporations SIDBI - Small Industries Development Bank of India SIDCs - State Industries Development Corporation SIDO - Small Industries Development Organization SISIs - imall Industries Service Institutes SRTOs - Small Road Transport Operators SSI - Small Scale Industry SSIDC - Small State Industries Development Corporation TCOs - Technical Consultancy Organizations UPTECH - Up-gradation of Technology Project/Program UTI - Unit Trust of India INDIA SMLL SCALa INDUsr PsaOMamwca, EVAMATTON AND AGENDA FOR REFORM VOLUM I Table of Contents Page No. Executive SuMMar . . . . . . . . . . . . . . . . . . . . . . . . . i Chapter 1 Government Policy Toward Small Scale Industry . . . . . . . . . . . 1 Introduction . . . . . . . . . * * . . . . . . . . . . . . . 1 Origins of SSI Policy . . . . . . . . . . . . . . . . . . . . 2 Objectives of Promotion of Small Scale Industries . . . . . . 4 Policy Evaluation & Institutional Framework . . . . . . . . . 5 Definition of Small Scale Industry in India . . . . . . . . . 9 Conclusilns . . . . . . . ............ . . . . . . 10 CAMSer 2 The Size Structure of Indian Industry . . . . . . . . . . . . . . . 12 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 12 output and Employment . . . . . . . . . . . . . . . . . 13 Product Composition. . . . . . . . . . . . . . . . . . . . . 16 Factors Affecting Entry by Small*Pirms. . . . 18 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . 21 Chagler 3 Incentives, Concessions and Technical Efficiency . . . . . . . . . 23 Introduction . . . . . . . . . . . . . . . . 23 Incentives and Concessions . . . . .. . . . . . . . . . . . 24 Technical Efficiency . . . . . . . . .. 32 Constraints and Obstacles . . . . . . . . . . . . . . . 38 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . 41 Pae No. ChLapter 4 Sickness in Small Scale industry . . . . . . . . . . . . . . . . . 43 Zntroduction . . . . . . a . . . . . . . . . . . . . . . 43 Prevalence of Sickness . .. . .. . . . . . . . . . . . . . 44 Causes of Sickness * ***.* . .......... .. 48 Conclusions . * * * * . . . . . . . 51 Chapter 5 Financing Small Scale Industry . . . . . . . . . . . . . . . . . . 53 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 53 Growth of Official Financial Intermediation . . . . . . . . 53 Informal Credit Markets.t.......... . 9 61 Policy Issues . . . . . . . . . . . . . . . . . . . . . 65 Summary and Recommendation ......... . ..... 72 Chanter 6 industrial Extension Services for Small Scale Industry o . . . . . 76 Introduction . . . . . . . . . . . . . . . . . . . . . . . 76 Organizations, Structures and Inst.-Itutional Framework . . . . . * . . . * . . . . * * . . . . 76 User Perceptions and Benefits *. .. . . . . . . ... . . 79 Assessment of Performance . . . . . . . . . . . . . . . . . . 83 Conclusions and Recommendations . . . . . . . . . . . . . . . 88 Chapter 7 Sub-contracting and the Small scale sector . . . . . . . . . . . . 95 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 95 Growth of Sub-contracting Activity in India . . . . . . . . . 97 Factors Influencing Growth of Sub-contracting in India . . . * . . . . * . . . . . . . . . . . . 103 Pattern and Strength of Inter-Sectoral Linkages . . . . . . . 108 Conclusions and Recommendations . . . . . . . . . . . . . . . 112 Page No. ChaBter 8 Agenda for Reform . . . . . . . . . . . . . . . . . . . . . . . . . 115 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 135 Policy Focus . . . . . . . . . . . . . . . . . . . . . . . . 116 Concessions and Incentives . . . . . . ...... . . . . 118 Regulatory Environment . . . . . . . . . . . . . . . . . . 119 Financial Intermediation for SSI . . . . . . . . . . . . . . 120 Industrial Extension Services . . . . . . . . . . . . . . . . 121 Inter-Firm Linkages . . .. .. . . . . . ... . . 122 Implementation and Reform Phasing . . . . . . . . . . . . . . 123 Biblioraphy . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 List of Text Tables Page No. Chapter 1 Asset Ceiling for SSI Status . . . . . . . . . . .. . . . . 10 Chapter 2 Unregistered Manufacturing and 881 Registrations . . . . . . 14 Small Scale Industry in the Factor Sector . . . . . . . . . . 17 Industrial Output and Value Added by Firm Size . . . . . . . 18 Role of SSI in Different Product Categories . . . . . . . . . 20 Chapter 3 Selected Structure Ratios by Employment Size Group . . . . . 35 Productivity and Relative Efficiency . . . . . . . * . . . . 36 Estimates of Technical Efficiency . . . . . . . . . . . . . . 37 Chater 4 Commercial Bank's Advances to SS: Sector . . . . . . . . . . 45 Number of Sick SSI Units *. . . . . . . . . . . . . . . . 45 Compojition of Sick Units . . . . .. . . . . . . . . .. . . 47 Comparative Ratios - Sick and Non-sick Firms . . . . . . . . 48 Chapter 5 Sector Deployment of Commercial Bank Credit . . . . . . . . . 55 Share of Small Industry by Different Interest Rates, Outstandinq Loans and Advances of Schedule Commercial Banks . . . . . . . . . . . . .. .. . 57 Sanctions and Disbursements of SFC Loans . . . . . . . . . . 58 Recovery Performance of SFCs . . . . . . ....... . . 59 Interest Rates of Commerical Banks and Informal Financial Intermediaries for SSI Units . . . . . . . . . . . . . 65 Bank Group-wise Break-up of Viability Position of Sick SSI Units (At the end of December 1987) . . . . . . . . . . 69 Chapter 6 User Perceptions of IES. . . . . . . . . . . . 82 Central Government Expenditure on IES . . . . . . . . . . . . 85 Pa-e No. Chapter 7 Vertical Integ4t :tn - Ratios of Value Added to Gross Ou . . . . . . . . . . . . . . . . . . . 99 Growth of Ancil! -ization and Sub-contracting in Public Sectir Undertakings (PSUs) . . . . . . . . . . . EE Growth of Ancillarization and Sub-contracting in PSUs - Industry & Fira Levei Data . . . . . . . . . . . 101 Cost of "Bought-out" Components. .. . . . . . . . . . . . . 102 Performance of Sub-contracting Exchanges . . . . . . . . . . 103 Workers in Organized and Unorganized Sectors: Some characteristics * . . . . . .*. . . . . . . .. 107 Technological Linkages . . . .. . . . .. . ...... . 110 &aknowledgements This report was written by R.J. Robinson (Task Manager, AS4ND), Peter Wogart (AS4CO, Industry Unit), Ms. Sunanda Sengupta, (AS4ND), Umnuay Sae-Hau (AS4CO) and Ms. Madhumita Gupta (Consultant, New Delhi office). A variety of other inputs in the fc.-m of background papers and research notes were provided by P.N. Agarwala (Con- Icant), D. Dasgupta (Consultant), Rajiv Kumar (Consultant), Dilip Sarwate (Consultant), Ms. Anuradha Seth (Consultant), Ms. Vinita Shankar (Consultant), Sanjay Sinha (Consultant), Saurabh Sinha (Consultant). Typing and report reproduction was managed by Ms. Renu Kapoor (AS4ND) and typing assistance given by Ms. Pramilla D'Souza. EXZCUTIVX SUVXMY Introduction (i) India has given strong emphasis to the development of the small scale industrial sector, with an array of policies designed to encourage the growth and development of smaller firms. Despite growth in the number of small scale firms over the past thirty years, and the contribution made to industrial output, employment and exports by SSI, there are doubts that this growth has resulted in an efficient and dynamic small scale sector or that it has created a balanced industrial structure with inter-firm linkages based upon non-distortionary resource allocation decisions. Throughout this period, there has been some ambiguity in the policy focus for small scale industry (SSI), and the main policy thrust, as manifested through the structure of incentives and concessions, has never quite made the distinction and dichotomy between encouragement of new entrepreneurship and healthy growth of existing SSI and protection on the basis of size per se. Furthermore, macroeconomic policies, public investment decisions and public administration systems have often acted against smaller scale producers and not created a market environment conducive to the emergence of new entrepreneurs, and the development and growth of viable SSI. (ii) Much of the earlier thinking on India's development and industrialization strategy, and the role of smaller firms, was based on a socio-political ideology of the benefits of traditional and village-based industries. As noted therefore, the focus on policy has often been more directed at size per se, where small size is conceived of having positive intrinsic socio-political benefits, irrespective of the efficiency of the allocation of resources. The emphasis has been somewhat less on the goal of broadening the entrepreneurship and .apital ownership base, although, this was explicitly mentioned in policy pronouncements. The prevailing view has been that the small scale sector is "weak", and in need of protection. There has been recognition of market failures in factor and product markets which inhibit the growth and viability of SSI, but government interventions to correct them have been inappropriate and aggravated these failures in unforeseen ways. While new small firms may be vulnerable, this is often times more a function of their newness, rather than the scale of their operations. But the concession structure that flows from the prevailing policy view provides special dispensations in perpatuity, and, in some senses, discourages successful firms from evolving into mature, medium site firms. (iii) This report provides a review of this policy emphasis on SSI in India. The report traces the evolution of the policy approach, and documents how the structure of India's industrial sector has changed, and the role that SSI has played in this change. The report examines the incentive structure, in the context of the government's stated policy objectives, the assumptions that underpin those objectives, and also provides empirical analysis of the relative technical efficiency of small and large firms. Given the fact that so much policy attention has been directed toward SSI in India, the report seeks to evaluate the health and viability of small scale firms, and whether government policies, and the incentive structure underpinning them, are contributing to a vibrant and self sustaining small scale sector. Constraints on the emergence of new entrepreneurs and efficient SSI growth are identified, and special emphasis has been given to an analysis of how taese constraints may be reduced or minimized. In particular, this involves a review of the system of financial credit flows to SSI, the system of industrinl extension support and the extent tc which inter-firm linkages might facilitate the flow of technology and marketin? support. The report concludes with a possible framework of policy reform, and actions designed to improve the environment conducive to the emergence of new entrepreneurs and the growth of efficient and viable small scale firms. Status of 88! in India (iv) From the variety of sources available it is evid .. that the modern small scale industry sector, and the so called unregistered man.facturing sector, have not consistently outperformed the large scale, regijtered factory sector in terms of output, value added and employment. Utilizing data from the Annual Survey of Industries, the share of small scale firms (defined as between 10 and 49 employees) in terms of employment in the factory sector has gone up from the early seventies to late eighties (from 14.4% in 1973/74 to 17.4% in 1987/88). What is remarkable however, is that the share of output, value added and productive capital in small firms has remained almost unchanged for fifteen to twenty years despite an array of special concessions for SSI. This observation is reinforced if one looki at unregistered manufacturing in national accounts data. The share of unregistered manufacturing in gross value added has declined from 42.5% in 1970/71 to 39.4% in 1989/90. (v) Looking at industrial output and value added by more desegregated categories of firm size, the industrial structure has been little changed, and if anything, the large firms (500 employees or more) have increased their dominance. The binodal structure of Indian industry, with a concentration of assets, output and employment in a few large firms and many small scale units, with poor representation from medium sized producers has important implications. Experience in other countries suggests that it is the medium sized firms that are more innovative, more able to respond to changing technology and market conditions and display greater technical efficiency in the use of labor and capital. (vi) Studies of the rate of creation and entry of new SSI show that small firm entry and presence tend to be greater in those industry areas with lower capital intensity,, lower d' qees of vertical integration and less scope for economies of scale in management. Furthermore, it was found that macroeconomic variables (levels of real interest rate, inflation and overall GDP growth) also had strong positive influences upon the rate of creation of new SSI. While many of these factors are somewhat obvious or tautological, it does suggest that policies that affect them may be more influential and effective in promoting the growth of new firms and encouraging the spread of entrepreneurship, than specific, ad hoc concessions and incentives. (vii) There is evidence to suggest that sickness within the small scale industry sector is becoming more serious. The proportion of units classified as sick has increased from 2.6% in 1981 to about 10% by 1989. In terms of credit outstanding to the sector, that portion of the commercial banks' SSI portfolio that is locked up in units that are classified as sick has increased from 9.1% in 1981 to over 16% in 1989. Furthermore, analysis by the commercial banks suggests that the vast majority of sick units are not viable. (viii) This increasing trend of sickness is disturbing, with serious implications for the financial sector. While there may be factors exogenous to firms that are contributing to this problem (factor. such as infrastructure constraints, raw material shortages, excessive regulation and frequent changes in government policies for example), by and large the main causes appear to be endogenous to the firm. This in turn reflects deficiencies in the finan:ing of small firms and in their access to managerial and technical advi.ce. In many instances, firms are weak or sick at inception due to inadequate project planning and appraisal. And the promotion and incentive structures may be stimulating excessive entry of non-viable firms. Ready access to finance and subsidized crAdit, without an adequate level of entrepreneur equity involvement, invites failure and default. From a public policy perspective, the emphasis must be on the prevention of sickness and less on the rehabilil:ation of sick firms. This means improving the quality of the lending to the SSI sector, and targeting extension and advisory services at the pro- investment stages of a new firm cycle. Issues and Reform Aaenda Policy Focus (ix) India has entered into a phase of structural adjustment and realignment of the economy. Reforms in the trade regime, the financial system, the system of price and distribution controls and the structure of fiscal revenues and expenditures will pose a considerable challenge to the country's industrial sector. Domestic and international competitive pressures will increase, which will in turn demand restructuring and reorientation of many firms and sub sectors. The small scale sector will not be immune from this, but this industrial reformation will also provide great opportunities for new entrepreneurship and the growth of existing small scale units. (x) While this report focuses vpon policies and issues directly related to SSI in India, it should be apparent that policies and reforms in the wider macroeconomic and industrial context will also be instrumental in improving the prospects for smaller firms and propagating the spread of new entrepreneurship. Appropriate exit policies for larger firms that allow them to flexibly and speedily adjust to changing circumstances, will have a positive impact upon the general environment for doing business. This in turn will improve the prospects for efficient SSI. Therefore, while the recommendation and agenda for reform contained below relate specifically to SSI, it must be borne in mind that these reforms should form part of a wider approach to industrial structural transformation. As this wider industrial transformation is now underway, it is appropriate, therefore, to embark upon a reform agenda that will allow new entrepreneurs and existing SSI to take advantage of the various opportunities as they emerge. iv (xi) The appropriate policy for SSI in the nineties and beyond should be focussed less upon the notion of size per e, and more toward new entrepreneurship creation and the need for viable and efficient SSI. This means focussing on measures that improve the working of factor markets (eg. financial, labor and material inputs), provide key informational inputs that improve the success rate of new firms, and permit firms to operate in a less restricted and controlled environment. The present policy desire of producing in SSI whatever can be prcd"cud there, needs to be replaced with a focus nn SSI that views smaller firms in the context of the overall pattern and pace of industrialization. That is, government policy should start from the premise that firm size should be determined more by the technology of production, the supply and price of factor inputs and the extent of market demand, rather than by some arbitrary and administratively determined compartmentalization of product categories and type of unit. The strongly held belief which has guided policy for so long, that small scale firims will be more labor intensive, without any efficiency loss and misallocation of resources is not valid. (xii) A large number of studies has been undertaken in India and other developing countries, investigating the relative technical efficiency of firms by different size categories. Not surprisingly, there has been debate about methodological issues: about the degree of product definition and comparobility, the quality of data and the statistical measurement techniques employed. The results of these studies are variable. At an aggregated level, SSI in India does not appear to be technically superior to large size firms in its use of factor inputs. At the technically more correct single product and item-specific level of analysis, the results, as one might expect, are variable. As a guide to SSI policy formulation, this array of research, while of academic interest, may not be quite so useful. If, for a particular item, it is shown that smaller size is irrelevant, then the smaller firm should be competitive without concessions. If, on the other hand, for another item, SSI are found to be less efficient, then any special concessions will merely result in wasteful use of the country's resources. (xiii) The essence of a sound SSI policy therefore should be oriented toward improving the functioning of factor markets, removing market distortions and creating a business and commercial environment that reduces barriers to entry for new firms and imposes no artificial constraints on the growth of existing firms. This is not to suggest that direct government interventions designed to assist the emergence of new small scale firms are always inappropriate. Existing market imperfections (many of which have been policy induced and should be speedily eliminated), together with deficiencies in the general support systems and infrastructure, may not be amenable to instantaneous change. Well-targeted government interventions designed to reduce the entry inhibiting characteristics of these imperfections and deficiencies may be warranted in the short to medium term. But, the policies followed, and the interventionc that might flow from them, must be flexible, monitored regularly and incorporate time constrained "way-points" where the intervention lapses. (xiv) While SSI policy involves State and Municipal governments the Central Government can, and dots, provide a leading, catalytic role in the v development of this policy. In this context, it would be appropriate for the GOI to draw up a comprehensive White Paper that sets out the policy framework for SSI that will be followed over the next decade. This White Paper could outline the philosophical underpinning for Central Government programs of assistance for SSI, demarcate the type and duration of special concessions that will be offered by the Center and other actions that might be taken to improve the general business environment and overcome clearly identified areas of market failure, and hence enhance the emergence of new entrepreneurs and ensure the growth of efficient SSI. The recommendations and observations outlined below could form the basis of some of the actions that would be outlined in the White Paper. Concessions and Incentives (xv) The array of concessions for SSI is prodigious, but their impact, transparency and economic costs are highly variable. Many small scale firms do not avail of the majority of concessions offered, and even where they do, the perceived benefits are quite small. In many cases, the concessions are considered irrelevant or unnecessary, and are often overshadowed by the binding constraints imposed by deficiencies in infrastructure or inputs into the production process. A perfect example of this relates to subsidies granted on power tariffs by the individual State Electricity Boards. Most firms canvassed would rather do without any special concessions, provided their power supply was regular and uninterrupted, and appropriate connections could be obtained expeditiously when needed. (xvi) There are a number of special dispensations, however, which impose considerable negative costs on the economy. Production reservation for SI is a very blunt policy instrument, which raises consumer prices, inhibits technical change and progress, reduces product quality, constrains the development of potentially internationally competitive industrial sub sectors and provides excess profits to the large firms who were in existence when the product reservation was imposed. Furthermore, the benefits in the form of entry of new firms are often short lived, and the resultant higher market prices inhibit the growth of demand, which in turn constrains the growth of employment in the reserved categories. As a policy tool this form of concession for small scale firms should be discontinued, with a halt to any further item reservation. The government should announce its intent to eliminate product reservation and draw up an action program that sets out a progressive program of dereservation, with the objective of achieving the complete program over a period of say three years from the date of announcement. (xvii) The excise tax exemption for SSI sales up to certain prescribed limits provides a significant cost advantage to smaller firms. However, this form of incentive has negative side effects insofar as it discourages growth and encourages a proliferation of "shadow" firms with nominee share-ownership. A further drawback of the present system is that the exemption exists in perpetuity, irrespective of unit level profitability. Accurate estimates of the fiscal costs of this concession are not possible, but given that approximately 40% of manufacturing output comes from smaller scale producers, it is not insignificant. Also, while it may not be possible to quantify the vi longer term, dynamic impact of such a policy of tax exemptions, it undoubtedly must inhibit market development of the more dynamic firms. Given this latter factor, as well as the need to broaden the tax base, the excise tax exemptions for SSI should be phased out. It would still be possible to encourage the entry of new firms, with a time limited system of partial rebate or exemption of excise taxes due. For example, a new entrepreneur might receive an 80% exemption in the first year of operation, 50% in the second, and 25% in the third, uith the full excise rate being levied after three years of operation. (xviii) The present system of "scarce" raw material quota allocations for an individual, registered small scale firm should be abolished. It represents a failure of other market systems, oftentimes as a result of other policy interventions (eg. steel and non ferrous metals which was subject to domestic production and distribution controls and central procurement of imports), which would be efficiently and effectively dealt with by removing the underlying causes for the market failure. As it presently stands, the present system of quotas, at administratively determined prices, is frequently abused, with many small scale firms merely acting as trading enterprises reselling their quotas at prevailing market prices. There are a variety of other special incentives and concessions on production inputs. They all have time limitations and overall their distortionary impact is quite small. The possible exception to this is the State subsidies on power tariffs, which should be eliminated. Reaulatory Environment (xix) A major constraint for new entrepreneurs and small scale firms in India is the very complex and burdensome regulatory and administrative environment. There is massive scope for a reduction in paperwork and bureaucratic requirements. The Government has already sought to take action to simplify procedures and legal requirements for all firms, however, much remains to be done. Reporting requirements for all firms, not only SSI, are excessive, and much could be achieved simply by amalgamating the periodic submissions that are required under various Central Government statutes (the labor laws are a perfect example). In many cases, the administrative burden is a function of municipal and State level requirements (sales tax, octroi, zoning, safety and health regulations etc.), with the result that Central and State level coordination and harmonization would be necessary. The Center can take the lead, however, in initiating a thorough review of the requirements, proposing an agenda for reform and harmonization and, through the industrial extension service system, providing guidance and assistance to small scale firms in dealing with this burden. Furthermore, the existing industrial extension system (through the DICs) could assume an ombudsman role in monitoring the impact on SSI of bureaucratic and regulatory requirements, bringing perceived excesses to the attention of the States' authorities. Financial Intermediation for 881 (xx) The system of financial intermediation supporting SSI is in serious trouble. Good progress has been made in improving the coverage of the financial intermediation system, but the system is under strain, which in part is a reflection of issues and pressures within the overall financial sector in vii India. The prevalence of sickness amongst small firms is increasing, with obvious negative consequences for the loan portfolios of commercial banks and state financial corporations. Furthermore, while the causes of this sickness are multifarious, there is evidence to suggest that the very system of financial support contributes to the incidence of firm failure and sickness (poor appraisal, too low owner equity contributions, poor monitoring and follow up and bifurcated financing sources according to type of finance). (xxi) Any reforms designed to improve the efficiency of the flow of financial resources to SSI must occur within the framework of a reform agenda for the entire financial system in India. There is a need for a market determined interest rate structure for lending to SSI determined by individual firm risk perceptions and a lending institution's cost of funds. While lending by the commercial banks and SFCs carries interest rates that are positive in real terms, the concessional rates charged by the SFCs in particular, are not conducive to ensuring the longer term viability of the financial intermediary. SFCs' margins are under considerable strain, despite the fact that a major portion of their resources are subsidized and have been made available at below market rates. (xxii) The nonperforming part of SFCs' portfolio is large and recovery rates are very low. This reflects poor project appraisal, lack of coordination between different types of lending institutions and poor loan administration. Technically, many of the SFCs are bankrupt and without preferential access to funds would not survive. The institutional framework, which imposes artificial restrictions on the commercial banks and on SFCs, has contributed to this problem. Unfortunately, an appropriate cure cannot be effected by marginal fine-tuning of existing operational practices. More fundamental reform of the inatitutional structures, modes and sources of finance, type and method of lending and management and administrative systems are needed. As such the Center, through IDBI and SIDBI, should initiate a thorough study of each SFC. These studies should provide a realistic review of loan portfolio quality, organizational structure and loan administrative arrangements, accounting and reporting methods, staff requirements and recapitalization needs. In the absence of recapitalization and a more efficient financial intermediation function, many of the SFCs should be dissolved. (xxiii) A fundamental requirement of reform is the removal of any artificial demarcation of sources and types of finance for SSI (i.e. long term and working capital requirements from different institutions). This system has not served the small scale sector's needs very well, and has made it difficult for the institutions involved to react more flexibly to the needs of emerging entrepreneurs. Lack of adequate coordination between the various financing institutions often means that realistic assessments of working capital needs are not made, with consequent liquidity problems for infant firms. The recently established "one window' program launched by SIDBI represents a positive step, but this program covers only a very small proportion of lending to SSI. (xxiv) The SFCs need to be given greater flexibility in the type of financing activities in which they engage (for example hire purchase and viii leasing operations), the interest rates that they charge for these financial services. Management autonomy needs to be enhanced, and in this context during a recapitalization exercise, a broadening of the ownership base of the SFCs to include private sector institutions and individual shareholders should be undertaken. These institutions need to be run on a sound commercial basis, free of state political involvement. Industrial Extension Services (xxv) The impact and effectiveness of industrial extension services on the small scale sector in India has been mixed. Where there has been a concentration of effort in delivering a specific service designed to overcome a clearly identified market failure, the impact nas, on the whole, been beneficial. But, in most instances, the variety of services offered, and the geographic area covered, has resulted in a dissipation of resources (financial and manpower), which in turn has reduced the quality and effectiveness of the services offered. Many of these services could more efficiently be provided by private sector, commercial activities. It is appropriate and timely therefore to initiate a thorough review and reappraisal of the whole gamut of industrial extension services, its methods of delivery, its institutional framework, its activity focus and its methods of funding. (xxvi) There is clearly an appropriate government role in the promotion of new entrepreneurship, particularly in a developing environment with deficient education and communications systems. This role should focus upon areas where there is clear evidence of market failure and intervention designed to overcome this failure. SSI in India face an array of constraints (infrastructure deficiencies and shortages in power and raw material for example) but an industrial extension service cannot overcome them. Rather policies need to be directed at the causes of the shortage or market failures. Rather than expend limited resources on administrative systems to allocate scarce factory space or raw materials through non-price means, efforts should focus on measures that can improve the efficiency of existing SSI and the likelihood for success of new entrepreneurs who have already arranged their infrastructural and input requirements. Experience in other countries (South Korea, Taiwan, Hong Kong, and Japan to name a few) has shown that an efficient information dissemination function (of commercial and technology information) can be highly desirable where the social benefits can far outweigh the social costs (see Appendix A5 in Volume II of this report). Inter-firm Linkages (xxvii) The extent of sub-contracting and ancillary activity has increased in India over the last decade. How much this is due to direct public policy initiatives is unclear, although directives to the public enterprise sector may have encouraged large, vertically integrated monopolies to reduce their in-house production to some extent. Progress toward a more balanced and integrated industrial structure will only occur, however, as the Government's wider industrial sector reform program proceeds. As domestic and international competitive pressures increase, as exit policies are liberalized and public enterprises restructured, the opportunities for sub-contracting should increase, and hence improve the opportunities for SSI. ix (xxviii) There are some specific initiatives that could hasten the extent of such activity. Recently, factoring services have been introduced in a limited manner, but this type of service needs to be expanded. Sub- contracting information exchanges, operating as part of an information oriented industrial extension service, could increase awareness of opportunities for both small and large firms. A further important contribution toward improving inter-firm linkages will be an improvement in the quality of infrastructure available for small scale enterprises in areas where there are large firm concentrations. Locating factory parks for SSI in isolated or remote areas inhibits the scope for sub-contracting and should be discontinued. Imlementation and Reform Phasin@ (xxix) The proposed governmental White Paper, that would set out a policy framework and reform agenda for SSI, should also set out an implementation mechanism and organizational structure that will shepherd the policy reform process. In this regard it is proposed that a Task Force be established that would oversee the progress of five functional working groups. The basic objective of this task force will be to identify areas of market failure, or past governmental policy failure, that need to be changed or which would be amenable to public sector intervention. The goal would be to have an ineustrial sector that is free of bo,:h policy induced and genuine market failure constraints. The working groups could be as follows: Finance for SSI; Reservation and Input Subsidies; Industrial Extension; Excise Taxes and the Regulatory Environment. The Task Force would be composed of the Chairmen of the Working Groups, plus independent members from the Planning Commission, the Ministry of Industry, the Ministry of Finance, the Ministry of Labor, and non-governmental academics and other specialists. (xxx) Timing of implementation of any reform agenda is critical to the ultimate success of the reform effort. Inevitably there are conflicts between the desire to mitigate any adjustment costs of the reform and the need to sustain the momentum and credibility of the reform exercise. The Task Force should be responsible for coordinating the timing of implementation. Some of the proposed reforms (dereservation and excise tax changes) can proceed quite speedily, and should not await the capacity to reform other elements. Reforms to both extension services and financial intermediation may need to await specific study of elements and components of both activities (eg. review of each SFC, or assessment of individual extension activities). Despite this however, the Task Force, should publicly announce its intent to effect reforms in ,hese areas, and the broad principles and objectives that will guide the reform effort. x BOX 8.1 SUGGESTED POLICY REFORM AGENDA PollEy lsue and HgAftons NecessarT Areas of Reform Overall olicv Focus The focus of Indie's SSI policy should bo reorionted toward en empha a on new .ntrepreneurshiporeotion. and tho fflolentSgrowth of SV end less upon protection ofll small scalc firms. This menns fousing on measures that improvö the working of factor merkets, reduces ortificial barriers to entry and enhances the quality of .infrastructure. To. effeot this reorientotion, it would bo necessary to draw up a comprehensive Governrienta White Paper that sets out the policy frame.work and reform. egenda for S5. as weil as providing . an implementation meochanism end orgonixationel structure that would shepherd the policy reform process. Suggested steps: A precise timetable for these Establishment of an SSI Policy actions may not be feasible. But Task Fore with mandate. the proposed - White - POper. * Establishment of flve functional together with the sub-component Working Groups: (Finånce, Working Group papers and Reniation, and Input Subsidies, mchedule could be targeted for a industrial Extension. Excise Taxes time four months prior to the ond the Regulatory Environment), annul Budget presentation, thus with manoates. allowlng for the introduction of Completion of initial Working specific reform measures. Group papers on reform in subject äroas. * Implementation schedule for the reform oroas "identified". Concession and Incer~ttiv. Reservation Announce governments' intent to Phasing out of production eliminats production reservation *"'*reservation should proceed -over a for SSI over a- specified time period .of three- years- following period. This should be announcement of the general occompanied by a phosed. Intent to dereserve production. grouping of product categories that will be dereserved. Exolse Tex Exemtilon Efiminate the present system of Progress. in adjustment of this excise tax exemption. This could excise tax regime appliooble to be replaced by a time based SSI should be as soon as concession designed to encourage possible. new entrepreneurship but not inhibit growth. xi BOX . I (continued) Polin.ieIses2j and Actione Neessary Timetable Areas of Reform Raw Material Quotes Special quotas of certain raw At a very early stage of the materiats .for SSI should be reform agenda. phased out,. If there are Identified failures of market and distribution systems then: the underlying causes should be remedied. Financial Intermedletiol nterest rates Lending rates for loans to SSI Reforms in the system of credit should be market determined. . for SSIs should proceed in unison particular the concessional rates with a wider financial sector charged by the SFCs should be- reform program. However, the replaced. by rates that reflect proposed review of the SFCs appropriate risk and market cost should be commenced as soon as of funds. possible. There is urgent need to undertake iwof each SFCs portfolio and capital adequacy. Following completion of this review a restructuring plan should be drawn up for each one, together with recapitalization requirements. The shareholding of SFCs should* be. broadened to Include other . institutions and thi genera. publid. The SFCs need to be given greater freedom in ther types of lending activities in which they can engage. Lending Demaration Artificial demarcation. of the types of lending that need to be undertaken by a particular institution needs to be phlsed out. In partioular, the demarcation between term and working capital lending should be abolished. Industrial Extension Services. There is need for a thorough 'This review should be undertaken review and reappresat of: the-, at a very early- stage of the whole gamut of extension- reform agenda. services provided to SS. This should cover funding, activity focus and the institutional framework. Greater cost recovery on certain services is needed, as well as a more sharply focused range of service activities. What resources are xil BOX 8.1 (continued) Policy cueotand action Timetable Areas of Rer available neod to be directed to cleerly identified areas of market failure (e.g. information transmission mechanisms' or tochnology transfer), eaving the priväto, seotor to provfde the remainder. Reauatorv nvronment The central governMent has The teask of drawing up a speciffc aready sought to simpilfy gnda of pr*cedura procedures, legat and burararatia aimplififatlons should be Initiated requiremento for all firma. But at an arly stage of the reform progresa has been very slow and agenda. thiore is an urgent ned- to improve the general business environmant . by a speedy elimination of most bureaucratio requirements. Much remalne to birdon to coordinate state and municpal levet orquiremente. Purthermote, Cpeifo ationh are necessary to reduc. the adminetrative burden imposed on SSI. through. the elimination or consolidation of certain reporting requirernents. ntrfl tnk' improvement of the sub- These actions. should continue contrå*ting informäth-o. :'.-fthroughout the reform agenda. exchanges. Doevelopment of infrastruture avallable for SS in greater proxdmity to large firm concentrations. Continued encouragement neede to be given- to the development of factoring and bili discounting services. CHAPTER 1 GOVERNMENT POLICY TOWARD SMALL SCALE INDUSTRY Introduction 1.1 The role of small scale industry (SSI), including traditional village and cottage type industries, in the Indian economy has been a specific focus of the Government of India (GOI) ever since independence. In fact, no other developing country has directed so much policy attention, created so many special dispensations or constructed such a network of support agencies to nurture SSI as has India. In this report, we seek to document and evaluate the evolution of this policy structure, its impact upon the growth and spread of entrepreneurship and SSI, and identify the difficulties and constraints that small scale firms presently face. In Chapter 1, we describe the evolution of SSI policy, the rationales and objectives underpinning these policies and the range of incentives and promotional devices utilized to achieve the policy objectives. Chapter 2 looks at the structure of Indian industry, the role that the small scale plays in this structure and how this has changed over time. In Chapter 3 we look in more detail at the premises that have been put forward to support various policy initiatives, in particular the impact of some of the special incentives provided for gmall firms, and evaluate their effect on the structure and performance of various sub-sectors of Indian manufacturing. 1.2 Notwithstanding the range of incentives and subsidies available to small scale firms and new entrepreneurs, they still face difficulties and constraints, some of which may be amenable to policy change and adjustment. Furthermore, the very incentives themselves maybe encouraging the investment and the allocation of resources in inappropriate areas of activity or in a manner that is not sustainable in the medium and long term. We examine these issues in the last part of Chapter 3 and in Chapter 4. In the latter we discuss in more detail the viability and health of small scale industry in India, and some of the factors that may be contributing to the rising incidence of sickness among small scale firms. 1.3 Chapters 5 and 6 address the system of credit delivery to SSI and the provision of industrial extension and assistance services to small scale firms. In both cases, the extent and coverage is documented, problems identified and possible adjustments that could be made to improve both the quality of lending and relevance and usefulness of assistance programs targeted toward the small scale sector. For many industrialized countries (Japan, for example), the role of sub-contracting and the small scale firm have been important determinants of the pace of industrial growth and the ability of smaller firms to overcome marketing and technology acquisition problems. In Chapter 7, we examine the extent of sub-contracting and the relationships between small and large firms in India. While data on this aspect of industrial structure and organization is not comprehensive, we attempt to document the growth of such activity, as well as identify factors that may be inhibiting a broadening of the industrial structure (i.e. a reduction in vertical integration) and an increase in the extent of sub-contracting. 2 1.4 The final chapter presents an assessment of the present policy framework. On the basis of this assessment, an agenda for policy reform is put forward, together with a suggested phasing of the proposed policy adjustments, designed to improve and accelerate the growth of new firms and improve the strength and viability of existing small scale firms. A separate volume contains a set of detailed appendices covering the following topics: a statistical appendix, including a description of the type of data available on SSI in India and its limitations; a detailed compendium of the range of incentives and special subsidies offered to SSI; a description of the steps necessary to establish a new firm in a sample state (Karnataka) including the procedures necessary to oLcain access to needed inputs and infrastructure and to avail of the various incentives offered; a detailed documentation of the structure and scope of industrial extension services offered by the government (both Central and State); and a description and assessment of the Central Government's procurement programs from the small scale sector. Origins of 881 Policy 1.5 The strong emphasis given by successive governments in India toward the promotion and growth of village, cottage and small scale industries stems in part from the independence movement. There was a widespread belief that the period of colonial rule caused a de-industrialization of the country, and that manufacture in Britain and other parts of the industrialized world led to a decline in traditional Indian handicrafts and artisan products. The call for 'Swadeshi' and the boycott of imported goods, which was a rallying point for the Congress movement, was synonymous with a desire to promote village based crafts and small scale enterprises. As early as 1902 the Indian National Congress had resolved that "practical steps in the shape of State encouragement be taken for the revival and development of indigenous arts and manufactures and for the introduction of new industries"'. 1.6 The rationale for state encouragement to village and small industries was greatly reinforced by Mahatma Gandhi's appeal to revive the village based industries and crafts, and by his identifying Khadi (hand-spun and hand-woven cloth) as the symbol of Indian nationalism. Consequently, the support of small and traditional industries became symbolic of the Congress's economic philosophy, and was considered essential to ensure the decentralization of economic activity and the successful functioning of democratic, self government2. It was therefore natural that amongst the first tasks undertaken by the Congress government after coming to power in August 1947, was a convening of the Industries Conference in December 1947, which devoted considerable attention to the problem of revival and development of cottage industries. 1.7 An understanding of the historical evolution of SSI policy in India, and its place in the evolving political structure, is important. First, it 'Quoted from Goyal, S.K. et at, Small Scale Sector and Big Business, mimeo, the Corporate Studies Group, New Delhi, p.1. see Government of India, Report of the Vittage and Smalt Scale Industries Comnittee, New Delhi, October 1955, p.45. 3 helps explain the ideological and historical pressures that exist for present day governments to be seen as supporters and promoters of small scale industry, as well as village based traditional activities and crafts. Second, the background of the national movement also helps explain the circumstances which have led to the treatment of small (but modern), village based, cottage and traditional handicraft industries as a single category for the purposes of policy formulation and the structure of incentives. This aggregation of policy formation has led to a blurring of policy objectives, particularly with regard to the more modern small scale sector, and imparted a degree of inflexibility into SSI policy change. 1.8 The fact that the popular national sentiment in favor of tiny and traditional industries, arising from the legacies of the national movement, has been carried over into the modern small scale industrial sector as well, has had two important implications. First, the focus of policy has often been more directed at size per se, as possessing some positive intrinsic socio-political benefits, irrespective of the efficiency of resource allocation and somewhat less on the goal of broadening the entrepreneurship and capital ownership base. This is manifested in an incentive and concession structure that is based upon a single administrative definition of firm size, irrespective of the nature of the product being produced'. This penalizes firms which may be more successful, but are constrained to remain "small" if they are to continue to avail of special dispensations (eg. location in a factory park in a metropolitan area) or concessions (eg. excise duty exemptions). Second, the modern small scale sector has been expected to fulfill objectives and functions which might more normally be expected to be served by other categories of units. A good example of this relates to the objective of dispersion of industrial activity. Traditional and smaller service units were already dispersed in the villages, yet considerable factory park development has occurred in, and various investment subsidies targeted to, so called "backward areas", despite the fact that for many modern small scale units, there is a clear necessity to locate in proximity to larger units and in more established urban centers. Given the very different requirements of the various categories of units in terms of input requirements, market access and competitive relationships with large and organized industry, the same policy instruments could be expected to have a differentiated impact on the various categories of units. By aggregating them in one category, the need for establishing a differentiated set of policy measures and incentives was overlooked. Furthermore, the application of a uniform set of policy measures has led to several inefficiencies in the actual implementation of these policies and in their overall economic impact.4 1.9 This is not to deny that there has been some recognition of the need for greater differentiation within the small scale sector. In the First Five 3See Dhar, P.N. and LydaLL, H.F., The RoLe of Small Enterprises in Indian Economic Development, Bombay, 1961, p.21. 4For example the needs of more traditional rural based industries can be quite different from a modern SSI sector. For one, the marketing of their products maybe very dissimiLar. To some extent this was recognized by GOl, resulting in differentiated institutional support structures (khadi), however, the basic policy framework and incentive structure has been overly influenced by the perceived weaknesses of cottage based, ruraL industries. 4 Year Plan, the whole group of small industries was divided into two broad groups: Village Industries and Small Industries and Handicrafts. The latter category was again sub-divided into two sub groups: one which utilized traditional skills and crafts and the other which utilized more modern production techniques. In 1977, the then government issued an industrial policy statement that identified a further category known as the 'tiny, sector which comprised units with investment in plant and equipment of up to Rs.100,000. This statement also proposed separate legislation to protect the interests of the cottage and household industries sector. These distinctions have continued to the present (however the investment classification for 'tiny' has been progressively raised to Rs.2.0 million). But, iespite this differentiation there is no independent policy for the different sections which manifests itself in a different array of concessions or incentives. Objectives of Promotion of Small Scale Industries 1.10 The most succinct statement of the objectives of promoting the small scale industry sector is to be found in the oft-quoted paragraph thirteen of the Industrial Policy Resolution of 1956. The paragraph states: "They, (cottage, village and small industries) provide immediately large scale employment; they offer a method of ensuring a more equitable distribution of the national income and they facilitate an effective mobilization of resources of capital and skills which otherwise remain unutilized. Some of the problems that unplanned urbanization tends to create will be avoided by the establishment of small centers of industrial production all over the country." (Dhar and Lydall, 1961). A more elaborate version of these objectives contains seven principal aspects: (i) increasing employment as the capital requirement per job created is lower than in larger firms; (ii) the potential to achieve a better distribution of personal incomes as the profits generated by smaller units are more widely distributed; (iii) being easier to disperse spatially, small units can also serve to achieve regional income equity; (iv) promotion of small scale firms broadens the scope for the development of new entrepreneurs and in turn broadens the industrialization process; (v) ensures maximum utilization of local raw materials and contributes to the achievement of local self sufficiency in consumer goods, thereby reducing pressures on the transportation system; 6See Government of India, Text of the Statement on Industrial Polfcy, New Dethi, 1977, paras 5-14 and GOI, Ministry of Industry, Text of Industrial Policy Statement, New DeLhi, July 1980, pp. 3-4. 5 (vi) small units help to mobilize local capital resources which would otherwise remain untapped, and (vii) restricting the rate of growth of urbanization by creating employment opportunities in dispersed rural and semi urban locations and absorbing the labor force in such small enterprises6. 1.11. This listing of objectives and assumptions underpinning the promotion of small scale enterprises has remained unchanged to this day. The statements on Industrial Policy issued in 1977, 1980, 1990 and most recently in 1991, assume the validity of these arguments and continue to support the promotional measures adopted. A analysis of the validity of these assumptions will be undertaken in Chapter 3. Suffice it to note at this point that the range of objectives, and their underlying assumptions, are not all borne out by empirical evidence, and in some cases, the variety of policies and promotional measures adopted have not been consistent with each other. Policy fvolution and institutional Framework 1.12 Government policy for the small scale sector can be traced back to the Industrial Conference held in December 1947. This Conference put forward three broad policy measures: i) establishment of national level organizations (eg. the All India Cottage Industries Board) to coordinate policies, development programs and promotional measures for the "decentralized" sector; ii) initiate a regime of preferential treatment of small scale firms with regard to factor inputs. This included supplies of raw materials, transport and credit at below market interest rates; iii) establishment of certain institutes and agencies (e.g. Cooperative Banks and marketing organizations) to particularly serve the needs of small and cottage industries. These recommendations were accepted by the newly established government and incorporated as part of the Industrial Policy Resolution of 1948. Following this a variety of different Boards were established whose basic objective and function was to advise the government on organization and development of the decentralized sector (e.g. the Cottage Industries Board formed in August 1948, Central Silk Board reconstituted in April 1952, Coir Board and the Small Scale Industries Board in 1954). 1.13 The First Five Year Plan document adopted a "Common Production Program" for small scale industry. This program included provisions for: i) reservation of sectors of production for the small scale sector; ii) a ban on capacity expansion by large scale units in the sectors reserved for SSI; iii) The views expressed in the Second Five Year Plan were similar to those in the Industrial Policy Resolution of 1956 and that of the Karve Committee (the Working Group for the Second Five Year Plan). The Third Plan also listed the same objectives as increased employment; labor intensive production of particularly consumer goods; encouraging and supporting small industrialists; and more equitable distribution of national income and balanced regional deveLopment. See GO!, Ministry of Commerce and Industry, Report of the Working Group on SmalL Scale Industries: Program of Work for the Third Five Year Plan, New Delhi, 1959, pp.10-11. The Indirect Taxation Enquiry Committee similarly observed that small scale sector should be encouraged not only because it generates greater employment but "more because it enables those who do not have large capital resources of their own but are otherwise capable of undertaking entrepreneurial functions to enter the industrial arena." GO, Ministry of Finance, Report of the Indirect Taxation Enquiry Committee, New Delhi, 1978, Part II, p.190. 6 imposition of a cess on large scale units to be used for the development of small scale firms; iv) preferential access to and special arrangements for supply of raw materials to small firms, and v) government coordination of research, training etc. required for small scale enterprises. 1.14 The Plan also made provisions for adequate availability of finances for this sector. The rules and conditions for granting of loans were liberalized and the powers for sanctioning of loans of the Director of Industries were enlarged. Some of the state governments started State Finance Corporations, which enjoyed refinancing facilities from the RBI which transferred these functions to IDBI in the seventies. The policy for reservation was also actively initiated during the First Plan period and sectors such as furniture, sporting goods, writing inks, agricultural implements etc., were effectively made inaccessible to the large scale sector for capacity expansion. 1.15 The promotional measures received a special thrust from the findings and recommendations of an "International Planning Team" which was sponsored by the Ford Foundation'. The team submitted its report in March 1954. Within a year, the Karve Committee, which served as the working group for small scale industries for the Second Five Year Plan, also submitted its own report. The recommendations of the Ford Foundation team along with those of the Karve Committee provided the essential core of the promotional policy package, which has continued to this day, with only marginal changes. 1.16 The Ford Foundation team placed great emphasis on the establishment of the necessary institutional and organizational structures required to address the functional weaknesses of the decentralized sector. The areas of functional and operational weaknusses identified by the Team were: Market Research; design; raw material availability; research and technical assistance; distribution and promotion; finance and professional management. Having identified the entire range of weaknesses, the Team suggested the establishment of four regional institutes of technology for small industries in Bombay, Calcutta, Delhi and Madras. These institutes were established as Small Industries Service Institutes at these four centers. At the headquarters in Delhi, the Team suggested the formation of a central monitoring and advisory organization in the Ministry of Industrial Development. This was the basis for the formation of the Central Small Industries Organization which was later expanded and renamed the Small Industries Development Organization (SIDO). 1.17 The Ford Foundation team had also recommended the formation of a Market Service Corporation to cater to the marketing needs of small scale enterprises. Further, a similar agency was recommended to assist the SSI sector in organizing its production. The government while accepting these suggestions, decided to establish an umbrella organization which would combine the two functions. Thus, the National Small Industries Corporation (NSIC) was established to render various types of technical assistance required by the 7See Goverment of India, Ministry of Comerce and Industry, Report on Smatt Industries in India, International Ptanning Team sponsored by the Ford Foundation, New DeLhi, 1954 7 small scale sector. The main functions of the NSIC, as originally envisaged, were to: (i) assist small scale firms to participate in government purchase orders; (ii) promote the growth of ancillary SSI; (iii) undertake market research on behalf of small enterprises; (iv) assist SSI in marketing and promoting their products; (v) arrange the uupply of machinery and equipment, and (vi) construct and manage industrial estates where the small scale firms were provided built up factory spaces and industrial plots at subsidized rates. 1.18 Government's acceptance of a majority of the Ford Foundation Team's recommendations and their implementation, ensured that the organizational and institutional structure required for the development of small scale firms was effectively in place before the launch of the Second Five Year Plan. The Karve Committee which also submitted its report in time for the preparation of the Plan built upon this set of recommendations by providing the longer term objective and vision for the growth of the small scale sector and also for the village based industry in the country. The Karve Committee stated explicitly that "The pattern of industrial activity that should gradually emerge is that of a group of villages having its natural industrial and urban center. These small urban centers will be similarly related to the bigger ones. Thus, a pyramid of industry broad based on progressive rural economy will be built up. In such organizations, small centers can experience a cooperative interest in the bigger ones, and these latter would develop in genuinely supporting instead of an exploitative relationship towards the smaller towns and countryside'." 1.19 The Karve Committee'c vision of the growth of decentralized industrial activity, with an important role for the small scale and rural industry, provided for a symbiotic development of the large scale industries with the small and rural industries. This complementary growth of different components of the industrial structure was envisaged in the context of a wholesale industrial transformation of the Indian economy and not in the context of a dualistic and enclave type of industrial growth. The Committee implicitly visualized the transformation of the agrarian Indian economy into a predominantly industrial one. This transformation was to be brought about by the spread of small rural industries which were organically linked to the larger units in a complementary manner. 1.20 This early vision of the role of the small scale sector in the Indian economy is important. The Karve Committee, and the drafters of the Second Five Year Plan did not envisage the possibility of dualistic development of industry, where the large and small grew in parallel and competition to each other. Especially, competitive growth of small scale units, with perpetual support from the government in the form of subsidies and financial concessions was certainly not envisaged by the Committee. In fact, the Committee was of the clear view that "the existing measures in regard to rebates, subsidies, differential excises etc. have been taken into account by us. We do not favor new measures for introducing the rebate on sales or production subsidy and indeed look forward to the Possibility of doing away eSee Karve Comittee Report, op.cit., p.22. 8 with them in the course of time. We are keen that the cost of schemes of protection afforded to any activity is readily measurable and that all schemes of protection can ultimately be withdrawn".' 1.21 By the beginning of the Third Five Yiar Plan (1961) the pattern for the growth of SSI had been fairly well established. Unfortunately, growth of the small scale sector did not follow the path visualized by the Karve Committee and took on an increasingly dualistic and competitive relationship via a via large scale units. Protective and defensive measures for SSI expanded and reinforced a policy focus on small firm size as desirable in and of itself, irrespective of the economics of optimum firm size for a given product. The symbiotic relationship envisaged earlier between small and large in a broad based industrial sector, which focused upon the development of new entrepreneurship, was increasingly lost sight of. The number of products reserved for exclusive production by small scale firms was consistently increased in the sixties and seventies, with a significant increase during the Janta government in 1977 (at present there are 836 items exclusively reserved for production by small scale firms). The Third Plan also saw the emergence of policy preferences designed to promote the development of ancillary units, and during the sixties and seventies, a number of industrial licenses were awarded with explicit conditionality for ancillary development by the large firm. 1.22 The most recent policy adjustments for small scale industry, announced in August 1991, do not alter the broad thrust of the previous policies, with one or two exceptions. Greater emphasis was placed upon the so called "tiny sector" (investment in plant and machinery up to Ra.500,000), however what specific measures are proposed has yet to be elaborated upon. This policy paper did announce an intent to reduce benefit entitlements to those parts of the SSI sector that do not fall in the tiny sector. In terms of the number of firms however, this has little impact as about 95% of all small scale firms (including the service sector) have an investment below Ra.500,000. But, there has been some recognition of the need to facilitate a more integrated and symbiotic relationship between small and large firms. Large enterprises are now permitted to invest up to 24% in the equity of a small firm, without the small entity losing its small scale status. Furthermore, it was proposed that a limited liability partner, ip law will be enacted which will limit the financial liability of non-acti4a partners to the capital invested. Both of thesa changes should enhance the flow of venture capital for small firms as well as improving the environment for sub- contracting and ancillarization, but it ts noteworthy that the policy focus has not changed from the consistent thrust to protect small firms simply because of their size and irrespective of how long a firm has been in business or whether this protection was resulting in the most efficient use of the country's resources. GKarve Comittee Report, op.cit., p.30. 9 Definition of Small Scale Industry in India 1.23 Given the policy desire to foster the growth of small scale industry, and the range of special concessions and incentives introduced to fulfill these objectives, it has been necessary to develop an appropriate classification definition. This definition of what is small has evolved over time, and in the fifties there was some confusion as to what would provide a precise definition. The first official criteria for small scale industry, formulated in the mid-fifties was in terms of the size of gross investment in plant and machinery and land and buildings and the strength of the workforce. This criteria went through a number of adjustments, with the worker component being dropped in January 1960 and with the inclusion of special criteria (i.e. higher investment ceilings) for ancillary units introduced in the Third Five Year Plan. By the mid-sixties, the sole criteria was the value of plant and machinery and this asset ceiling has been periodically raised, to reach the present level of Rs.6.0 million (US$240,000 approximately) and Ra.7.5 million for an ancillary. 1.24 With regard to the asset ceiling as a classificatory device, there is no announced policy criteria or formula for determining its level. In fact, perusal of Table 1.1 seems to suggest that in real terms, the level of asset ceiling has been relatively unchanged since 1970-71, and for a large part of the seventies and early eighties was below this level. What this may mean in terms of its impact in an environment of changing technology is uncertain, and of course will differ across product groups and different sub sectors. In the case of some products and items reserved for the small scale sector, the declining or constant asset ceiling in real terms, could have condemned the production of the item in question to a more obsolete method of production that was less capital intensive. By and large however, given that for the vast majority of registered small firms, asset levels are below Rs.500,000, the asset ceiling does not appear to have been a binding constraint for most production by small scale firms. 1.25 As a measure of SSI, arbitrary asset ceilings has its drawbacks. But so do other demarcation measures such as employment or sales turnover. Assembly operations in electronics may require limited investment in plant and machinery, but many employees, and petrochemical plants high investment with a small workforce. The point being that product and process determine the range of optimum firm size, and to determine an incentive policy framework irrespective of the economics of production runs the risk of severe distortion and resource misallocation. It is far less distortionary to base special incentive programs on overcoming entry barriers to the creation of new entrepreneurship and new firms. If factor input prices are free of distortions, then the entrepreneur is the one best placed to determine the technical mix of production. This is not to deny that government can and should take a proactive role in fostering the growth of new entrepreneurship, particularly in the face of market imperfections. However, the focus of this effort should not be upon arbitrary assessments of small and it should not always assume that smaller scale business is weak and always in need of special dispensations. These factors are elaborated upon in chapters 3, 6, and 8. 10 TABLE 1.1: ASSET CEILING FOR 881 STATUS Rs. million) Year calling Asset cailinan For ancillary unite was change Nominal Real- Nominal Rea 0 0.63 .e. 1973 0.7' 0.54 1.0 0.72 1975 1.0 0.58 1.5 0.87 1980 2.0 0.84 2.5 1.04 188W 3.5 1.04 4.5 1.33 1991 6.0 1.18 7.5 1,471 * Defined as value of plant and machinery at original purchases price paid by the firm. For imported equipment, duty, International freight. Insurance, etc. are Included but not costs of local transportation from port. Indirect taxes on both domestic and importedequipment also are Included, but installation charges and financing costs are not. * Ancillaries were defined as units supplying 50% or more of their output to one or more other industrial units. In 1988 this was changed to 30%. but in 1991 the criterion again reverted back to 50%. The nominal asset value was deflated by the wholesale price index (WPI) for machinery and transport equipment, inI 1970-71 prices.. Before 1960 the definition of SSI was based on size of workforce. * For units which undertake to export at least 30% of their output within 3 years. the ceiling would be Re.7.5 milio. t Based on the price deflator for manufacturing as a whole. Source: World Bank. Indla: Industrial Regulatory Reform, Sector Report. May 1991. Conclusions 1.26 In this chapter we have endeavored to trace the evolution of Indian Government policy toward the small scale sector, to outline the objectives and rationale of the policy approach adopted and to set a context for this policy frame which caat explain the continued strong emphasis given to the sector in policy pronouncements. The fact that much of the earlier thinking on India's development and industrialization strategy was based upon socio-political ideology and a philosophical perception of the benefits of traditional and village based industries has undoubtedly affected policy toward small scale industry. A desire to foster new entrepreneurship and assist the development and growth of small firms are not necessarily conflicting objectives. Having a policy program, with an attendant incentive and concession framework, that fosters new entrepreneurship in an environment of market imperfections and high barriers to entry can be quite justifiable. But, if at the same time the interventions chosen circumscribe the growth potential of these new entrepreneurs, overly shelters the inefficient and creates pockets of industrial activity that are only sustainable by special concessions and subsidies, then the policy can cause a considerable misallocation of resources, harm long term growth and ultimately penalize the very people it set out to help. This fact was recognized by some early policy makers (for 11 example the members of the Karve Committee who formulated policy inputs into the Second Five Year Plan), but appears to have been lost as policy has evolved. 1.27 Policy measures have provided an array of special concessions and established a complex and extensive institutional system for technical assistance and support for the sector. The prevailing view is that the small scale sector is "weak" and as such, is in need of protection. While new small firms may be vulnerable, this is oftentimes more a function of their newness rather than the scale of their operations, but the concession structure that is in place has no firm level time limit. It provides special dispensations in perpetuity, and in some sense discourages successful firms from evolving into mature, medium size firms. 1.28 The focus of policy should be reoriented toward more emphasis on new entrepreneurship creation and the growth of efficient SSI. This means focussing on measures that improve the working of factor markets (eg. financial, labor and material inputs), provide key informational inputs that improve the success rate of new firms, and permits firms to operate in a less restricted and controlled environment. In many ways, the pervasive regulation, which has spawned a host of governmental procedures, penalizes small firms to a greater extent than their larger, established brethren, because they are less able to deal with the administrative burden. 1.29 Government policy should therefore attempt to revive the objectives of the Karve Committee in formulating promotional measures for small scale and village and cottage industries. The present policy desire of producing in SSI whatever can be produced there, needs to be replaced with a focus on SSI that views smaller firms in the context of the overall pattern and pace of industrialization. That is, firm size should be determined solely by the technology of production, the supply and price of factor inputs and the extent of market demand, rather than by some arbitrary and administratively determined compartmentalization of product categories and type of unit. In this manner the natural and beneficial inter-relationships between firms of different sizes can be allowed to develop and flourish. 1.30 As we sought to show in this chapter, the government of India has devoted considerable attention toward the small scale sector in its drive to industrialize. While we argue that the policy thrust has increasingly become misdirected, there is no doubt that the considerable growth of small scale industry over the past four decades suggests that positive achievements have been made. But this may have been at the cost of a faster pace of overall industrialization. In the next chapter we discuss the changing industrial structure in India, and the role that SSI plays in this structure. 12 CHAPTER 2 THE SIZE STRUCTURE OF INDIAN INDUSTRY Introduction 2.1 The present structure of Indian industry is a function of the country's resource endowment; however industrial and trade policies adopted over the past forty years have had a significant influence on this structure. Industrial licensing, constraints on MRTP firms (those firms classified under the Monopolies and Restrictive Trade Practices Act), quantitative restrictions and high tariffs on imports, exit restrictions, price and production controls, public investment choices and, of course, small scale industry concessions and incentives have all created differential barriers to entry, growth and exit for different size classes of firms and categories of industrial products. Past-studies have shown that these barriers have been high for medium and large scale firms, and lower for small scale firms'. As a result, many industry sub-sectors are characterized by a binodal size distribution of firms, with a concentration of assets, output and employment in a few large firms and many small units, while the middle sized producers have not emerged. This structural feature of Indian industry has important implications, which, if the experience of other countries is any guide, reduces flexibility in response to changing technology and market conditions2. Moreover, data suggests that the degree of industrial concentration is high, which in the absence of competitive forces (eg. a highly protective trade regime) can lead to oligopolistic business behavior which is inimical to technological progress, cost reductions and quality improvements3. 2.2 Before proceeding to an analysis of some of the above issues and how SSI's contribution to industrial output has been changing over time, it is necessary to clarify some issues related to the quality and type of data available and the definition of small scale that is used. As with many countries, the type of data on SSI in India is not comprehensive on an inter temporal basis, nor is the quality of much that is available, very high. In part this reflects the very difficult, and expensive, exercise of enumerating and reaching a very large number of small enterprises in the informal sector, many of whom are highly mobile and whose longevity is low. The preface to the Statistical Appendix contains a description of the type of data that is 'See World Bank, Industrial Requtatory PoLicy Study, Vol.1, December 1986 and I.M.D. Little, D. Mazumdar, and J.M. Page Jr. Small Manufacturing Enterprises: A Comparative Study of India and Other Countries, WorLd Bank, Washington D.C, 1985. 2See 1. Karnmen and N. Schwartz. Market Structure and Innovation, Cambridge University Press, Cambridge, 1982 and I.M.D. Little, op cit. 3See World Bank, December 1986 op.cit and World Bank "India: Industrial Regulatory Reform", May, 1990. 13 available, its method of collection and some comments on its limitations'. Censuses are undertaken, but the last published one was in 1973/74. A more recent one has been completed; and this is presently being processed and once available could provide some valuable insights, as well as enabling suitable adjustments to the sampling frame for the national accounts, etc. 2.3 Basically there are two main annual sources of data on small scale manufacturing activity; the unorganized (or unregistered) sector of the national accounts and those firms that are covered under the Factories Act and included in the Annual Survey of Industries (ASI). Neither source provides a single measure of small scale industrial activity, and given the time gaps between censuses, the estimates of unregistered business activity may not be very reliable. There is also a third source of information through the Small Industry Development Organization (SIDO) which maintains a nationwide registry of small scale firms. This data must also be treated with caution for a number of reasons. Firstly, many small units do not register with their local District Industries Centers and second, of those that do, many may not survive but deletions to the registered list of firms are not made (where surveys have been undertaken using these lists as much as 30% have been found to be no longer ii, existence). Given the above limitations, we utilize all three sources, &n the belief that the trends displayed, if taken together, can provide a good indication of SSI's role in the industrial sector and how this has been changing over time. Finally, when using ASI data, we classify firm size by employees (i.e. these with 10-49 employees are classified as small) rather than by the official investment in plant and machinery classification. Both systems of classification have faults, but given the inflationary impact on the prices of plant and machinery over time, it is felt that the employment criteria may be less distortionary. Output and 1ovment 2.4 Over the past twenty years, total Indian manufacturing value added has grown at a compound annual growth rate of about 5.4%, while the growth of the unregistered portion has been about 5.0% per annum. As a consequence, the share of manufacturing value added contributed by the unregistered component has declined from 42.5% in 1970/71 to 39.4% in 1989/90 (See Table 2.1). During most of the seventies, registered and unregistered manufacturing grew at a similar pace, but from the late seventies to the mid-eighties, there was considerable divergence between the growth rates of the two components. The registered manufacturing annual growth rates increased, but the unregistered sector's growth declined significantly. In the latter part of the eighties, growth of both sectors picked up, with the unregistered part surpassing slightly the registered. *Also there are a number of excellent articles on this data availability, and the sampflng techniques and collection methodology employed. For example, see G. Ramachandran, "Data Base for Small Scale Industries: An Appraisal, M. R. Satuja, "Data Base of the Unorganized Manufacturing Industry: An Appraisal", and K. Sundaram and S.D. Tendulkar, "An Approximation to the size structure of Indian Manufacturing Industry", all in Small Scale Enterprises in Industrial Development, The Indian ExperienceL K. B. Suri (ed), Sage, N. Delhi 1988. 14 2.5 The cause of the slower growth rate for the unregistered manufacturing sector during the latter part of the seventies to mid eighties is unclear. A number of factors may account for it. The bulk of the reservation to small scale industry of certain products by broad category occurred in the early seventies, which may have sustained the growth rate of the unregistered manufacturing sector during most of this decade. Furthermore, the process of economic liberalization started in the early eighties (which included delicensing and more ready granting of industrial licenses and some trade TABLE 2.1 UNREGISTERED MANUFACTURING AND SSI REGISTRATIONS 1970171 1974/7 1978/79 1980181 1983/84 1985/88 1986187 1987/88 1988189 1989/901 GrUs Valg Added of trdan Manufac&ing . . .... 41R. billion at 1980/81. prices) TotpalMenft 171.4 171.4 225.4 221.4 279.7 2 2.9 335.6 360.5 390.8 404.9 Registered 85.9 96.5 129.5 126.4 172.0 191.3 203.5 218.9 239.5 245.2 Unregistered 63.4 74.9 905: 95.0 109.7 121.6 132.1 141.6 151.1 159.7 % share unreg. 42.5 43.7 42.5 42.9 39.2 38.9 39.4 39.3 38.7 39.4 Growth Rate % per annum) 1970/7-1978/79 1978/79-1985/86 1985/86-1989/90 Registered 5.27 5.73 6.40 Unregistered 5.31 3.45 7.05 Grose Domiestic investment Total IViftg. Registered 48.44 78.07 90.76 8260 106.24 119.31 115A3 Unregistered .29.23 57.94 66.88 57.48 80.31. 90.05 81.33 % share unreg. 19.21 20.13 23.88 25.12 25.93 29.26 33.60 No., of Units Total fin 200'e: 41 . 734 874 1158 1355 1464 1586 1712 1827 100 Re.gistered 159 334 .448 689 855 950 1048 1159 Unregistered 257 400 426 471 500 516 538 553 Employment (in 000-s 3970 6380 7100 8410 9600 10140 10700 11300 11850 Growth Rates (% cor annum) 1974175-1978/79 1978179-1985(86 1985/86-198919Q Total Units 15.25 9.15 7.78 Employment 12.59 6.01 5.41 u' Source: CSO, National Accounts, 1991 and Quick Estimates dated February 19. 1991. 21 Quick Estimates. 3' Annual Report, 1989/90, Small Industries Development Organisation. 15 reform) most probably benefitted the larger manufacturing sector (e.g. in consumer durables and transport) to a greater extent initially than smaller scale producers in the unregistered sector. During this period export growth was low, and there are some key product areas in India's export basket (garments and leatherware for example) in which the small scale industry presence is high. The causes of the slow export growth are many. But it is noticeable that from 1979 to 1985. the Real Effective Exchange Rate (REER) appreciated by about 20%, and once a resumption of exchange rate depreciation occurred in 1986, export growth revived significantly. Manufacturing exports increased more than 20% p.a. between 1986/87 and 1989/90'. A final factor was the very severe drought that Indian agriculture suffered in 1979/80, which undoubtedly affected village and cottage type industries, all of which fall under the unregistered manufacturing sector. 2.6 Data from SIDO on the total number of SSI units and employment indicates a somewhat different trend than that shown by national accounts data. Over the past fifteen years, tho number of units has increased by over 300% from 416,000 to 1.827 million. Employment in SSI has also increased significantly over the same period (nearly 200%) from 3.97 million to 11.85 million. In terms of period growth rates, the rate of growth of SSI units and employment in the sector, has been declining. During the period under analysis, from 1974/75 to 1985/86, the rate of growth of employment in SSI increased at a faster rate than the rate of growth of value added of manufacturing in the unregistered sector. However, from 1985/86 to 1989/90 this phenomenon was reversed. Given the unreliability of some of the data, too much should not be inferred from this, but it may indicate a gradually improving trend of labor productivity within the small scale sector. 2.7 Utilizing data available from the Annual Survey of Industries (ASI) similar trends emerge (See Table 2.2). Output growth declined in the late seventies to mid eighties, and picked up again in the latter part of the eighties. However, in terms of new units, the growth rate has been continually declining since the late seventies. This direction of change is consistent with data on small units provided by SIDO, however there is a significant difference in the pace of growth of new small scale units (e.g. during the period 1978/79 to 1985/86, ASI data reveals an annual growth rate of 1.97% , whereas the SIDO data reports an annual growth rate of 9.15%). With regard to employment, annual employment growth in small firms in the factory sector has been on a declining trend. Annual employment growth amongst small firms from 1985/86 to 1987/88 was 1.75% (with output growth of 8.21% p.a. suggesting a considerable improvement in capacity utilization during this period), whereas annual employment growth in larger firms was 2.15% over the same period6. 2.8 Some striking results are revealed when one looks at the data on the share of small scale compared to larger firms in the factory sector. Over the fifteen years from 1973 to 1988, in terms of number of factories, productive capital employed, gross output and value added, there has been almost no change in the share (or a modest decline in the case of output) contributed by the small sector compared 6For a detailed discussion of this see World Bank. Strategy For Trade Reform, Sector Report, November 1990. eEmptoyment data can also be misleading during this period. Given the difficulties encountered by organized sector firms in restructuring their workforces, many firms have resorted to increasing use of irregular, non-permanent employees. This substitution between types of tabor may understate therefore actual employment. 16 to the contribution of the larger firms. This observation is mirrored to some extent by data on the unregistered sector in the national accounts, which in terms of gross value added saw a decline in share from about 42.5% in the early seventies to about 39.5% in the latter part of the eighties. Only with respect to employment has there been a noticeable change, whereby the share accounted for by small firms rose from 14.4% in 1973/74 to 17.4% in 1987/88. However, this change is accounted for more by changes in employment in the larger firms, than employment growth in the small scale sector. In the period from 1978/79 to 1985/86, employment in larger firms declined by 0.03% per annum. 2.9 The above result is somewhat surprising given the strong policy emphasis directed at the promotion of the SSI sector over this period. Caution must be exercised however in extrapolating the inferences of such aggregate data to suggest that the variety of SSI policies have failed entirely. In the first instance, they may have forestalled a more rapid decline in the role of small firms in Indian industry. In the second instance, one needs to look at specific policy initiatives in a more disaggregated manner to assess their effectiveness, as we attempt to do in chapters 3 to chapter 7 of this report. Nevertheless, as perusal of Table 2.3 reveals, there has been very little change in India'a industrial structure in terms of firm size, and if anything, the large firms (500 employees or more) have increased their dominance. Furthermore, the binodal structure identified and discussed in other studies has remained unchanged over two decades, with a significant under-representation of medium sized firms. In this context, two special concessions to SSI have probably contributed significantly to the maintenance of such a structure. The excise duty exemptions for sales up to a certain level discourage growth beyond a certain point and encourages a proliferation of small firms producing similar products (oftentimes under single ownership hidden by proxy shareholders). And product reservation policy may have also contributed to a distorted industrial structure insofar as it may encourage new small firm entry, but discourage these same new entrants from expanding beyond the plant and machinery value ceiling that administratively determines SSI status. Product Composition 2.10 In terms of output and value added, modern small scale industry7 dominates in textile products, (in garment manufacture SSI accounts for 77.7% of employment and 84.3% of output in 1984/85), wood and furniture, and has a strong presence in food products, beverages and tobacco, leather goods, and metal products (see Table 2.4). Since the latter part of the seventies there has been strong growth, and hence a rising share of output and value added, in beverages and tobacco, leather goods, non electrical and electrical machinery. For all ether categories (as measured at the two digit National Industrial Classification level) the relative share of output and value added contributed by SSI remained quite constant over time. ?As is shown In Table 4 we have spliced data from the ASI with data that is available from two Directory of Manufacturing Establishment Surveys. In this manner we cover quite accurately firms from 6 employees to 49 employees, and this is probably a more accurate representation of what is often called the modern SSI sector. Unfortunately this combination could only be done for two years (1978/79 and 1984/85). 17 TABLE 2.2 SMALL SCALE INDUSTRY IN THE FACTORY SECTOR" 1973174 1980/81. 1987/88 1973174-78/79 1978/79-85/86 1985186-87/88 % Share 77.0 78.4 77.7 Period Growth Rate (%.p.a.l 6.98 1 .97 0.27 (5.06) 2 00) (2.01) Employees %Share 14.4 13.8 17.4 Period Growth Rate (% p.a.) 5.00 2.91 1.75 (4.40) (-0.03) (2.15) Productive Capital % Share 6.2- 5.4 6.4 Period Growth Rate (% p.aJ 4.39 10.23 -2.37 (6.51) (5.6) (7.87) Grose QOIufut % Share 14.9 13.5 13.9 Period Growth Rate ,% p.aj 10.49 4.74 8.21 (12.24) (5.20) (6.66) Neat Vefu Ad % Share 8... 8.5 8.8 Period Growth Rate (% p.e.) 7.84 7.13 -2"40 (10.12) (3M18 (4.90) Productive Caital/Emofovee Ratio of SSI to non SSf 0.39 0.3e 0.32 Value AddedfEmolovee Period of SSI to non SSI 0.57 0.58 0.46 u The date has been derived from the Annual Survey of industries over various years. The defiittloi of SSI is those firms that have 49 or fess employees. 2J The current price values from. the ASI are deflated by the Machinery and Transport -quipment index of the Wholsale Price Index (1970/71 - 100).. * The current price values from the ASI are deflated by the Manufactured Products index of the Wholesale Price Index 2.11 At more disaggregated levels, the patterns of product concentration is more revealing. Utilizing only ASI data, SSI accounts for about 80% of employment and value added in garment manufacture, 92% of employment and 80% of value added in the manufacture of metal utensils and 93% of employment and 80% of value added in grain mill products. As might be expected, the role of SSI in basic metal industries, chemicals and transport equipment is relatively low, given the large capital investment needed in these industries. 18 TABLE 2.3 INDUSTRIAL OUTPUT AND VALUE ADDED BY FIRM SIZE (% Share Firm Size -,Out IOt Value added (No. of 1973 19751 19801 19871 19731 19751 19801 19871 Workers)_ 74 76 St 88 74 76 St 8 0-49 14.9 14.1 13.5 13.9 8,7 8.2. 8.5 8.8 50-99 8.0 7.3 7.8 8.1 4.9 5.0 5.6 6.1 100-199 8.8 8.2 8.6 9.5 7.4 6.8 7.1 8.6 200-499 14.8 15.3 15.1 12.9 13,4 12.5. 13.0 13.3 500-1999 29.4 30.4 28.2 31.1 31.3 34.0 29.8 31,3 2000 and above 24.3 24.8 26.8 24.5 34.3 33.5 36.1 31.9 Source Annual Surv'ey of Industaev.arious leaue. 2.12 With respect to India's exports, SSI plays a significant role, accounting for about 40% of the country's manufacturing exports directly (and indirectly much more through the provision of inputs to larger exporters), and about 30% of total exports. And this excludes the very large exports of gems and jewellery, which comes from predominantly small firms. In 1989/90, SSI exports accounted for 100% of sporting good exports, 90% of garment and marine product exports and 75% of the exports of leather and leather products. The fastest growing areas of SSI exports over the past decade have been in basic chemicals (at least 34% p.a. in nominal US dollars, but starting from a very low base) garments (13.6% p.a. in nominal US dollars) and leather products (10.3% p.a. in nominal US dollars). Factors Affecting Entry by Small Firms 2.13 The data presented above suggest considerable inter-industry variations in the presence of SSI and in its contribution to output and value added. Some studies have sought to explain these inter-industry variations at a point in time, consecutively with inter-industry variations over time. The studies have yielded some interesting results. The presence of small scale firms was higher, the less vertically integrated the industry, the lower the extent of economies of scale in management (as measured by a ratio of workers to total employees), and the higher the labor productivity of small firms relative to the total industry sub-sector. Furthermore, small firm entry was higher for industries with lower capital to labor ratios, and where uncertainty (measured as an index of deviation of actual output from predicted output, where predicted output is retrieved from an auto regressive process with a lagged dependent variable) was lower?. Of particular importance, these studies found that small firm entry was facilitated during periods of eSee Ira N. Gang "SmaLL Firm Entry in Indian Manufacturing", "SmatL Firm "Presence" in Indian Manufacturing", and "The Inter-Industry Size Structure of Indian Manufacturing", mimeos, December 1990. 19 higher GDP growth, lower real interest rates and lower inflation, suggesting that macroeconomic policies that affect these variables have a sinificant impact both on investment expectations amongst new entrepreneurs and the ease with which new firms can carve a market niche for themselves. It was also found that small firm presence and entry was greater in a specific sub sector, the slower the actual growth rate of the industrial sub sector. It is noteworthy that these studies, utilizing ASI data could fi.nd no evidence (through the use of industry specific dummy variables) that the bureaucratic or policy environment affected small firm presence0. 2.14 While it may not be clear from the aggregatq data exactly what the influence of the varie', of small scale industry policies followed over the past two decades has been, it is clear that other aspects of industrial policy have affected the growth patterns and firm structure of larger firms, and hence influenced the role that small scale firms play in the overall industrial sector. In particular, the labor laws and job security legislation (most notably the Industrial Disputes (Amendment) Act of 1976, subsequently amended in 1982 and 1984)" have affected the growth of employment in the large sector and created a distinct dualism in the labor market. In addition, there is a complex structure of minimum wage laws, which vary from state to state and across industries and occupations within states. Enforcement of these laws varies; however, their impact is greater on the larger industrial firms rather than on SSI, simply because of the administrative difficulties involved in monitoring. 2.15 As a result of labor laws and other factors, there is a dichotomy in wage rates between the organized and unorganized sectors, and hence between large and small scale industrial enterprises, which, together with greater unionization within larger firms, has created a privileged work elite2. For the larger firms there are greater costs and obstacles to work force adjustment, with the result that they are less flexible in reacting to changing market conditions. A recent study hag-shed some light on the impact OSimilar studies undertaken in more industrialized countries have often found that new small firm entry has been greater during slower, stagnating growth periods, see Highfield, Richard and Robert Smiley, "New Business Starts and Economic Activity: An Eapirical Investigation, Interntional Journal of Industrial Organization, 1987,5, pp. 51-66. 00f course the aggregated nature of data used could account for this. "This Act makes "ay off retrenchment and closure illegal except with the prior permission of Government", Government of India, Indian Labor Statistics, Bureau of Labor Statistics, 1978. It is noteworthy that the 1976 legislation was struck down by the Supreme Court as unconstitutional. '2Various studies and surveys support this view. Utilizing 1974-75 data, a survey found that average earnings in small establishments was 58% of that earned in firms in the factory sector (see L.K. Deshpande, Segmentation in the Labour Market: A Case Study of Bomba, Pune: Orient Longman, 1985). A tatter survey found that contract workers earned 64% of average earnings of regular employees, and casual workers about 50% of the same base (see S. Archaryn and A.V. Jose, 1990, "Labor Market and Mobility: A Study Among Workers of Low Income Households in Bombay", New Delhi: ILO/ARTEP). Finally, data from the Annual Survey of Industries shows that average pay in factory sizes of 10-49 employees is tower than all other employment size categories (eg. 10-49 employees = 1.00; 50-99 = 1.14; 100-199 = 1.35; 200-499 z 2.01; 500-999 = 2.64; 1000-1999 = 3.11). 20 TABLE 24 ROLE OF SSI IN DIFFERENT PRODUCT CATEGORIES (Percentage share) OUTPUT VALUE ADDED SSI & DME SSI SSI & DME nS_ 1978/ 1984/ 1978/ 1984/ 1987/ 1978/ 1984/ 1978/ 1984/ 1987/ Total 79 85 79 85 88 79 85 79 85 88 Food Products 49.6 26.5 26.3 25.8 28.4 29.9 13.1 14.3 14.2 Beverages, tobacco, etc. 43.3 20.8 19.7 25.3 28.7 24.7 14.8 13.8 21.7 Cotton Textiles 26.4 7.6 8.8 9.5 13.0 9.3 1.4 5.3 5.1 WooL, silk etc. 27.3 15.2 15.0 15.8 21.3 27.8 8.7 11.3 9.0 Jute textiles 8.9 3.1 2.5 4.0 1.3 2.2 0.7 1.1 2.8 Textile Products 77.1 36.4 37.9 36.5 65.9 62.8 26.7 25.9 30.1 Wood, furniture etc. 79.1 52.4 41.8 49.4 74.0 78.0 39.0 37.5 42.3 Paper and Painting etc. 30.1 18.6 17.4 19.5 24.0 27.8 13.8 14.5 16.2 Leather and fur products 47.0 23.2 15.5 21.3 33.9 47.9 16.0 16.5 19.7 Rubber and petroleum 11.8 7.0 6.9 8.1 14.4 19.0 8.6 10.9 8.5 Chemicals 18.2 10.2 9.2 10.8 11.1 10.0 7.8 6.7 6.7 Non metallic prod. 25.2 10.3 9.1 10.8 28.9 20.3 10.2 8.2 10.0 Basic metal ind. 8.1 10.8 9.6 11.7 8.8 9.0 6.3 5.5 7.2 Metal products 56.6 36.3 31.6 32.7 40.5 56.5 24.9 24.1 24.0 Mon elect. machinery 29.8 13.6 17.0 16.2 16.8 23.0 11.1 15.5 13.8 Electrical machinery 24.5 11.2 11.9 14.2 10.7 12.0 7.3 7.1 9.6 Transport equipment 14.7 6.3 5.8 6.7 6.8 14.2 3.8 4.2 5.1 Other manufacturing 55.7 29.2 22.6 22.8 60.1 46.9 21.3 15.9 19.3 EMPLOYMENT SSI & DME SSI 1978/ 1984/ 1978/ 1984/ 1987/ 79 85 79 85 88 Food Products 48.1 53.5 14.9 19.6 20.6 Beverages, tobacco, etc. 56.6 49.7 31.3 28.3 37.8 Cotton Textiles 38.5 45.7 6.6 8.6 9.8 Wool, silk etc. 59.8 50.7 16.1 13.1 11.9 Jute textiles 2.2 2.7 0.7 0.7 1.2 Textile Products 85.8 88.8 31.3 33.2 30.0 Wood, furniture etc. 84.2 89.5 50.3 50.9 49.9 Paper and Painting etc. 43.7 49.4 21.2 21.1 23.3 Leather and fur products 46.9 59.5 23.7 17.3 18.9 Rubber and petroleum 45.2 49.2 24.7 2'.6 29.7 Chemicals 29.7 33.8 13.8 13.7 14.8 Non metallic prod. 69.9 65.7 20.2 24.5 27.3 Basic metal ind. 20.0 19.5 11.7 11.7 13.3 Metal products 65.9 72.3 38.7 38.8 37.8 Non etec. machinery 33.9 41.5 20.2 22.6 23.3 Electrical machinery 22.4 30.7 12.3 14.8 16.3 Transport equipment 11.7 15.9 6.4 7.5 9.0 Other manufacturing 85.9 84.7 31.0 29.1 29.7 Source: Annual Survey of industries, various issues and Directory of Manufacturing Establishments Survey. This latter survey covers those firms in the organized sector which had six or more employees at least one of whom was hired. The DME survey was only conducted in the years shown. 21 of such policies13. Utilizing ASI data on the census and sample sectors, the authors found the job security legislation significantly reduced the demand for workers at given levels of output for those firms subject to the Act (those with 300 or more employees from 1976 to 1982 and those with 100 or more employees from 1982). For the 35 industries covered for the period 1959/60 to 1981/82 they found that employment was 17.5% lower than it might have been in the absence of the legislation, ranging from highs of 42.4% (non-electrical machinery), 33.3% (soaps and cosmetics), 36.1% (cotton textiles) to lows of 3.3% (flour and bakery), 3.2% (bicycles) and 0.0% (leather products). Of even more import, they found no econometric evidence that job loss in the census sector produced parallel job gains in the sample sector (i.e. 10 to 50 workers using power or 100 workers without power) through the transfer of workers across establishments, through sub-contracting or through adjustments in establishment size. 2.16 Hence, while one might conjecture that policy induced distortions, which affect the price of labor differentially for different size categories of firms, might cause a shift away from the size category adversely affected (i.e. the larger firms), this did not occur in the factory sector, at least up to 1981/82. Thereafter however, the employment share data in Table 2.2 suggests that a greater degree of sub-contracting and/or "farming out" by larger firms has occurred. This trend is elaborated upon further in Capter 7, and anecdotal information drawn from a number of discussions with large firms suggests that labor cost differentials between large and small firm employees have widened. It is also noteworthy that the coverage of the legislation was broadened in 1982 (to cover all firms with 100 or more employees) and this may have accelerated any earlier tendencies for output substitution between firm sizes. Conclusions 2.17 In this chapter we have endeavored to show the role of the small scale sector in Indian's industry. Notwithstanding the data limitations, it is clear that the role that SSI plays in the industrial sector is significant and in certain product areas dominant (eg. garments, leatherware and grain mill products). What is striking, however, is that over the past two decades this role, in terms of value added and output, has changed very little. Furthermore, the binodal industrial structure fconcentration in very large firms and small units) has not changed. The importance of SSI in terms of employment has changed, but this may be due more to policy induced labor price differentials that have provided a highly protected environment for the privileged workers in the larger scale firms. But as studies have shown, this may have been at the very high cost of reducing firm flexibility, damaging long term employment growth and reducing growth in these product areas in which India might be expected to enjoy some comparative advantage. 2.18 It was also noted in this chapter that small firms' entry and presence tended to be greater in those industry areas with lower capital 13Fatton, Peter R. and Robert E.B. Lucas, "The Impact of Changes in Job Security Regulation in India and Zimbabwe$, The World Bank Economic Review, Volume 5, No.3, September 1991. 22 intensity, lower degrees of vertical integration and less scope for economies of scale in management. Furthermore, the influence of macroeconomic variables, (levels of real interest rates, inflation and overall GDP growth) also had strong positive influences upon the rate of creation and entry of new SSI. While many, if not all, of these factors are somewhat obvious or tautological, it does suggest that policies that affect them may be more influential and effective in promoting the growth of new firms and encouraging the spread of entrepreneurship than specific, ad hoc concessions and incentives. In the following chapter, we shall examine in more detail the nature of these incentives and concessions and provide an assessment of their implications and effectiveness. This will be undertaken in the context of the objectives of the policy, and the real constraints that new entrepreneurs and small scale firms face in an economically developing environment. 23 CHAPTER 3 INCENTIVES, CONCESSIONS AND TECHNICAL BPPICIENCY Introduction 3.1 The arguments put forward to favor SSIs in developing countries rest on two fundamental approaches. The first suggests that the smaller firms' allocative efficiency is higher from a social perspective because they face lower wage and higher capital costs than larger firms and this more accurately reflects the social cost of labor and capital'. Following on from this, is the argument that smaller firms produce a unit of output with less capital but more labor, when compared to larger scale firms, with the result that more output and more employment is generated, if an industrial structure is composed of a greater number of smaller firms. 3.2 Another fundamental argument put forward rests upon principles of equity and income distribution in environments with highly unequal income and capital distribution and a market mechanism that exhibits imperfections that are not amenable to speedy change. In environments with deficient education systems and information transmission mechanisms, it is argued that special assistance programs and/or concessions are necessary to overcome excessively high barriers to entry for new entrepreneurs.2 In India, as in other developing countries, this argument has been used to support special programs to develop certain regions (spatial dispersion of industrial activity) and categories of population groups (engendering entrepreneurial skills in the economy). The latter objective of accelerating the growth of an entrepreneurial class, while having strong income distributional objectives, also is seen as a decentralization of economic power with positive political and social harmony effects. 3.3 Whatever the case put forward for special concessions for new entrepreneurs and small scale firms, there are some costs to these special dispensations, which are born by the taxpayer and the consumer. The validity of the above arguments, and the benefits that accrue, are empirical issues, which often only come to light over time. The same may be said of the costs to society of special programs designed to benefit particular groups. Often, 'For a fuller description of some of these arguments see I.M.D. Little, Dipak Mazumdar, J. M. Page, Small Manufacturing Enterprises. A Comparative Analysis of India and Other Economies. Oxford University Press, 1987. pp.1-32. 2in the context of this argument, one may counter that it would be more efficient to eliminate the market imperfections and ultimately this would be correct, however the time required to bring noticeable changes in the output of education systems (which should still be undertaken of course), or overcome capital market constraints, may be such that direct interventions of assistance and concessions are mooted as short to medium term palliatives and remedial actions. Furthermore, the privileges enjoyed by protected groups are not easily overcome, particularly if these privileges are the result of past institutional and administrative policies. The perfect example in India is the organized Labor market (i.e. that found in the larger sized firms of the factory sector) and the labor Laws that protect it. Different factor price ratios facing producers of different size could obviously account for SSI opting for more labor intensive techniques. The removal of the distortions in the factor markets is the preferred solution, however this may not be feasible with the result that a special case is made for the encouragement of SSI. 24 these costs accrue over time and are not amenable to easy quantification (the dynamic, technology implications of restricting production of certain items to SSI is a good example). 3.4 Whatever welfare gains and losses may arise, they do depend directly on the instruments adopted. In this chapter we discuss the range of special dispensations and concessions that are available to SSI and new entrepreneurs, examine the welfare implications of these measures and provide an assessment of their efficiency in achieving both the broad goals and objectives of the SSI promotion policy package as well as their wider impact upon the efficiency of resource allocation within the economy. Incentives and Concessions 3.5 Appendix A2 provides a detailed list of incentives that are available to SSI in India. Concessions are provided by the Central Government and the State Governments. The range of instruments is very broad covering exclusive product reservation, tax breaks, input subsidies and price preferences. The magnitude of the subsidies is of course variable, but in some cases the benefit afforded to small scale producers is very high. For example, with regard to excise tax exemptions for products such as cosmetics and toilet preparations the excise duty ranges from 20% to 105% of ex factory value. Input subsidies, on the other hand tend to be relatively modest, ranging from 0.4% to 6.0% of the ex factory value depending upon the product in question and the State.3 3.6 Product Reservation. A major element of support for SSI in India is the reservation of about 831 product groups4 for exclusive production by SSIs as defined by fixed investment in plant and machinery. Once a product line is reserved, those firms with levels of investment exceeding the SSI limit are restricted to production at levels equal to their installed capacity at the time the reservation was imposed.5 This method of fostering the growth of SSIs was first introduced in 1967, and progressively the range of products has increased, however by the early eighties, the use of this policy instrument has declined significantly. In terms of commodities and products, the majority of reserved items are in the light engineering sectors (about 55%) and the production of chemicals and chemical products (about 27%). The relative frequency of reserved items is not however a good guide as to the importance of reservation for the structure of production within each industry (for example there are 164 items in the category of pairts, varnishes and lacquers (NIC 312), most of which are eight digit classifications of dyes, napthols and color bases). Reservation in textiles, handtools and general hardware, and electronics and electrical appliances, though smaller in terms 3See S. K. Tulsi "Incentives for Small Scale Industries * An Evaluation", Economic and Scientific Research Foundation, New Delhi 1980. 'The exact nunber of items can very slightly depending upon the fineness of the product classification. For example in 1978 is was decided to recast the reserved List by using the NIC (National Industrial Classification) Codes. As a result of this process the List of reserved items expanded from 504 to 807 items. The full list of items is shown in Appendix A2. 'There is an exception when a large firm gives an undertaking to export 75% or more their total production. 25 of numbers of items, has a much more pervasive influence on the patterns of production in a sub sector. The importance of reservation to SSI in terms of output is difficult to guage because of the absence of data at disaggregated levels. Utilizing data from the 1972 census, about 24% of SSI output was said to consist of reserved products. It is unlikely that this proportion has increased and it is noteworthy that SSI produces in excess of 5500 industrial items and in terms of products, reservation accounts for less than 15% of this. 3.7 The fundamental rationale underpinning product reservation as a policy instrument to foster the spread of entrepreneurship is far from clear, and some of the reasons put forward by the early policy makers do not stand up to close scrutiny. If there are considerable barriers to entry for new firms in an industrial sub-sector, then it would be more efficient to seek to reduce these barriers if they are amenable to change6. Furthermore, if they are not amenable to change, then the desire for a broader firm base for a particular item, should be achieved through a time limited method of intervention, not a perpetual form of protection. If small firms in a certain industry require permanent shielding from large firm competition, then the encouragement of resource use by small firms can impose high costs on a society. As Box 3.1 shows, the consumer is always worse off compared to a regime of non reservation, and the main beneficiaries may well be the larger firms that existed prior to the introduction of production reservation. 3.8 The effect of reservation is hard to assess in India because of the lack of sufficiently disaggregated product level data on output, factor use and value added. In fact, given the potential distortions that such a policy can have, the lack of regular assessment of the policy's impact on industrial structure is a serious omission. The office of the Development Commissioner (Small Scale Industries) has made an assessment before and after in the early eighties, but unfortunately this analysis failed to control for other factors that could have influenced the growth of firms and output. In the majority of cases (72% of 112 products studied) output rose faster than the growth of the number of firms, and in another study it was found that capacity increased faster than the number of units in over 60% of the 262 products assessed. These fiudings suggest that a large proportion of the growth witnessed in the reserved product categories may simply be due to growth in the general economy and rising market demand. Of course, thIs is not to deny that the firm level composition of this supply may have been changed, but unfortunately it is not possible to assess how much of this was due to reservation. There are some barriers to entry such as the technological requirements in production, or the capital Investment needed, which will inhibit the extent of firm entry, which are not amenable to change. In this case, what is necessary is a policy environment that allows for a ready mobilization of financial and other resources, free of monopolistic or otigopolistic practices, and not based on artificial constraints on factor choice or firm level capacity Limitations. Another, off-cited barrier to entry are the economies of scale inherent in marketing and distribution and the inertia inherent in consumer brand loyalties. Here again however, the extent to which these factors pose a rest constraint to new firm entry is often exaggerated. For many consuner items for example, price consciousness is very high (particularly in developing countries) with the result that there is plenty of scope for new firm entry into branded item markets provided they are cost competitive and focus attention on specific market segments based on regions, income groups or other identifiable characteristics. 26 BOX 3.1 THE IMPLICATIONS OF PRODUCT RESEWATION FOR SSI D4 Ss Price D3 D2 P33 iE3 ES P 2 ....*S1 S1 El D2 sl I D 1 I I I 0 Q1 Q4 Q5 Output In order to more fully understand the implications of capacity limitations on existing large scale firms and the reservation of future capacity for SSI It is useful to utilize the simple, static analysis of demand and supply curves. Immediately prior to reservation, assume a market equilibrium at El, with price of OP,, and output 001. Consumer surplus is P, D1El and the producer surplus is PiSLE1. Following imposition of a capacity constraint on existing large scale producers and reservation for SSI, the new industry supply curve becomes SLE3 er The SSI portion of this is EIS, on the basis of the assumption that per unit costs of production are higher than for larger scale firms. This assumption has some logical validity, Insofar as if the per unit costs where the same or lower, then there would be no need for the reservation policy In the first place. If there is no change in demand, then the initial market equilibrium remains unchanged. But as demand increases (with GDP and national income growth for example), price will rise up to a point (OP3) that it is viable for smaller scale producers to enter the market. But note that up to this point, the existing producers (possibly a mixture of large, medium and efficient small scale producers) benefit by a considerable increase in their producer surplus by the amount of P1 P3E3E, and even with the advent of new SSI producers, this increased producer surplus for the pre policy intervention existing units, still remains. Depending upon the extent of difference in the per unit costs of new SSI entrants and the existing firms, the existing firms, following the SSI product reservation, are always better off. Furthermore, the consumer is always worse off. With no policy intervention, and demand at level D4, the market equilibrium would be at E., with price of OP2 and output of 005. Consumer surplus would be P9D4E5, which is less than the policy induced market equilibrium (E4) consumer surplus of P404E4. Finally, this analysis also shows the greater vulnerability of the new, SSI entrants, to changes In demand or down tums in the economy. If demand falls from 04 to 03, then all of the new entrants are squeezed out. This simple, static analysis can be a ittle misleading insofar as technological change can change the position of the small scale Industry's cost curves (and hence the supply curve), but a priori there is no reason to believe that this change would not also affect the production costs of the larger firms. While they cannot take advantage of this to increase their output, their producer surplus is unchanged. To conclude, product reservation raises the producer surplus (profit or return on capital invested) of the existing firms; causes prices to be higher and output lower than it might otherwise have been without the policy intervention, and hence reduces consumer surplus or welfare; and may possibly create a large component of an industrial sub sector that is more vulnerable to short term demand fluctuations induced by changes in national income. The irony of all this is that the existing owners (and the work force) of the larger scale firms are better off than they otherwise would have been without the policy intervention, and the goal of an improvement in income distribution is diluted and undermined. 27 3.9 What is noticeable is that the assessed impact on the number of firms and output is highly variable. In part this reflects the somewhat arbitrary nature of the product categories chosen for reservation7. Eighty percent of the reserved items are concentrated in 11 three digit NIC categoriesO. The remainder are spread over 90 three digit categories. This heavy concentration of policy incidence, together with a "long tail" demonstrates to some extent, successful lobbying by specific industrial interests, and in the absence of a well defined criteria for product selection, the scope for such action remains large, and its potential for harm increases commensurately. 3.10 Another aspect of reservation that is difficult to quantify is its negative influence upon technological change in both product and process. Successful firms are discouraged from modernization or the introduction of efficiency enhancing product and process refinements because this may cause a firm to grow beyond its SSI status. Product quality can also suffer as obsolete machinery and production techniques are employed long beyond what might otherwise occur in a more dynamic environment. Ultimately of course, this has a detrimental impact upon market development, and in an export context, allows other countries (with similar factor endowments) to develop markets abroad in high growth product areas at the expense of the technological laggards. While quantification of this is difficult, there is anecdotal evidence to suggest that this is a growing problem in India (most notably in diesel engines, garment finishing, consumer electronics and leather products)'. 3.11 In broad terms, the reservation policy followed over the past thirty years has probably not been as detrimental nor as beneficial as many oveervers have argued. The vast bulk of SSI production is not covered by reservation, and in many cases the protection it offers may be redundant. For many items, the economies of scala and other production and distribution factors are such that small scale firms can be quite competitive with the large (garments maybe a good example, as well as certain processed foods). Furthermore, other special dispensations for SSI (exemption from central excise taxes for example) may make it difficult for larger firms to compete effectively with small units. Finally, the short term benefits, in the form of a surge of new firm entrants, appear not to be sustained in the medium to long term'0. 'At one time, table fans were reserved for smalt firms, while ceiling and pedestal fans were not. This was rectified in March 1988, when table fans were deleted from the reserved list. "Knitting in Mills (260), Manufacture of Plastic products (303), Manufacture of basic and industrial organic and inorganic chemicals (310), Paints, varnishes and lacquers (312), Photochemicals, sensitized fibres (319), Fabricated metal products, metal boxes, cans, safes and vaults (340), Hand tools and general hardware (343), Electrical appliances, domestic appliances, switches and sockets (363), Auto parts (374), Bicycles, rickshaws and parts (376), Mathematical and misceLtaneous instruments (380). OSee also Little, Mazundar and Page op.cit., Chapter 3. toSee J.C. Sandesara. "Small Scale Industrialization The Indian Experience", Economic and Political Weekly, pp. 640-654, March 26, 1991. 28 3.12 This is not to suggest however that this policy approach to fostering the growth of small firms should be maintained or enhanced. At certain product or sub-sector levels, its negative effects may be very large, and equally important, the existence of such a policy tool will always encourage lobbying by vested interests to have their own special interests catered to. Rather, production reservation for SSI should be eliminated, with greater policy emphasis being given to more time-constrained, more transparent and less discretionary interventions designed to encourage the establishment of new firms. 3.13 While the output of reserved items in total industrial output is very small, it is an emotive policy issue and as such its elimination may have to proceed progressively. Nevertheless, the Government shouid announce its intent to eliminate the device, and draw up a time phased agenda that eliminates first those items which are most distortionary in terms of the use of resources and have a high negative impact on consumer welfare and surplus. An exact determidation of this might not be easy, and, is not advocated, but there are certain general criteria that might be followed which could be used to draw up lists of products that should be subject to dereservation in the first anA subsequent rounds. It is recognized however that this approach to policy reform is a second best solution, and by focussing in the first instance upon those items which are most distortionary, implies that what remains are those items that are in less need of the special protection, whare indeed, small scale firms may enjoy natural advantages over their larger bretheran. 3.14 There are some general criteria that could be followed in choosing the products for the various rounds of dereservation, and these are listed below, but these are not exhaustive, are not theoretically valid for all products, and are merely put forward as an operational convenience to deal with a sensitive policy reform program. (i) A large number of the reserved items involve a relatively simple basic production process, such as molded plastic products or a mixing of basic pigments in paint and varnish manufacture. As a broad generalization the more simple the manufacturing process, the more suited it is to automation and mass production, the greater the scope for economics of scale and the greater the likely per unit cost differential between small and large scale producers. Moreover, for many of these product items, the related marketing, quality assurance, packaging etc. requirements are complex and offer great scope for economies of scale. As such, products that fall into these categories should be amongst the first to be dereserved. (ii) Because of transport costs, and the need for local customer contact, many products are more suitably produced in spatially dispersed units (eg. furniture products and certain perishable items). Items falling into this category might therefore prove to be less distortionary if produced by SSI, and could comprise a subsequent round of dereservation. (iii) The higher the degree of customer specification, product differentiation, and the more diverse customer needs, the more likely that small scale firms might offer some natural advantages and the less 29 distortionary would be the product reservation. Examples include printing, furniture production, certain types of casting and forging and some types of fabricated metal products. Items falling into these categories could be dereserved in later rounds. (iv) Small scale units often have natural advantages in batch production of a limited number of items, and where there is rapid change in product design or style. This is true in jewellery, fashionwear, bakery products, some types of footwear and home accessories for example. Items on the reserved list that fall under this criteria would have less distortionary effects and as a result could fall under a later stage of formal dereservation. (v) There are a number of items on the reserved product list where the main activity is basically an assembly process with little value added. This is particularly true for a number of electronic items and household durables. Not only are per unit costs high, but quality variability inhibits market development both domestically and internationally. Items that fall into such a category should be dereserved in the early stages of a reform program. (vi) There are a number of products on the reservation list where technology has been stagnant in India, but not elsewhere. A perfect example is low speed diesel engines where a complex array of small scale firms interact in the production of parts and final assembly. Items where there is a noticeable gap between the domestic and international technology of both product and process, should be dereserved in the first phase. (vii) Finally, there are many items which form an input into final products that are produced by both large and small firms. As a result, inefficiencies in the production of these items can be transmitted to a much wider spectrum of industry, with a possibly serious adverse impact. These inefficiencies manifest themselves in high ex-factory prices, variable quality and irregular supply, or all combined. Examples include construction materials, packaging products, electronic and electrical parts, auto parts and chemical products. Given that the distortionary impact of many of these inputs is hard to quantify, they should receive early attention in the dereservation reform. 3.15 Governmental Procurement. Since the initiation of the Government Stores Purchase Program in 1956, the GOI has followed an explicit policy to extend marketing support to SSIs through preferential procurement policies". This set of concessions involves reservation of over 400 items for exclusive procurement from SSI and a 15% price preference given to small firms when engaged in competitive bidding with large firms. As with many policies designed to foster the growth of new entrepreneurship and small firms, the "See Appendix A6 in VoLume II for a fulL description of this program. 30 underlying rationales and objectives are somewhat confusing and murky2. The procurement preference is subject to a minimum "technical norm" requirement, which allows a wide margin for administrative discretion by individual procurement agencies. Furthermore, as all government departments are subject to budget constraints, the 15% price preference is not universally applied13. 3.16 Overall, while the procurement reservation is distortioaary and represents an implicit tax on the rest of society, the magnitude of the "tax" is not large. The reservation policy covers about one third of total Central Government SSI purchases, and hence about 3.5% of total Central Government consumable purchases. For certain products produced by SSI, procurement by the public sector can represent a major market (for example, chemical products, electrical machinery and textiles) however, the overall impact of the incentive and special privilege structure on the growth and viability of the Small Scale Sector is not large. 3.17 Excise Tax Exemption. A major incentive provided by the GOI to SSI is exemption from the payment of central excise tax on the ex-factory price of output". Under this fiscal incentive, sales up to Rs.2.0 million are exempt, between Rel 2.0 million to Rs.7.5 million there is a gradual application of the tax, and for sales beyond Rs.7.5 million, the full excise tax is applicable at the rate designated for the particular item. As an additional marketing incentive for SSI products, a 5% excise duty concession is given to medium and large firms on their purchases of inputs from SSIs under a value added drawback scheme (MODVAT), irrespective of whether the SSI paid excise duty or not. 3.18 The importance of this exemption for SSI can be significant given that excise rates range from 10% to over 100%, with the higher rates payable on luxury and consumer goods and the lower rates applicable mainly to intermediate and capital goods. In 1980, it was calculated that at an output level of Rs.1.0 million, the excise tax exemption accounted for 62% of the total incentives for cosmetics and toilet preparations and about 30% for paints and varnishes, rubber products, glass products and hand tools.'s 3.19 The importance of this special dispensation for SSI lies in smaller firms, ability to have higher per unit production costs and yet still remain competitive in the market and earn profits. Furthermore, given that wage rates in smaller firms and the unregistered sector tend to be much lower than those found in the organized factory sector, the potential for much higher rates of profit in smaller firms can be significant. The fact that profit rates for smaller firms are not higher than for medium sized firms (see 21n some cases the procurement reservation mirrors the production reservation, making the former redundant. "in practice, in order to maximize the use of budgetary resources, those responsible for procurement often inform the small scale supplier that their prices must be reduced, citing ficticious larger firm bid prices, if they are to receive the supply contract. "There are other fiscal based incentives, such as exemption from State level sales and turnover taxes. 16See Tulsf, op cit. 31 Table 3.1 and paras 3.27 and 3.28, below) suggests that levels of inefficiency in some product categories produced by smaller firms must be very high indeed. 3.20 The present system of excise tax exemption discourages small firms from growing into medium and large scale entities. This has serious implications if India is to develop an industrial sector that is internationally competitive and able to face competition from abroad as the trade regime is liberalized. In many consumer product categories, the capacity to garner economies of scale in marketing and distribution is an essential ingredient for survival in a market of rapidly changing consumer tastes. 3.21 Accurate estimates of the fiscal costs of this concession are not available, but given that about 40% of manufacturing output comes from SSI, it must be quite significant. Given the negative aspects of such a tax exemption system that exists in perpetuity, and the general fiscal need to broaden the tax base, excise tax exemptions for SSI should be phased out. 3.22 It is often argued that given the large number of small firms (many of which do not keep proper accounting records), it is not practicable to seek to collect excise revenue from SSI. But, the validity of this claim is undermined somewhat given the present system of SSI registration, the number of differnt "inspectors" that visit a small scale firm and the fact that many of these firms receive financing from state financial institutions and commercial banks. There is a record "trail" of small scale firms, particularly in the modern small scale industry sector. 3.23 It would still be possible to encourage the entry of new firms, with a time limited system of partial rebate or exemption of excise taxes due. For example, a new entrepreneur might receive an 80% exemption in the first year of operation , 50% in the second, and 25% in the third, with the full excise rate being levied after three years of operation. It might be argued that this type of excise tax system would merely promote excessive closure and rebirth (under a new name but with the same owner) of firms. While there is substance to this argument, there are transaction costs to establishing an entirely new legal entity (particularly for bank financing, industrial park factory space, power utility connections, and where brand loyalties and awareness are involved), which would serve to reduce the extent of this type of tax evasion. 3.24 Raw Material Ouota Allocations. For a variety of basic raw materials (eg. steel and non-ferrous metals) a system of quota allocations for individual, registered small scale firms is implemented by SIDO and the various State industry departments. These items are deemed "scarce", and are often sold at controlled prices. Small scale firms do complain of shortages of raw material inputs, or the irregularity of supply. But this administrative approach to deal with the issue is inappropriate. Problems in supply represent a failure of market systems, oftentimes as a result of other policy interventions (trade, licensing, pricing and distribution controls), which would be more effectively and efficiently dealt with by removing the underlying causes for the market failure. As it presently stands, the present 32 system of quotas, often at administratively determined prices, is frequently abused, with many small scale firms merely acting as trading enterprises reselling their quotas at prevailing market prices. 3.25 Input Subsidies. There are a variety of input subsidies provided to SSI. The most pervasive and important are the interest subsidies on credit to the small scale sector, discussed in more detail in Chapter 5. There are also a variety of special incentives and concessions on production inpute. They all tend to have firm level time limitations, and by and large their distortionary impacts are quite small, with the possible exception of two areas; rentals on factory space in public sector constructed factory parks and power tariffs. In the former case, below market rental charges for scarce factory sheos inhibit the supply of such facilities and often induce entry of non viable small scale units which locks up use of the facility by more viable entities. A more detailed analysis of India's Industrial Estates Program is shown in Box 6.2 of Chapter 6. Suffice it to note that rentals in these parks should be on a full cost recovery basis and reflect more closely, the prevailing local market prices for space. With regard to the State Electricity Boards' subsidies on power tariffs, little is known of the annual revenue loss that accrues. This in itself is cause for concern. As a general principle all subsidies should be transparent, and it would be preferable if the State Electricity Boards collected the full, appropriate power tariff, with any rebates given being fully compensated by the respective State Governments. Technical Efficiency 3.26 As noted earlier, the case for special promotion of SSI has rested upon assumptions about relative factor intensities. This view suggests that developing countries are short of capital and labor abundant, and small firms are believed to be more labor intensive and less cdpital intensive than larger firms, and hence better suited to the factor proportions in a developing economy. A large number of studies have been undertaken to empirically verify this contention, both in India and other developing countries.16 3.27 Looking at the partial factor productivities calculated in Table 3.1, which utilized data from the Annual Survey of Industries and therefore excludes firms with 9 or fewer employees, there is evidence to suggest that smaller firms utilize capital more intensively than larger firms, and, as a reflection of labor intensity, the output per worker is lower in the smaller 1Dhar, P.N and LyndaLL, H.F, The Role of small Enterprises In Indian Economic Development, Asia Publishing House, Bombay, 1961; J.C. Sandesara, "Scale and Technology in Indian Industry", Oxford Bulletin of Economics and Statistics, Volume 28, August 1966, pp 181-198; A. Bhavani, "Relative Efficiency of the Modern Small Scale Industries", unpublished N. PSiL dissertation, University of Delhi, Delhi 1980 and "Some Economic Aspects of the Modern Small Scale Industrial Units in India", unpublished Ph.d dissertation, University of Delhi, Delhi 1989; K. Kaur, "A Study of Cost and Productivity Relationships in the Small Scale Leather Industry of India", unpublished Ph.D dissertation, University of Delhi, Delhi 1983; J.M. Page Jr., "Technical Efficiency and Economic Performance: Some E4idence from Ghana", Oxford Economic Papers, Volume 32, No. 2, July 1980, pp.319-339 and "Firm size and Technical Efficiency: Applications of Production Frontiers to Indian Survey Data", Journal of Development Economics, Volume 6, No. 1-2 (September/October) 1984, pp 129-152; B.N Coldar, "Unit Size and Economic Efficiency in Small Scale Washing Soap Industry in India", Arthaviinana, Volume 27, No.1 (March), 1985, pp.21-40; I.M.D. Little, 0. Muzumdar and J.M. Page Jr. Small Manufacturing Enterprises: A Comparative Analysis of India and Other Economies, Oxford University Press, New York 1987, and K.V. Ramaswamy, "Technical Efficiency in Modern SmaLL Industry in Indial, unpublished Ph.D dissertation, University of Delhi, New Delhi 1990. 33 firms. In terms of profitability, as measured by the rate of return on productive capital, the smaller size firm tended to show higher levels of return. Closer scrutiny of this data however, reveals much more. Capital and labor productivity tends to be greater in firm sizes of 50 to 200 employees, which is also reflected in higher rates of return on productive capital invested. There is considerable variability on a year by year basis, particularly with regard to rates of profitability of different size classes. Finally the very poor profitability and capital and labor productivity of the very largest category of firms (5000 employees and above) is quite revealing. It is noteworthy that nearly 70% of the output in this category is accounted for by public enterprises. 3.28 But assessment of relative technical efficiency in terms of partial capital and labor productivity has serious limitations. Partial factor productivity can differ between firms due to factor price difference, differences in the levels of technology, varying rates of capacity utilization, differences because of non constant returns to scale and differences in the degree of vertical integration. It is analytically more sound, therefore, to treat factor inputs symetrically, assuming positive opportunity costs for all inputs, and seek to measure total factor productivity. Finally, in any cross firm comparability it is more meaningful to disaggregate the data down to very detailed item classifications, to be assured of comparing like with like. 3.29 The conclusions of the variety of studies undertaken in Indian that utilize more disaggregated data are mixed. Work by Little, Muzumdar and Page (1987), Goldar (1985), Sandesara (1966) and Shavani (1989) tend to suggest that small firms, as opposed to medium sized ones, are not the most efficient in a total factor productivity sense. Goldar and Sandesara found in particular that small firms utilize more labor and capital per unit of output for the products that they chose to analyze. Kaur (1983) and Ramaswamy (1990) on the other hand founi the opposite result for leather products, motor vehicle parts, plastic products, agricultural machinery and parts and machine tools and parts. 3.30 In this study, we utilized a State-wise breakdown of ASI data for 17 different 3 digit NIC product classifications, for the year 1984-85. It is recognized that this level of aggregation can have methodological problems, however, given the broad cross section of products analyzed, it does provide some useful insights into relative efficiency of small and large firms in India."1 3.31 In the first instance, relative efficiency was measured by using partial productivities and constructing an index of total factor productivity utilizing the relative shares of the returns of capital and labor as weights. A Cobb-Douglas production function form was used, with an assumption of "Because of the nature of the ASI breakdowns obtained, a small firm Is classified as one having an investment in plant and machinery of up to Rs.2.OM. It would have been more useful to have the classification on the basis of employment but this was not possible. 34 constant returns to scale. The formula was as follows: Efficiency Index = (LPj/LPt)* (KPj/KP) Where a + b = 1, LP and KP denote labor productivity and capital productivity, and the subscripts i and t relate to the size class and the aggregate. The results of this are shown in Table 3.2. 3.32 Of the seventeen product groups, only four showed that small scale was compa=able, or superior to, the larger sized producer in terms of relative total factor productivity. These products were Spinning, Weaving and Textile Finishing, Garment manufacture, manufacture of Footwear and Structural Metal Products. It is r. teworthy, that garments and leatherware are leading export sectors, in which there is a large SSI representation, so one would assume that SSI efficiency and competitiveness would be relatively high. In the Structural Metal Product category, Ramaswamy (1990) also found, using more disaggregated data, a similar resulc as that portrayed in the table. Both of these factors suggest that the analysis is relevant and quite indicative of the relative efficiency of aSS. Furthermore, the fact that about 75% of the product categories showed SSI to be less efficient, sometimes by a significant margin, is very revealing. 3.33 A superior form of analysis of our three digit data set is to utilize a deterministic production frontier econometric approach." This approach provides for comparisons across firm sizes, relative the 'best practice' observed within the data set. The results shown in Table 3.3 are not absolute measures of technical efficiency,but do enable an assessment of efficiency across firm size that is not constrained by the assumption of constant returns to scale. 3.34 Of the sixteen product groups analyzed, only three showed small scale industry to be technically more efficient in production (Grain Mill Products, Spinning, Weaving, Finishing of Other Textiles, and Knitting Mills). The manufacture of garments showed no significant difference in the technical 8A Cobb-Douglas functional form is again used: Ya BLOKbe Where Y a value added, L a Labor, K a Capital and *U a a measure of technical efficiency. If a firm is on the production frontier, u is zero, so that * takes on the value unity. The parameters a and b represent elasticities of value added with respect to Labor and capital respectively and their sum provides a measure of returns to scale. The estimated form is: Log Y = c + a log (L) + b Log (K) -u. Where c a tog B. The method used to isolate the efficiency factor inherent in u, is Corrected Ordinary Least Squares, thus: tog Y a c' + a log (L) + b tog (K) *w. Where w a u -m and m is the mean of u and u is assuned to have a gama distribution. Given this later assumption an estimate of m is given by the variance of Ordinary Least Squares (OLS) residuals. If e, is the OLS residual for firm t, then an estimate of technical efficiency for that firm is given by the exponental (e, -m), since u = w + m and e a -w. To obtain an estimate of mean technical efficiency in the two different size classes, the geometric mean of the individual firm Level estimates are taken. 35 TABLE 3.1 SELECTED STRUCTURE RATIOS BY EMPLOYMENT SIZE GROUP FIRM SIZE BY OUTPUT/EMPLOYEE RATIO (RS. MILLIONS) EMPLOYMENT RANGE 1973-74 1978-79. 1985-86 1987-88 (1) (2) (3) (4) (5) 0-49 0.03479 0.05777 0.12473 0.15828 50-99 0.03274 0.05354 0.12242 0.15759 100-199 0.03156 0.05229 0.14270 0.17726 200-499 0.03754 0.08042 0.14426 0.19339 500-999 0.04262 0.07027 0.20658 0.26061 1000-1999 0.04122 0.07508 0.22309 0.27971 2000-4999 0.02908 0.05705 0.16963 .0.22489 5000 and above 0.02377 0.04513 0.16400 0.15990 Total 0.03362 0.06118 0.1608Z 0.19777 FIRM SIZE BY OUTPUT/PRODUCTIVE CAPITAL RATIO (RS. MILLIONS) EMPLOYMENT RANGE 1973-74 1978-79 1985-86 1987-88 (1) (2) (3) (4) (5) 0-49 3.05779 3.48542 2.53249 3.16836 50-99 3.25500 3.44279 2.08033 3.30561 100-199 2.30216 2.99462 2.08436 2.02849 400-499 1.43952 2.79956 0.95685 2.15759 500-999 1.06031 1.62740 1.20960 1.54907 1000-1999 1.40454 1.56257 1.36510 1.56107 2000-4999 1.40335 1,69859 1.89218 1.63828 5000 and above 0.44487 0.37358 1.05343 0.05079 Total 1.27271 1.41163 1.43240 1.45222 FIRM SIZE BY PRODUCTIVE CAPITAL/EMPLOYEE RATIO (RS. MILLIONS) EMPLOYMENT RANGE 1973-74 1978-79 1985-86 1987-88 Cl) (2) (3) (4) (5) 0-49 0.01138 0.01657 0.04925 0.04996 50-99 0.01006 0.01555 0.05885 0.04767 100-199 0.01371 0.01746 0.06846 0.08739 200-499 0.02608 0.02873 0.15076 0.08963 500*999 0.04019 0.04318 0.17078 0.16824 1000-1999 0.02935 0.04805 0.16342 0.17918 2000-4999 0.02072 0.03358 0.08965 0.13727 5000 and above 0.05342 0.12081 0.15568 3.14820 Totat 0.02642 0.04334 0.11227 0.13618 RATE OF RETURN ON CAPITAL: (NET VALUE ADDED - EMOLUMENTS)/PRODUCTIVE CAPITAL FIRM SIZE BY (RS. MILLIONS) EMPLOYMENT RANGE 1973-74 1978-79 1985-86 1987-88 (1) (2) (3) (4) (5) 0-49 0.24091 0.27928 0.21832 0.20031 50-99 0.22580 0.24229 0.16262 0.25854 100-199 0.23101 0.24264 0.20414 0.19668 200-499 0.15967 0.4547 0.9952 0.2902 500-999 0.12659 0.19039 0.13619 0.13084 1000*1999 0.16263 0.19080 0.11473 0.17210 2000-4999 0.18130 0.19093 0.25180 0.16845 5000 and above 0.05623 0.06055 0.12145 0.0486 Total 0.13880 0.15733 0.14526 0.13443 SOURCE: .(1) For data covering the years 1973-74, 1978-79 and 1985-86: INDIA DATABASE - THE ECONOMY (Annual Time Series Data, Vot.1) H.L. Chandhok and The Policy Group. (pp. 1030-1033) (2) For data covering the year 1987-88: ASI, Sumary Results of the Factory Sector (1987-88). (p. 17). 36 TABLE 3.2 PRODUCTIVITY AND RELATIVE EFFICIENCY Product Category & NIC Number Gross Value Added/ Gross Vatue Added/ Enployee (Rs.000) Productive Capital Small Large Total Small Large Total Manufacture.of DairyProducts (201) 13.52 30.39 27.68 0.42 0.38 0.38 Grain £I 1 Products 7.94 29.39 9.36 0.36 0.33 0.35 Mfj.of Other Edible Oils (211) 15.50 40.99 20.93 0.35 0.40 0.37 Printing, Dyeng/Bleaching Cotton.Textites (232) 14.14. 20.89 17.10 0.65 0.76 0.71 Spinning, Weaving & Textile Finishing (247) 21.47 38.48 35.76 0.77 0.45 0.47 Manufacture of Knitwear(260) 22.63 49.91 27.13 0.58 0.72 0.62 Mfg. of all types of Garments (264) 20.27 17.14 19.57 1.11 1.12 1.11 Printing & Publishing (285) 15.22 22.80 20.41 0.84 0.69 0.72 *Manufacture of Footwear (291) 14.07 13.27 13.66 0.85 0.49 0.62 Nfg. Drugs.& Medicines (313) 30.77 60.87 50.31 0.80 0.58 0.62 Mfg. of Structural Clay Prod; (320) 6.02 27.55 10.04 0.70 0.39 0.50 Foundries for Casting Iron & Steel (331) 14.16 29.97 24.22 0.57 0.38 0.41 Mfg. of Fabricated Metal Prod. (340) 21.07 47.56 32.41 0.72 0.78 0.75 *Mfg. of Structural Metal Products (341) 18.66 .36.85 24.46 0.83 0.48 0.62 Mfg. of Handtools & Gen. Hardware (343) 15.18. 33.70 25.08 0.55 0.53 0.54 Mfg. of Metal Utensils (345) 16.28 -48.60 18.96 0.48 0.92 0.53 Nfg. of Electricat/Industrfat Apparatus & Parts (360) 20.63 60.65 53.14 0.52 0.65 0.63 Product Category & Productive Capitat/ Relative Efficiency NIC Number Employee (Rs.000) Index Small Large Total Smat Large Total Manufatike of Dairy Products (201) 31.87 79.64 71.98 0.77 1.04 1.00 Grain Milt Products (204) 22.02 87.76 26.38 0.94 1.53 1.00 Mfg. of Other Edible oils (211) 44.91 102.72 57.24 0.89 1.26 1.00 Printifi*, Dye1ng/Bteaching- Cotton Textiles (232) 21.60 27.46 24.17 0.87 1.15 1.00 Spinning, Weaving & Textile Finishing (247) 27.68 85.28 76.09 1.10 1.00 1.00 Manufacture of Knitwear (260) 38.83 69.38 43.86 0.91 1.32 1.00 Mfg. of all types of Garments (264) 18.29 15.24 17.61 1.01 0.96 1.00 Printing & Publishing (285) 18.03 32.89 28.21 0.87 1.06 1.00 *Manufacture of Footwear (291) 16.50 27.07 21.88 1.17 0.88 1.00 Mfg. Drugs & Medicines (313) 38.37 104.51 81.31 0.92 1.06 1.00 Mfg. of Structural Clay Prod.(320) 8.58 71.07 20.23 0.89 1.53 1.00 Foundries for Casting Iron & Steel (331) 24.95 - 78.09 58.76. 0.86 1.09 1.00 1fg. of Fabricated Metal Prod. (340) 29.36 61.26 43.02 .-0.80 1.21 1.00 *Mfg. of Structural Metal Prod. (341) 22.51 76.40 39.69 1.03 1.07 1.00 Mfg. of Handtools & Gen. Hardware (343) 27.59 63.57 46.84 0.76 1.18 1.00 *Manufacture of Metal Utensils (345) 33.96 52.76 35.52 0.88: 2.00 1.00 Mfg. of Electrical/Industrial 39.50 93.97 83.75 0.60 1.07 1.00 Apparatus & Parts (360) Source: The date is drawn from the 1984/85 ASI broken down by State. Small Is classified as units with investment in plant and machinery up to 20 takhs, and large for those firms with plans and machinery exceeding 20 takhs. ESTIMATES OF TECHNICAL EFFICIENCY Number F Return Tech. Efficiency Index att=1.0) of NIC Code (3-digit) Constant j jg Stat. to scal Large Small All Laqe Smat Observ. 201 Manufacturing of dairy products 0.803 0.219 0.995 0.80 37.2 1.21 0.72 0.60 0.65 1.11 0.92 19 (.74) (1.09) (3.34) 204 Grain mitt products 1.871 0.580 0.238 0.65 30.5 0.82 0.52 0.61 0.56 0.93 1.09 33 (1.88) (2.55) (1.37) 211 Manufacture of other edible oits 2.779 0,199 0.735 0.47 11.43 0.93 0.76 0.53 0.50 1.52 1.06 25 (1.37) (.65) (2.23) 232 Printing,dyeing & bleaching of cotton textiles 0.318 0.655 0.398 0.96 218.8 1.05 0.95 0.92 0.93 1.02 0.99 20 (.55) (4.90) (2.86) 247 Spinning,weaving,finishing of other textiles 0.562 0.596 0.454 0.99 639.4 1.05 0.90 0.98 0.94 0.96 1.04 20 (1.86) (7.51) (4.17) 260 Knitting mitts -0.562 0.642 0.563 0.91 63.6 1.21 0.65 0.78 0.74 0.88 1.05 13 (-.51) (2.41) (1.83) 264 Manufacture of at types of garments -0.063 0.573 0.580 0.85 32.4 1.15 0.71 0.70 0.70 1.01 1.00 12 (-.04) (1.45) (1.53) 285 Printing and publishing 1.387 0.090 1.063 0.97 477.2 1.15 0.94 0.92 0.93 1.01 0.99 32 (4.11) (1,03) (10.27) 313 Manufacture of drugs and medicines -0.301 0.689 0.454 0.91 158.0 1.14 0.84 0.76 0.79 1.06 0.96 29 (.45) (5.15) (2.76) 320 Manufacture of structural clay products 2.003 0.663 0.152 0.72 32.1 0.82 0.80 0.78 0.79 1.01 0.99 25 (1.80) (6.40) (1.33) 331 Foundries for casting and forging iron/steel -0.527 0.447 0.757 0.94 255.8 1.20 0.88 0.78 0.82 1.07 0.95 34 (-.76) (3.62) (5.98) 340 Manufacture of fabricated metal products -0.582 0.685 0.482 0.90 126.7 1.17 0.82 0.75 0.77 1.06 0.97 28 (-.69) (3.15) (1.91) 341 Manufacture of structural metal products 0.981 0.250 0.918 0.95 225.8 1.17 1.01 0.88 0.91 1.11 0.97 25 (2.35) (3.66) (10.44) 343 Manufacture of handtools and general hardwar -0.369 0.581 0.580 0.96 337.9 1.16 1.04 0.87 0.92 1.13 0.95 26 (-.70) (5.50) (4.29) 345 Manufacture of metal utensils -0.720 0.398 0.897 0.86 65.2 1.30 1.21 0.68 0.74 1.64 0.92 22 (-.54) (1.23) (2.59) 360 Manufact.of electr.indus.apparatus and parts -0.349 0.747 0.355 0.97 418.0 1.10 0.94 0.88 0.90 1.04 0.98 25 (-.81) (5.89) (2.16) Remarks: 1. Figures in parenthesis are t-statistics; 2. Efficiciency index is a ratio of technical efficiency of one class of firms over sanple average. 38 efficiency of production between large and small firms). In two of these cases, production showed diminishing returns to scale or modest increasing returns. In the case of Knitting Mills however, the results showed quite strong increasing returns to scale, and yet the small scale sector was about 20% more efficient than the larger firm sample. This seeming anomaly may be explained by the degree of product aggregation used in the analysis. There may be considerable product differentiation within the three digit aggregation, such as style and design inputs, with the result that the value added by smaller firms increases significantly. The same may also be said of garment manufacture and printing and publishing. 3.35 Two product groups had relatively low adjusted R statistics (Grain Mill Products and Manufacture of Edible Oils) suggesting that the specification of the production function has omitted some important variables. It is noteworthy that in both product categories there are considerable policy interventions in the form of price and distribution controls. The smaller scale producers may be better placed to circumvent these controls, hence improving their value added relative to larger scale producers. This may also explain the observed decreasing returns to scale in both categories. 3.36 In all other products cases, small scale firms are shown to be less efficient than larger scale producers. The difference is larger, the higher the estimated returns to scale (for example, in the case of metal utensils, the returns to scale were estimated at 1.30 and larger firms were found to be 43.8% more efficient than the small scale firms in the sample). Constraints and obstacles 3.37 In an economically developing environment there are many constraints and obstacles confronting new entrepreneurs and the growth of smaller scale units. Many of these obstacles are often a negative function of the degree of development of the country. Deficiencies in basic infrastructure, in education and vocational training, in information transmission mechanisms, in legal systems and institutions and other commercial infrastructure that serves to reduce transaction costs, all can inhibit the establishment of new firms or the growth of existing ones. Some constraints are industry or sub sector specific, such as specific technology or skill requirements; others can be more macro in nature, such as policy induced trade and licensing regimes that distort relative prices or raise barriers to entry. Furthermore, many of these constraints are not universal in their impact, particularly across firms of different size classes. Larger firms are more able to deal with regulatory requirements (such as import licensing regimes), or, through already established market power, with infrastructure constraints (such as transport and telecommunications)." 3.38 Structural adjustment and reform of an economy that reduces the scope for administered controls and improves the market allocation of '9uch of this section draws upon a very interesting study by Brain Levy, *Obstacles to DeveLopment SmaLL and Medium Sized Enterprises - An Empirical Assessment", WorLd Bank Working Paper, February, 1991. 39 resources and inputs will reduce the scope and extent of discrimination against smaller scale firms and new entrants. Nevertheless, these macro level reforms, may not, in and of themselves, produce a significant response from small scale industry. The reason is that the institutional structures may still reflect the pre- reform patterns of economic organization, and the market networks necessary to facilitate the entry of new entrepreneurs and allow existing firms to grow (such as financing and distribution systems) may be weak or highly distorted. 3.39 Bureaucratic systems and procedures tend to be enduring and resistant to change, even though the policy structure has made much of the administrative requirement redundant. And oftentimes, the very incentive structures (discussed earlier in this chapter), designed to remove barriers to entry, impose constraints on growth or extra bureaucratic costs. Appendix A3 provides a flow chart example of the steps and procedures required for the establishment of a small scale firm in the state of Karnataka. If a new entrepreneur requires no financial resources, does not wish to avail of any incentives or concessions, and has his own land and suitable building, the required procedures and paperwork are still prodigious, and it can take from six to twelve months just to obtain the necessary approvals. Furthermore, nonofficial payments are often necessary just to obtain the necessary application forms. The time spent in dealing with these administrative requirements adds costs to either new entry or expansion, in both financial terms as well as the opportunity costs of the finite amount of the entrepreneur's time. In this latter context, larger firms have a distinct advantage insofar as specialist employees can be earmarked to deal with the regulatory burden. The GOI recognizes these difficulties and is anxious to effect reforms A specialized committee submitted a report in December 1990, that addressed these issues.0 In addition, a variety of forums of national and State level associations have met to seek a reduction in these administration burdens. As the aforementioned report states "........ a large number of regulatory as well as promotional laws (have) become counter productive. The only saving grace is that the staff for ensuring compliance of these welfare laws is so limited that it is not possible to check and visit each and every unit and, therefore, respite that the small scale units have is, only by default and not due to any legal relaxation in their favors."1 3.40 It has been estimated that a small scale industrial unit has to deal with about 20 governmental departments (both Central and State) and interact with about 50 inspectors. The number of reports and returns required to be submitted is much more. With respect to labor laws, there are about 45 Acts which are applicable to industries uniformly, irrespective of the size of the unit, involving about 30 inspectors from different departments.A There have been some efforts at simplification and in 1988 the Labor Laws (exemption from furnishing returns and monitoring registers by certain establishments) 2Report of the Comnittee Simplification of Procedures for Smatt Scale Industries. Ministry of Industry (Department of Smal ScaLe Industries, Agro and RuraL Industries), New DeLhi, December 1990. 21Ibid, page 5. 22Ibid, page 26. 40 Act (1988) combined returns for 9 different Acts. Nevertheless there is much scope for a further reduction of this administrative burden. In numerous discussions with small scale firms and in the survey work undertaken during the course of this study, owners were quite vociferous in their complaints of the regulatory regime and the negative Impact this had on their business. In many instances, entrepreneurs favored elimination of special dispensations and concessions for SSI, provided it was accompanied by an easing of the regulatory environment under which they operated and an improvement in the supply of basic infrastructure (power and suitable factory sites and buildings). In fact, considerable cynicism was expressed as to the usefulness of many concessions, given the administrative burden and time delays experienced in trying to avail of them. 3.41 The extent and need for government intervention in the promotion of industrial development depends critically on how efficiently relevant markets function. With perfect markets (notwithstanding income distribution issues) the best strategy is one of minimal governmental intervention. But in many developing environments there are failures in markets (e.g. factor markets--physical infrastructure, labor, human capital, science, and technology; and product markets--anticompetitive behavior by large firms in oligopolistic markets, lack of information and high transaction costs in marketing and infant industry "learning costs"), which are amenable to rectification by some form of intervention. The case for this intervention rests on three things: the nature of the market failure; the availability of market based solutions; and the ability of government to design and implement correct solutions, where market based solutions are likely to be absent or inadequate. These market failures are more likely to be partial and change over time, and will vary across countries. The important issue, however, is the ability to identify those governmental interventions that aggravate or contribute to these failures. It is apparent in India that many government interventions to assist SSI growth and creation, add to the burdens faced by new entrepreneurs and small firms. 3.42 In common with studies of SSI in other developing countries, small scale firms in India perceive major constraints in access to finance (particularly working capital), in keeping abreast of technological developments and in marketing. While some of these constraints reflect individual firm or entrepreneur characteristics, they also reflect weaknesses in the support systems external to the firm. Knowledge of new production techniques, requirements for new markets and methods for skill enhancement may be deficient in part because the information transmission mechanisms are weak. Whether this is a function of market failure or a policy induced environment is not always clear. Furthermore, the public sector role in effectively alleviating some of these constraints has often been misplaced or overstated. In Chapters 5, 6 and 7 of this report we examine in detail the financial systems available to SSI, the industrial extension services put in place to assist small firms and the extent of sub-contracting activities and how this activity may serve to alleviate some of the perceived constraints. 41 Conclusions 3.43 A considerable array of concessions and special incentives have been provided to SSI. The most significant of these are the production reservation of certain products, excise duty exemptions and a range of input subsidies. In terms of efficient resource allocation and the development of a dynamically efficient industrial sector, the production reservation and the excise duty exemptions are the most distortionary. The priority sector lending and subsidized interest rates for SSI borrowers have also had some highly negative effects (this issue is discussed more fully in chapter 5). Product reservation raises the profits (and the returns to labor) of existing large scale firms; causes prices to be higher and output lower and hence reduces consumer surplus and welfare. Product quality and technological growth have suffered, and components of certain industrial sub-sectors have been made more vulnerable to short term demand fluctuations. The irony is that the existing owners of the larger firms (and their workforces) may well be better off because of the capacity constraints imposed than they otherwise would have been without the policy intervention. As a 'esult, one of the objectives of an improvement in income distribution may have been diluted and undermined. 3.44 The present system of excise tax exemption has also had some negative side effects. As it is presently structured, it discourages small firms from growing into medium sized ones. This in turn has negative implications for developing an industrial sub sector that is competitive internationally and able to be an active exporter. Furthermore, this system of excise tax exemption has considerable fiscal costs, particularly given that about 40% of manufacturing output comes from SSI. 3.45 The case for special promotional efforts for SSI has rested upon assumptions about the relative factor input intensities between firms of different size categories. This view suggests that SSI are more labor intensive and capital saving than larger firms, and hence, better suited to the factor proportions found in a developing economy. Empirical evidence on partial factor productivities for many product categories in India supports this view. But this superficial analysis can be very misleading. Partial factor productivity can differ between firms for a host of different reasons (factor price differences, different rates of capacity utilization, degree of vertical integration, differences in product quality or specification). It is more sound therefore to look at total factor productivity, whereby all factor inputs are treated symmetrically, assuming positive opportunity costs for all inputs. When this is done, a much more variable picture of SSI technical efficiency emerges. As might be expected, for certain products SSI is efficient, simply because diminishing returns to scale set in very quickly. But utilizing aggregated data, this study found, of sixteen 3 digit NIC categories, 75% showed the larger firm (above fifty employees) to be technically more efficient. This finding, together with a host of earlier empirical work, suggests that the notion that SSI is equally efficient, with a different factor input proportion, should be treated with a great deal of sceptism and caution. 42 3.46 Rather than a whole range of special incentives and costly prohibitions, a more effective policy tool would be to address directly the many constraints and obstacles that confront the new entrepreneur and inhibit the growth of smaller firms some of which may be the result of market failure and some as a result of inappropriate government interventions. The regulatory and administrative burdens for industry in India are high, which adds to the cost of entry or expansion. More importantly the relative burden is greater on the smaller scale firms which have less administrative resources to deal with the burden. Deficiencies in basis infrastructure, education and vocational training, information transmission mechanisms and legal systems affect all firms by raising transaction costs. But this impact is not uniform across firms of different size classes. Larger firms are more able to deal with regulatory requirements (such as import licensing regimes), or, through already established market power, with infrastructure constraints (such as transport and telecommunications). 3.47 The whole incentive structure for SSI in India is in need of a thorough review. The production reservation policy should be phased out. The present system of excise tax exemption should be adjusted, possibly toward a time based system of partial rebate that encourages new entry, but does not discourage growth or the proliferation of "paper" companies. Raw material quota allocations for SSI represents a failure of market systems, and the appropriate remedy should be the removal of the underlying causes of the marker failure. Finally, although the large variety of input subsidies may not have a highly distortionary impact, they should be administratively adjusted to make them more transparent, and with a time based eligibility for each firm. 43 CHAPTER 4 SICKNESS IN SMALL SCALE INDUSTRY Introduction 4.1 As has been seen in earlier chapters, considerable policy attention has been directed toward the promotion and development of SSI in India. This effort has been a sustained and consistent one over the past thirty five years, and has spawned a variety of special programs and incentives designed to facilitate new entrepreneurship. That there has been considerable growth in the SSI sector (both in terms of new firms and in terms of output) is undoubted. What is not so clear, however, is how much individual incentives and specialized assistance programs have contributed to this growth, and how much stems from the general growth and diversification of the Indian economy. Of more significance perhaps, is an understanding as to the sustainability and viability of these small scale firms and whether, in fact, the policy promotion regime and the incentive structure are encouraging the efficient use of resources. 4.2 In every economic environment new firms emerge and disappear, and in a dynamic situation where technology, consumer tastes and factor prices are in a continual state of flux this even more is to be expected. Oftentimes, new entrepreneurs may endeavor several times to establish a firm before success is achieved, and much of the process represents an information and experience gathering exercise. Furthermore, this cycle of firm fortunes is not an unhealthy or detrimental aspect of economic development and growth, but rather a healthy signalling as to the appropriate and efficient allocation of economic resources. But, in an environment where the free movement of resources and factor inputs is inhibited (and of course in an environment that provides artificial protection to output and/or subsidizes inputs) unviable firms may linger for many years. Loans may not be repaid, adequate provisions for the replacement of the capital stock are not made and factor inputs used by the firm may be under-utilized. Ultimately of course, the firm will not survive, but the period of sickness may be a lengthy one, and in the meantime resources are locked up that could be more beneficially utilized elsewhere in an economy. Such a difficulty exists in India, where labor legislation makes closure of a firm difficult and a cumbersome legal system makes recovery of loans and firm obligations problematic'. 4.3 In this chapter we examine the phenomenon of sickness in the SSI sector, paying particular attention to the magnitude and character of the problem, whether this problem is becoming more acute and the likely causes that account for sickness amongst small scale firms. Before proceeding further, it would be useful to clarify some definitions. There is no recognized, single definition of firm sickness or insolvency, other than the 'For a more thorough examination of the adninistrative and legal impediments to firm level adjustments see World Bank, "India' Industrial Regulatory Reform*, Sector Report, May 1991. 44 closure and bankruptcy of a firm. Even in this latter instance, the decision for closure of a firm by its owners, or its creditors, is dependent upon both quantifiable parameters (erosion of net worth for example) and subjective assessments of future viability. The most operationally useful definition in terms of analysis of sickness in the SSI sector in India is that provided by the Reserve Bank of India. Guidelines issued by the RBI for use by commercial banks in sickness classification suggest that a unit should be considered sick if it has - incurred cash losses in the previous year and is likely to incur cash losses in the current accounting year; - accumulated losses equal to a exceeding 50% of its peak net worth in the immediately proceeding five accounting years. - continuously defaulted in meeting four consecutive quarterly installments of interest or two half yearly installments of principal on term loans; and - there are persistent irregularities in the operations of its credit limits with the bank. 4.4 Obviously, the criteria listed above can understate the extent of sickness, particularly for very small, unregistered firms who do not avail of borrowings from the commercial banks. Furthermore, it is not clear whether the number of classified sick SSI firms includes those that have borrowed from the State Financial Corporations, but not from the commercial banks. Nevertheless, while the number of sick firms may be understated, the trends shown in published data should be indicative of wider trends that might affect the whole small scale sector. Prevalence of Sickness 4.5 Perusal of Tables 4.1 and 4.2 suggests that sickness amongst SSIs that have borrowed from the commercial banking sector is a growing phenomena. The proportion of units classified as sick has increased from 2.6% in 1981 to about 10% by 1989. In terms of credit outstanding to the sector, the portion of the commercial banks SSI portfolio that is locked up in units that are classified as sick has increased from 9.1% in 1981 to over 16% in 1989. Analysis by the commercial banks suggests that the vast majority of the sick units are not viable. At the end of 1987, of the 204,259 classified sick units, 186,834, or 91%, were considered non viable. 4.6 Given the legal impediments to foreclosure and the sale of collateral by financing institutions, and the unwillingness of banks to write off non performing loans, the statistics on sickness are cumulative and may distort somewhat an assessment of its incidence. However, if we look at the incidence of new sick firms as a ratio to new borrowers, the trend suggests that sickness within the SSI sector is becoming more prevalent. This ratio has increased from about 6% in the early eighties to an average of 13.5% from 1985 to 1988. 45 TABLE 4.1 COMMERCIAL BANKS' ADVANCES TO 881 SECTOR (AS ON THE LAST FRIDAY OF DECEMBER 1981 TO SEPTEMBER 19891 (R. billion) As on.. Total SSI Sector Total Total % of % of Slok SSI Units % of % of lost :Amount Priority Bank column column Amount column column Friday of Outstanding Sector Credit 2 to-3 2 to 4 Outstanding 7 to 2 7 to 4 December (1) (2} (3) (4> (5) (6} :7) (9) 1981 39.53 108.02 290.91 36.0 13.6 3.59 9.1 1.2 1982 44.64 123.42 342.29 36.2 13.0 5.69 12.7 1.7 1983 53.89 148,81 412.92 36.2 13.1 7.29 13.5 1.8 1984 65.37 183.29 462.95 35.7 14.1 8.95 13.7 1.9 1985 78.29 216.31 528.42 36.2 14.8 10.71 13.7 .2.0. 1986 91.27 252,24 403,12 36.2 . 15.1 1.3.0 14.3 2. 1987 085 292.69 678.55 36.8 15.9 17.971 16.7 2.6 1988 129.68 325.63 721.74 37.8 17.1 21.4 16.5 3.0 September 1989 137.81 362.37 807.72 38.0 17.1 n.g n.a. n. Source: Report on Currency and Finance 1989/90 TABLE 4.2 NUMBER OF SICK SSI UNITS 1000'6 Ason Total Sick % of lest Friday Registered Unite Sick of Decormb.r SSI 1 (2) (3) (4) 961 25.34 2.6 1982 1050 58.55 5.6 1983 1238 78.35 6.3 1984 1455 92.38 6.3 1985 1642 117.78 7.2 1986 1877 145.78 7.8 1987 2227 204.28 9.2 198 2533 240.57 9.5 §gugg: Report on Currency and Finance. 1989190 46 4.7 Other indicators also suggest that the incidence of sickness and failure amongst small scale firms is not insignificant. A survey undertaken by the GOI in 1985 showed that of 7890 units selected, 1211 were found to have permanently closed (i.e. 15.35%) and of the remainder 6.1% were classified as sick2. A study undertaken in Tamil Nadu, found that at and March 1988, of 83190 registered small scale firms in the state, 24,517 units (29.5%) were found to be permanently closed'. Panel data on a sample of firms from 1975/76 and 1989/88 (i.e. a gap of 1; years) found 49% of the sample were no longer in existence, and of those that had closed 25% had closed in the first five years of operation'. Finally, data from the State Financial Corporations suggests that all may not be well with the SSI sector. For example, for the Anchra Pradesh State Finance Corponation the percentage of SSI borrowers in arrears has increased from 29.5% in 1984/85 to 34.2% in 1987/88, and of those borrowers in arrears 54.3% were overdue more than 12 montha. Finally, in a survey undertaken in the course of this study in Andhra Pradesh, of 422 firms approached, 125 were found to be closed (29.62%), and of those operating (297), 52 (17.51%) were found to be sick'. 4.8 Utilizing information from the aforementioned survey, some characteristics of sick via a vis healthy firms are contained in Table 4.3. By and large, sickness is spread across all product categories, although it appears to be slightly more prevalent in the services and rubber and plastics sub sectors. Sole proprietor-ships displayed a greater degree of sickness when compared to partnerships, but interestingly, private limited companies also displayed an above average incidence of sickness. From the sample, the incidence of si aness is much higher amongst smaller firms (i.e. those with a capital size below Re.100,000), and this observation is reinforced when the classification is by employee size. Also the incidence of sickness was considerably higher than the average for newer firms, that had been in operation less than three years. 4.9 In the large survey conducted by the DCSSI in 1985, a number of other interesting observations emerge as to the incidence of sickness amongst small scale firm6. Sickness tended to be higher in rural and backward areas; was more pronounced for those units that have obtained term loans and asistance to fixed asset formation than those that have merely obtained assistance for working capital; and was greater amongst units that have received assistance from the State Financial Corporations (and interestingly it was revealed that the incidence of sickness was higher in the case of units which have prepared project reports). It was also found that sick units tended to have higher investment in fixed assets; gave less importance to 20ffice of the Development Comissioner (Smatt Scale Industries), HDiagnostic Survey Regarding Sickness in the Small Scale Units", Ministry of Industry, New DeLhi, October 1985. 3M. Velmurugan, "Sickness in SSI Sector in Tamit Nadu: An AnaLysisu. SISI, Madras undated mimeo. 4Nayer, Reema, uAn Investigation into the Life Span and Growth of SmatL Firms in India",Mimeo, Brown University, March 1991. 5nA Study on SSI in Andhra Pradesh", WorLd Bank Survey, February, 1991. 6Office of the Development Conmissioner (Smatt Scate Industries). October 1985. 47 working capital in their investment structure; and had a greater reliance on borrowed funds. Furthermore, sick units tended to have a higher proportion of fixed assets to borrowed funds when compared to non sick firms (See Table 4.4). TABLE 4.3 COMPOSITION OF SICK UNITS* Sick Healthy % of total Product CategorV mp 1 1 Total 17.51 82.49 100.00 Services 20.80 79.20 16.16 A.Food Processing 10.07 83.93 18.86 Paper Products/Priting. .18.87 8$1 .13 17.85 Leather - 100.00 1.68 Rubber and Plastic 28.67 73.33 5.06 Chemicals 10.00 90.00 3.37 Machinery 17.39 82.61 7.74 Electrical Appliances 100.00 2.02 Electrical Machinery - 100.00 1.35 OtherlMisoellaneous 18.18 100.00 25.93 Tyo of Firms Proprietorship 19.59 80.41 68.67 Partnership 12.50 87.50 30.24 Private Umited 22.22 77.78 3.09 Cagital Size of Firm Below Re. 100.000 25.58 74.42 44.95 Above Re. 100,000 22.22 77.78 5.05 Age of Firm Less than 3 yrs 26.47 73.53 12.19 3 yre to 6 yre 17.19 82.81 22.94 Over 6 yrs 14.36 85.64 64,87 Type of Unit Non Ancillary 18.50 81.50 83.35 Ancillary 17.50 82.50 16.67 Wmooyee 1-10 21.85 78.15 87.84 Over 10 .14.81 86.1% 12.16 * Source: Survey undertaken by World Bank in Andhra Pradesh, February 1991. 48 TABLE 4.4 COMPARATIVE RATIOS - SICK AND NON-SICK FIRMS OCSSI SamolekI Fixed Assets/Total Investment 0.53 0.40 0.31 Working Capital/Fixed Assets 0.90 1.10 0.95 Outstanding Loans/Total Investment 0.34 0.17 0.28 Outstanding Term Loanstrotal Loans 0,30 0.27 0.26 Outstanding Term Loans/Fixed Assets 0.19 0.10 0.16 X1t Diagnostic Survey..... in Small Scale Units, DCSSI, New Delhi, 1985. \ Drawn from thirty interviews with SSI producers of diesel engines, leatherware and PVC pipes. 4.10 Given the above analysis, it is apparent that sickness within the SSI sector is a growing problem, which has important ramifications for the economy, employment generation and resource allocation. And, if the prevalence of sickness continues to expand, relative to the universe of operating small scale units, then some segments of the financial system could be severely prejudiced. It is useful therefore to explore some of the causes of failure and sickness amongst newly emerging entrepreneurs and small scale firms, and identify those factors, extant from the wider macroeconomic conditions and policy environment which effect all firms equally, which are amenable to change and, if adjusted, would improve the success rate of new firms and entrepreneurs. Causes of Sickness 4.11 The causes of firm failure are many and stem from exogenous influences, as well as factors endogenous to the firm. But it is important to recognize that the growth and failure of firwa is not a random process. A host of studies have been undertaken in India oa sickness in small and large firms, with a variety of reasons being put forward to explain the phenomena. Unfortunately, most of these studies have confused the causes of sickness with the symptoms of a failing business. For example, a very high inventory to sales ratio may be a function of bad inventory management, deteriorating product quality, a changing market environment or some other internal problems. Ex-post, all sick firms will have a high inventory to sales ratio, but it may not be true that bad inventory management is one of the causes of the sickness. 4.12 A problem cited in nearly all studies concerns the difficulties that small scale firms encounter in obtaining adequate levels of working capital. Interviews with failing small scale firms consistently raise this issue as a problem. But again, it is difficult to disentangle cause and effect. An ailing firm will encounter liquidity and working capital difficulties (as 49 sales decline, capacity utilization declines, inventories increase etc.), and furthermore, the entrepreneur will inevitably claim that with further access to working capital lines of credit, the firm's difficulties will be overcome. Despite this confusion however, the sheer frequency with which this factor arises in interviews, together with analysis of the system of credit and finance for SSIs, suggest that many small scale firms fail because of structural weaknesses in their initial financial composition and the fact that this financial structure focuses heavily on capital goods investment requirements, with too little regard to a new firms' working capital needs. This issue is elaborated upon in Chapter 5, which shows that the system of financing for SSIs, whereby investment and working capital financing may be obtained from two different sources (i.e. State Financial Corporations and Commercial Banks), does not lend itself to a pragmatic and realistic assessment of the total financing requirements of a new venture. 4.13 It has been shown from many of these studies (in particular the DCSSI study of 1985 and the RBI study of 1986), together with anecdotal evidence drawn from discussions with entrepreneurs, bankers and extension service employees, that the incentive and promotional programs designed to provide ready access to credit for new entrepreneurs aggravates the incidence of sickness. Econometric analysis (contained in Box 4.1 in this chapter) clearly reveals the importance of owner equity financing and its influence on the likelihood of failure or success of a small scale business. Of all the variety of influencing variables tested, the extent of owner financial involvement in the total firm financial structure was the most important positive influence on the probability of firm success. Given this finding, it suggests that many of the schemes that seek to provide the bulk, if not all of the equity for a new SSI venture (such as the Scheme for Self Employment of Educated Unemployed Youth), may not be sustainable and have a limited longer term development impact. Unfortunately, follow up analysis of these special schemes to evaluate entrepreneurship and firm success rates is not undertaken. 4.14 Newly emerging and existing small scale firms may be more prone to sickness and failure partly due to an inability to weather short-term business cycle fluctuations, and partly due to a poorer information base available to management. Establishment of a i-w firm involves a learning process as knowledge of the market, technology (both product and process) and other elements of the general business environment and how it affects a firm are acquired. Studies do show that the probability of exit falls with the duration of business (Nayer, 1991). The fact that firms fail is not in and of itself a great cause for alarm, certainly to the extent that these failures reflect movement along a learning curve that reveals inadequacies in market demand, changing technology or deficient management expertise. However, in an environment that provides public resources and inputs at concessional or highly subsidized rates, which in turn reduces considerably the entrepreneur's risk exposure and shifts this risk exposure to the taxpayer, then the issue of firm failure and sickness takes on a greater significance, particularly if its incidence is increasing. 50 BOX 4.1 CAUSFS OF SICKNESS AND FAILURE IN SMALL SCALE INDUSTRY Utilizing data obtained from a survey of 100 sick and 100 healthy firms undertaken in Andhrs Pradesh,. econometric analysis was used to investigate factors that could explain the incidenice of sickness within the crose sectional sample. A LQGIT probability modelling technique was utilized. The explanatory variables osefortesting are Iated below : Age of Firm .The hypothesis is that the longer a firm survives, the lower the probability of*U sickness. *. Equity Participation - The lower the debtlequity ratio, (the higher the owner equity position) the lower:the prDbability of slckness. This hypothesis-is based upon two broad suppositions: first the higher the owner's financial Input the greater the commitments to the venture and second, the higher the equity, the more able is the firm to weather business uncertainties and fluctuations. Customer Concentration * The hypothesis is that the higher the concentration of customers, the greater the chance that the loss of one will cause difficulties and sickness. Labor Quality - This variable sked owners to rank the quality of their labor force on a ten point scale in terms of skills, reliability etc. The hypothesis is the higher the perceived quality, the lower the probability of sickness, Product Reservation'-The hypothesis here Is unclear. Reservation could protect and hence mitigate against sickness, or it could promote excessive firm entry which would negatively affect individual firm capacity utilization and henceicrease the probability of firm sickness. Raw material availability- Regular supplies of certain key raw material (many of them controlled items such as steel and certain non ferrous metals) are a problem cited by many small scale firms. Hence the hypothesis tested is the greater the owner perceived difficulty in obtaining raw material (based on a ten point scale), the greater the likelihood of sickness. Power availability - The hypothesis followed is analogous to the raw material availability variable. A range of different functional forms were tried, examples of which are shown in the table below. The dependent variable is sick (1) or non-sick (0). 1 2 3 4 5 6 Variables Constant 1.192 2.517 1.655 -0.194 1.937 3MB (2.033) (3.8321 (2.562) (-1.076) (1.970) (2.974) Self Financing -0.015 -0.018 *0.016 -0.021 .0.018 C-2.696) (-2.945) (-2.637) (-2.686) (-2.772) Labor Skill -0.203 -0.132 -0.205 -0.121 -0.162 (.3.131) (-2.007) (-2.925) (*1.367) (-2.356) Product Reservation -0.528 -0.292 (-1.5341 (-0.743) Raw Material 0.131 -0.106 -0.160 0.101 (2.346) (-1.938) (1.986) (1.656) Power Availability 0.089 0.019 (1.360) (0.235) Customer Concentration 0.435 -0.005 (0.986) (-0.734) Age of Firm . -0.061 (-0.408) Log UkellhoodV -112.382 -102.77 *109.83 -102.52 *85.589 -95.351 Note Items in parentheses represent the 't statistic. 11 This measure is equivalent to an unadjusted R' in an ordinary least squares regression. The higher the log likelihood, the higher the predictive value of the equation. This can be adjusted to derive a Count R2. by looking at the proportion of correct predictions of the estimated equation (see G.S. Maddale, Introduction to Econometrics, Macmillan Publishing Company, New York, 1989). 51 BOX 4.1 (continued) From the variety of functional forms triei, some clear results emerge. The extent of owner financing in 6 small scale firm appears to be a significant determinant-of the probability of success of an mtegiseo This variable was significant it all the functional forms. In additio, labor quality and skills was also a key factor i avoiding sickness. Problems with raw material and power availability did not appear to be uignifident influences on the health of the smalt firms in the sample. Also product reservation did not emerge as significent,aithough in all cases the sign'of the coefficient suggested an inverse relationship between sickness and produot:reservation.. That Is, the likelihood of sickness seems less for those firms producing a product reserved for the mamll scale sector. 4.15 Diagnostic surveys (DCSSI, 1985, RBI 1986, Tiwari Committee 1984,FICCI, 1988) all reveal that a major cause of sickness within the SSI sector is internal managerial deficiencies. Furthermore, other reasons cited (lack of adequate market, inadequate technical expertise and obsolete production processes, raw material and/or infrastructural constraints) suggest that initial project appraisal or feasibility analysis is deficient. A large share of the blame for this rests with the financing institutions, and to some extent those parts of the public sector's extension services who are tasked with providing technical advice and assistance to newly emerging entrepreneurs. This is not to imply that the financing institutions, or the extension services must take responsibility for firm success or failure. But, in the first instance, insistence on a thorough feasibility analysis, together with a proper financing plan that shows cash flow requirements (which clearly indicates working capital needs) over the life of the investment, under varying assumptions about expected sales performance, should be a fundamental requirement before any loan is sanctioned. In the second instance, if the entrepreneur, who might have an adequate technical or production background but lacks adequate financial expertise, then a properly staffed extension service could provide assistance in this project appraisal function on a cost recovery basis. These issues are covered more deeply in the following two chapters. Conclusions 4.16 Evidence does suggest that sickness is becoming a more serious problem within the small scale industry sector, which has serious implications for the financial sector. While there may be factors exogenous to the firm that are contributing to this problem (factors such as infrastructure constraints, raw material shortages, excessive regulation, and frequent changes in government policies, for example), by and large the main causes appear to be endogenous to the firm. This in turn reflects deficiencies in the financing of small firms and in their access to managerial and technical advice. In many instances, firms are weak or sick at inception due to inadequate project planning and appraisal. And, in this regard the promotion and incentive structures may be stimulating excessive entry of non-viable firms. Ready access to finance and subsidized credit, without an adequate level of entrepreneur equity involvement, invites failure and default. 52 4.17 From a public policy perspective, the emphasis must be on the prevention of sickness and less on the rehabilitation of sick firms. This means improving the quality of lending to the SSI sector, and targeting extension and advisory services at the pre-investment stages of a new firm cycle. How this may be achieved are elaborated upon in the next two chapters. 53 CHAPTER 5 FINANCING SMALL SCALE INDUSTRY Introduction 5.1 The rapid growth of small firms and the increasing trend towards sophistication and modernization in manufacturing and services has resulted in a need for larger flows of credit to small and medium enterprises around the world. With weak capitai structures and limited or no access to the capital market, small industrial units often find it difficult to meet their working and investment capital requirements. Normal commercial banking channels frequently regard the small units as poor risks due to lack of demonstrable creditworthiness. The emergence of a new class of entrepreneurs, whose only recommendation for loans is their technical knowhow, has exacerbated this problem. It is in this context that the need for provision of increaped credit to the small sector ha.s ausumed importance in both developing and industrialized countries. 5.2 India decided shortly after independence to address the credit needs of small firms and new entrepreneurs by directing commercial banks (CBs) to set aside a proportion of their lending for SSIs as part of so called priority sector lending to satisfy the remaining long-term requirements, over and above the entrepreneurs own equity injection. India's Union and State Governments also created the State Financial Corporations (SFCs) and the State Industrial Development Corporations (SIDCs)'. While some of these institutions also furnish limited loan finance for working capital, the State Bank of India (SBI) and other commercial banks provide the bulk of medium-term finance, and take care of most of the working capital requirements of small units2. Growth of official Financial Intermediation 5.3 India has developed a wide ranging net of financial institutions, which - with the exception of the commercial banks - specifically cater to SSIs. Chart 5.1 highlights the rather tight compartmentalization of the system. On top are the two major public sector institutions, one supplying mainly short-to-medium term credit (CBs) and the other catering almost exclusively to long term credit (SFCs). These intermediaries have different apex institutions witb different government connections, making it difficult to unify guidelines for asset and liability management as well as accounting 'The latter's involvement in SSI financing is limited to providing seed capital which they adninister on behalf of the Industrial Development Bank of India (IDBI) and its subsidiary, the Small Industry Development Bank of India (SIDBI). There are, however, nine SIDCs in the smater states (mainly the North-eastern Region) which have been extended recognition as SFCs by IDBI for the purpose of extending financial and other developmental support to SSIs. 2A considerable amount of credit to small enterprises is undertaken in the informal sector as discussed below. In addition, two extension service institutions, NSIC and the SSIDC, are offering credit in specialized areas such as hire-purchase, leasing and the financing of receivables for sales to the public sector. They are examined in greater depth in Chapter 6 on Industrial Extension Services. 54 rules and regulations. 5.4 There are also two types of specialized credit institutions, the National Small Industries Corporation (NSIC) and the State Small Industries Corporation (SSIDCs); but they are actually more part of the extension services. A new source of financial support which comes first and foremost as equity or as conditional loans, is delivered by venture capital companies, whose customers are new small firms, mainly in high technology areas. Finally, there are private sector intermediaries, most of whom work in the informal sector, and therefore require substantially higher interest rate premia. 5.5 It is apparent that the type and the form of credit provisions by the various financial intermediaries is molded by the institutional framework in which they are operating. Similarly, the legal and institutional framework governing the two major sets of credit granting institutions affect the SSIs in their demand, use and repayment of loans. 5.6 Commercial Banks - Flow of Credit to SSI Sector. Until independence, commercial banks in India confined themselves to the financing of working capital requirements for trade and medium-to-large industry. Since the banks were operating with short-term deposit funds, they were reluctant to go in for industrial finance on a medium and long term basis, as the perceived risk in that type of lending was high, especially in the case of lending to small scale industry. In successive development plans in the post-war period, the Government of India identified small scale industry as a priority sector for commercial bank lending and required banks to increase their exposure to SSls. Soon after the nationalization of the most important commercial banks in the 1960s, the share of SSI sector loans amounted to only 5% of total bank credit. It was increased to 7% in 1968 and 12.4% in 1980. Currently, lending from commercial banks to the SSI sector comprises about 15.3% of the total outstanding credit and about 40% of the credit to priority sectors. The total outstanding credit to SSIs from commercial banks as at March 31, 1989 was reported to be Rs.131 billion, out of which SBI accounted for Rs.36 billion. Credit by way of term Loans of Re.18 billion to the SSI sector from commercial banks accounts for the around 14% of the total credit to this sector. As Table 5.1 indicates, moet of the growth of credit to SS7s was at the exper3e of the credit share going to larger firms. On the other hand, other sectors such as agriculture received "priority credit" at an even faster rate than SSIs. 55 TABLE 5.1 SECTOR DEPLOYMENT OF COMMERCIAL BANK CREDIT (Outstanding as of March 31) (Rs. billion) YEARS 1976 1980 1985 1989 1990 1991 Tgtid Cammorisal 2MMk C .dt 212.4 JZ% 10 i2.7~ 1177.2 Priority Sector Credit JgI 26.9 67.3 184.1 342.1 403.8 428.8 %)(24.5). 431.7) A38. (39.9) (39.31, 438.41 Small Scale Industry 11.8 26.4 66.1 131.3 155.4 171.5 (%) (10.7) (12.4) (13.8) (15.3) (15.1). (14.6) Medium & Large Industry 49.0 82.7 159.4 321.6 382.6 444.3 (%) (44.6) (38.9) (33.2) (37.4) 437.3) (37.7) Figures iri brackets idicate percentage share in total commercial bank credit At Include agricultural and SSI lending Source: Report on Currency & Finance 5.7 The share of total bank credit that has flowed to the SSI sector has risen by fifty percent in the last fifteen years; however, this share has stabilized at about 15.0% over the past three years. The share of advances to the medium and large sector showed a declining trend throughout the sixties, seventies and eighties, and only in the last three years has this declining trend been arrested. The vast bulk of commercial bank lending to SSIs is of the shorter period, working capital type, accounting for 86% of the total. Total term loans from the commercial banks to the SSI sector comprise about 50% of the total extended by the SFCs. Within the commercial banking sector, lending to SSI is dominated by the State Bank of India (SBI), which accounts for over one third of the total commercial bank credit to the sector. While separate term loan figures, and their analysis, are not available, SBI is reported to be meeting 50% of the term loan finance flowing from commercial banks to the SSI sector. 5.8 A size-wise analysis of available data indicates that the vast majority (nearly two thirds) of the lending is directed to units receiving advances of up to Re.1 million, 17% for advances ranging between Re.1 million and Rs.2.5 million and the remaining 20% are beyond Rs.2.5 million. This structure reflects the fact that 75% of the SSI units are very small, managing assets of less than R9.500 thousand (i.e., less than the equivalent of US$20,000; 43% are below US$5,000). While interest rates are fixed, the analysis of interest charged by the commercial banks on advances to SSIs shows that less than 8% of the advances were made at rates ranging from 6% to 12%; 20% were in the range of 12% to 14%. Similar to interest charged for loans to medium and large industry, two thirds (62%) were in the range of 14% to 18% and over. The weighted average was close to 14%3. 'For a slightly higher estimate see Table 5. 56 Chart 5.1 Current Financial Infrastructure for SSIs Ministry f IDBI Finance RBI R'Stt Govts. SIDBI Refinance, Refinance Bond- Commercial SFCs Banks' External Protection Domestic Policy/ Incentives Venture Capital Companies -------Extension Service ICICI, UTI, Informal \ (rgNICn IDBI, IFCI Credit \SSIDCS) Markets Publio Institutions Private Institutions CAK\W49306AA 57 TABLE 5.2 SHARE OF SMALL INDUSTRY BY DIFFERENT INTEREST RATE OUTSTANDING LOANS AND ADVANCES /a OF SCHEDULE COMMERCIAL BANKS AS OF 31 DECEMBER 1988 Rs. billion) Total Loane & Share of Small Advances Industry Seator Outstanding Amount Percentage l1terest Rates Outstanding Share 6% and less 13.8 0.2 0.3 6% -12% 63.7 5.6 7.4 126 15% 151.8 28.1 37.2 15% .17% 1it.3 36.3 48.1 Over17% 45.4 5.3 7.0 465.8. 75.5 100.0 1 Relates to accounts with credit limit over Re.25,000 Excluding Bills discounted gg RBIa Banking Statistics: Bank Credit Provisional Estimate December 1988 5.9 After having rapidly expanded their SSI credit during the 1970s and early 1980s, commercial banks have become much more hesitant to increase further. This is particularly true of term loans for which the SFCs continue to be the main provider to the SSI sector. One of the reasons for commercial banks' reluctance to step up lending to SSIs seems to be the classification of SSIs as "priority sector" and the ceilings on interest chargeable. The priority classification served its purpose when the lending base was low. Most of the large banks have surpassed the priority lending target of 40% and now prefer to lend more to commerce as well as to medium and large industries where transaction costs are less, yields are higher and perceived risks are comparatively low. If the cemmercial banks are to be induced to step up their lending to SSIs, it would seem that restrictions and regulations must be decreased and relative profitability increased. 5.10 State Financial Corporations. Established under a special Act in 1951, the State Financial Corporations (SFCs) have become the most important channels for term credit to small and medium scale industries in the country operating in their respective states or union territories4. SFCs provide financial assistance of up to R9.6 million to projects which may cost up to 4Some of the SFCs as in Assam, Delhi, Maharashtra, Tamit Nadu and West Bengal also cater to the requirements of the neighboring states/union territories which do not have SFCs of their own. In all, there are 18 SFCs. 58 Rs.30 million each, singly or jointly with SIDCs and commercial banks5. While the SFCs are empowered under the Act to subscribe to equity shares of borrowing companies, they actually have not been participating in equity. SFCs do, however, operate the IDBI sponsored Special Capital and Seed Capital Schemes, which provide equity support to industrial projects. TABLE 5.3 SANCTIONS AND DISBURSEMENTS OF SFC LOANS (Rs. billion) Year Loan (April-Match) Sanctions Disbursements Outstanding at Year end 1984-85 7.78 4.96 21.44 .19886 10.30 6.06 25.49 1986-87 12.44 7.84 30.52 A9g:74 13.52 9.34 37.22 1988-89 14.69 10.48 44.42 Cumulative up to March31, 1989 85.20 63.00 47.20bl i Estimated Source: IDB, Data on Operations of SFCs. Bombay. 1990. 5.11 Most of the SFCs have been in existence for over three decades and have not only served the needs of small scale industrial units but also small road transport operators (SRTOs). As Table 5.3 indicates, their assistance to the small scale industrial sector doubled in absolute terms from 1984 to 1989, but so did the credit to transport enterprise, with the shares of these two groups in total financial assistance remaining nearly constant (75:25). The size-wise classification of assistance from the SFCs shows that about 85% of the units assisted accounted for loans below Rs.0.5 million each. Actually, 40% of the units received loans up to Rs.50,00O each. Thus, the "tiny" sector continued to be the major beneficiary of assistance by SFCs by numbers of firma receiving credit. However, 60% of the total assistance in Rupees sanctioned went to 10% of the projects, with loans above Rs.1 million each. 5.12 While the seventies and eighties saw a quantum increase in SFCs' business, the growth rates varied from one SFC to another, ranging from a low of 5% in Orissa to a high of 52% in Kerala. Moreover, the rapid expansion of most SFCs hid an ever more serious collection problem. Recovery of dues out of current demand and overdues has not kept pace with the growth in sanctions and disbursements achieved by the Corporations. Table 5.4 gives both the 6The SFCs Act empowers 1DBI to authorize SFCs to extend term toans beyond Rs.6 miLion up to Rs.24 miLlion. This provision is seldom used however. 59 average and the range of the current recovery performance among SFCs, net of suit-f.led cases and after rescheduling. Current SFC recovery was low at 55% in 1987 and declined further to less than 50% in 1989. At the same time, the variance among the 18 SFCs recovery records increased, signaling trouble in a rising number of very poorly performing SFCa. Total recovery performance was worse, with data provided by one institution showing an average of around 40% and more recent detailed studies of a sample of SFCs putting that average closer to 30%. Whatever the actual rate, there is now widespread recognition that the recovery rate for most SFCs is extremely low, has worsened in recent years, and, if not urgently corrected, could have very serious repercussions for the whole financial sector. TABLE 5.4 RECOVERY PERFORMANCE OF SFCs Current Recovery Falling Due 1907 1988 1989 Average 55 so 49 Minimum 35 22 20 Madmum 82 81 80 Standard Devlation- 14.8 .6.8 18.1 Source: Computed from IDBI, "Institutional Aspects of Small Industry Lending in India," Bombay, 1990. 5.13 These institutions are allowed by Section 29 of the SFCs Act of 1951 to take possession of the assets of defaulting units and/or effect changes in management of the units. Out of 18 SFCs, 13 SFCs have reported that Section 29 has been used for helping recoveries7. SFCs used both options available under Section 29, viz., taking possession and sale of assets as well as change of management for realization of their dues. In spite of these actions, slow recovery of loans remains one of the major problems facing the SFCs. The government and monetary authorities are aware of these difficulties, and over the past five years a variety of studies and special OS. Patia, "InstitutionaL Aspects of Small Industry Lending in India,, Bombay, 1990. P.S. Srinivasan et at., "Review of Financial Results and Performance of Selected State Financial Corporations" Bangalore, A.F. Ferguson 1991. Both of these documents have served as major background paper for this chapter. ?The Dethi SFC found it most effective while the West Bengal SFC has reported that disposal of assets taken over under Section 29 is difficult, as borrowers take the matter to courts. WhiLe some SFCs used Section 29 on a large number of defaulters (Karnataka - 667 units, Maharashtra * 253 units, A.P. - 115 units), others had been selective (M.P. - 30 units, Punjab - 14 units, Bihar - 57 units). 60 committees has identifiec. the major shortcomings of the SFCs. However, little in the way of remedial action has been forthcoming. 5.14 In 1984, a committee was appointed to examine the financial structure of SFCs, with a view to improving their resource base through recoveries and recycling of funds, a balanced debt-equity ratio, and an adequate debt-service coverage. It was observed then that SFCs reliance on refinance borrowing from IDBI was excessive (65% to 70%). Refinance, being a back-to-back facility, strained the debt-servicing ability of SFCs, as the recovery of dues from the borrowers did not match with the SFC's obligation under the refinance scheme. The Committee recommended reduction in refinance with a corresponding increase in longer term funding for SFCs either through share capital or an appropriate long term instrument. The Committee then suggested the following pattern of resource-mix for meeting the future disbursement needs of SFCs: share capital 10%; refinance and others 55%; bonds (net) 25%; and internal generation 10%. Apart from improving the earning capacity of SFCs, the suggested resource-mix was expected to improve the liquidity and debt-servicing capacity of SFCs. 5.15 IDBI and SIDBI Assistance to the Small Scale Sector. IDBI has played a key role in increasing the flow of financial assistance to the SSI sector. While the bulk of assistance is channelled through various refinance schemes, IDBI also supports the sector through special seed capital schemes, as well as equity/bond support to SFCs. This type of assistance increased significantly from a level of Rs.260 million in the early 1970s to Rs.1.26 billion in 1976-77, to Rs.4.20 billion in 1980-81 and to Rs.9.21 billion in 1984-85. In 1988-89 (July-March) assistance to the SSI sector amounted to close to Ra.15 billion (or Re.20 billion on an annualized basis). As a result, the share of small scale sector finance in aggregate IDBI financial assistance to industry, has increased significantly from 19% in the early 1960s to over 30% in the late 1980s. 5.16 Supporters of the current level of IDBI involvement in SSI lending have argued that there are a number of possible advantages which flow from the operation of the Refinance Scheme. Among them is the notion that the appraisal standards of primary lenders have improved over time due to the secondary appraisal done by IDBI for proposals beyond Ra.0.75 million. This is not borne out by the recovery performance which has become worse overtime. On the other hand, critics have maintained that refinance by IDBI of loans given by primary lenders adds to the transaction costs, which is a particularly crucial handicap in a sector in which the yield to the primary lender and to IDBI are restricted and margins are low. 5.17 With the priority given to the SSI sector in the Seventh Five Year Plan, and to further finance the already impressive growth of this sector, IDBI set up the Small Industries Dsvelopment rund (SIDF) in 1986, with the principal objective being to provide a focal point which would coordinate the availability of financial and non-financial inputs required for the orderly and healthy growth of the SSI sector. After setting up SIDF, IDBI identified a wider target group (women entrepreneurs, ex-servicemen) for finance under the Refinance/Seed Capital facilities, extended assistance for setting up 61 Quality Testing facilities and increased the flow of assistance to extension service organizations like SSIDCs and NSIC. Out of the creation of SIDF came the Small Industries Development Bank (SIDBI) as a wholly owned subsidiary of IDBI in 1990. 5.18 SIDBI has taken over several functions of IDBI, providing SSI financial assistance through the Refinance and Bills Rediscounting Schemes. However, IDBI will continue to exercise supervisory functions over institutions like the SFCs, the SIDCs, the TCOs (Technical Consultancy Organizations), and the EDIIs (Entrepreneurship Development Institutes). The immediate thrust of SIDBI will be on: a) developing of cottage and tiny industries, especially in semi-urban areas to create more employment opportunities and thereby check the migration of population to urban areas; b) initiating steps for technological upgradation and modernization of existing units; c) improving their competitiveness in domestic and overseas markets; and d) expanding the channels for marketing their products in domestic and overseas markets. 5.19 SIDBI has ambitious goals to expand the growth rate in the flow of financial resources to the small-scale sector, and its management has targeted an increase in sanctions and disbursements of 20% in FY91/92. To achieve this it will need to expand significantly its own resource base, and SIDBI has plans to raise funds through domestic market borrowing, under the umbrella of its parent IDBI. Given that the financial viability of many SFCs is in doubt, SIDBI should be highly cautious and not engage in an active market borrowing program until remedial measures have been undertaken within the SFCs and their collection performance improved. This issue is discussed further in the latter part of the chapter. Informal Credit Markets 5.20 In India, as in most other Asian ':ountries, there exist highly diversified and dynamic informal cred.t marh ts, in both rural and urban areas. Informal finance plays a particularly important role in channeling credit to small scale borrowers, underpinning the credit requirements of a large section of economic activity. It constitutes an important source of working capital for enterprises of all sizes, and serves to counteract a number of inefficiencies in the allocation of formal sector credit. While there are no official statistics available, it would seem that the informal sector has also been able to mobilize considerable savings. 5.21 Recent studies have estimated that the share of informal credit in the country-side and in urban areas is about 73% of gross bank credit available. The bulk of credit is in the form of trade credit and is particularly important in the garment and textile sectors, and wholes4le and retail trade. Excluding trade credit, informal intermediation is estimated to account for about 18% of total advances. While the share has been declining 'Das-Gupta, A "Report on Informal Credit Markets in India" (Report prepared for the Asian DeveLopment Bank) New Dethi: Instituted of Pubtic linance and Poticy, 1989. 62 in agriculture, and is below the shares of that type of credit in other Asian countries, it has remained an important source of finance not only for farmers and households, but also for small industrial firms which could not function without informal credit arrangements. About 55% of SSI credit is drawn from the informal credit markets. 5.22 For various industrial activities, the most important source of credit is often that emanating from trading companies in specific sub-sectors. The existing trade credit network in textile distribution highlights the flexibility of the informal credit system. According to the above mentioned study, textile wholesalers paid in cash for over 50% of their purchases from the mills, while credit they received was for an average of 31 days, whereas the credit they.extended was for an average of 55 days. Semi-wholesalers, who constitute the next rung in the distribution ladder and whose main function is to reduce the search costs of retailers in their regional sub-markets, are also net suppliers of credit, but to a more limited extent, financing 67 percent of purchases on an average of 48 days of credit and 77 percent of sales on an average of 57 days of credit6 However, their inventories represent twice as many days of sales as that of wholesalers. While maintaining eren higher inventory in terms of days of sales, retailers are net users of credit, acquiring 55 percent of purchases on credit for an average of 51 days, while selling either on cash or very short term credit. 5.23 A somewhat different system operates in the footwear industry, where the chain of supplier credit starts at the input side of the small leather manufacturer and ends at the final retailer. In both cases, the advantage for the borrower is obvious, since he or she is not hampered by regulations imposed by the formal credit agencies regarding capital, reserves, liquidity and audit3.ng requirements. In addition, it has become known that informal intermediaries can tap large reservoirs of private savings relatively easily. 5.24 Two factors have helped to keep informal credit thriving: so called "black money" in the informal sectors of the economy and excess regulations in the official banking system, which has to deliver "priority credit" to the small scale sector. In the first instance, the increasing amount of income which is hidden from taxation in India finds an ideal outlet in unregulated credit markets in the small scale sector. Secondly, in spite of being targeted as priority credit, and while official flows have kept pace with increased output and exports of SSIs, many of the still smaller firms use informal credit. The reason would seem to be less in the area of overall availability of that type of credit than the unwillingness of the customers to contend with the regulations and rules of the official financial institutions. 5.25 Since informal credit markets are still highly fragmented (which of course is one of their strengths as their knowledge of the customer base is very high), reliable information on interest rates is difficult to come by, especially since non-price competition plays an important role. As Table 5.5 indicates, the interest rates charged by private finance corporations and the hire purchase companies were significantly above the average commercial bank lending rates, with the gap increasing during the second part of the 1980s. The interest charged by the shroffs (i.e. the traditional group of money 63 dealers and lenders in Western India) were lower than the other intermediaries, but the gap between their rates and the bank rates also widened. 5.26 The informal credit markets in IndiA, with a few exceptions, tends to be more efficient than the more highly regulated formal sector. Establishment costs are low and default rates are much better than that found in the commercial banko or SFCs. Estimates of bad debts in the informal sectrr range from 5% to 10% of earnings, with collection rates in excess of 90% The study cited above (footnote 8) found informal sector credit was not expioitative, despite higher interest rates, and was welfare improving, particularly for the economically weaker sections. Furthermore, with regard to the provision of informal finance in the textile distribution system, the study found this to have positive inter-regional distribution effects. Finally, the study found that informal loans showed greater diversity and readier adaptability to borrower convenience, with much speedier credit assessments and loan sanctioning procedures'. 5.27 The informal finance system has an important role to play in a number of sub-sectors of India's SSI activities. It seemingly has increased credit availability to quite a number of small enterprises, which have been neglected by the official system or found it easier to borrow from an informal source, even at substantially higher costs. While informal credit is still too fragmented to substitute for official funds in India's credit markets, it would seem that a policy of lesser regulation, increased competition and open promotion of the linkages of the two sources of credit should benefit all sectors. OIt is worthwhite citing a quote from a more general study of finance in developing countries: "Specificatty, financial repression and the ensuing credit rationing worsen income distribution and increase industrial concentration. The evidence presented .....indicates that subsidized credit policies discriminate against rather than favor smaLl borrowers", N.J. Fry, Money, Interest and Banking in Economic Development, John Hopkins University Press, Baltimore, 1988, p.165. 64 Box .1 FACTORING SERVICES As was seen In Chapter 3, one of the more difficult constraints facing SSt* In India (and for newly emergent entrepreneurs in al environments for that matter) is the management of working capital. Inevitably. small firms, with limited credit histories, and narrow pioduct and customer bases, are perceived as higher risk borrowerfend hence face difficlides in acquiring adequate levels of shorttrm working capital finance. Moreover, working capital difficulties are often a result of Insufficient levels of squity Iastment in the firm and 'aak of appreciation by the new entrepreneur of the o aehfl cycle. of the proposed busnesa ctity. In part, these problem* can be minimized if there is adequate consultations between theo rm lending Institutions, the short-term lenders and the entrepreneur which culminates in a realistio assessment of the venture's future cash flow and the working capital requir -ntent that will stem from this. As we have seen In this chapter, the institutIonal framework-and structure for rending SSIs Is highly deficient In this regard, with a lack of adequate coordination between the various parties involved in providing finance to the small scale sector. Improvements in,this Institutional structure and coordination should reduce some of the working capital difficulties, but there are other services that the financial system could provide which could also have a major impact. One of the more .Important of thse.ls the prevision of factoring services, where a firms open account credit sales are purchased. or collected by specialized agencies. It is a common concern expressed by many SSIs In-India, that payment for- supplies of goods, particularly to medium and large purchasers, suffers 1ordinste delays. Furthermore, these small firmy fel constrained i pressing their clalime for payments of goods supplied, or charging penalties for overdue receivables. because of fears of prejudicing a market. relationship in which the large buyer constitutes a large proportion of the market share of the smaller seller. With market interest rates in excess of 20% (above 8% in real terms). even to large corporate borrowers, the Incentive to extend the period before payment of open account payables is very high. This problem occurs throughout the SSI sector, and involves both public and private sector medium and large firms. It le particularly acute for those SSIs involved In ancillary relationships, where the seller may only have one buyer. The Govermnt of India, has recognized some of these difficulties, and In early 1988 convened a Study trtsp to excamne the issues related to starting fatoring organizations in India. A report wee submitted to December 1988*, ari confirmed the reed and feasibility of establishing eueh activitiesin the country. While It found tht existing faw (Seiddon 13.0 of the Transfer of Property Act. 18821covers debts that are actionable arir t t Wan found that existing laW has "o express tulet with regard to. pilorities between successive assgvnents of the same debt and that there was no law restricting the Introduction of a stipulation In the contract of Sal of Goods and $ervices that prevents the creditor assigning the debt to someone else. In this later case, a *powerful" buyer may be able to Insist on such a stipulation and effectively deny the selfer the advantages of factoring. This possibility does not occur in the U.S.A (or Europe) as the Uniform Commercial Code prohibits such an inclusion. A further problem Inhibiting the Introduction of ^actoring services in India, Is that the various States levy a stamp duty (ranging from I to 2%) on the value of transferred assets, including assigned debts. Given that factoring services operate with narrow margins, this stamp duty constitutes a major obstacle to the establishment of such services. The State Bank of India, together with the SIDB. have recently launched SBI Factors, to operate in the Western region of the. country with an equity of Rs.250m. Other Banks are looking to the possibility of launching such services In other regions of the country. This Is a welcome development, as not only will this improve the efficiency of open account trading practices. and hence assist In overcoming lquidity problems in the. SSI sector,. but as the necessary firm data bases are established, It will encourage a more efficient credit performance reporting system which wi benefit all those engaged in the buying and selling of goods. Despite the above developments however, the full range of factoring services, most notably assignment of debts without recoutse to the sellet, is still not possible because no actions have been taken on the legal and stamp duty impediments cited above. As such, much of the proposed factoring services are more akin to debt collection agencies, which fals short of what is needed. Given that factoring services are complementary to other banking and financial services, and that this facilitates more efficient working capital management for SSie in particular, the necessary legal amendments should be enacted. Finally, it is envisaged by the financial regulatory authorities (and recommended by the Kalyanasundaram Report, cited above) that Factors should only be allowed to operate on a regional basis drawing clients from within a specified region. This Is a needless restriction and could Inhibit the development of the full scope of factoring services, particularly for those medium and large scale clients with multi-plant operations throughout the country. Put simply, factoring firms and services should be allowed to establish and operate anywhere the investors believe their business could 65 TABLE 6.6 INTEREST RATES OF COMMERCIAL BANKS AND INFORMAL FINANCIAL INTERMEDIARIES TO SSI UNITS (Percent per annum) Year Commealat Finance Hire Purchase Shroffs Banka. Corporations Companies 1970-71 9.3 NA 18*30 15 1980-83 16.5 18-31 NA 18 1984-85 16.5 22-36 36 NA 1986 17.5 32-37 38 NA 1988 16.5 NA 38 21 Source: Des Gupta, A *Report on Informal Credit Markets in India" (Report prepared for the Asian Development Bank) New Dethi: Institute of Public Finance and Policy. 1989. Policy Issues 5.28 The evaluation of the most important financial intermediaries supporting SSI has shown that there are a host of issues, many of which are a reflection of wider difficulties within the financial sector in India. This is particularly true for the commercial banks, the problems and prospects of which have been examined in a number of financial sector reports by the Bank0. Given the desire to broaden the base of entrepreneurship, encourage a more equitable distribution of the ownership of capital, and expand the industrial coverage and range of small scale firm activity, many of the policy foci introduced forty years ago were appropriate. The coverage and network of financial intermediation was inadequate (as was the network of industrial extension services and the pool of technical talent) with many imperfections in the systems for the provision of financial capital. Therefore, on both political and social arounds, as well as economic, there was ample justification for some of the institutional frameworks established. It is apparent forty years on however, that economic, political and institutional environments have changed, and the existing systems and structures may have lost some of their relevance. More ominously, some of these systems and structures may now be retarding and inhibiting achievement of the broad policy objectives set for SSI in the early 1950s. It is necessary now to look more critically at the economics of financing SSIs; the adequacy of the total flow of financial resources going to the sector and the role that financial sector subsidies play in benefitting new and existing small scale firms. 5.29 Among the many issues hampering the efficient operations of financial intermediaries, one can broadly differentiate between exogenous and endogenous constraints. In the first instance, laws and the rest of the institutional framework surrounding the financial intermediaries on the one hand and a number of macroeconomic and financial policies on the other have loSee for the most recent assessment: IBRD, "India: Financial Sector Report #8264-IN, Washington, D.C., 1990. 66 been crucial in shaping the operations of the financial institutions. The commercial banks and SFCs have had little influence on that environment. In the second instance, there are a great number of problems which are firm specific. While analysis of balance sheets, loan portfolios, appraisal and supervision methods and procedures reveal a vast degree of difference among institutions, many problems are shared by the majority of them and suggest common deficiencies. 5.30 Supoly. Demand and Costs of sSI Credit. The discussion of the lending activities of commercial banks and SFCs has shown that credit to SSIs has grown rapidly in the last decade, outstripping output and investment growth by a wide margin. Statistics on SSI units assisted are even more impressive. While just over 1000 units had recoived loans (from IDBI through SFCs) in the late 1960s, that figure had increased to nearly 20,000 by the mid-1970s and over 225,000 by the late 1970s and early 1980s. An earlier survey by the Reserve Bank of India concurred with this assessment. However, it maintained that the proportion of units benefitting from financial assistance in relation to total registered SSI units had remained small. Furthermore, it confirmed our earlier observations that reliance on institutional sources increased with the size of the units. Finally, it was made clear that the informal sector had played an important role in providing relatively expensive but stable amounts of needed credit". More recent field research in two industrializing areas in the state of Maharashtra noticed a tendency (which was also mentioned in the RBI study). Namely, firms in the more developed areas borrowed relatively more from the informal markets, highlighting the institution' role in fostering newcomers in less developed areas2. The implications and interpretations of these observations are many. On the one hand, they may indicate that the catalytic role of the broadening of institutional credit availability to SSI that previously had no access has been successful. On the other, it may indicate that there are serious deficiencies in the provision of institutional credit but that prospective and existing entrepreneurs in the less developed areas have fewer options for obtaining finance. It could also indicate that the focus of the institutions (particularly the SFCs) is directed more towards "new" projects and firms, with inadequate support and follow-up for clients who wish to expand or modernize. No definite interpretation can be given, and in all likelihood the reasons for the dichotomy in borrowing patterns may contain elements of all the reasons cited above. What is apparent, however, is the need to look more carefully at SSI borrowing patterns across districts and regions. 5.31 With respect to the cost of credit, interest subsidies granted by the commercial banks have played a lesser part than commonly believed, and interest charged was in most cases positive in real terms. Table 5.2 suggests that in the late 1980s less than 15% of the credit going to SSIs were granted at interest rates below 12%, with the bulk going at 15%, a rate which was "Reserve Bank of India, "Survey of Small Industrial Units" Bombay: RBI, 1979. '2V.S. Padverthan, "The Role of Small Scale Industries in the process of Industrialization", New Delhi: ICSSR, 1983. 67 positive in real terms and seemed to be sufficient to cover the costs of the intermediaries to both attract funds and cover their own operational costs. Lending by the SFCs is based on fixed low interest rates. While the average interest rate of commercial banks to the SSI sector has recently averaged 18%, SFCs are still charging only 12.5% p.a. If the borrowers prioritized their payments of outstanding debt on the basis of the costs of funds, payments to SFCs would probably be at the end of the queue. On account of the actual delays, however, SFCs charge a compound rate of interest on the defaulted sum. These penalty payments improve the interest spread for the SFCs and may account for a significant portion of their net revenue if recorded, but this system does not compensate for a more feasible interest rate structure, determined by individual firm risk perceptions, and a more robust project appraisal and more rigorous collection procedures. 5.32 Shortcomings of the Institutional Framework. While being the primary institutions in India's financial system, including for the financing of SSIs, commercial banks have been weakened by Government policies over the last few decades. The Reserve Bank's micro-management of financial policies, ranging from targeted lending to restrictions on earnings for all but a small part of the portfolio has made it difficult for banks to cover their relatively high costs. As a consequence, commercial banks have been found to be uncompetitive and overstaffed, providing poor quality services. For the SkCs the institutional framework and control mechanisms are quite different. The special SFCs Act gives detailed provisions as to incorporation, management, default clauses and rights, investment of funds and accounts, but it has no common rules on such important issues as accounting policies, presentation of financial statements, disclosure by management, and issues to bo reported by auditors. According to Section 39 of the Act, the State Governments decide on questions of general policies after consultations with IDBI. But although IDBI is the apex institution for long term finance to SSIs, and is the major source of finance for the SFCs at the moment, it does not function as a regulatory body. It can only request the SFCs to furnish returns under Section 38 of the SFC's Act. It has not laid down guidelines on accounting and management aspects, nor has it dealt with such important policy matters as taxation and resource mobilization. While it may have avoided problems with the typical overcentralization of many public sector operations, the decentralized financial structure of the SFC Act has revealed serious monitoring and control weaknesses. 5.33 Portfolio Problems. It is difficult to judge the quality of portfolios of both ths commercial banks and the SFCs from the published annual reports and annual accounts. In the case of the CBs, advances are shown as net of provisions made for bad and doubtful debts and the ratio of provisions to outstanding debt is not indicated, although provisions are made "to the satisfaction of auditors". In many instances, auditors qualify their report, relating to the real value of these assets. For instance, in the case of one of the leading b1.nks, the auditors have stated: "loans and advances outstanding from certain sick/dormant units as well as suit filed and decreed accounts have been considered good on the basis of estimated value of securities, rehabilitation/nursing programs, guarantees and claims pending with Credit Guarantee Organizations". In the case of the value of Commercial 68 Banks' investments, the auditors have maintained: "the Central Government has exempted Banks from disclosing the market value of investments. The market value as on March 31, 1989 is lower than the book value, and adequate provision for the difference has not been made". It is apparent that policies related to the classification of advances and investment of commercial banks in India are not in line with internationally accepted prudential accounting standards. 5.34 Commercial banks follow the mercantile system of accounting and the presentation of annual accounts is on an accrual basis. However, that does not give a complete picture of the financial health of the banks, since the policy on income recognition and portfolio classification and provisions is not revealed. It also appears that many banks are invoived in litigation with the Income Tax authorities. The commercial banks' move to reflect greater transparency in presentation of accounts and adopt International Accounting Standards applicable to banking institutions should benefit better monitoring of their SSI portfolio. It would also be useful if the accounting policies are spelled out in the annual accounts, and include the policy on income recognition and portfolio classification. 5.35 As was discussed in Chapter 4, the problem of sickness among small scale units has serious implications for the financial institutions. At the end of 1987, it was estimated that the "sick" portfolio in the medium and large sector (Re.28 billion) constituted 11.10% of the bank credit (RO.252 billion) to the industrial sector and 4.13% of total bank credit. The portfolio identified as sick in the SSI sector constituted 2.6% of total bank credit and 16.7% of the credit to SSI sector in 1987, nearly twice what it had been in 1981 (9.1%). The ratio of the "sick" industrial portfolio to total credit has shown an increasing trend despite the rapid growth in total bank credit. Much of the portfolio, since the commercial banks have classified 72% of the sick SSI portfolio as non-viable. 69 TABLE 6.6 BANK GROUP-WISE BREAK-UP OF VIABILITY POSITION OF SICK 81 UNITS (AT THE END OF DECEMBER 1987 (Re. billion) Bank Group Potentially Non-viable Viability not Units put under Total viable gnits u6il -yet decided nursina roaam Amount Amount Amount Amount Amount Outstanding Outstanding Outstanding Qutstanding Outstanding (1) (2) (3) (4) (5) (8) Nationalized Banks 2.50 6.56 0.80 1.85 11.71 State Bank of India and its Associates 1.18 5.82 0.32 0.87 8.19 Other Private Sector Banks 0.20 0.43 0.10 0.15 0.88 Total 3.88 12.81 1.22 2.87 20.78 5.36 Discussions between the Reserve Bank of India (RBI) and the commercial banks regarding -he quality of the portfolio of commercial banks in India are now underway. There is an urgent need to have information on recovery rates, to undertake an age analysis of arrears, and to examine the basis and adequacy of provisioning. RBI has initiated a program in which independent audit firms are to assess the portfolio on the basis of internationally accepted accounting standards. This exercise is being done independently of the statutory audit of the banks, and, once it is completed, RBI plan, to draw up a comprehensive program for portfolio clearing and, if needed, for recapitalization. 5.37 Recovery performance is a matter of even more concern in the case of the SFCs. The arrears-affected portfolio is large and the rapid increase in the non-performing portfolio has had an adverse effect on the health of many SFCs. As shown earlier, the average ratio of current recoveries over current amounts collectable was 55 ia 1987 and fell to below 50 in 1989. The averages for total recovery are worse and are estimated in the 30-40% range. Clearly this situation cannot exist for very long without a complete collapse in the SFC financing system which would have severe repercussions in other parts of the financial sector. IDBI adopted in July 1987 an action program to improve loan recovery levels, but this has :aad little impact. Given the gravity of the situation, there is urgent need for a more concerted program, which would include a thorough portfolio review, portfolio clearing and rehabilitation packages. 5.38 Further areas of weakness in the SFCs are the excessive dependence on external funds, such as fresh share capital infusion, refinance and bonds. Poor internal cash generation on account of the low recoveries of loans and advances has led to average DSCRe below one. The inability to raise resources from shareholders other than State Governments and IDBI has not only led to excessive dependence of SFCs on IDBI, but also to shrinking margins caused by the rising cost of funds. SFCs capitalization needs to be viewed in the short 70 and long term. The SFC Act envisages a debt equity ratio (DER) of 10:1. The average for all SFCs is currently below four, with the highest DER having been 6.2 as of March 1989. In the immediate future, SFCs should be able to operate without substantial addition to the equity base; however, refinance facilities with back to back arrangements do not suit SFCs, since they bring undue strain on their liquidity and servicing ability. So, in the short term improved recovery and lowering costs is crucial. Judgement on the solvency of the SFCs through a review of the statutory accounts is difficult because of their general policy (with a few exceptions) of not providing for doubtful loans. 5.39 The long term perspective regarding capitalization in SFCs is more clouded. IDBI is a major provider of equity in partnership with State Governments. The return on equity is, however, low (7.5%), and the investment becomes illiquid as there is no market for SFCs equity. Given the size of the non-performing portfolio in many SFC's, this equity has been seriously eroded, if not eliminated in some cases. IDBI's investment in SFC's equity amounted to Rs.4 billion in 1990, ar seems to have reached the limit of tolerance'3. It is necessary to restructure the SFCs' capital base and with it reduce the demand on IDBI. Before this can be done of course, there must be a thorough reappraisal and purge of the SFCs' assets portfolio. 5.40 SFCs' margins are under strain, despite the fact that a major portion of their resources are subsidized and made available at below market rates. The reasons for the current crisis are not hard to find. SFCs operate with a narrow product-mix, mostly long term loans in a comparatively high risk area. The Corporations have little flexibility in operations. There are limitations in the SFCs Act (ceiling on lending is Rs.6 million and ceiling on the net worth of an assisted company is Rs.30 million). There are also limitations imposed under the IDBI/SIDBI refinance scheme where an individual project cost should not exceed Rs.30 million. Interest rates are administered. SFCs do not have the flexibility regarding interest rates which has been recently given to commercial banks. SFCs desiring to go into new types of businese such as leasing and hire-purchase have not been given permission to do so. Along with a capital restructuring and portfolio clean up, it is apparent therefore that if the SFCs are to be self-sustaining and provide a useful role for SSI, they must be given more operational flexibility in the types of lending activities in which they are allowed to engage. 5.41 Inadequacies of Accounting Rules and Standards. Out of the 18 SFCs, 16 follow the cash system of accounting and two follow the mercantile system. Most SFCs switched over to the cash system of accounting following the Supreme Court decision in the case of State Bank of TravancGre - SBT (1986), decreeing that when accounts are maintained on the mercantile basis, accrued income (by the way of interest on loans) becomes taxable. Tax relief could be sought only if the bank writes off the income/debt as a bad debt. Even before the Supreme Court judgement, there were discussions regarding the desirability of SFCs switching over to the cash system of accounting, as most SFCs had not adopted prudential income recognition policies and tended to inflate the real income on accrual basis. Besides resulting in heavy income tax payments, the accounts did not reflect a "true and fair" view of the likelihood of collection. "With the creation of SIDBI, Rs.3750 miLlion became a Loan of IDBI to SIDBI, which is now the major creditor and sharehoLder of the SFCs. 71 5.42 The limitation of the mercantile system could hava been obviated by adopting a uniform prudential income recognition policy applicable to all SFCs. But this became redundant after the switch to the cash accounting system. That switch was effected in consultation with the Office of the Comptroller and Auditor General of India (CAG) and certain leading audit firms in the country. The general consensus was that the cash system was not consistent with accepted standards of accounting policies, but in the light of the adverse Supreme Court judgement and the recovery record of the SFCs, it seemed prudent to give SFCs the option to switch over to the cash system. While that system has helped in better management of tax liability and has brought a degree of uniformity in income recognition policy among SFCs, it has also given rise to certain grey areas, particularly the accounting for interest expenses, and in certain cases, non-payment of dues by SFCs. 5.43 A recent review made by IDBI revealed that some of the SFCs do not make any provision for doubtful debts on the plea that the interest accrued but not paid, which is not accounted for as income in the books, provides adequate cushion towards doubtful debts. Other SFCs have been making a general provision towards doubtful debts, but the amounts provided are small compared to the outstanding portfolio and the arrears position. As of March. 1989, in the case of nine SFCs, the amount provided toward doubtful debts ranged from 0.01% to 1.9% of the total outstanding portfolio and from 0.04% to 6.93% of the overdue portfolio. Such provisions, by any standard, are grossly inadequate and given the recovery performance, rep: sent highly irresponsible financial management. 5.44 Oroanizational Issues.. The organizational structure of the SFCs is governed by a functional approach in which its business is dealt with in.terms of the different stages through which financing activities take place, i.e. appraisal, sanction, disbursement, recovery, rehabilitation, etc. Though this approach does bring about the specialization required for each type of business activity, it lacks accountability, and, more important, it does not contribute to continuing linkage with the client through the course of his dealings with the institutions. What would be more much appropriate is a matrix organization which provides for specialization but at the same time ensures appropriate accountability and a linkage with project appraisal and firms loan performance. Because of logistics constraints and the organizational arrangements there is no structured feedback on a continuing basis. Whenever a unit defaults or an account becomes contaminated, the appraiser is not informed about this through a structured reporting system. There is no formal evaluation to cross check what exactly went wrong and presenting this observation with specific case by case references to persons who were involved in appraising those accounts at the initial phase. This kind of feedback would help in fine tuning the appraisal system and serve as a "learning base" for use in future appraisals. 5.45 The organizations presently do not have a cell to monitor performance of the clients' accounts. Since the SFC structure is established around functional tasks, monitoring of performance gets a secondary emphasis and this is linked to the recovery function. The only monitoring is during the project implementation stage, which is concerned with physical progress. Monitoring of financial accounts of SSI borrowers is deficient and is a disservice to both the SFC and the borrower. Even if a borrower is current with repayment obligations, continuing financial appraisal by knowledgeable professionals can give advance warning of adverse financial trends, which if 72 Box 5.2 VENTURE CAPITAL AND ENTREPRENEURIAL DEVELOPMENT Venture capital differs from other forms of more conventionet fivestment and debt funding primarily in the duration of investment and the importance attached to the quality of the entrepronour. Returns are linked to the suocess of the venture. Often technioally oriented entrepreneurs, with high risk, but potentially high return, marketable technologies fack the necessary capital to launch a new enterprise or expand an existing one. Furthermore, these smaller sooe enterprises often lack a vital management, marketing.or processing skill needed to ensure the success of a now venturei Specialist venture capital companle: may have this knowledge and capacity, with the result that a linkage between them and: a now entrepreneur brings: a range of technical assistance services besides the more provision of The concept of venture capital is not new, a is evidenced by the acttie of business In the Italian city states or the financing of merchant traders during Sngand's development of ovirsese trade. Furthermore, In developing ..untries, the 6is of uentiire 4apitals unaMeans of funding high rsk tradirig activitie dates back maniy centuries (India and China provde good examples of thls). But this type of activity has become more institutionalized since the late 1940s with the emergence of specie companies oriented. toward equity.and quasi equity investments in new. technology or. new product concept firms.. The United States has been a leader in such type of financing, following the passage in 1958, of the Snial Business investment Act, which provided the basis for the creation of Small Business Investment Companies (SBICs) as vehicles for small business financing under the assistance and regulation of the Small Business Administration. SBICs are funded through a contribution of privately raised capital and government loan funds, up to three times the private capital. Despite a slow beginning, the SBICs were the most popular venture capital organization during the 0s and 70s in. the United States. This development, together with progressive reductions in capital gains taxes., has brought forth a veature capital pool of more than US$22 billion by 1987. Today the industry consists of over 600 firms divided Into three broad categories: (i) about 150 independent venture capital firms, which manage about 70% of the available funds: (ii) about 430 SBICs. which manage about 12% of the available funds, and (MY) subsidIario* of tAmge corporation mwhich admintster'the remaining 18% of avalable funds. Moderaventure capital activity in India stems from 1980/87. when the Central Government introduced a cess of 5% on all payments. fo the import of technical knowhow. The concept was to create a pool of funds for venture capital activities. to be handled by IDBL Also ICICI created a company. Technology Development and Information Company of India Ltd.(TOIC), at about this time. To date, there are now nine companies in operation, suggesting that initial succeises have enjoyed. Comipany .Number of Asueted Units Finance lRs.mlifia TODC 100 540.0 101 51 350.0 Risk Capital & Technology Finance Corp. 36 180.0 Canbank Venture Capital Fund 24 80.0 Gujarat.Venture Finance Corporation 2 10.0 Credit Capital Venture Fund 6 20.0 20th Century Venture Capital Corporation 5 25.0 Indus- Venture-Capitat Fund 8 25.0 Andhra Pradesh IOC Venture Capital. 15.0 TOTAL 1600.6 The recent progress in venture capital in India is encouraging, and it clearly has great potent;al as a source of funds for the modern smell scale sector. Further Impetus could be given to this activity with a reduction in capital gains taxation, and early establishment of an over-the-counter market to improve the tradeability of these equity investments. For further Information on venture capital experiences and issues sea Feman Ibanez, "Venture Capital and Entrepreneurial Development*, World Bank, Working Paper Series, WPS 53, August 1989. 73 not rectifted, could lead to future default. This is a full time task requiring necessary organizational emphasis and a specialized effort in this area would supplement the recovery activities of the corporation. 5.46 The SFCs suffer from significant staff constraints and inappropriate staff mixes. Considerable internal and external training is required to upgrade the skill of the staff and officers to enable them to carry out the different activities of the lending institutions. A broad analypis of the role and responsibilities involved reveal that in order to be effective, the organizations should be more officer/supervisor oriented as most of the tasks of the corporation require analytical and evaluation skills. Presently, the focus is more on clerical staff operating within a highly structured and mechanistic loan appraisal process. Firm infornation is compiled but evaluation of this information is deficient. Comprehensive computerization of all routine application systems would ensure proper information support to experienced supervisors and evaluation officers. 5.47 A final organizational issue relates to the extent of State Government ownership of SFCs. Unfortunately, the presentipattern of owndrship has led to excessive political involvement in the choice of senior managers and even in operational lending decisions. This has often led to the appointment of top maaagement (Chairmen and Managing Directors, for example) who are not qualified and experienced bankers or financial professionals, and whose period of tenure is too short to allow for a fuller understanding of the operational requirements and financial management of an SFC. Clearly, senior management of such entities should have a degree of autonomy and security of tenure that insulates them from untoward influence on operational management issues. This could be achieved with a broadening of the ownership base of the SFCs. Therefore, as the needed capital restructuring of the SFCs and their source of financing is undertaken, the ownership base should be broadened by having equity participation by other financial institutions, as well as private sector and individual shareholders. Sumary and Recomendations 5.48 The foregoing discussion has outlined the major issues facing the financial institutions which serve SSIs. In principle, the financial sector has fully supported GOI's desire to improve the flow of finance to SSIs. Financial support to the sector has increased rapidly in the last decade, outpacing output, investment and export growth of SSIs. And, it would appear that there has been more than an adequate amount of credit available to what is called the "modern" emall scale sector. Interest subsidies of commercial bank lending have played a relatively minor role, but in the case of the SFCs, the interest subsidy has became more serious, as the gap between long and short term rates has widened. In addition to distorting factor proportions towards capital intensity, it seems also to have led to perverse behavior by the financial institutions which attempted to boost their revenue with the help of hefty penalty payments. The interest rate structure of the SFCs should be much more flexible, and should be more closely related to mark2t rates. Compared to interest rates in informal markets, neither commercial banks nor SFCs charge anywhere near a realistic rate reflecting the greater risks and increased costs of the SSI loans. 74 5.49 As a consequence of ample credit at low prices, the Gov-rnment promoted programs have contributed to insolvency in the participaL..ig financial institutions and are therefore not sustainable. The large and increasing sick portfolio of aSI loans (higher percentages than for other loans) also suggest that the resource allocation effects of past and current policies have been directed into maintaining employment and stability rather than fostering output growth and with it the creation of new jobs. 5.50 The major causes behind the problems of insolvency and mis- allocation have been the existing incentives for financial institutions, which have favored expanding credit through provision of subsidized funds through the sFCs and directed credit through the commercial banking system at rates which were insufficient to cover the costs of these programs. Faulty accounting and reporting procedures of the financial institutions and the absence of strict prudential standards encouraged financial institutions to expand lending with insufficient attention to project considerations and repayment capability. A fundamental reform in these areas will be essential to the austainability of the credit system for SSs. 5.51 In the case of the commercial banks, accounting and reporting standards, and adoption of prudential standards, will need to be undertaken on a systemwide basis. The system of directed credit no longer provides incentives for expanding lending to SSI and should be replaced by a more flexible system of interest rates which would allow the commercial banks to price the cost of their loans consistent with the real risks involved. The existence of a parallel market operating at higher rates suggests that many SSIs do in fact have the capacity to service loans at a rate more commensurate with the risks involved. These reforms would create the capacity tor a more sustainable banking system which would still have incentives to lend to SSI in substantial amounts but for projects with higher financial ilet - .. 5.52 The same issues also apply for the state financial institutions, except that the solvency issues are even more serious. Basically, incentives for these institutions will need to be revised as described above and many of the institutions recapitalized as they are essentially bankrupt. Also, ways will need to be found to ensure the autonomy of these institutions. This will involve in the first instance highly professional and consistent senior management. In the intermediate term, selling of shares will be essential to the objective of autonomy, once the basic solvency and profitability issues have been solved. In addition, the range of both resources and services will neeu to be expanded - it may also make sense for some of these institutions to merge with other financial institutions. If these conditions cannot be met, then the state financial institutions will not be viable and sustainable, and would need to be closed down. 5.53 Institutional, managerial and accounting changes should take place irrespective of other desirable changes in the SSI financing system. But their character and scope will be quite different, if one assumes a scenario in which the financial sector is 13jLaralized. In that context, the very existence of specialized institutions lending to SSIs will be questioned, since commercial banks should not only be lending short and medium but also increasingly long term funds to SSIs. The SFCs would need to broaden their product mix and clientele in order to compete successfully with other financial institutions. 75 5.54 In the present institutional framework, with very few exceptions in the commercial bank area and one venture capital company, all financial intermediaries catering to the SSIs are government organizations. In the future, this needs to change with a greater degree of private initiative in the informal sector, which can function efficiently under a flexible regulatory framework. Privatization is a priority in the field of venture capital and in the specialized extension servije-cum-finance agencies. At the same time, there is good reason to also initiate private sector participation in capital and management at the commercial banks and SFCs. 5.55 The dichotomy of sources of types finance for SSI (i.e. long term and working capital requirements from different institutions) has not served the small scale sector well. Artificial restrictions on the commercial banks and the SFCs has made it difficult for these institutions to react more flexibly to the needs of emerging entrepreneurs. More ominously, as was seen in Chapter 4, the lack of adequate coordination between the various financing institutions has often contributed to sickness and poor performance for new firms, even before actual production has commenced. Project appraisals have often not reflected realistic assessments of working capital needs, with the result that firms experience severe liquidity problems at their most vulnerable, infant stages. SIDBI has established a "one window" program, however relative to the full range of institutional credit to SSI, this program is very small. 5.56 Commercial banks do have experienced cells of operational staff, who have dealt with project financing, technical analysis, supervision and lending development (witness the SBI's UPTECH as an example). Their flexibility to engage in the full funding of SSI needs, at interest rates that reflect the perceived risks, needs to be enhanced. The same can be said of the regional financing institutions, the SFCs. Before this can occur, however, the whole system of lending and the organizational structure of the SFCs will need to be transformed. 5.57 IDBI has been encouraging the SFCs to undertake organizational studies conducted by outside professional management consultants with a view to helping the SFCs to revamp their organizations in line with the growth in their operations. Such organization studies have been made in several SFCs. In the direction of information building and upgradation of human skills, IDBI has also been subsidizing the cost of training of officers of SFCs besides reimbursing the cost of training equipment required for in-house training cells of the SFCs. IDBI has also been assisting SFCs in computerization of their cperations and has been subsidizing the cost of hardware required for this purpose through its Technical Assistance Fund. While the impact of this assistance should be felt in the coming years, training must be linked closely to clearly identifiable tasks needed in the reorganization of the SFCs. 76 CHAPTER 6 INDUSTRIAL EXTENSION SERVICES FOR SMALL SCALE INDUSTRY Introduction 6.1 One of the most important policy instruments utilized by the GOI over the past thirty to forty years to promote and develop small scale industry (SSI) in India is a wide network of industrial extension services (IES). The basic rationale for the provision of such services has been to promote "first time" entrepreneurs, and provide services and support in those areas which are perceived as cost ineffective for any individual firm to undertake by itself, due to the relatively low levels of operation. Broadly, IES in India is in the form of technical advice and training and direct infrastructural support. These services are targeted at firms at the pre- investment, investment or post-investment stages of production. 6.2 The coverage of these services is very broad, and in many respects India has been a leader in the developing world in introducing programs to assist the small scale sector. They include advice and direct assistance in obtaining: basic infrastructure; plant and equipment; financial capital; raw materials; appropriate technology (including access to prototype development and tooling centers); training (in entrepreneurship and in job skills); quality testing and control; and marketing, both domestic (including participation in government purchase programs) and exports (including participation in export turnkey projects). At present these services are channeled through a vast network of organizations: central government institutions and branches; state government supported extension services; financial institutions; industry/trade associations (including 'self-help' programs); and non-governmental organizations (NGOs). Based on their respective areas of specialization, these facilities are available to all units falling under the general definition of a SSI and which are registered with the Dirtrict Industries Centers (a full description of the services offered and the institutions involved is shown in Appendix A4). 6.3 Since the Industrial Policy Resolution of 1948, there has been a strong emphasis on the promotion of cottage and rural industries and SSI. This pol.cy resolution annunciated * policy to encourage SSI through Government provision of scarce raw materials (including power), technical advice, marketing assistance, and protection from "intensive competition" from large scale industry. In furtherance of this policy, the GOI, in conjunction with the Ford Foundation, fielded an study team to inspect and assess the conditions of SSI in India. In 1954, this Team concluded that the measures adopted in the First Five Year Plan (1951-56) for the development of SSI were insufficient to ensure the growth of an efficient, modern and technologically progressive SSI. The Team observed that "better marketing, better financing, better finish, better equipment for manufacturing, better power facilities were not separate remedies but required simultaneous attention in order to 77 solve the problems of the SSI sector" (Ghosh, 1985). Subsequently, it recommended the creation of a specialized small scale sector department within the Ministry of Industry along with multipurpose institutes to serve the needs of the SSI. In particular, the Team recommended the following: - the establishment of a small industries corpiration to improve credit flows to SSI and also to provide marketing support including participation Ly SSI in government purchase programs; - the establishment of a multipurpose institute of technology to ensure a modern and technologically progressive small scale sector; - the establishment of centers equipped with appropriate machinery and other facilities in order to provide SSI with training centers for small industries; and - to,etrengthen trade associations and cooperatives involved with. SSI. Mraisations-r Structures and Institutional Framewpr 6.4 As a result of the above recommendations, three institutions were formed at the central government level: the Small Industries Development Organization (SIDO), the National Small Industries Corporation (NSIC) (along with its Prototype Development Centers (PDTCs), and the National Institute of Small Industry Extension Training (NISIET). The founding of these agencies marked the formal commencement of the SSI program, and the beginning of a policy distinction between "small scale" industries and "cottage" or "village" industries and handicrafts (the latter two falling under the purview of their respective Boards). Chan 6.1 Flow of Industrial Extension Services to SSI PLOW OF INDySTRMIL 11TSO SUPORT SERVICES To TUB 8X CENTRAL 5STAT E AGENCIES! :AGENCIES SNON-GOVERNn!:* BC:IATERAL ORGANIZATICNS AGENCIES FN1A N CIAL PRIVATE SECTOR AGENCIES I (INCL. TAE INDC'STRY ASSON.) 78 6.5 The Central Government Institutions and their branches form the core of the industrial extension services provided to SSI in India. Central assistance, mostly financial in nature, is further extended to State level institutions and financial organizations providing IES support. Over the years, at the State level, a comprehensive range of services have emerged; however, the focus appears to be on a few specific areas such as the establishment of industrial estates, provision of raw materials, marketing assistance, etc. with less stress on the development of tooling and testing facilities, prototype development centers, etc. Several bilateral and multilateral foreign agencies are also involved, channeling their assistance through NGOs and Central and State Entrepreneurship Development Programs (EDPa) (most of which can at best be described as "Awareness" programs), however a few private sector organizations, mainly small scale associations, have emerged recently to provide more direct IES (such as tooling and quality testing facilities) either on their own or through programs initiated and supported by the financial institutions. 6.6 'The Small Industries Development Organization (SIDO) forms the nucleus of the IES network at the Central level. Constituted in 1954 under the Ministry of Industry (MOI), SIDO continues to act as the apex body for formulating, co-ordinating and monitoring policies and programs for the promotion and development of SSI in India. It provides direct support services to SSI through its Small Industries Service Institutes (SISIs), which currently consist of 27 Service Institutes, 31 Branch Institutes and 37 Extension Centers - forming the second largest IES network in India'. Around 13 IES institutions and their branches (including SISIs and Production Centers) fall under the purview of the SIDO: 5 directly and 8 as registered Societies. At present, the SIDO reports directly to the Department of Small Industry and Agro-Industrial Development, which is responsible for providing the overall policy framework for SSI under the MOr. Also reporting to the Department is the National Small Industries Corporation (NSIC). The NSIC provides finance2 and marketing assistance3 to SSI and operates a number of Prototype Development & Training Centers (PDTCs). 6.7 Each state has developed a framework for assisting SSI, some more elaborate than others. The main organizational frame for this are the District Industries Centers (DICs), of which there are 422, covering 431 of 436 districts in India. The DICs are the focal organizations in the State IES structures and have both regulatory and promotional functions. However, the emphasis tends more toward the former. They are the first contact point for a nascent entrepreneur, and the various registrations and applications for inputs and services are made through these entities. The DICs report directly to the State Directorate of Industries (DI) under the respective Ministries of '. The District Industries Centers (DICs), a State level agency, have the largest network, operating at the District, Stock and sub-divisional levels. . By way of machinery/equipment on hire purchase/lease basis. . Including SSI participation in Government Purchases Schemes. 79 Industries in each state. In addition, in each state, there are a variety of specialised "industrial development corporations", whose mandate is to provide infrastructural and service support to SSI. 6.8 The all-India Development Finance Institutions (most notably IDBI), the various State Financial Corporations and the nationalized commercial banks also sponsor a variety of specific industrial extension programs for SSI, either in conjunction with the various state agencies or with sepaiite public organizations such as the Technical Consultancy Organizations and Quality Testing Centers. Some commercial banks have started specific modernization and technology improvement programs, focused upon particular products or geographic clusters of small scale firms. The most notable in this regard is the State Bank of India's UPTECH program, designed to provide both financial and technical assistance to improve the efficiency of SSI output in certain product groups (small horsepower pumps and diesel engines for example). User Percetions and Benefits 6.9 The coverage of IRS for SSI in India is indeed very broad; however, it is not clear whether this array of diffarent services is effective and brings forth the benefits that its proponents suggest. Furthermore, for many programs, the beneficiary base is so small that it may raise a question as to whether the resources expended are justified. Evaluation of the effectiveness and efficiency of any service activity that is either provided of free of charge or on a highly subsidized basis is difficult, if not impossible. What is clear is that in terms of economic efficiency and the efficiency of rescurce allocation, the marginal benefits and social returns from many of the activities and programs is unlikely to exceed the social cost of the provision of these services. SIDO and other organizations have undertaken periodic evaluations of particular programs, but in the vast majority of cases, these evaluations are limited in scope and focus upon inappropriate and misleading measures of effectiveness and performance. For example, for many service activities the DICa may report on the number of firms "assisted" and participants in a training program, but with no follow-up assessment of the actual effectiveness and results of these program. (see for example the box in this chapter on Entrepreneurship Development Programs). Furthermore, the intensity of interaction between beneficiary and service providers is often so limited (for example a one hour annual visit by a DIC officer to an individual firm) that it is hard to imagine whether any benefits accrue at all. This is not to imply that in certain pockets, and in more directly targeted intensive programs, benefits do not accrue. Nor does this imply that there are not many individuals involved in the provision of IES who are highly dedicated and committed to assisting new entrepreneurs and small firms. Clearly there are. Rather, with limited resources, a large array of functional activities, and no efficient mechanisms for allocating resources to those activities which are proving more effective and away from those that are not, it is apparent that there is need to reevaluate the scope and method of industrial extension activity in India. 80 Box 6.1 ENTREPRENEURSHIP DEVELOPMENT PROGRAMS IEPP) Within a decade of the issuance of the [idustriot Poticy Resolution of April, 1956, it was fett that fisoal ond financial incntives were not, in themselves, sufflclent to .ncourege the growth of entrepreneurhip or apeedity propagote the oredtion of a new class of entrepreneurs in Indis, Within tidia, and with the encourgememnt of acadeio and educational. institutions abroad, it wos felt that to encouirage nasoent entreprnermhip in ubackward urss,a* and amongut *non.traditional classes", If was necessry to havs more focused motivatlonat tratning and development Efforts were initiated ln the oarly 1980s, to conduct much progrorm,.and in the folowing .two. deadeo, a host of Institutions have ernerged ta further this alm (the National Institute of Small industry Extension Tralning (NiSIET). Hyderabad;.National Institute for V-tivation and Institutional Development (NIMID4 BombayI Centre* for Entrepreneurship Development in varilous State# National Institute of Entrepreneurghip and Small Business DeVelopment (NIESBVDY¿ New Oelh;tha Entrepreneurship Oevelopment institute of indla (EDI}1 established by the ali-indla development finance institutions and the State Sank of i and the Nitdonaä Science and Teohriclogy Entreproneurehip Development Board (NSTEDB> set up by the Department of Science änd Tchnology. to name but a fewM. Tcday----ther a u ? differenforgmnizetionsengagednconducting EDP in the country. Invo4n9 Centra Government, State Govemmonts öN 0 s end votuntary brgarzatlon* and a hoat.of 4duc4tion. entite. The effectivenes :of thi. array faotvty owever Isot suifom,and the usefulnss::of manyof the program. le eublot to qustl. The termEDP; Is somewhet loosf, given. the ranand diversity of scbemo. that ea offered or undertake. Som. öntall nothingmor4 th. n short; òns or two day ewerenese mars,on the vous governmental development cchemes available or the bureaucratdo hurdies that must·be negotiated (ln this taitter cass, thisoan-be quito useful in the indien environment given the excessive regulation and red tape). Other programo.run up to three montho, are normally eponsored by the financial institutions, and encompass motivation and poreonality development, as weil as basi oaccounting. management and other business skills. including the preparation f a feasibillty/project report. These longer progrems can be useful. especially if they seek to overoomw oome of the deficiencies of the oarlier education system, or impart business administratdon Information to thos w*tha mora techniqal or engineering beckground. 0, programs drw upon a generalized pool of potential entrepreneurs, othere target specifi group. such a* soeduled oestestribes, retiring defence p,rsonnei, educated eployed youth, and women, rural or artisan anrerpreneur. Fulnding for the variety of program b lso tends to b- very diverse. Porthe Centres for Entrepreneurship Development Iw the vAeriouå States, the all-India development finance institutions provide resources provided a spocifiod eore curricula Is followed end the supervisor is tralned by EDi or NIESSUD,. This funding normalty amounte to about Rs.2,50d per participant, half of which will come from the respective state govemment. For other orgonizetion., funds are either raised by charging user fees, voluntary contributions, or by direct uubvention from the various state development institutions. In this lotter osse however, funding levola are normafly very tow (Rs.100 ts: Re.200 per perticipant. w;th.e conuequent impact upon course content and effeotiveness. There is no cauntrywide compilation of the number of program. undertaken nnually. nor is there a consolidated count sf the-bneflciarie .. The DFI. fund programs that provide courses for about 3500 to 4000 persdn. perannum Som.istateS do mantan:good recordas. During 1970 to1984 '312 program. were conduoted in Gujarat with-7710 partloipants. Of this numbert,about 435058%Y aotually established a business subsequently end about 3250142% of total trainees) remolned In business efter two years. Interestingly, It was found in Gujrat, that the success rate for women entreprmneur trninees tas m«esured by firm creations> was higher than for their male counterports. By and largo however. evaiuation and monitaring. of the effectivenoss of the variety of programs undertaken is woefully inadequate. For any EDP to be succesful, Intensivt follow up and evoluotion le necesoary to establish the effioaoy of continuing with o particular type of program, and correct emphasis or course content. Too often, the emphosis is upon *numbe graduated", paying but lip service to the fundamental concept and ideal of EDP, with little attention to the quality and effectiveness of the program. As a result, the overai! effectiveness of thoec programs in India may not be as high as it is claimed. 81 BOg., (continued) With such 0i large nunber of organizations involved In EDP. there is considerable overlap, duplication and dispersion of effort. The availability of a subsidy program often entices a variety of wall meaning organizations to undertake EDPs, without a 4sately qualified or trained staff. or without adequate supplementary inputs and teaching materle. While the EDII has brought about some standardization of course curricula, this has not 9ffectively raise the quay of many EDPs. It la oteworthy that afarge prootion of the Distd0 industdal Co*trb are tasked with ertain quote targets of honefisries of DP, but thee DiCs laok eppropriately trained staff with the result that while the activity is cusodly undertaken6 it. inpact is neligible. The rationale for EDP is that *achlevermient motivation* can be developed, and that: training can effectively !nculate appropriate entrepreneurial traits -or expand upon what is latently hidden, Furthermore, in. an environment wher the formal educsdon system is deficient, and many tohnical and oreftsma*4ike skills are learnt on the job, EDP (or adult business educatio. programsl4ai move some way towardsromoving obstacles to the emeorgeice of new:entrepreneuro. However, these program. need to be Intensive, with extensive follow. up and monitorltg. It they are to make anoticeable differene and not simply raise the expectations of those that have participated In them. By and forge, the experience with India and other developing countries tend* to suggest that FPs have a higher rate gofconversion of participants toentrepreneurs i i is aseiated with otheroompimentary activities necessary for the creation of anew business. for example, EoPs W or 'ponored by commeriel banks often result in very high levelsof subsequent firm istiblishment, as laoi inanoc le ofte times moreadily available. Another promsing possibility is the concept of Technology Business Iribubator Centres. The Maharashtre tndustrial and Technical Consultancy Organization (MITCOM) is seeking to establish such a Centre I Pune. Its* goal is to Induce and encourage entrepreneurship from salaried professionals within larger Industry in the stedogether with the provision of otheT business services (communloations. infrastruature eta.) and an attemptto establish technology sourao Information systems and. greeter Interactici with R&D Institutions end venture sapital firms. As with much- of Industrial extension service, it to mere affective and beneficial if It Is Intensively itrgeted, with adequate funds ar resources, rather-thari overly ambitious schemes that attempt a broad coerage with !Wited resources and hence-a negligible impact. Sources: D.M. Sarwate, Sudy of Entrepreneurehip Development ProgramO . World Bank. mimeo., New Delhi# March 1991, V.G. Patel, 'Entreprensurship. Development Programs In India and its Relevance to Developing Countries", Entrepreneurship Development Institute of India, Ahmedabad. August 1987. 6.10 In the course of this study, the views of nearly 400 small scale firms and various trade associations were obtained. Almost universally, considerable scepticism and cynicism was expressed about the worth and benefits of much of the publicly provided extension services. In the majority of cases, the major obstacles encountered by small scale firms were infrastructural and material input constraints (lack of factory space, power, raw materials and transport), and while mauy of these services are provided at concessional rates, the majority of the small scale firms considered the low cost iactor unimportant compared to the need for ready accessability and timely availability of the services. (Of course, subsidizing the provision of any of these inputs will create excess demand and this fact was recognized by many of the small firms that were spoken to in the course of this study). Furthermore, many of those firms receiving advice or guidance on marketing or production techniques felt that the information received was either outdated or reflected insufficient knowledge of existing market circumstances and product requirements. 82 6.11 Reproduced below are the results of a survey of 200 firms in Andhra Pradesh, which indicates some large variations in both awareness and usage of IES. By and large SSI seem well aware of assistance being offered to procure basic infrastructure (factory premises, etc.), plant and equipment and raw materials, and a considerable proportion of firms have used these lacilities in one form or another. However, the awareness and usage of other types of IES is much lower. With regard to awareness of the institutions that provide the variety of services to the small scale sector, firms seem well aware of the SISIs, NSIC, the State level industrial development corporations and the DICs; awareness of other institutions is very low, however two interesting facts emerge. First. given that all firms are supposed to register with the DICs to obtain the variety of concessions that might be available to an SSI firm, it is quite surprising that only 63% of the firms expressed knowledge of the entities. Two factors may have affected the results: There may be some confusion among the respondents between the Directorate of Industries (DIS) and the District Industries Centers (DICs); or, more revealingly, that a large proportion of the SSI (nearly 40%) are not taking advantage of any of the concessional incentives and are operating outside *he formal commerciAl sector. Second, that those institutions that arc noed under the financial institutions and the Industry/Trade Associations provide IES do not appear to be very well known. 6.12 With regard to assessments of the quality of service provided, the Central and State Government entities' services were considered inferior to private sector organizations, industry/trade associations and other types of voluntary organizations. Only in respect of the cost of service provision were the public sector entities considered to be at an advantage. TABLE 6.1 USER PERCEPTIONS OF IES las a % of Total Respondents) Assistance Available Awareness Use In Obtalning TOTAL RESPONDENTS (IN NUMERS) 195 180 1 Basii lfrastruOture 9 2.. Plant t6quipment. 85 62 3. Raw MaterIal 64 42 4. ToolIng Center Faciite. 19 3 1. Prootye Oewelopment Facilitie 9 1 0. OueliIty Testing Centers 23 3 7. Entrepreneurship Training 15 4 8. Technical Training 26 3 9. Voostional Training 4 10. Assistance in Marketing 11 2 11. Assistence in Procuring Govt. Order* 8 4 Table continued overleaf 83 AWARENEMOVIES INSTITON RATING OF IES INSTITUTIONS BY 881 (as a 1%) of Total Respondental a a %) of Total Respondents) IES Institu&tions Awareness TOA EPENTSOt KI UPEES) 2l9 TOTAL R.ESPONDENTS (IN NlUMBERtS) 9S2 Central Govt. Levot Intitutons: 1 Central/State Level GoV?, intt, T. SISI 87 Setter 25 2. RTCs~ 28 Cheaper 86 3. PPDC1 Qulaker 6 4. NIES8UD 6 5. CTTC. 19 2. Industryrade Association . NSIC 63 Setter 49 7. PDTCs 9 Cheaper 5 Quicker 23 Organizations under Financial inett: 8. SSIDC. 58 3. NG0s & Volunt1r Organizaions 30 107d & hae 28 __ _ _ _ _ _ _ . ...: > : : ~ :~Quicke .. State Level Ititutions: it. $80Cs 5 4. Privateeotor IES Or..a. . 12. DICs 83 - Better 73 13. Indivual Product Corpns. - Cheaper 18 "Quicker 92 Industry/Tradb Assoiation.: MS-FASS, 13 SOURCE: A Study on S$t I, Andhra Pradeeb. Consultanc Group yderabd (1991) Asse.sent of Performance 6.13 Coveraae and Intensity. Over the past thirty five years, the structure of IES in India has evolved in a somewhat haphazard manner. Organizations have emerged and activities were adopted, as and when specific needs were identified. Often new activities and institutions have beerL introduced without reinforcing (or terminating where appropriate) existing activities and institutions. Consequently, this has caused the dissipation of a relatively limited resource base over a wide range of activities, failing to satisfy the actual requirements of any one service (i.e. the intensity of the service has became deficient at the firm level). This has affected the quality of delivery.* In many instances, the same organization has attempted to provide both promotional and support services or play both a regulatory and 4. The SIDO had been initiaLly designed, through its SISs, to "supplement" some of the services to be provided by other support organizations which were in the pipeLine. At present however, the SISIs play more than a supplementary role. Through their 27 field offices, 31 branch offices and 37 extension centers, the SISs provide services in 8 broad areas, which include both promotional as well as support services. As a result, their resources, both financial as well as manpower are dissipated over too many activities. 84 promotional role (as in the case of the DICs). This effort by individual organizations to cover a wide range of services has prevented them from attaining the scale of operations required to gain from the benefits of specialization. At the same time, there has been an absence of diversification within a specified area of activity which has inhibited flexibility and the capacity to adapt to the changing needs of newly emerging SSI and different market requirements.5 In some cases duplication of effort is a problem; however, given the low intensity of service activity and its geographic diversion this does not appear to be a critical problem., 6.14 As noted above, a fundamental problem with IES in India is that the coverage and the range of activities have been increasing, but the resources allocated to undertake their activities has not. This dissipation of funds across an increasing array of activities has diluted the intensity of effort and, in many cases, prejudiced the delivery of any services to SSI beneficiaries. Over the last decade, budgetary resources have increased by 5S% in real terms, but the number of registered small scale firms increased by 151%. Hence expenditures per firm have declined by 39% over the same period* (See Table 6.2). 6.15 The result of this declining resource allocation is that an effective and sustained service effort becomes less possible. Shortages of financial resources have inhibited both machinery modernization and the recruitment of qualified personnel. Inadequate staf4ing in turn has affected the optimum utilization of already installed machinery.' In addition, the operational mandate given to many institutions inhibits operations on mare commercial lines in order to supplement resources available. The offering of free or heavily subsidized services undermines the capacity of the institution to charge, on a full cost recovery basis, for the same service provided to another firm. Finally for many IES institutions, locational policies have added significantly to the financial costs of operation which cannot be *. Where diversification has been adopted, it appears to have been successful. The strength of the NSIC for instance, has been in its ability to forecast and diversify according to the needs of the SSI and the prevailing market trends. However, unlike the SISIs, the NSIC has limited the sphere of its operations, targeting its services to the supply of machinery and raw materials and marketing assistance (i.e. concentrating on the intensity of the services offered). This has helped the SSI as well as the viability and healthy growth of the NSIC. . For instance, the pump set manufacturers in Coimbatore have been the target of several programs: the STEP Program being conducted by the IDBI, the UPTECH Program being conducted by the Sol, as well as being on the PPDCs list of future expansion plans. . At the Chemical Lab at the Bombay RTC for instance, shortage of funds have prevented the Center from maintaining back-up staff. Certain tasks are being handled by only one person (chemical testing for example). Consequently, if the uone" person is on Leave, all tests are stalled. Similar problems exist at the State Level also, at the Bombay DIC for example, inadequacy of funds to cover recurring expenses have prevented the appointment of Project Managers. 85 recouped from budgetary iesources nor from commercially oriented activities. TABLE 6.2 ,ENTRAL QOVEPNMENT EXPENDITURES ON IES (Re. million) . FY'01 FY84/85 FY88/89 Cuttent Cutta:t Constaott Crren t Constant Proaurement 18.58 315.8 228.7 458.7 246.9 Capital (Inatuding Loans/Advances) 26.8 67.7 49.0 94.4 50.8 Total 381,1 2~I.ZZL JUU 222.7 Self Employment Schene fort 998,3 722.8 805,4 4334 Educated Unemployed Youtha'. No,of registered SSUnit. 485 800 .220 Expenditures per Unit(R&.) , 3464' 453. Delisted usgj GDP deflator in PY 80181 prioes , Schqme Intended to hup the unemployed **teblie enal firwa introduced in Agut 1983. to provid oteS eonjuct~i wi temorli b#anks fryouhfbetwee th# as of 18 d 35. Sources (s)# li00Annuar Reoort. 1989-90 bS. uuna..r.Ai, Union Budget Docujment, 1982-83, 198-87& 1990.1. Mnietrof Fna08. New 0e1hi, 6.16 Governmental Controll. To provide a degree of flexibility and independence in day-to-day operations, several institutions providing specialized services were registered as "Societies" under the GOI Societies Act XXI of 1960. In theory, this was to allow them to by-pa.. certain government formalities (both in terms of administration and finance), i.e. they would be able to recruit staff through open advertisement, retain funds generated through commercial activities, etc. It was proposed that the SIDO would financially support these institutions in the initial years, but gradually withdraw support as the institutions became self-sufficient. The Societies were to be governed by a Board of Directors, comprised of members from the Central Government, the State Governments, industrial units, trade/industry associations as well as from the academic community, with the *. This is a problem faced by several IES support inst'tutions Located in backward areas. For example, the Electronics Service & Training Center (set-up by the Central Government to provide support services to promote growth of the Electronics industry in the region), is situated 6 K1 from the nearest town, Ram Nagar in Uttar Pradesh. There are no regular transport facilities and infrastructural support is totally lacking. Good hcusing for the staff is not available. Thus attempts to attract qualified staff involves substantive financial effort on the part of the Center. In contrast, Agra, being an established industrial belt in Uttar Pradesh, facilitates the running of the PPDC (in providing support services to the local casting & forging units) since it does not have to concentrate any of its resources on basic Infrastructural development. 86 head of SIDO as the ex-officio chairman. Orgaizations registered as "Corporations" at the State level carry a similar status. 6.17 In practice, however, this concept has failed to materialize, and thead arrangements remain reliant upon the Government for financial support. The level of commercial activity necessary to attain self-sufficiency and commercial viab'.lity has been low, partly due to the problem of distinguishing between "free" act1'* :ies and "chargeable" activities. In some instances, self generated funds do not alleviate resource inadequacies, as these amounts are deducted from grants and budgetary resources received, with no reduction in mandated responsibilities (this occurs with NISIET, for example). There are a few support organizations which do not provide any free services, with the result their financial position is more secure. The CTTC at Bangalore has been totally self sufficient since 1983, covering all of its running expenses, a part of its depreciation cost and a part of its modernization efforts, through the manufacture and sale of components. Hoiever, this diverts production capacity away from tool m'anufacturing for the SSI sector in-the area, and ironically in certain cases, places the CTTC as a competitor to those it is mandated to assist. This raises a fundamental question with regard to IS, as to whether any subsidy element should exist in the provision of certain services, particularly when the,assistance provided is of direct benefit to the recipient.9 6.18 Another implication of the administrative and organizational arrangements is that IES institutions are burdened by excessively bureaucratic, operational requirements. In the area of staff recruitment, promotions, career development, working conditions, etc., rigid Government policies prevail, which oftentimes inhibits the Societies ana Corporations in their own personnel policies. This problem was found to exist at Central Government agencies (e.g. SISI, RTCs, IDEMI, NISIET, the Electronic Service & Training Center, CTTCs, etc.), the State Government agencies (e.g. DICs), as well as within agencies set-up by the all-.Lndia financial institutions (e.g. TCOs). As a result many professional posts remain vacant, or the incumbents do not have the requisite experience and qualification. Zurthermore, the Chief Executives of the various institutions which are governed by a Governing Council lack sufficient operational power in the day-to-day workings of their organizations. This excessive bureaucratization results in delays in procedural activities, stifles incentives to grow and diversify and inhibits innovation. Moreover, success evaluation criteria have become blurred, with the result that "output" (provision of a support service to SSI in an efficient manner) is lost sight of. Officials of Central and State Governments are aware of these problems; however, the goal of operational flexibility and broad operational independence remains illusory. 6.19 Relevance to SSI Needs. As a result of the limited resources (and spreading these resources over too many activities) and excessive *. The STEP programs (under the IDBI), offers no subsidized services. The entrepreneurs Located in the factory parks under the STEP Program are expected to pay comnercial rates for alt facilities used after the completion of their third year in the park. They are infact subject to royalty payments for products and processes developed within the park premises, even after they leave. 87 bureaucratization and administrative rigidity, many institutions have been unable to moderntze and keep abreast of the latest trends and developments. This has undermined their relevance and usefulness to emerging entrepreneurs and existing small scale firms alike. In some cases, institutions have not been able to modernize since their inception. For example, the PDTCs were formed in the late 195Gs and early 1960s. Consequently, the plant and machinery are in dire need of modernization, especially at the Okhla (established in 1962) and Howrah (established in 1963) centers. As promoters of technological excellence and modernization for SSI, this is definitely affecting the quality and relevance of the services provided. It is also affecting their capacity to earn commercial revenues, as products produced during the process of training are not easily saleable due to their inferior quality. Outdated production facilities are a'so slowing down progress in the area of prototype development. At the Okhla center, over the past ten years only 41 prototypes have been developed. 6.20 Thtre is also very little skill enhancement of technical staff necessary to keep them abreast of latest developments and current international standards. Many of the staff members are sent to NISIET for training, however this is purely managerial in nature. Upgrading of market information (which enables organizations to effectively advise entrepreneurs) is almost totally lacking. Budget constraints are also preventing the maintenance of up-to-date libraries, particularly of technical books and materials. This problem is evident at all levels (i.e. for organizations falling under the Central and State Governments as well as for organizations supported by the financial institution).1o As a result, the quality of services as well as the ability to respond to the needs of the clients have suffered. 6.21 The IS institutions which have been particularly successful in delivering services appear to be those which have not only kept abreast of all latest developments in process and product technology, but which have also been able to adapt innovations and/or inventions to the local needs and conditions. For instance, several institutions have combined shop floor training at the institutional level with hands on training at users premises, adjusting, focusing and customizing the assistance to the requirements of clients and to the local environment (i.e. concentration or intensity of the services at the client level)." Proximity to the manufacturing units is also o. The three major aLt-India IES institutions: the SISIs operating at the Central Government level; the DICs operating at the State Government level; and the TC0s operating at the level of the financial institutions, are all faced with the critical problem of modernization, updating of technical documents/tibrary materials and enhancement of staff knowledge and skills. This renders their function as carriers of information, latest production methods, etc. to the SSI ineffective. For example, "When the SISI was created more than three decades back, there was practical ly no smal I scale sector to render assistance to.... The structure of the organization contained technical officers of different disciplines, workshops in various trades and mobile demonstration vans for some selected disciplines. The sai-t structure is being continued even today although the small scale sector has undergone a fundamental change." ("Small Industries Services Institutes and its Activities", the SISI, West Bengal). ". A good example of this is the PPDC at Agra which displays an impressive array of inported machinery for product and process development and testing, but it attempts to replicate the local factory environment to visualize the modifications and adjustments necessary in the equipment to improve ond enhance the local manufacturing processes. 88 crucial to the success of any service activity. 6.22 Another direct outcome of the poor resource situation and excessive bureaucratization has been neglect of and insensitivity to the construction of an information bass. This includes the collection of basic statistics, demand informat.on as well as information which enables the various institutions to evaluate their effectiveness in the delivery of services on overall SSI performance. Field surveys and visits appear to be limited. Most ZES institutions seem to place a low priority on monitoring and evaluation in their basic work program. Instead of active monitoring, the majority of the institutions expect their clients to come and inform them to whether they find the services useful. Evidence indicates that even - ,nizations having large networks (such as the STSIs, DICs, and the TC09) ara aot utilizipg their comparative advantage (with the assumption that a large network facilitates data collection) to gather necessary information.12 There is also little interaction between different IES agencies. For those few organizations which recognize the importance 'and merits of monitoring and evaluation, inadequate, staff size and lack of computerization have become major bottlenecks. In general, proximity to the clients seem to help in the monitoring/evaluation process - which again suggests that the intensity of the service is an important factor in its overall effectiveness." Co=cIgsions and Recoymedations 6.23 To conclude, the impact or effectiveness of the industrial extension services on the small scale sector in India has.been mixed. In general, where there has been a concentration of effort in delivering a specific service, covering a limited area, the impact has been beneficial. Where too many varied services have been undertaken by a single organization, or an attempt has been made to cover too wide a geographical area, the quality of the services has suffered as resources (financial and manpower) are dissipated. Expansion in service activity has been at the expense of adequate funding and modernization of on-going activities. Furthermore, with a commitment to . The SISIs do submit quarterly and annual reports to the SIDO as well as Action Plans, however their effectiveness becomes qu ionable in the absence of the required information base. A similLr situation exists in the case o. t .e DICs. Although DIC Inspectors are to visit the field twice a week and Regional Directors every week, it is not feasible with an average staff size of 30, not all of whom are professional or technical staff, to adequately monitor and follow-up on the small scale units registered in an area. For example, in the Thane District (in Maharashtra) alone more than 13,000 small scale units are registered with the DIC. On the other hand, there appears to be no format sampling technique which could be utilized to compensate for this handicap. 13. in the case of most Industrial Estates (where basic data collection and monitoring should be a relatively manageable task given the proximity of the units); there appears to be little or no attempt at monitoring and collection of information. Even basic information such as the number of sick units within a given Estate is oftentimes Lacking. Early detection of problems which lead to sickness can prevent it. For example, at the Behala Industrial Estate (administered by t' West Bengal Small Industries Corporation) a chemical unit was recently allotted space on top of a recording studio with the result that the studio is now incurring Large expenses in order to sound proof its premises against the heavy machinery employed by the new unit. 89 BOX 0.2 INDUSTRIAL ESTATES PROGRAM IEP) Towarde the and. of the Firat PIve Year Plan period (1951-56), it was feit that avaiabllty of the baglo Infreastruotural foollitiec at on. location, would greatlyfaoliitate the development of the small sol scotor In Indla. in 1965, amog devalopirg ocuntrios indta became ona ofthe Bfrat to ddåpt the.IEP asa *peclfio measure for the :deveepmqnett th be Peranog~öined "tnifloant mon uduñag thn oarff Flyg tear Pon period (1966-G1l. Ths;Third Flv. Yo lagan placéd snch grssteremph.cais utflization of indmtriul states a en instrument for dieprwal ofindiutyto ruralsnd baokwardaoreas. o th.itoeliagoc with lesethen 6,000 inhabitanto and iooated atasuuffiient dlstono*.framferg oltie and towns* (Sokhar.f183).The Plan alse mub4lided.the other lndMdual wtateaInte'urban* osatee <ln aities/towns with e population oxaaeding 50,000> and "sami.úrbanl ostates (in smallitowns with.a population betwoen 6.000.ond 60,000). By the and of the Third Five Year Plan pedaod (1560>,ai total of 483 Industuiat estotes had been conatruåted, of *hloh 208 (43%): were funotional und.275 (7%). wr. at vrous utegasf devolopment. During the seventie. W(ourth 4nd FIfth Plan periode, 1970 to 19704 the nrmber of.induïtdl.sltateå In oöäretion neerly doubled (from 327 to 633L the number of Inductrial unitt functioning in the *aesta mora thon tripled (fram 5,442 to 18,421) and output -from them mor: than quadrupled (in nomina! tens from R.1.48 billion to Rs.8.03 billion). while total enployment genar*ted rose by 176% (s Table betow). By March 1981, 799 entates hed been aponcored under the Fivu Year Plans, og: of which 059 (82%> had beoone funotional .n, the ensuing years. policy. ak#rs eleo attempted to uae the Prograncsettiod for turgeting development to seleoted groupa of Industries and entrepreneur. As.a result, sveral estatesaismisged to encourage the developmnrt of oaillestec hnoce, artisan.ontrepreneurs, export~ oriented unitu, eto,: Unf9rtunaty,there are no.omprohenuive data avaliable on the Industrial estas after 1981 and neither thå SID no the Union Pfunninq.Comisuion wcrö ,åå to potide nf lon efte 1979 INDU'5TRIAL ESTATE8 PROGRAMS (lEP~ Growth of fndustraEtatctes (n Est.) fn Indi 1956 1961 1966 1970 1975, 1979 1981 1.Nu-hrefTIndt. Est. Spnsored 13 120 483 519 656 796 799 2.t`uab!r of ldi. Eat. Functioninga n.a. 53 208 327 469 633 659 1Jrban n.a. n.*. 106 147 231 296 n.. Semi-urbant n.. n.a. 63 107 135 169 n.a. RuruL nu. n.u, 39 73 103 168 n.. 3.Nubr of Indt. Est., completed but not fti ontflfig n.a 14 97 91 104 72 36 4.Number of fndt. Est. under constructio n.a.. 53 178 101 83 91 104 5.occupancy percentage of piuta n.a. n.e. n.e. n.a. 51.80 69.80 p.a. 6.0ccuancy percentage of sheds n.a. n.a. n... 78.40 83.80 90.00 n.a. 7.Nuber of ndi. Units functioning n... n.u. n.a, 5,442 ¶2,376 18,42.::.e. 8.EpGomen' gnoratod in. Indi. Est, n... n.a. n.a. 103,675 185,429 286,201 n.. 9,Prodctionl gänerated int indi. Lat. dw'insg year <Rs, blitioni n.., n.u, n,. 1.485.0,0000.03. V:Source: HaTf-yearly Progress Reports on Industriat Etates", Development Couissfoner, S, Govt. of Indi, and y.S.P. Rao & D. NDgae §M. . r Develoment in. ndiep D sIovery Pu sigHouse, Naew DelhI, (1991>. At present alarge portion of the funds for the 1EP are genaåted y Way of term löann from commarcall banka and SFC with refinancing available from the IDBI/SIDB. Approvals får refinance assfstancc to the Industrial estates by the 101 increased from Rs.3 million in 1973ý74 to Rs.224 million In 1986-87 to Re.425 rnilläon over the period 1986-87 to 1990-91. over the same periode, disbursement increased from Re.2 million to Ra.198 mililon to Rs.423 million respeotively (direct finanoing is alao available from the 01 for projects costing morae than R9.30 million). 90 Although the majority of the estates continue to be promoted by State level institutions, a conscious effort has been made over the years to Involve entrepreneurs in the operational management of the estates and in some cases, even In their financing. A number of estates have been constructed by State Corporations at the request of local entrepreneurs. The operational management of some of these have subsequently been entrusted to local non- government bodies.. During the Fourth Five Year Plan period, cooperative estates.were encouraged to grow. The Idea was to Inculoate a sense of responsibility In the entrepreneurs right from the conception of the estate proposal. In the states of Maharashtra and Gularst, several Industrial estates have been promoted on a cooperative basis. The cooperative societies, consisting of rtrepreneurs, develop the tend, construct the shedalbuildings and subsequently make them available to their members on lease basis. The financing pattern followed in a cooperative estate is usually 20:20:00 (i.e. of the total projeotonst. Including building construction, the member' share capital contribution is around 20%, the state government's contribution is another 20% and treated as a long-term Interest free loan, and the remaining 60% is obtained at a long-term loan from the financial institutions. The land is acquired and given by the state government on lease to the Society. Over ie years a number of estates have also been promoted and developed by the private sector. Such estates are estimated to account for around 5% of the total number of industrial estates In India. At the end of the Fifth Plan period, the estates only accounted for 5% of estima:ad total output and 4.5% of employment in the SSI sector as a Wholo at the end of the Fifth Plan period. The share of 'rural" and 'sem-urban' Industrial *state& to total functioning industrial estates remained around 22-26% and 27-33% respectIvely over the 70., while th share of *urban remained around 45-46%. 8^y the Sixth Five Year Plan, considerable concern was being raised regarding the performance of the IEP, 'While the number of industrial estates and areas are fairly large, their functioning has not been uniformly satisfactory, the shede and plots developed have not been fully occupied and become functional. The performance of seml-urban and ruralindustrial estates has been relatively less encouraging* (Sixth Plan Document). Often, the most important factor contributing to the inadequate performance of the estates has been poor locational hoice, In many cases, careful techno-economic surveys were not conducted to ascertain the suitability of theaee rtr0ps of proximity to markets, availability of raw materials, labor (especially skilled workers). transportation facilities, etw4 Contrary to economic rationality, to encourage dispersal of industry many states located the estates 2 to 4 miles outeld of the municipal Imits eventhough the municipals were smelt towns. *TN. Inevitably resulted in serious bottit"ks irttransport facilitie, and in the supply %f other essential Inputs Ilke water and electricity* (Sekhar. 19883). In th0ei enthusia to promote the program, certain states decided to locate one or more estates in every distriot. "In many of the states, It was considered a matter of political prestige to locate an estate in each district as the district was not considered to have come of age otherwise' (Sekhar, 1983). According to a UNIDO study, political factors might also have played an Important r.e in the process of site selection. Up until the Sixth Plan period, selection was based on 'quiok techno-economic surveys' (Fourth Plan Document). As a result, by firm level performance, at the end of the three Annual Plans (1969). 78% of the completed sheds located in Urban estates were functional while only 50% and 57% of the shade were functional in the rural and semi-urban estates respectively. This was clearly Illustrated in the State of West Bengal where sheds in rural and semi- urban estates remained vacant for lengthy periods while estates closer to Calcutta registered high occupancy. From the beginning of the FoUrth Plan period to the end of the Fifth, the share of rural and seni-urban industrial estates to total functioning estates dropped from S%. to 63%, while the share of urban estates Inoreased from 45% to 47%. At the end of the Fifth Plan period, studies conducted in the State of Rajasthan showed that firms located in the urban estates were Ywore successful: they had higher utilized capacity (52.58%) than units located in rural estates (44.58%), their net profit on net assets wee higher by 10% while their gross profit on total capital employed was higher by about 9%, as compared to firms located In rural and semi-urban estates. Similarly, in the State of Gujarat, the average profitability of firms located on urban estates was found to be consistently higher. Often easy access to basis infrastructural facilities at oonoessional rates has facilitated and induced the entry ofa number of small scalotnits which continue to remain basically nonviable. In general, the efficiency of firms located within industrial estates (even on Urban estates) are found to be lower than those located outside the estates: Numerous studies indicate that the Rates of Return of firms located within the estates are, on average, much lower than those located outside (Bandopadhyays, 1 59; 3andeeara, 1988: Oher & Lydell, 1958), Availability of Inputs at concessional rates (financial assistance, raw material, etc.) has also, at times, made it more lucrative for firms to remain within the estates and take on trading activities, i.e. to resell the inputs outside at a profit than to go into actual production. 91 BOX 6.2 (continued) Therefore, often the management of the estates has been both diffloult and stool. In the majority of oases, the sensitivity of exit poliies. have deterred estate authorities from eviating non-desirable and non-viable units. Management tems from. sveratlestates admitted that evn if the units sae taken t9 court,evation becomes a e otremely-1ongnd tedious process as ulit, appeal to higher kcoutAlarg proportitw of units Ir many industrial esitates thoreforareimain nor-funato most oftthe timeC however those moribund rnits contie to hold onto their plats and faclitIes. It was noted during our discussions with several estate authorities, that the percentage of sick firms witti industrial estates may be as high a* 20-30%. As a result, there is a chronic.under-utilization of land and facilities at many states. To check this probem most eistates have stopped the oristructio and renting of shade and buildingsi instead they pow offer developed land for sals on hire purchase basis to small scalefirms This isalso expected to out down on the delays and administrative procedures that plague most firms locating on estates. However, given the differentials etwteen the et6development of estate land and (to highly subsidized sale, a greater degree of scrutiny of pirospentive;tenante 1s imperatlve. AoordIng to a conservative estirriate the development cost of one square mater of estate land (whihJ liude, the provisorV of roade street lighting, water supply electricity, etc.) is around R.40, the sale price however may be as low as Rs,10 Rs.1 5 per square meter. ThiAdifferential increases for estates located in the backward areas where additional infiestructural support: may be required to make them viable. Often, it Is more lucrative fri hebtnya to recall immrediately at asubstantial premlide. By and large, the estate authoritise do not monitor uitis tocated o thliei taites Monitorin of"tenant unite Ie strongly advised as it enables the authorities to detect firm sicknese st an early stae. Despite considerable effort on the part of the Central and State Governments to promoto the IEP, the severest difficulties encountered by the SSt In India continues to be the leak of adequate factory space and infrastructural facilities. Although attempts have been made to review the Program (during the Fourth and Fifth Plan periods), it has not been sufficient, Therefore, after 35 Vears It is time to take a comprehensive look at the IEP, its objective and its modus operttdi, Source: ..P. Re & D. Nagaly (ad. SmelItndustry Development I india. e- Delhi Olse6viy Pubishing SuAuse, l991. V.A. Sekhar, Industrial Locatio PolcV The f6dian Exoerf@Mg, World Bank Staff Working Paper No.620, .183. P.K. Basu, *Cost-benefit Analysisof"Industrial Estates: A Locational Comparison. Unpublished Ph.D Thesis, provide most services at subsidized rates, the ability to raise resources through commercial activity (where permitted) has been limited. Since private sector/NGO participation remains confined to a few areas of IES, the government organizations have continued to expand. In addition, the majority of the IES institutions falling under the purview of the Central and State Governments, including registered "Societies" and "Corporations" have been subject to a host of government rules and regulations at the operational level. This has created a strong element of bureaucratization within the institutions, which is inappropriate to the dynamic, advisory roles called for in assisting SSI. The importance of monitoring and evaluation in delivery of quality IES has also been greatly underestimated; only a few IES organizations have attempted to assess either the usefulness or the quality of the services rendered. Moreover, because of inadequate interaction between the various institutions providing IES, effective networking of services and interaction between different agencies has not materialized. 6.24 A fundamental reappraisal of the whole Camut of industrial extension services, their methods of delivery, the institutional framework, the activity focus and methods of funding is long overdue. Partial reviews of the system 92 of IES have been undertaken, but these studies have not examined the totality of services that would be of most use to SSI, and who should provide them." The industrial environment facing India today is quite different from that prevailing in 1953 when the first recommendations were put forward to establish IES activities to assist SSI. 6.25 Fundamentally, IES is an information dissemination function, and attempts to go beyond this can best be undertaken by normal commercial activities. In a developing environment, with deficient education and communication systems, providing efficient transmission mechanisms for commercial information, production information and technology information is a highly desirable activity, in which the social benefits can far outweigh the social costs. This is true of promotional activities that assist a nascent entrepreneur, as well as for support services for already existing firms. But two crucial elements are necessary for this. First, the purveyors of such information and advice services would need to have up to date information, and this would need an infrastructurp that continually dpdates this information base. Furthermore, those that provide such services should realize that there is a limit to the types and range of information that can and should be provided. Advice on marketing requirements (e.g. packaging and health regulations) is one thing, even suggesting fruitful markets or possible market contacts based upon consumer research can provide good support, however assistance in the marketing function beyond this point should be solely a commercial activity. Second, to provide advice and relevant information to SSIs requires staff that are skilled, armed with contemporary technical or commercial information, motivated and commercially oriented. A bureaucratic, regulatory and public administration orientation in the provision of IES reduces its flexibility and hence its relevance as a facilitator of commercial activity and emerging entrepreneurship. This is probably one of the most serious faults of the present system of IES in India. The DICe are basically regulatory agencies, with little or no commercial orientation. Hence they are viewed as part of the administrative and licensing network, rather than as a tool to assist the small scale sector. 6.26 Appendix AS provides a short overview of IES in a few other Asian countries. It is apparent from the experiences of these countries that successful programs are highly focused, with intensive and sustained interaction with SSI beneficiaries. And, they are dynamically flexible so that services can be speedily adjusted to the needs of the small scale producer. The range of activities is clearly defined and limits are set on what is expected from the support services offered. These focused programs are properly and adequately funded, ensuring a high quality of extension staff. They are not viewed as "social welfare" programs, but conceived more as commercial adjuncts to successful business activities. They are both reactive in responding to standard information requests from their small scale ". For example, the Program Evaluation Organization of the Planning Commission has taken up evaluation of the DIC program. Earlier, the office of the DC SSI had commissioned five reputed institutions, namely IIN, Bangatore; Institute of Economic Growth; Delhi University; IIM, Ahmedabad; Gujarat Industrial & Technical ConsuLtancy Organization (GITCO); and Ahmedabad Management Development Institute, Gurgaon, for indepth evaluation of the DIC program. Around 55 DICs were selected. 93 constituency, and proactive in bringing to the attention of SSI changing technologies in production systems and market opportunities. They have an educational role and in some cases serve as catalysts for the provision of advisory and consulting services by the private sector. 6.27 Besides the generic problems of capital constraints, market access and diseconomies of low levels of production, encountered by SSI or new entrepreneurs everywhere, SSI in India faces major infrastructure and input constraints. Small firms complain of the lack of adequate factory space that is close to appropriate markets (many industrial estates are located in so called backward areas that lack adequate infrastructural support), deficiencies and irregular supplies of power and raw materials and excessive regulatory bureaucracy. Industrial extension assistance cannot overcome or compensate for these constraints. Rather, general policies need to be adjusted so that resources can more readily flow into those areas which market prices indicate would provide suitable returns on the investment. Concessional power rates for SSI mean nothing if supply is irregular; subsidized factory rentals in public sector industrial estates may benefit the lucky recipients, but do nothing for those prospective entrepreneurs who cannot find appropriate facilities; and raw material quota allocation systems simply facilitate black marketing of the scarce items or low levels of capacity utilization across a wide range of small scale firms. An administrative system to allocate these resources amongst aspiring entrepreneurs through non price means, (although corruption often introduces a price mechanism to the allocation process) is not an IES. Instead, the limited resources available for industrial extension should be directed into those information transmission activities that can improve the efficiency of existing SSI and the likelihood for success of new entrepreneurs who have already arranged their infrastructural and input requirements. 6.28 Given the above comments, the proposed review should cover the following areas: - Assess the full range of existing programs, both governmental and non- governmental, that are offered. - Evaluate the effectiveness of these programs and schemes in the context of the resources expended on them. Investigate mechanisms to implement regular monitoring to ensure that the usefulness/relevance of the programs and schemes that are put in place and their viability are maintained, in keeping with the changing policy objectives and needs of SSI. - Clearly differentiate those types of activities that should be provided on a full cost recovery basis, and those information transmission (and adult education) programs that have extenalities which would warrant provision on a less than full cost recovery basis. - Identify specific areas, under the general set of extension services, where the public and the private sector have their relative comparative advantages in terms of technical expertise and resource availability. Experience from other environments suggests that public 94 sector information based and educational promotional activities can have a useful role to play if they are structured with a commercial orientation/approach and are adequately funded to attract highly qualified personnel. Thus a public sector role can be beneficial at the pre-investment stages, but beyond, that most activities can be provided by private sector agencies and industry associations. - Given the above differentiation and identification, appropriate action plans should be drawn up that divest those activities that can be run on a full cost recovery basis. The variety of tool room, and testing and quality control centers should, for example, be run entirely on a commercial basis and hence diveste. to the private sector. - Once a classification of the public sector's role has been made, an appropriate organizational framework should be drawn up. This framework should be structured in such a way that each service delivery center is self contained, located in areas where the demand for its services is greatest, have a great degree of autonomy in daily operation and administration, have a staff policy that is not constrained by Central or State Government staffing rules (including salary structures), and have a network that links the various service delivery centers and hence facilitates the establishment of appropriate information bases. Finally, these institutions, programs and schemes should be adequately publisized to ensure maximum visibility by potential clients. 6.29 Inevitably, industrial extension services in both economically developed and developing environments suffer from a confusion of appropriate roles and objectives. They often take on social welfare obligations and development objectives that far exceed their initial mandates and limited resource bases. As a result, the quality of service support declines, there is a degeneration into regulatory and administration functions, credibility and usefulness is eroded and potentially beneficial services are ignored or neglected. Unfortunately, this has occurred in India with the provision of IES to the small scale sector. There are a number of examples of useful services operating in the country and in all cases they are either operated on commercial lines (NSIC is a good example, however there is a need for more entities of this type that operate in the private sector) or have more limited objectives with services intensively targeted (e.g. the STEP and UPTECH programs). The role of "leadership" was also noted to be an important factor in motivating staff, maintaining service quality and ensuring the viability of the institutiots (NSIC is again a good example along with the CTTC at Bangalore and the PPDC at Agra). There is an urgent need therefore, to thoroughly reappraise the present system of IES in the country. 95 HMER 7 SUB-CONTRACTING AND TE SML SCALE SECTOR Intzoaion 7.1 Earlier chapters of this report identified some of the major constraints which inhibit the potential growth of SSI in India. Among others, they include scarcity of working capital, difficulties in procuring necessary inputg, inaccessibility to appropriate technology, and lack of an adequate marketing infrastructure. A wide range of Government supported programs, both at the Central level and at the State level, have attempted to alleviate some of these constraints. The results have bean mixed. In this chapter we examine the role that sub-contracting can play in overcoming these constraints. 7.2 Sub-contracting, or ancillarization, may be defined as an inter-sectoial relationship (generally between a large firm and a small firm) involving complementary activities, which are external to "pure market transactions"' (Lall, 1978). Such linkages play a vital role under imperfect market conditions where free movement of resources and factor inputs is inhibited and vertical integration is unecoy.omical. Experience further shows that these relationships are particularly helpful in the transfer of technology and skills from the large-scale to the small-scale sector, thus diffusing technology to a wider industrial base2. Costs and logistics of marketing are also minimized as such linkages provide ready, predetermined outlets for small scale industry products. Since such relationships are borne out of voluntary action, based on mutual economic gains and without direct Government intervention, the benefits accruing from the relationship are expected to lead to a long-term sustainable development process. The speed or extent of the benefits however, depend largely on the industry, the structure of the economy and the stage of industrialization. 7.3 This form of inter-sectoral linkage is known the world over by different terminologies: ancillarization, sub-contracting, vendor/vendee relationship, preferred suppliers, etc. In the Indian context, a sub-contractor or an ancillary unit is distinct from all other suppliers in the market place, in that it supplies according to some "specification" of its buyer (i.e. on a made-to-order basis). This may include the manufacture, processing, assembly or sub-assembly of a part or whole of a product which the buyer (i.e. parent firm) will tinally sell as its own (see box). Generally, a 'contract* is involved, written or verbal, setting out the terms and conditions between the 'Where anonymous buyers and sellers exchange goods in discrete transactions at prices determined in conpetitive markets. 2Even "the amount of contribution made by imported technology depends on the extent of its diffusion within the country". Modernization of Japanese industries, for example, was accelerated "not by free or cheap access to foreign technologies but by adaptation and swift diffusion of technologies that were imported selectively but at high prices" (Watanabe, 1983). In fact, the Japanese experience of sub-contracting, with its widespread linkages and its stimulation to technological diffusion has been held up as a model for LDCs (Latt, 1978). 96 BOX 7.1 TYPES OF SUB-CONTRACTING RELATIONSHIPS IN INDIA t. ComoonentSub-ontrating: A parentflrmtimiteit. 4, Activies Sub-ontraadno: .ome productlon sodivitlee to the manufacture of crttisf (technotogy- proce~sesoonsist of distinotly separato activities whloh ItensKve) Vomponett and sseinbly of the final need not be oadhd out oontinuously on the same product. $ub-assemblies end manufacturc of reltively prem:sJe, Tho pärent 6gin rOtains the eritil a~tivite.. labor-intensive componente ar. oarried out by the sub- and off loade other activities or procesese to- its sub- contraotoro. Testing end inspection of 00ntractors. Ti type of Mrangement ts seen in the components/sub-assemblies and the final production of Raiway Industry, where all machining operations are the Item is retalned In-house by the parent firn,. usually don: through .ub-contractors. Another typloal Des1gnstdrawings end speelfloation c are supplied by exempIe is elootropating ctivity, which is generelly the perent firrn to the sub-ontreotor. Depending on sub-contracted out by the parent firm. mutuhl conven*oe and oxigencies of a porticular situation, the peront fin may also euist the sub- 5.Lab.or Sub-contractn : This type of arrengement is contractor with dyesljigm/flxtureslraw materils ed in- prevalent in the oastings and forgings industry n india: proces* quulity control faliltes. * This typ. of : <2 . rot where many smal å nd medium foundris are arrangement is very 4omon in the Engin.edng loated, euboontreoting of moulding and casting Industry ln india. where manufacture of simple operations la reorted to. The sub-contreator bings his mohined ompononts, fobrioted itemo, ocstings and team of cki~led worcero to the foundry end undertake forgings are lef with the sub-"ontraotors. Typica. moulding and ocatfng of products. Tho foundry owner exa *ples are Diesel Engines and Sewing Machine save. on supervlsion cost (especially in the event of industry, lobor voret nd 0dditional oost on labor if ho wera to employ them reguady. A variation of this arrangement 2. Assembyi Sub-contraatina: In the Electronios Is where the factory owner legas out part of the Industry, prodution of oomponent like the chip, production machines to e sub-ontractor. The eapee tor, tr*nsistor, and T.V.. pioture tubes are capital mechines phyuically raela on the pramises of the intenuive processes requlirng high technology, perent flrm. The sub-oontractor employs hio own wheress, mmnufmoturn of finel products by eesembiing workoro end the prodution~ Is bought by the parent thtese ¢Obn¢gtU ere labor and skill intenslv. The firm tmutually greed price. The sub-contractor has lettar eotivtyf 1* therafore, normelly uub-contracted to the flexibility to mmnufacture items for other customners smalt entreprmneur.. The parent firm 10pplies the depending on the epare capecity aveilabie. omplet. kit to-the sub-contraator and taks away the assembled product for marketing under ito own brand name. 3. Product Sub-contractino:. Under this errangemnent, the sub-contractor mnanufactures the complete produat end the parent firm markets the product under Its own brand name. Typica excamvple. are Domestic Eletical Applianoes end Leather Produota. Under this type of arrangement, the produat design and quulity is generally controlled by the parent firms. Source: Negaraj, R., 1984. "Sub-oontraoting in Indien Manufacturing Industriest Analysil, Evidence and Issues sub-contractor/ancillary and the parent firm (Watanabe, 1983>. An ancillary unit3 is distinct from a sub-contractor, in that the former often ha. a longer-term relationuhip with his buyer with guaranteed steady off-takes, while the latter is generally involved in "job work" operations frequently involving smaller volumes or one tim. transactions. This distinction, 3Frequently, in the case of 'exclusive' or 'captive' anciLLaries, where s single buyer of f-takes a 100% of the unit's production, the parent firms are found to be involved in the initial promotion and development of the ancitlaries. In such cases, the terms and conditions are aften foiund to be <mare binding. 97 however, is not hard and fast. Manytimes, vendors referred to as "sub- contractors" by parent firms are found to have lengthy and binding relationships, in some cases, involving steady 100% off-takes. Most firms we interviewed did not make the distinction and neither does general economic literature. A distinction, however, does exist under GOI policy, although, it is more classificatory than economic in nature, designed to accommodate differential fiscal incentives. In this chapter, we use the term "sub- contractor" to describe both a sub-contractor as well as an ancillary unit, except when the need for specificity arises. Growth of Sub-contracting Activity in India 7.4 There is no systematic time series data that shows the extent of sub- contracting and/or ancillarization in Indian industry. Nevertheless, partial evidence, drawn from discussions with larger firms and information drawn from public enterprises, suggests that this type of activity has been increasing, particularly in the eighties. Given the relatively .low level of industrialization at the time of indepeidence, together with the strong emphasis placed upon the development of heavy industry in the First to Fourth Five Year Plans, and the role of public enterprise investment to achieve this goal, Indian industrial firms tended to be highly vertically integrateds. Furthermore, the government's desire to promote a greater degree of regional dispersion of industrial activity (which was manifested in its industrial licensing policies and its public enterprise investment decisions) probably contributed to a structure of more vertically integrated firms than might otherwise have evolved6. 7.5 There is considerable proxy evidence to suggest that India's industrial sector has broadened, and the extent of inter-firm linkages has increased. The average size of manufacturing plant in terms of the number of workers, has shown a secular decline in practically all industry groups over the period 4Ancittary Industries are Undertakings having investment in fixed assets (plant A machinery) not exceeding Rs.7.5 million and engaged in:- (a) the manufacture of parts, components, sub-assembLties, toolings or intermediates; or (b) the rendering of services, supplying or rendering or proposed to supply or rended 30% of their production of the total services, as the case may be to other units for production of other articles. Provided that no such undertaking shall be subsidiary of or owned or controtted by any other undertaking. Source: Small Scale Industries in India: Facts and Figures, DC, SSI. In order to ensure adequate production capacity of ancitlaries in meeting the demands of large public sector units, ancillary undertakings have consistently been allowed to have a higher investment ceiling over small scale units. 6See S.A. Ishfkawa, "A Comparison of Size Structure of Indian and Japanese Manufacturing Industries", The Hitotsubushi Journal of Economics, Volume 2, No 2, March 1962. 'iscussions with many firms that were established in the fifties bears this out. In many green field sites, the degree of supporting services and production inputs available from local firms and suppliers was virtuatty niL. And, given an underdeveLoped transportation and distribution infrastructure, with its attendant uncertainties surrounding delivery schedules, many firms chose to do as much as possible "in-house". Obviously this imposed extra costs in the form of higher inventory Levels and under-utilized assets and workers in non- core departments. But, many firms felt this extra cost justifiable in order to avoid disruptions in the production of the mainstream departments. It is also noteworthy, that the variety of tabor Laws that inhibited a firm's ability to rationalize its productive structure and Lay off workers, "locked in" a particular firm structure once this had been chosen, irrespective of improved possibilities for sub-contracting or "out sourcing" of components and serfices. 98 1950 to 1980, with this decline accelerating from the mid seventies7. Furthermore, using the measure of the ratio of value added to gross output as an indicator of the extent of vertical integration, is even more revealing (see Table 7.1)8. At the two digit level (National Industrial Code Classification) every category, except "food products" and "other manufacturing" experienced a decline in the eighties when compared to the seventies. At the more disaggregated three digit level, the same trend was observed, although with some variations. There have been significant declines in the ratio in consumer electronics, casting and forging, manufacture of paper products and containers and cotton textiles. However, the change in the ratio has been modest in tyre and tube industries, machine tools, industrial electrical machinery and electrical apparatus and motor vehicles. This modest change may reflect that a certain optimal firm size and industry structure was in place in the seventies (driven by technology and product specific considerations); however, it is notable that both machine tools and industrial electrical machinery are denominated by large public sector enterprises. 7.6 Although modest, an increasing trend towards ancillarization and sub- contracting is also perceptible in the public sector. Over the period 1978-79 to 1985-86 (see Table 7.2), the total number of ancillaries/small scale sub- contractors supplying to PSUs went up from 5072 to 16166, registering a compound growth rate of 18.01% per annum. Over the same period, 'total purchases' from this group, as a percentage of the 'total value of production' of PSUs, went up from 0.50% to 0.76%. Evidently, the growth in the number of small scale sub-contractors has been much higher than growth in the number of ancillaries. A review of the same data shows that while the number of ancillaries registered a compound rate of growth of 11.21% (from 805 to 1963) per annum, the number of small scale sub-contractors have grown at almost double the pace at 19.07% (from 4267 to 14473). Looking at a more disaggregate level of data (see Table 7.3), i.e. the performance of 29 PSUs (Industry-wise) covering the period 1977-78 to 1985-86', indicates similar results: while the number of small scale sub-contractors increased at a compound rate of 17.66%, the growth in the number of ancillaries registered only 10.27%. In general, the use of small scale sub-contractors by PSUs appear to be more prevalent in industries like Light and Medium Engineering, Pharmaceuticals etc., (i.e. where the divisible nature of production lends itself more to sub-contracting) and less in industries like Heavy Engineering, Fertilizers, etc. At a further disaggregated level, looking at PSUs which have been active partners in the Bureau of Public Enterprises' (BPE) Ancillary Development Program, reinforces this trend. For example in 1985-86, BHEL, HMT and ITI respectively, purchased Re. 63.23 million, Rs. 218.26 million and Re. 1154.22 million from small scale sub-contractors as against Re. 51.37 million, 'R. Nagaraj, "Trends in Factory Size in Indian Industry. 1950-1980; Some Tentative Inferences", L,P_ Volune XX, No.8, February 1985. Olt is rec)gnized that a change in this ratio can be caused by changes in factors other than a change in vertical integration. For example, a change in technology, or a change in a sub sector's competitive environment, could both cause a change in value added as they affect the wages and profits of a firm. 'To note, the monitoring of the Ancittary Development Program by the SPE stopped in 1985-86. Thus, official data is not available for the following years. 99 TABLZ 7.1 VERTICAL INTEGkATION RATIOS OF VALUE ADDED TO GROSS OUTPUT " 1970's * 1980'a * Z Change Food products . .0,098 *0.1095.. . 11.7 9everages, tobacco products 0.2705 0.2166 -19.9 Cotton textfles 0.2480 0.1984 -20.0 Woot, Sitk, Synthetic Fibres &Textites 0.2391 0.1783 .25.4 Textfe Products 0.1667 0.1552 -6.9 Manf. of Texti Le Garments 0.1817 0.1562 -14.0 Wood & wood Products, Furniture 0.2302 0.2004 -12.9 Manuf. of wooden furniture/fixtures. 0.3145 0.2350 -25.3 Paper, Paper products, Printing 0.3215 0.2088 .35.1 Manuf. af containers/boxes of paper 0.1844 0.1352 - -26.7 Printing l Pubjishing .4470 0.3773 15.6 .eathe.r & leather products 0.1482 0.1327 -10.5 Manuf. of Footwear 0.3137 0.2096 .33.2 Manuf. of leather consumer goods 0.2024 0.2364 16.8 Subber, Plastic, Petrotea 0.1645 0.1187 -27.8 Tyre .iTbe industries 0.2125 0.2091 .1.6 Manuf. øf Plastic products 0.2084 0.1668 -20.0 Chemicals & chemicaL products 0.2377 0.1794 •24.5 Hanuf. of Fertilizer 0.1861 0.1384 -25.6 Paint & varnishes 0.2631 0.1958 .25.6 Oruigs & medicines 0.2920 0.250? -14.4 Mon-Metat.lcfainerat products 0.2563 0.2350 -8.3 Manuf. O Glass & gtass products 0.2871 0.2313 -19.4 Sesi Metal & AlLoy Industries 0.2187 0.1542 -29.5 Foundries,casting,forging,fron & steel 0.2280 0.1660 -27.2 Manuf. of Ferro A.toy. 0.2393 0.1905 -20.4 mnuf. of MetaL products 0.2400 0.2234 •6,9 Manuf. of fabr. metal products 0.2212 0.1854 -16.2 Manuf. of structural metal products 0.2960 0.2607 -11.9 Mnuf. f HandtooLs : generaL hardware 0.3123 0.2615 -16.3 Mau-f. of Metat utensits 0.1980 0.1543 -22.1 anuf. of Machinry 0.2753 0.2493 .9.4 ndustrial machinery 0.3246 0.2643 -18.6 Manuf. refrigerators & A/Cs 0.2655 0.2180 •l7.t Machine tools . prts 0.3483 0.3417 -1.9 Etectrcal machinery 0.2633 0.2397 .9.0 : Industrial: EIectrical muchinery, 0.2929 0.2764 -5.6 Electrfcat apparatus 0.2178 0.2095 -3.8 Radio & TV 0.3533 0.2484 -29.7 Electronic computers 0.3573 0.3039 -14.9 Transport equip. & parts 0.2841 0.2459 -13.4 Motor vehicles 0.2534 0.2468 -2.6 Motorcycls &.A scooters 0.2114 0.1871 •11.5 Sicycles cycle rickahaws 0.1658- 0.1338 : -19.3 Other manufacturing 0.2979 0.3135 5.2 Data- drawn from the Factory Sector data of var!ous Issues of the Amual Survey of Industries. Average of FY70/71, FY73/74, FY74/75, FY78/79. Average of FY82/83, FY85/86, FY86/87; FY87/88. 100 TABLE 7.2 GROWTH OF ANCILLARIZATION AND SUB-CONTRACTING IN PUBLIC SECTOR UNDERTAKINGS Year No. of PSU* No. of SS/Anc. Total Value of Purchase fro Reportfnr Purchaa from SS/Am. as % ****: ----~-~--*-* SolAno. Units of Total Value of $8 Anc. Total (RS,Millions) Prodtion of PSUs 1 ?: . 3 4 5 4 7 ....... ....... .............- 1974-75... * .A 432 432 293.1 r .CA- 1975.760 '.A 479 479 363.6 N.A 1976-77' . it.A 508 508 438.4 X.A 1977-78 - N.A 550 550 805.7 LA 1978*79 75. 427 809 5072 964.4 0.50 1979-80 80 3841 888 4729 1119.6 0.51 1980-81 80 4340 984 5324 1519.0 0.57 1981-82 102 7143 1078 8221 2332.6 0.66 1982*83 113 12861 1176 14037 2838.4 0.70 1983-84 132 13492 1412 14904 3194. 0.72 198485 151- 13391 Wd48 15039 3630.4 0.69 1985-86. 153 14473 1693 16166 4480.0 0.76 *-information or the No. of S1, Scote units supplying to PUs, not *Vaftabe PIUs * Pubitc Sector Undertakinge; SS * Sat Scate Units Anc. * Anolaries, Source: For 1974-75 to 1976*77, see Nagaraj 1984. For 19T/-78 to 1985*86, see Handbook of Statistics, 1989, 0CSSI. Re . 140.78 million and Re. 1010.03 million from their ancillaries. The data is thus indicative of the growing preference for the use of small scale sub- contractors rather than using ancillary units. 7.7 Although there is paucity of data on industrial sub-contracting and ancillarization in the private sector, interviews with large private houses across the country and with numerous small scale sub-contractors, indicate a substantial growth in the activity over the past decade. The majority of the large private sector houses now carry a special "Vendor Development Division" under a Senior Manager with explicit responsibilities to develop vendors/sub- contractors on a long-term basis as supply sources for components.10 Interviews with private sector companies in the engineering sector indicate that most have doubled the number of sub-contractors used over rhe past decade: Larsen and Toubro from 1500 to 3760; Philips India Ltd. irom 625 to 1500; Blue Star Ltd. from 50 to 150, etc." On average the cost of 'bought out' components as percentage of 'total cost' (see Table 7.4) is around 50% to 60%. Since many of the sub-contractors are themselves sub-contracting out a part of their activity, the extent and level of industrial sub-contracting in India may be substantially more than what is indicated by the data presented; toThis is distinctly different from the roLe of a Material Manager who does not develop supplies to farm out manufacture and/or sub-assembI les of components. "Due to confidentiality of data only a few example have been cited in the case of private sector units. However, they confirm the general trend. 101 TABLE 7.3 GROwTH OF ANCILLARIZATION AND SUB-CONTRACTING IN PSUs: INDUSTRY AND FIRM LEVEL DATA Rate of Growth* . 4ams of PSUI (1977.78) (1985-86 (1977-78 to 1983-84) EA.U. S.S. Tot. E.A.U. 8.. Tot. E.A.U 8.8. Tot. Coat and lignite Bharat:.Coking Coat Ltd. . - 5 5 53. 81. 134 - 41.64 50.84 Minerats & Netals Bharat AtuninfunI Korba 9 6 15 12 141 153 3.66 48.38 33.68 Petraleum. Madras Refineries - 87 87 * 186 186 . 9.96 9.96 ChemicaLs 8 Pharmaceuticals Hindustan Antibiotica Ltd. - 5 - 23 7S 98 21.02 - - JDP. 24 21 45 23 236 260 0 . 35.31 24.51 Indian Petrochemicat Corpn Ltd., -arod . 116 116 5 285 290 11.89 12.13 Sub.totat 29 137· 161 52 596 648 7.57 20.17 19.01 fertilater oFertilizers Corpu indfu td. 6 64 2 12 84 96 9.05 3.06 3.66 $ub-totak.: Neav ing Sharat (v840yEt*CtMfär å Ltd` 125 353 478 141 1169 310 1.52 16.15 13.43 Bharat Keavy Platesand Vessela Ltd., VfRag 2 48 50 16 24 40 29.68(8.30M2.75 evy Engineering Corpn., Ranchi 52 - - 62 413 470 2.22: Mining and Attied Machinery Corpn. . 163 .163 . 180 180 1.25 1.25 Sub-totat- • 179 564 691 219 617 1594 2.55 1.13 11.01 Medium & Light Engineering Bharat Dynam. l • • 138 138 - - - Oharat EledtrOnc& Ltd. 14 250 264 21 556 577 S.20 10.51 10.27 Sharat P Co and compressors Ltd. . 35 35 5 127 132 + 17.48 18.05 Electronica Corpn. of ndia L.td. . 223 223 ~ 15 768 783 . 16.72 17.00 10tTI 61 10 71 214 1002 1216 16.99 77.87 42.63 eiddustan tLtd, Iyabad 7 62 69 J ..I.IIdutmn Toisp'nters .td. 60 60 . 284 284 21.45 21.45 1;psentatton ,td. 13 94 107 30 205 235 11.48 10.24 10.33 IT. .76 • . 105 171 276 4.12 - - National Instrunents • 90 90 110 100 210 . 1.33 11.17 Praga Toots 16 16 15 130 145 • 29.93 31.72 Sub-total 164 778 942 515 3543 4058 15.38 20.86 20.03 Transportation Bharat Earth Mvers Ltd. - 115 115 16 541 557 • 21.36 21.80 Garden Reach Workshop - 200 200 . 350 350 7.25 7.25 Goa Shipyard Ltd. 13 - . 22 22 • Hindustan Aeraautics Ltd. 21 237 258 29 739 768 4.12 15.28 14.61 Mindustan Shipyerd Ltd. - 67 67 38 166 204 . 12.01 14.93 Scooters India Ltd. . 29 • 31 75 106 0.84 - Suib-totat * 63 619 682 ¶14 1893 2007. 7.70 15.00 14.44 ----.-**----------------* 450 2262 2537 984 8310 9294 10.27 17.66 17.62 Abbreviatins: PSU5 Public Beotor Undertakinge 8.AU- Exlusive AnciltLary Unlta 8.8. * SmIut Scale Units Tot. - Totat Cmunded over 6 years Source: Smalt Industries Development Organizatfon (SIDO>, Office of the Development Comissioner, SSt, New Delhi. 102 TABLE 74 COST OF 'BOUGHT OUT' COMPONENTS AS A PERCENTAGE Of !TOTAL COST' IN SELECTED LARGE PRIVATE ENTERPRISES Nam of Firm No. of Ancittarles/ Value of. Components as Subcontracting Percentage of Total Cost 1.-vaifAuto Ltd. Arund 700 ore than .S% 2. Nahindra & Mahindrs Around 800 Around 65% Ltd. (Jeeps, tractors 3. Marutt Udyog Ltd. 379 Around52%, plus 6 joint venture (Passenger cars) companies supply another 14.8% 4. TELCO (Bus, truck) More than 1000 Around 60% 5. Sa Etectricats 200, plus 1000 Total production by vendors Ltd. (Domestic sub-vendors electrical appliances) 6. Kirtoskar on 850 Mre than 60% Engines Ltd. (Engines) besides, many of the sub-contractors at the lower end of the sub-contracting chain may not even be registered units. 7.8 Another source of data which may be indicative of the growing trend of industrial sub-contracting in India is the performance of the Sub-contracting Exchanges (run by the Small Industries Service Institute (SISl)). Perceiving the need for an institutional set-up to bring large and small firms together2, Sub- contracting Exchanges were established by the Okfice of the DC SSI in various industrial centers of the country in the 70s. The first two Exchanges were set up in 1970 in Bombay and Madras. At present, there are 16 such Exchanges. By and large, they concentrate on the Engineering Industry. According to the SISI, around 20% of the participants consist of PSUs while the remaining 80% are from the private sector. Although the number of units registered with the Exchanges (i.e. buyers) have remained in the range of 1200-1600 over the period 1981-82 to 1990-91 (see Table 7.5), the number of units assisted by the Exchanges (i.e. potential suppliers) have risen sharply from 3676 in 1981-82 to 16166 in 1990-91. Even though the numbers are still small, it is an indicative trend of the growth of sub- contracting." "The tasks of the Sub-Contracting Exchanges were to gather and disseminate information about demand and supply of Industrial requirements; to assess the capacity of SSI units (on a voluntary basis); to register the spare capacity in various product areas; to supply this information, free of charge to interested parties, and to organize exhibitions of components/sub-assemblies by the buyers and sellers. In att, the Sub-contracting Exchanges were to act as the nodal agency for the promotion of industrial sub-contracting in India "The performance of the Sub-contracting Exchanges have been poor, however, this has not been so much due to the tack of interest in sub-contracting as due to the poor functioning of the Exchanges themselves. According to the SISI, there has been inadequate number in trained staff to run the Exchanges; the information transmission has been stow; there are no provisions for receiving feedback from the benefactors of the services, etc. In general, there is a tremendous dearth of information on the general functioning of the Program. 103 TABLE 7.6 PERFORMANCE OF SUB.CONTRACTING EXCHANGES Year No. of Units No. of SS unfto Financial Outlay Colum (4) In registered with assisted by for promoting Constant Prices Sub.contracting Subcontracting Sucontracting (1980*81*00)f Exchanges Exchanges. Exchanges ....... ...... ...... .I.a.000s. .. 1 2 3 45 Upto 1980-81 6315 N.A 444'00 1981*82 1501 3676 355.00 321.85 1982-83 1412 4116 408.00 344.30 1983*84 1509 4810 265.00 206.23 1984-85 1693 6157 287.00 207.82 1985-86 1199 6709 266.00 179.49 1986-87 1508 10443 343.00 216.95 1987-88 1683 10333 291.00 169.58 .1988-89 1455 9306 484.00 260.50 1989-90 1263 8156 727.00 366,62 1990*91. .1206 12635 844.00 375.88 Using fipIlcit price deflator for gross Domestic Product (at market prices).. Sourcer Devoopment Conissoner smatt scate industries. Factors influencins arowth of sub-contractine in India 7.9 The "make or buy" decision at the firm level is principally guided by the "relative" cost (and flexibility) of production within the firm and outside". In India, the operation of this micro-(firm) level principle has been greatly influenced by macro-economic variables such as the stage of industrialization, the institutional framework of the market, policy regime, etc.'s For instance, at the time of India's independence, the structure of the market did not lend itself to large-scale sub-contracting. The overall industrial base was relatively narrow, dominated by a few large scale public sector undertakings (PSUs). To ensure full control over their production linkages, in the absence of reliable and competent small scale feeder units, the large firms tended toward a more vertically integrated structure.14 Cost efficiency consideration were less binding on these firms given the monopolistic or oligopolistic market structures, with very high levels of trade protection. The government's desire to promote a greater degree of regional dispersion of industrial activity to industrially backward areas (which was expressed as e-rly as the 1950s) further strengthened the vertical 14i.e. on the cost differential between large and small-scale firms. "See Nagaraj, 1984 'For example, public sector enterprises such as Bharat Heavy Electricals Ltd. (8HEL), had initially taken a decision to manufacture al components in-house. This was planned accordingly in the absence of adequate infrastructure in the country as welt as suppliers which could provide items to their desired specifications. 104 integration process.1 7.10 In the early 1960s, as part of a continuing effort to promote the growth of SSI in India, the concept of "exclusive" ancillaries was introduced in the hope that ancillaries would provide the means for broadening the industrial base of the country by sharing out production activity between large and small scale firms. Since small scale firms were considered to be capital- saving/labor-intensive producers, it was assumed that ancillarization would lead to greater employment generation. Although sub-contracting was not a new concept to Indian industry", this was the first time that it was formally introduced as a policy tool.1 Initially, PSUs took to ancillarization only in persuance of Gol directives and not as a natural growth process of industrial development.3 Most had already created in-house facilities for items which now had to be sub-contracted out and "cost" considerations did not arise given the assured market conditions. In fact, for many PSUs, ancillarization created a situation where both in-house and ancillary capacities remained underutilized, adversely affecting both the buyers and the- suppliers. 7.11 The success of sub-contracting in Japan did influence GOI policy towards sub-contracting (ancillarization) in India. But, the forms of inter-sectoral linkages fostered by the policy initiatives were quite different from that experienced in Japan. For example, while Japan had relied on strong financial ties in securing the relationship between the large and small enterprises, thereby building in an element of trust, the GOI discouraged, links which may '7The inability to purchase from already establish sources competted firms located in industrially backward areas to invest in a much greater range of facilities. According to NegaraJ (1984), this is reflected in the size distribution of factories located in the backward regions, which tend to be larger than those in advanced regions. "'Sub-contracting activfty in India can be traced to the British period with the establishment of the Jute, Textiles and RaiLway Industries. For example, Indian railways had established a large network of sub- contractors who supplfed thousands of items for coaches and engines. Such Items included axle-boxes, bearings, springs, signalling equipment, etc. 1eFor example. PUs like HNT, ITI, BHEL and others were encouraged to establish ancitary industrial estates near their plants. Besides providing industrial sheds and other facilities, estates also provided technical assistance on production and quality control as welt. In 1960, the Bureau of Public Enterprises (PE), under the Ancillary Development Program, persuaded large PSUs to farm out production of simlar components and sub- assemblies to ancillaries (the guidelines under the program have subsequently been modified to improve their effectiveness). During the same period, special industrial estates were created to house ancillary units. In 1971, detaiLed guidelines were brought out for setting up separate cells for ancillary development in each PSU. Plant Level Comittees were also set up to identify and match components with entrepreneurs under the Program. State Level Ancillary Development Committees were formed with Secretary Industries as Chairman and Director and regional SISI as the Member Secretary to oversee and coordinate the developmental activities. Progressive ancitLarization program were taken up for each large firm in the State. This involved: * identification of items to be farmed out * selection of suitable SSI's to supply the items * promotion of new SSIs where necessary and feasible * assistance in the negotiations between parent and its ancillaries - organization of seminars and buyer-setter meets to further the cause of ancillarization 2This was true of Large scale private sector firms as well. According to LatL (1978), AL and TELCO, both had initially undertaken in-house production of certain parts and components which their counterparts in developed countries would have sub-contracted. After some effort and under GO pressure, they were able to farm out many of these tasks to independent suppliers. 105 covertly become means of control by the large enterprise. 7.12 As India's industrial base has gradually broadened (i.e. with the entrance of numerous firms leading to increased competition and expanding market demand), the need for greater degree of cost consciousness has grown. The role of sub-contracting, in containing production costs and providing flexibility in a competitive and fluctuating economic environment, has been increasingly recognized by firms, in the public sector (which initially had to be coerced into ancillary development), as well as in the private sector (some of which had now become large scale enterprises).21 Large enterprises could also create their own suppliers base by encouraging employees (who had acquired certain technical skills) to leave and become sub-contractors to them.21 7.13 The major determinant of sub-contracting still continues to be the differential in the cost of production between large and small firms. Since the comparative cost advantage of small firms lies In lower per unit overhead costs (given the relatively small size of operations)23 and lower per unit labor cost (given their ability to tap unorganized labor markets)2, large scale firms selectively sub-contract out the manufacture and service of components and sub-assemblies which require low technology and labor intensive operations. This is based on the assumption that capital is cheaper for, and more readily available to large scale enterprises. Large firms therefore find it more profitable to specialize in the manufacture and service of technology intensive, high value added items. This also ensures a higher return on the capital employed.25 Thus, sub-contracting acquires a much greater 21Sam earlier writing on LOC auto industries (Baranson, 1969) and on the dynamic process of vertical integration and disintegration (Stigler, 1951) suggested that new industries (or enterprises setting up in new areas) would tend to start relatively highly integrated, but that buying out would increase with the growth of industrialization. (Lalt, 1978). A case in point is the desert-cooter which is widely used during sumner In North India as a cheap substitute for air-conditioners which had earlier been marketed by a handful of manufacturers under their brand names. These were priced high and attracted higher tax duties. Customers were also limited. Gradually, with increasing popularity, a large nunber of smatL manufacturers entered the field. Specialization developed to cut back on costs and manufacture of several components were sub-contracted out (e.g. fans, water-pumps, steel body, wood-wool, etc.). 2Such relationships generated greater confidence as the parties were mutually known to each other. Furthermore, since the newly established supplies were sub-contractors themselves, they had no inhibitions in sub-contracting out a part of their own activity. "And also because small scale firms do not have to carry overheads for Corporate Planning, Public Relations, etc., which Large scale enterprises are subject to. 24Discussions with large scale sub-contracting firms such a Bajaj Electricals, Godrej Refrigerators, Bajaj Auto, etc. indicate that cost of overhead and tabor for sub-contracting may be three times higher for parent firms. 251n industries where the production process is divisible (such as machine tool production), economies resulting from specialization can be substantial. The extent of such specialization is largely determined by the scale of production. When the scale increases, it becomes economical for a number of specialized firms to start operating which, in turn, reduces the average cost. In many cases however, it is not the total volune of production that is crucial but the batch quantity of production as well. For instance, where the investment required by sub-contractors to service the job is substantial (viz. skill, machinery and/or production process), parent firms need to ensure a steady flow (time and batch quantity wise) to enable sub-contractors to earn an adequate return on their investment. If the jobs are infrequent and/or erratic, then large firms may not be able to attract and retain smalL firms for sub-contracting operations. (Nagaraj, 1984). 106 significance when large and small firms face different factor market conditions. Table 7.6 presents, among other parameters, an example of the wage rate differential which exists between the organized and unorganized labor markets India. It is based on a sample survey conducted in the Bombay area, which is one of the more commercially and industrially active centers in India.6 According to the Survey results, while the average wage rate is lower by almost 23% for male workers in the unorganized sector, it is lower by more than 55% for the female workers. Discussions with numerous firms involved in sub-contracting in the Delhi region indicate that this differential may be as high as 100% among semi-skilled/skilled workers and over 100% among unskilled workers." 7.14 Growing trade union activity in India has also compelled large enterprises to sub-contract out larger parts of firm operations in order to contain the size of the workforce and thereby curtail the power of the workers' unions. A small workforce also permits firms facing competitive and/or uncertain market conditions to operate with a greater degree of flexibility and to circumvent much of the panoply of legislation which govern all aspects of labor and labor relations and hinder management from cutting back on workers, especially during market downturns. Sub-contracting also enables firms to minimize both capital investment (i.e installed capacity) and inventory holding periods (i.e. to move towards a 'just-in-time' (JIT) concept of inventory management) - thus allowing them to cut back on production levels without incurring "excessive" losses (similarly, when demand rises, sub-contracting enables firms to capture greater market shares and/or rapidly move into niche markets (which may suddenly develop due to shifts in consumer demands or changes in input conditions), without having to increase their capital investment). In the process, however, given the unequal relationship between the parent firm and its sub-contractors, a major brunt of the market volatility is borne out by small industries.= The former frequently shifts the burden to small firms by a) delaying payment of bills, b) refusing to take delivery of goods, and c) postponing inspection of materials. During the course of our interviews such tendencies were observed in the case of both public and private enterprises. "Therefore, it is assumed that this difrerential will be more pronounced in Less active areas of the country, where the unorgan;zed workforce will have less of a bargaining power. 21Numerous regulations govern compensation and Limit management's options, including the Payment of Wages Act of 1936, the Minimum Wage Act of 1948 and the Payment of Bonus Act of 1965. Other Laws set terms for workers benefits. These various provisions add to the cost of Labor. The government's extensive, detailed rules on pay and benefits for its own employees and those of public sector undertakings set an example of high compensation for the latter to emulate. (World Bank Sector Report on Industrial Regulatory Reform, 1991). For example, according to most large firms we interviewed, they paid a basic salary of Rs.1500-1600 plus benefits (including Provident Fund, pension, LTC, gratuities, etc) over-time, bonus (around 20% of basic), etc. In contrast, unskilled workers in the organized sector may receive around Rs.700-800 (depending on whether they can negotiate mininum wages) plus negligible benefits. "Since small firms face unorganized tabor markets and, in general, carry smatter production capacity, it is assumed that they can more easily adjust production levels by Laying-off workers and shutting off production lines. 107 TABLE 7.6 WORKERS IN ORGANIZED AND UNORGANIZED SECTORS: SOME CHARACTERISTICS Selected Organtzed Sector Unorganized Sector VarfableS *.** ...*.*.* (%t Me Fei Noate Flom . .2 3 ...... . . 5 .. ..... Proportion of Contract & Casual Workers of Regular Employees 2.7 16.7 25.8 62.7 Format Training 7.7 0.0 4.2 1.0 Trade Union embership 68.9 83.3 6.7 0.8 Average Weekly Income (indexed) 100.00 100.00 77.16 43.82 workers receiving Accomodation Attowance 67.1 16.7 5.9 0.3 workers receivtip transport; At lowance 6R.9 33.1 6,3 1.4 Marker ecelvin-FPaid Leave 88 .50.0 9. L5 Workers receiving Bonus 90.2 66.7 13.6 21.0 Source Acharyed S" and Jose, A.V. (1991. Employment and Mobility: A Study Among Workers of Low Income Households in Sombar City. ARTEP Working Papers, ILO, New Delhi. 7.15 In addition to specific GOI initiatives which directly aim to encourage growth of sub-contracting in India, a number of macro-level policies have also affected the spread of sub-contracting. These include production reservation policy, priority sector lending programs, backward area development policies, MODVAT, the MRTP Act, etc. Of these, locational policies have the least favorable impact on industrial sub-contracting. Introduction of Locational Policy (in the 1950's), resulting from GOI's concern over unbalanced regional industrial development,. has continued to place a steady pressure on investors to locate to backward areas.A However, since developmental costs are generally higher in such areas" and the absence of a local manufacturing base poses problems of sourcing inputs and services, the tendency is for firms to vertically integrate. 7.16 In contrast, the Policy of Product Reservation (see Chapter 3 for a detailed discussion) has opened up large possibilities for 'product sub- contracting' in a wide range of consumer items (domestic electrical appliances, leather products, steel furnishings, etc). Under this arrangement the supplier provides a complete product to the buyer, which the latter then markets under its own brand name. The product design and quality is therefore carefully supervised by the parent firm. Consequently, the strongest inter- sectoral linkage between a small and a large scale firm can be found under this form of relationship. Priority sector lending policies which included "Through selective delicensing and adninistrative actions. "Given larger investment requirements for infrastructural development. 108 SSI in the 'priority sector* of the economy (and thus eased their access to institutional finance) further provided an impetus for large enterprises to enter into sub-contracting relationship with small firms. Through such a relationship, large firms could minimize their working capital requirements and delay bill payments especially in times of recession. In this context subsidized credit for SSI also benefitted large firms. Similarly, special fiscal incentives in the form of MODVAT, ceterus paribuo, have made procurement from small firms more attractive. The concept of 'notional credit' was introduced which provides the parent units with 5% credit advantage (over the excise rate paid by the small firm, with a ceiling of R8.20 million) at the time of paying its own excise duties. Indirectly, this also encourages small firms to register with the excise authorities.3 7.17 Two further factors affecting the scope for sub-contracting have emerged out of recent liberalization trends in the Indian economy. Import liberalization for capital goods has enabled firms to access state-of-the-art, scale intensive machinery and equipment, geared to meet world competition. To exploit the economies of such scale operations, (with the intention to reduce coste) it has become necessary for firms to specialize in those processes or stages of production where capital intensity is required and to sub-contract out the manufacture and service of the remaining intermediate stages where labor intensity is called for. Similarly, relaxation of regulations governing foreign collaboration agreements has facilitated the entrance of large firms into the international markets by becoming sub-contractors to more capital intensive overseas producers. To maintain price competitiveness in the international arena, firms are resorting to sub-contracting wherever possible. In certain cases, this has resulted in the diffusion of foreign technology throughout the sub-contracting chain. Pattern & Strenfth of later-sectoral Linkaaes: 7.18 Three forms of linkages emerge from sub-contracting relationships in India; they are marketing linkages, technological linkages and financial linkages. In the majority of cases, all the three forms co-exist. Their nature and strength however, depend to a large extent on the age, size, institutional status (whether public or private sector), technological capabilities and, locations of the firms involved. The results obtained from 11 case studies of engineering firms in the Delhi region are presented in Table 7.7A and Table 7.7B of this chapter=. 7.19 The marketing linkage, defined as 'guaranteed off-take of predetermined 31Policies guiding the enforcement of safety and health regulations in large factories (and the workers' increasing awareness of them) is, in some cases, also competLing firms to farm out the manufacture/service of hazardous components and sub*assemblies to small scale units. Given the overriding need to gain access to assured markets and an unorganized workforce, the small scale sub-contractors readily accept such jobs. In contrast, the MRTP Act of 1970 (which aims to police and reduce concentration of economic power, especially in large industrial houses), does not appear to have any major impact on firm decision to 'make or buy'. 3Consisting of 5 Large scale units (3 in the public sector and 2 in the private sectors). 3 medium scale units and 3 smatL scale units (at( in the private sector) which, except for the 3 public sector units, are both sub-contracting work out as well as being sub-contractors themselves. The range of activities for the 11 units vary widely: from production of sophisticated radar equipment for the Ministry of Defence to sifple polishing of hub-caps for a motor vehicles manufacturer. 109 levels of production', is by far the strongest of the three linkages and exists regardless of firm characteristics. On average, small scale sub- contractors sell 70% of their output to large enterprises on the basis of prior orders, while they contribute around 20-30% to the output of the buyer (defined as the percentage of 'bought out components' to "Gross Sales"). This scenario does not seem to have changed very much over the past 10 years. Estimates made by Papola and Mathur in 1979 (based on a sample survey of 441 firms in the metal engineering industry in Kanpur) indicated that while around 75% of small scale sub-contractors sold 61% of their output to large enterprises on the basis of prior orders, they contributed around 27% to the output of linked enterprises. In a limited numbers of cases, the buy back arrangement is also accompanied by direct supply of raw materials by parent firms to the sub-contractors. Although, this is primarily limited to sub- contracting involving 'processing' activities as against the production of components, sometimes assistance may be provided for the purchase of critical, scarce or imported raw materials which pose procurement problems for -small scalq firms.3' Buyers may also engage in purchase of material where large price concessions can be gained from bulk buys (as in the case of steel), or quality of the material input needs to be ensured. Subsequently, the material is distributed to the various suppliers.3 In general, however, parent firms do encourage their sub-contractors to become self-sufficient and establish their own supply channels; they do not want to be burdened with the administration or the expense associated with material procurement. 7.20 The strength of the technological linkage is primarily determined by a) the "similarity" of activity between the parent .firms and sub-contractor and b) the degree of technological sophistication involved in the manufacture or service of the bought out components and sub-assemblies.6 The majority of sub-contractors interviewed receive some type of technical assistance from their buyers under the sub-contracting arrangement, which according to them, they would not have received otherwise. Generally, such linkages take one or more of the following forms: transfer of equipment, sharing of technical know- how (domestic and/or foreign, including provision of production specifications) and transfer of skills (management assistance/ training, 3Often, in the case of 'processingi activities such as polishing, buffing, cutting into strips, etc., the raw material is supplied by the buyer. In the Papota & Mathur study, such arrangements existed in 20% of the firms studied. "For example, in Loll's study (1978), both AL and TELCO occasionally undertook to procure raw material (mainly steel) for the small suppliers during periods of scarcity when these suppliers were either deprived of supplies or else were charged extortionate prices, however, this linkage was set up reluctantly and both AL and TELCO induced their suppliers to buy their own materials as soon as supplies eased. 3Although we were not able to ascertain a percentage for marketing Linkages which are accompanied by the supply of raw materials, discussions with both buyers and suppliers indicate that it may exist in only 30% of the cases. 3An example of inter-sectoral relationship involving a "dissimilar" technology would be the case of a 'thermos flask' manufacturer sub-contracting out the production of rubber rings from its suppliers. In the case of an inter-sectoral relationship involving "similar" technology between the buyer and the supplier, the former usually retains the in-house manufacture of the critical components (involving higher value addition). Therefore, the complexity of the task sub-contracted out becomes a direct function of the technological Level of the buyer. 110 TECHNOLOGICAL UNKAGES: CASE STUDY OF 11 ENGINEERING FIRMS AROUND DELHI TABLE 7.7A NO. OF CASE STUDIES .Large Mediun SmaLt 5 3. 3 M Technotogical Linkages only Ni Nit Nt t> francit LInkage only . 4 KIL MIL~ < al>Nrketing t.,*nages only# *.. NU» MIL NU.. W>-I At Uji.nkage: (i) & (I I» 5 33. FINANCIAL LINKAGES: (i) Equi ty Support MIL milt Nit <i> Credit in the form of Advmnce Paymna 5 2 2 M4ARKCN LNKAGES: ( It U s th suppty of Rat Materiat 3* 1 MII (i) Without suppty of Raw Materiat 4 2 3 TECHNOLOGICAL LINKAGES I>Tranisfer- of Technotogy -Domestic 5 2 1. Foreigr 3 1 (II) Production Specifications 4 2 2 )f0 Training (or Seconnhnt- ofWorkers ... 2 1 1 OV> Management Assistance .2 Ni Nit v) Testing/nspection Assistance 4 1 2 Notes: * incese of imported or cr-tical raaerfats. Sorce:: Field survey undertaken in the Delhi area. TABLE 7.7B NO. OF CASE STLDIES Large Mediua Smat 5 3 3 TECHJOLOGY LINKAGES INVOLVING: (>* Dissiilar Teochnotogy of a Si(pte ....Nature.::: ti> DiOfsslniia TechnoLogy of a Complex. Nature. 1 1 MI <fil> Slinttar Technotogy of: a Siple Naturw. 2 3 (iv): Simitar Teochnotogy of a co ex Nature 2 mit Nit 111 secondment of workers and/or training, assistance in quality control/ inspection, etc.). 7.21 According to most sub-contractors we interviewed, information on 'production specificatione' (i.e. drawings, designs, guidance/advice of experts, etc.) is the most vital technological linkage since they must provide goods and services on a made-to-order basis.37 To an extent, buyers also provide technical knowhow (even foreign) to their suppliers (although in most cases this is strictly limited to what is required by sub-contractors to meet their commitments).38 In contrast, however, parent firms show a definite reluctance in providing technical assistance by way of worker training or managerial guidance (i.e. preparation of project reports, maintenance of records, etc.).39 If such support is provided, it is usually to 'exclusive' or 100% captive suppliers which have been promoted and developed by parent firms and are frequently located in industrially backward areas. Assistance to suppliers for quality testing and inspection is equally limited, unless it fnvolves complicated testing procedures.4 When such assistance is provided, the Cost of the testing/inspection is usually recouped through the pricing mechanism. In general, it was observed that while a relationship between a large buyer and a large supplier involves a two-way flow of information, the same relationship between a large buyer and a small supplier involves a one- way flow with the buyers providing a more-or-less continuous flow of technical assistance. It is usually the smaller and newer firms which most require the assistance, while it is the more established large-scale firms which appear to have the confidence to part with it. 7.22 Evidently, the financial linkage is the weakest of all three linkages, partly because of government policy to discourage links which may covertly become means of control by the large enterprises and partly because the large enterprises themselves do not wish to internalize financial risk on behalf of small, independent units.41 Financial assistance by way of equity participation is almost non-existent under such inter-sectoral relationships in India. However, most buyers do seem to provide some financial support from time to time, by way of advance payments, usually for the procurement of tooling and materials. The cost of the financial assistance is generally amortized over a negotiated period. In a limited number of cases where the "Unless the task contracted involves very sinple technology as in the case of certain 'processinq' operations like polishing, buffing, etc. "Only in two cases did parent firms feel that such transfers pose a conpetitive threat to them. In contrast, in one case, a japanese firm (partner to the Indian parent firm under a joint venture) is providing direct guidance to the sub-contractor of the Indian firm, for the production, testing and inspection of the bought-out component. 3OLatt (1978) found a similar sftuation in case of AL and TELCO. The two automobite manufacturers sometimes undertook to providing management accountancy and training to the small suppliers, however this was not a systematic or widespread practice and therefore, according to Latt, "must count as a discontinuous linkage". 4In most cases, visual inspections are sufficient as the jobs assigned to sub-contractors involve the use of relatively sinple technology. 'This is strikingly different from Japan, where there are strong financial links between firms and their families of small suppliers. (Lat, 1978). 112 sub-contractor is a 100% captive unit, financing may be provided for the purchase of machinery and equipment, however, usually at the market rate of interest2 (under the Public Sector Ancillary Development Program, attempts were made by the Government to encourage public sector units to provide some concessional financing to their ancillaries for the procurement of plant and machinery; however, since the monitoring of the Program ceased in 1986, such assistance has sharply declined). Conclusions and Recomendations 7.23 Notwithstanding the lack of systematic data, it is apparent that sub- contracting activity has increased in India, particularly in the last decade. As industrialization has proceeded, together with a degree of liberalization that has created more competitive markets, firms have been obliged to become more cost conscious and more flexible in their production methods. Given that wage rates and employee benefits in the unorganized sector are considerably lower than those found in the organized factory sector, it is not surprising that highly vertically integrated firms have sought to increase their out- sourcing of components and semi finished products. In the past, a number of factors have constrained them. The lack of exit policies and the difficulties firms encounter in restructuring or rationalizing their productive systems that might entail redeployment or retrenchment of labor have meant that firms remain more vertically integrated than they otherwise might, simply to utilize their labor force as intensely as possible. Backward area and locational policies, manifested in the form of investment licensing, investment subsidies and public enterprise investments, have aggravated the tendency toward more vertically integrated firms and inhibited the scope for sub-contracting. 7.24 Government policy directives to public enterprises to increase the extent of their sub-contracting and ancillary development have brought an increase in such activity. But this has often not brought an improvement in the cost efficiency of production. Monopoly enterprises have felt little competitive pressures, and inefficiencies in the parent firms are often transferred to the promoted ancillaries and sub-contractors. Cost plus pricing techniques utilized by the larger firm in its sales, often to other parts of the public sector, are simply transferred to the sub-contractor. Furthermore, public enterprises' active role in promoting and establishing a sub-contractor or ancillary, often with ownership and management drawn form retired officers of the public enterprise, causes wage and benefit structures and productivity norms of the large firm to be adopted by the ancillary/sub-contractor. This sort of difficulty can only be solved by increasing market competitiveness and a macro policy framework that encourages this. 7.25 Small scale firms do benefit from sub-contracting and ancillary relationships, particularly with regard to technology transfer and market development. The extent of benefits varies on a case by case basis, 42According to Lai's study of the automobile industry, "direct grants were never given to suppliers. Loans were sometimes given in temporary financial difficulties, but commercial rates of interest were charged. Accelerated or advance payments were, similarly made in special cases, but the buyers were very reluctant to enter into such linkages. In fact,Uno instances could be found where auto firms had sold their depreciated capital equipment suppliers, a feature quite coamon in Japan". 113 determined by product type, length of the relationship and proportion of small firm sales to the larger firm. But there are difficulties. Smaller firms do encounter liquidity problems due to late payments, and given their dependence on the larger firm they do not feel able to press their claims. Backward area industrialization policies limit opportunities for small scale sub- contracting, and where this does occur, inevitably the small scale firm is totally dependent on a single large firm for its sales. In isolated factory parks, the scope for a small firm to diversify its market, and hence reduce its vulnerability to market fluctuations, is limited. 7.26 As a distinct policy approach for SSI, the most important contribution that could be made toward improving the scope for sub-contracting would be to improve the competitiveness of the market in which large firms operate. An increase in competitive pressures from both home and abroad will provide a strong incentive for large firms to become more cost conscious and reorient their production patterns in a less vertically integrated manner. Greater flexibility afforded larger firms, through more liberal exit policies than presently exist, will also facilitate this reorientation. Furthermore, there- may be scope for utilizing displaced workers as suppliers and sub-contractors. 7.27 There is a need for a wider availability of factoring and bill discounting services to allow small firm sub-contractors and ancillaries to better manage their working capital requirements. An initial step in this regard has been made by SIDBI, in conjunction with the State Bank of India (the largest commercial bank), however, the scope of this initial step needs to be broadened. Furthermore, the modality and availability of such services needs to be publicized to SSI and promoted. 7.28 Improvements in infrastructure (factory parks, power and transport linkages) will improve the opportunities for sub contracting. However, these facilities need to be developed in closer proximity to potential markets. Establishment of an extensive information network would be of great assistance to both large and small firms, in furthering sub contracting. The present system of Sub-contracting Exchanges run by the SISI's needs to be revitalized, more commercially oriented and improve the screening process of potential suppliers. This could be done in conjunction with a revitalized IES as discussed in the previous chapter. 7.29 The existing distinction of an ancillary in the GOI's SSI classification is redundant. The investment ceiling for ancillaries was placed at a higher level (presently Rs.7.5m) to allow suppliers to cater to the requirements of large public enterprises. But, with the broadening of the industrial base, and an increase in the number of potential vendors and buyers, the separate classification is superfluous and misleading. Furthermore, it could discourage a small scale firm from seeking to broaden its buyer base, which would reduce its vulnerability, because it might lose its "ancillary" status. The classificatory distinction should therefore be dropped. 7.30 Based on the recent industrial policy statement of the GOI, large firms are now allowed to hold an equity stake up to 24% in a small firm, without the latter losing its classificatory status. This is a positive step, as it could improve the flow of technology transfer and consolidate marketing arrangements 114 and distribution systems. There is no real reason why this equity stake ceiling should not be raised or eliminated altogether. This in turn focuses upon the relevance of the core notion of having an SSI classification at all. There is no economic reason to have to have such a dichotomy, and as noted earlier, firm or unit size should be dictated by technology and other factors. This elimination of an SI classification does not preclude programs of assistance to enhance the spread of new entrepreneurship, nor will it preclude the existence of specialized institutions designed to facilitate this process. 115 CHAPTER 8 AGENDA POR REFORM Introdction 8.1 India has given strong emphasis to the development of the small scale industrial sector, with an array of policies designed to encourage the growth and development of smaller firms. Given the growth in the number of firms over the past thirty years, and the contribution made to industrial output, employment and exports by SSI, it is evident that some measure of success has been achieved. Nevertheless, throughout this period, there has been some ambiguity in the policy focus, and the main policy thrust, as manifested "hrough the structure of incentives and concessions, has never quite made the distinction and dichotomy between encouragement of new entrepreneurship, protection on the basis of size per se and the need to foster growth of efficient SSZ production. Improvements in income and capital distribution.and broadening of the entrepreneurship base, are desiderata common to most, if not all, developing countries. 8.2 In every economy, there are market imperfections and deficiencies in support systems and infrastructure. In developinq countries these are often more acute. But, it is also often true that public policy interventions aggravate these deficiencies, and spawn an environment of control and regulation that is not conducive to a dynamic creation of new firms. This is particularly true with interventions in factor markets (financial ,labor, and material inputs), which create gross distortions in relative prices, misdirect investment decisions and distort modes of production and industrial structure. Industrial licensing, labor laws and exit policies in India have created an industrial structure that is characterized by very large, multi-plant firms, with a high degree of vertical integration, together with a large number of small firms, with poor representation in medium scale firms. This could have negative consequences for the sustainability and dynamism of India's industrialization, particularly as the country becomes more open to competition from abroad. Furthermore, the structure of industrial policies, and the policies designed to foster SSI, are often at odds, creating a "competitive" environment within India's industrial sector, between pockets of firms producing similar products based upon firm size. Policies should rather be designed in such a way that the natural, symbiotic relationships between firms of different sizes, based upon the technology of production, the supply and price of factor inputs and market demand, is allowed to evolve and flourish. 8.3 The evidence on the relative efficiency of small versus large firms is variable. The majority of studies undertaken suggest however, that for most manufactured products, the notion of a small, labor intensive producer being as technically efficient as a medium or large size firm is fantasy rather than fact. Furthermore, if issues of quality and technological change (in product and process) are included, the smaller scale producer compares even less favorably. This is not to deny that there are many product areas suitable for efficient production by SSI. But this choice 116 of appropriate products should be left to the entrepreneur, and not arbitrarily decided by a policy maker. The role of the government should be to create a policy environment that facilitates this choice, and limits policy interventions to clearly identified sources of market failure. 8.4 Progress has been made toward achieving a more balanced industrial sector, with growth in sub-contracting and ancillarization, most notably in the eighties, and a broadening of the industrial product base. In part, this is due to a progressive delicensing of industrial investment and changing consumer tastes, which has made the underlying markets much more price competitive. As the gap between the prices of factor inputs (most notabl labor) in the organized and unorganized industrial sector has widened, large firms have become more cost conscious and more active in "out- sourcing" parts of their production process. They are still inhibited, however, by the country's exit and labor laws from rationalizing and restructuring their operations in a less vertically integrated manner, to the detriment of the smaller scale industrial producers. 8.5 India has entered into a phase of structural adjustment and realignment of the economy. Reforms in the trade regime, the financial system, the system of price and distribution controls and the structure of fiscal revenues and expenditures will pose a considerable challenge to the country's industrial sector. Domestic and international competitive pressures will increase, which will in turn demand restructuring and reorientation of many firms and sub sectors. The small scale sector will not be immune from this, but this industrial reformation will also provide great opportunities for new entrepreneurship and the growth of existing small scale units. As progress is made in restructuring and improving the efficiency of public sector enterprises for example, scope will exist for a greater degree of sub- contracting and a more efficient utilization of many of the technical skills that exist in these firms. Clearly, this should be beneficial to SSI. 8.6 It should be apparent from the foregoing that while we have focussed in this report upon policies and issues directly related to SSI in India, policies and reforms in the wider macroeconomic and industrial context will also be highly instrumental in improving the prospects for smaller firms and propagating the spread of new entrepreneurship. Appropriate exit policies for larger firms that allow them to flexibly and speedily adjust to changing circumstances, will have a positive impact upon the general environment for doing business. This in turn will improve the prospects for SSI. Therefore, while the recommendation and agenda for reform contained below relate specifically to SSI, it must be borne in mind that these reforms should form part of a wider approach to industrial structural transformation. As this wider industrial transformation is now underway, it is appropriate, therefore, to embark upon a reform agenda that will allow new entrepreneurs and existing SSI to take advantage of the various opportunities as they emerge. Policy Focus 8.7 The appropriate policy for SSI in the nineties and beyond should be focussed less upon the notion of size per se, and more toward new entrepreneurship creation and the growth of efficient SSI units. This weans 117 focussing on measures that improve the working of factor markets (eg. financial, labor and material inputs), provide key informational inputs that improve the success rate of new firms, and permit firms to operate in a less restricted and controlled environment. The present policy desire of producing in SSI whatever can be produced there, needs to be replaced with a focus on SSI that views smaller firms in the context of the overall pattern and pace of industrialization. That is, firm size should be determined more by the technology of production, the supply and price of factor inputs and the extent of market demand, rather than by some arbitrary and administratively determined compartmentalization of product categories and type of unit. 8.8 A veritable cornucopia of studies has been undertaken in India and other developing countries, investigating the relative technical efficiency of firms by different size categories. Not surprisingly, there has been debate about methodological issues; about the degree of product definition and comparability, the quality of data and the statistical measurement techniques employed. The results of these'studies (discussed in Chapter 3) are variable. At an aggregated level, SSI in -India does not appear to be technically superior to large size firms in its use of factor inputs. At the technically more correct product and item specific level analysis, the results, as one might expect, are variable depending on the product under analysis. As a guide to SSI policy formulation, this array of research, while of academic interest, may not be quite so useful. If, for a particular item, it is shown that smaller size is irrelevant, then the smaller firm should be competitive without concessions. If, on the other hand, for another item, SSI are found to be less efficient, then any special concessions will merely result in a wasteful use of the country's resources. 8.9 The essence of a sound SSI policy therefore should be oriented toward improving the functioning of factor markets, removing market distortions and creating a business and commercial environment that reduces barriers to entry for new firms and imposes no artificial constraints on the growth of existing firms. This is not to suggest that direct interventions designed to assist the emergence of new small scale firms are always inappropriate. Existing market imperfections (many of which have been policy induced), together with deficiencies in the general support systems and infrastructure, may not be amenable to instantaneous change. Targeting interventions designed to reduce the entry inhibiting characteristics of these imperfections and deficiencies may be warranted in the short to medium term. For example, providing a good information and techtiology dissemination service to SSI, where there are clear market failures, could have social benefits that far outweigh the social costs. But, the policies followed, and the interventions that might flow from them, must be flexible, monitored regularly and incorporate time constrained "way-points" where the intervention lapses. 8.10 Adjusting policies for SSI in India is a complex process, due in no small part to the respective roles of Central and State governments in industrial development and promotion. A particular State can have highly individual tax policies (eg. sales tax exemptions), utility pricing policies (eg. subsidies on power tariffs), lending policies (eg. specific criteria for lending from State Financial Corporations) and infrastructure development approaches (eg. factory park construction and location). Nevertheless, the 118 Central Government can, and does, provide a leading, catalytic role in the development of SSI policy. In this context, it would be appropriate for the GOI to draw up a comprehensive White Paper that sets out the policy framework for SSI that will be followed over the next decade. This White Paper could outline the philosophical underpinning for Central Government programs of assistance for SSI, demarcate the type of special concessions that will be offered by the Center and other actions that might be taken to improve the general business environment, and hence the emergence of new entrepreneurs and the viability of existing SSI firms. The recommendations and observations outlined below could form the basis of some of the actions that would be outlined in the White Paper. Concessions and Incentives 8.11 As Chapter 3 showed, there are a variety of special concessions grante4 to SSI in India. While the array of concessions is prodigious, their impact, transparency and economic costs ar6 highly variable. Many small scale firms do not avail of the majority of concessions offered, and even where they do, the perceived benefits are quite small. In many cases, the concessions are considered irrelevant or unnecessary, and are often overshadowed by the binding constraints imposed by deficiencies in infrastructure or inputs into the production process. A perfect example of this relates to subsidies granted on power tariffs by the individual State Electricity Boards. Most firms canvassed would rather do without any special concessions, provided their power supply was regular and uninterrupted, and appropriate connections could be obtained expeditiously when needed. 8.12 There are a number of special dispensations, however, which impose considerable negative costs on the economy. Production reservation for SI is a very blunt policy instrument, which raises consumer prices, inhibits technical change and progress, reduces product quality, constrains the development of potentially internationally competitive industrial sub sectors and provides excess profits to the large firms who were in existence when the product reservation was imposed. Furthermore, the benefits in the form of entry of new firms, are often short lived, and the resultant higher market prices inhibit the growth of demand, which in turn constrains the growth of employment in the reserved categories. As a policy tool this form of concession for small scale firms should be discontinued, with a halt to any further item reservation. The government could then announce its intent to eliminate product reservation and draw up an action program that sets out a progressive program of dereservation, with the objective of achieving the complete dereservation program three years from the date of announcement. 8.13 The excise tax exemption for SSI sales up to certain prescribed limits provides a significant cost advantage to smaller firms. This form of incentive has negative side effects insofar as it discourages growth and encourages a proliferation of "shadow" firms with nominee share-ownership. A further drawback of the present system is that the exemption exists in perpetuity, irrespective of unit level profitability. Accurate estimates of the fiscal costs of this concession are not possible, but given that approximately 40% of manufacturing output comes from smaller scale producers, it is not insignificant. Also, while it may not be possible to quantify the 119 longer term, dynamic impact of such a policy of tax exemptions, it undoubtedly must inhibit market development of the more dynamic firms. Given this latter factor, as well as the need to broaden the tax base, the excise tax exemptions for SSI should be phased out. It is often argued that given the large number of small firms (many of which do not keep proper accounting records), it is not practicable to seek to collect excise revenue from SSI. However, the validity of this claim is undermined somewhat given the present system of SSI registration, the number of different "inspectors" that visit a small scale firm and the fact that many of these firms receive financing from state financial institutions and commercial banks. There is a record "trail" of small scale firms, particularly in the modern small scale industry sector. 8.14 It would still be possible to encourage the entry of new firms, with a time limited system of partial rebate or exemption of excise taxes due. For example, a new entrepreneur might receive an 80% exemption in the first year of operation, 50% in the second, and 25% in the third, with the full excise rate being levied after three years of operation. It might be argued that this type of excise tax system would merely promote excessive closure and rebirth (under a new name but with the same owner) of firms. While there is substance to this argument, there are transaction costs to establishing an entirely new legal entity (particularly for bank financing, ine-atrial park factory space, power utility connections, and where brand loyalties and awareness are involved), which would serve to reduce the extent of this type of tax evasion. 8.15 The present system of "scarce" raw material quota allocations for an individual, registered small scale firm should be abolished. It represents a failure of other market systems, oftentimes as a result of other policy interventions (eg. steel and non ferrous metals), which would be efficiently and effectively dealt with by removing the underlying causes for the market failure. As it presently stands, the present system of quotas, at administratively determined prices, is frequently abused, with many small scale firms merely acting as trading enterprises reselling their quotas at prevailing market prices. 8.16 There are a variety of other special incentives and concessions on production inouts. They all have time limitations and overall their distortionary impact is quite small. The possible exception to this is the State subsidies on power tariffs; unfortunately little is known of the aggregate revenue loss that accrues which in itself is cause for concern. It is not clear that this subsidy is necessary for SSI and should be discontinued. RIequLatory -nwironment 8.17 A major constraint for new entrepreneurs and small scale firms in India is the very complex and burdensome regulatory and administrative environment. There is massive scope for a reduction in paperwork and bureaucratic requirements. The Government has already sought to take action to simplify procedures and legal requirements for all firms, however, much remains to be done. Reporting requirements for all firms, not only SSI, are excessive, and much could be achieved simply by amalgamating the periodic 120 submissions that are required under various Central Government statutes (the labor laws are a perfect example). In many cases, the administrative burden is a function of municipal and State level requirements (sales tax, octroi, zoning, safety and health regulations etc.), with the result that Central and State level coordination and harmonization would be necessary. The Center can take the lead, however, in initiating a thorough review of the requirements, proposing an agenda for reform and harmonization and, through the industrial extension service system, providing guidance and assistance to small scale firms in dealing with this burden. Furthermore, the existing industrial extension system (through the DICs) could assume an ombudsman role in monitoring the impact on SSI of bureaucratic and regulatory requirements, bringing perceived excesses to the attention of the States' authorities. Financial Intermedation for SSI 8.18 The system of financial intermediation supporting SSI is in serious trouble. Good progress has been made in improving the coverage of the financial intermediation system, but the system is under strain, which in part is a reflection of issues and pressures within the overall financial sector in India. As was shown in Chapter 4, the prevalence of sickness amongst small firms is increasing, with obvious negative consequences for.the loan - portfolios of commercial banks and state financial corporations. Furthermore, as was shown, while the causes of this sickness are multifarious, there is evidence to suggest that the very system of financial support contributes to the incidence of firm failure and sickness (poor appraisal, too low owner equity contributions, poor monitoring and follow.up and bifurcated financing sources according to type of finance). 8.19 Any reforms designed to improve the efficiency of the flow of financial resources to SSI must occur within the framework of a reform agenda for the entire financial system in India. The Narasimbam Committee set up by the Government has completed a review of this system and proposed just such a reform agenda. What is proposed here however, focuses explicitly on the needs of the small scale sector, although there is some overlap with the needed wider financial sector reforms. 8.20 There is a need for a market determined interest rate structure for lending to SSI determined by individual firm risk perceptions and a lending institution's cost of funds. The recently announced interest rates on term loans for SSI (October 9, 1991) from commercial banks and SFCs, which mandates a structure of rates according to size and sector of loan needs to be abolished. While lending by the commercial banks and SFCs carries interest rates that are positive in real terms, the concessional rates charged by the SFCs in particular, are not conducive to ensuring the longer term viability of the financial intermediary. SFCs margins are under considerable strain, despite the fact that a major portion of their resources are subsidized and have been made available at below market rates. 8.21 The non performing part of SFCs1 portfolio is large and recovery rates are very low. This reflects poor project appraisal, lack of coordination between different types of lending institutions and poor loan administration. Technically, many of the SFCs are bankrupt and without 121 preferential access to funds would not survive. The institutional framework, which imposes artificial restrictions on the commercial banks and on SFCs, has contributed to this problem. Unfortunately, an appropriate cure cannot be effected by marginal fine-tuning of existing operational practices. More fundamental reform of the institutional structures, modes and sources of finance, type and method of lending and management and administrative systems are needed. As such the Center, through IDBI and SIDBI, should initiate a thorough study of each SFC. Thaqe studies should provide a realistic review of loan portfolio quality, organizational structure and loan administrative arrangements, accounting and reporting methods, staff requirements and recapitalization needs (the full range of the topics that require attention within the SFCs is shown in paragraphs 5.27 to 5.57 in Chapter 5). Whatever the results of these individual reviews, all the SFCs snould make a realistic assessment of their financial viability and where additional equity is necessary, if it is not forthcoming, should cease further lending operations. 8.22 A fundamental requirement of reform is the removal of any artificial demarcation of sources and types of finance for SSI (i.e. long term and working capital requirements from different institutions). This system has not served the small scale sector's needs very well, and has made it difficult for the institutions involved to react more flexibly to the needs of emerging entrepreneurs. Lack of adequate coordination between the various financing institutions often means that realistic assessments of working capital needs are not made, with consequent liquidity problems for infant firms. The recently established "one window' program launched by SIDBI represents a positive step, but this program covers.only a very small proportion of lending to SSI. 8.23 The SFCs need to be given greater flexibility in the type of financing activities in which they engage (for example hire purchase and leasing operations), and the interest rates that they charge for these financial services. Management autonomy needs to be enhanced, and in this context during a recapitalization exercise, a broadening of the ownership base of the SFCs to include private sector institutions and individual shareholders should be undertaken. These institutions need to be run on a sound commercial basis, free of state political involvement. 8.24 As the overall financial sector reform program advances, with a greater degree of liberalization of intermediary activity, the need for specialized institutions lending to SSls will be diminished considerably. In this context it will be crucial for SFCs, if they are to survive, to broaden their product mix, and to some extent their clientele, in order to compete successfully with other financial institutions. With a specialized and experienced project appraisal cadre, that is fully aware of local business conditions, SFCs should be able to provide a valuable medium and long term financial service to new entrepreneurs, without the mandatory and artificial segmentation that characterizes the present system. Industrial Ratension Services 8.25 As was shown in Chapter 6, the impact and effectiveness of industrial extension services on the small scale sector in India has been 122 mixed. Where there has been a concentration of effort in delivering a specific service, the impact has, on the whole, been beneficial. But, in most instances, the variety of services offered, and the geographic area covered, has resulted in a dissipation of resources (financial and manpower), which in turn has reduced the quality and effectiveness of the services offered. It is appropriate and timely therefore to initiate a thorough review and reappraisal of the whole gamut of industrial extension services, its methods of delivery, its institutional framework, its activity focus and its methods of funding. 8.26 The initiation of such a review could be announced in the proposed small scale industry policy White Paper. The coverage and scope of the review is discussed in paragraph 6.28, Chapter 6. A more focussed and truncated range of activities would increase the beneficial contributions made to SSI and new entrepreneurs and should focus on those areas where there is a clearly identified market failure that is amenable to public sector support. There are many activities presently undertaken for which full cost recovery could be obtained or which can be provided by normal private sector commercial activities. Experience in other countries suggests that an efficient information dissemination function can be useful in improving the general business environment for new entrepreneurs and helping existing SSI grow, particularly in developing countries. To achieve this more limited objective, however, will require organizational changes that allow for a flexible response to changing SSI information needs, and a staff complement that is of high calibre and commercially oriented. A regulatory and public administration orientation toward the provision of such services will inhibit their effectiveness and reduce their contribution to the emergence of new firms and the growth of existing firms. Inter-fir Likaaes 8.27 The extent of sub-contracting and ancilliary activity has increased in India over the last decade. How much this is due to direct public policy initiatives is unclear, although directives to the public enterprise sector may have encouraged large, vertically integrated monopolies to reduce their in-house production to some extent. Progress toward a more balanced and integrated industrial structure will only occur, however, as the Government's wider industrial sector reform program proceeds. As domestic and international competitive pressures increase, as exit policies are liberalized and public enterprises restructured, the opportunittes for sub-contracting should increase. 8.28 There are some specific initiatives that could hasten the extent of such activity. Recently, factoring services have been introduced in a limited manner, but this type of service needs to be expanded. Sub- contracting information exchanges, operating as part of an information oriented industrial extension service, could increase awareness of opportunities for both small and large firms. A further important contribution toward improving inter-firm linkages will be an improvement in the quality of infrastructure available for small scale enterprises in areas where there are large firm concentrations. Locating factory parks for SSI in isolated or remote areas inhibits the scope for sub-contracting and should be 123 discontinued. 8.29 Based on the recent industrial policy statement of the GOI, large firms are now allowed to hold an equity stake up to 24% in a small firm, without the small firm losing its classificatory status. This is a positive step, as it could improve the flow of technology transfer and consolidate marketing arrangements and distribution systems. There is no real reason why this equity stake ceiling should not be raised or eliminated altogether. This in turn focuses upon the relevance of the core notion of having an SSI classification at all. There is no economic reason to have such a dichotomy, and as noted earlier, firm or unit size should be dictated by technology and other factors. Elimination of an SSI classification would not however, preclude programs of assistance to enhance the spread of new entrepreneurship, nor will it preclude the existence of specialized institutions designed to facilitate this process. Imleentation and Reform Phasin 8.30 The proposed governmental White Paper, that would set out a policy framework and reform agenda for SSI, should also set out an implementation mechanism and organizational structure that will shepherd the policy reform process. In this regard it is proposed that a Task Force be established that would oversee the progress of five functional working groups. The working groups could be as follows: Finance for SSI; Reservation and Input Subsidies; Industrial Extension; Excise Taxes and the Regulatory Environment. The Task Force would be composed of the Chairmen of the Working Groups, plus independent members from the Planning Commission, the Ministry of Industry, the Ministry of Finance, the Ministry of Labor, and non-governmental academics and other specialists. 8.31 The Working Groups should reflect a suitable cross section of relevant governmental institutions and departments, together with representatives from the academic community, SSI associations and other specialist members. The mandate of each Working Group would be to draw up an implementation schedule for their respective component of reform, put this forward to the Task Force, and monitor implementation of the reform agenda. 8.32 Timing of implementation of any reform agenda is critical to the ultimate success of the reform effort. Inevitably there are conflicts between the desire to mitigate any adjustment costs of the reform and the need to sustain the momentum and credibility of the reform exercise. The Task Force should be responsible for coordinating the timing of implementation. Some of the proposed reforms (dereservation and excise tax changes) can proceed quite speeaily, and should not await the capacity to reform other elements. Reforms to both extension services and financial intermediation may need to await specific study of elements and components of both activities (eg. review of each SFC, or assessment of individual extension activities). Despite this nowever, the Task Force, should publicly announce its intent to effect reforms in these areas, and the broad principles and objectives that will guide the reform effort. 124 BOX 8.1 SUGGESTED POLICY REFORM AGENDA Policy Ieues and Agtionj Nacssary Area* of Reform Overall Polioy Focu . The focus of India's SSI policy ohould be reorientod toward en emphaele on new 4atreprenqurship orntiond tho effolent growth of s and los. i.on protection of all small scal . fims. This means focusing on measures that Improve the working of factor . markets, reducen ortiftial berriers to entry and enhances the quality of - infrosruture.- To Offect this reorientation, It would bo n,--ecessary to draw up a' comprehensive Governmental White Paper. that- saets out the policy fromowork and reform Agenda for SSI, as well as providing an implementation mOChonism and orgonizational otructure that would shepherd the policy reform process. Suggested steps A precisa timetable. for thisa Establishment of an SSI Policy actions. may not bo feasible. But Taek Force with mandate. the proposed White Paper. * Establishment of five functional: together with the åub-component Workng Groups (Finnce, Working Group papers. -and Reservatton, and Input Subidies, sohedule could bo targeted for a Industrial Extension, ExcissTaxes tim. four months prior to the and the Reguletory Environment), ennual Budget presentation. thus with mandatet. allowing for the introduction of "Completion. of initial Working. specific reform measures. Group papers on reform in subject Oeeas. Implementation schedule for the reform areas *identified". Concesslon and incentives Reservation Announco governments' intent to Phasing out of production elirinate production reservation reservation should proceed over a for SSI over - specified time period of threo years following period This should be announcement of the general accompenied. by a phösed intent to dereserve production. grouping of produat categorles Xhat will ba dereserved. Excise Tax Exemation Eliminate the present system of Progress in adjustment of this exclse tax exemption. This could excise tax regime applicable to be replaced by a time based SSI should be as soon as concession designed to encourage possible. new entreproneurship but not inhibit growth. 125 BOX 8.1 (continuedi Poi9v lesug and Aggon& Necesqr Timetable Areas of Reform Rnw Material 0uotas Speala quotas of certain raw At a very carly stage of the materiale for $Si should be reform agenda. lhasod out. ii there are identified faHure of inarket and distribution system.' then the underlying oauses ehould be remedled. Lnanlei intermedfatlon nterest ras Lending ratas for loana to SSI Reforms. In the system of credit shöuld be mårket determined' ln for SSIs should proceed in unison partioulr tho concessonal rotas with a wider financial sector Iharged by the S1PC should be reform program. However, the replaced. by roten thot reflect proposed review of the SFCs appropriate rielt and market cost .. should be commenced as soon as of funde .. possible. Theres urgent need to undertake o review of each SFCs portfollo end capital adequcy. Following completion of this review a restructuring plan should be drawn up for åach one, together with reoapitalization requlrements The aharehoiding of SFCs hould be broadeneo te inciude other inatltution* and the general public. The SFs naed to be given greeter freedom ln the type of lending activlties in which they can engage. Lendina Demarcation Artificial demarcation of the types of lending that need to be - undertaken by a. particular institution needs. to be phased *. out.. in particular.:h demarcation between term and * working capital tending should be abollohed. Industrial Extensn Service There is need for w thorough This review should be undertaken review and reapprelsat of the at a very early stage- of the whote. gamut of extension reform agenda. services provided to SSiK This. should cover funding, actvity focus and the institutional framework. Greater cost recovery on certain services is needed, as wel as a more sharply focused range of service activities. What resources are 126 BOX 0.1 (continued) Pollox INGuGG and ioN Eim Area* of Reform evailable need to be directed to cloemy Identifled areas of markit ailuro (e.g. information transtmission mochanisms or teohnology transferl, leaving the privato~ sctor to provide the remainder. Reaulatorv Environment The central government has The task of drawing up a specific already sought -to simplify agenda of procodure procedurn. legal and burearoratio simplifications should be Initiated requiremento for all firmo. 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