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What are MSMEs? Why are They Important for the Indian Economy?

May 16, 2020 11:10 AM 5 min read

In her press conference recently, Finance Minister Nirmala Sitharaman made quite a few announcements on Micro, Small and Medium Enterprises (MSMEs).

These included ₹3Lcr ($39.9bn) in credit guarantees, a ₹20,000cr ($2.6bn) subordinate debt scheme and the creation of a fund to infuse ₹50,000cr ($6.6bn) in equity to MSMEs. Significantly, it was also announced that the very definition of MSMEs would be revised.

In this article, we’ll dig deep into the world of MSMEs. We’ll explore why these small businesses are important, what are the challenges they face, and the challenges that await them in a post-COVID India.


What Exactly Are MSMEs?

We’ve heard it countless times: politicians and analysts deifying MSMEs as the “backbone” of the economy. But what exactly are they?

As the name suggests, MSMEs are small businesses. Around the world, definitions of what an MSME varies. The World Bank says a business can be classified as an MSME if it meets three main criteria – employee strength, assets size or annual sales. While countries define the limits as per their own rules and norms, most use only one variable to define MSMEs (and the most commonly used one is number of employees).

In India, the definition has evolved. Previously, under the Industrial Development and Regulation (IDR) Act, 1951, the criterion used was number of employees. But it was found that ascertaining actual employee data was difficult.

Then in 2006 they were defined based on investment in plant/machinery or equipment.

It is this definition that the Government changed on Wednesday.

What is the New Definition of MSMEs?

Let’s explain this with tables. Micro, small and medium enterprises were classified under the manufacturing and services verticals thus before Wednesday:

What are MSMEs? Why are They Important for the Indian Economy?

 With the new changes, the investment criteria has been increased and an additional factor of annual turnover has been added:
What are MSMEs? Why are They Important for the Indian Economy?


Why Was the Definition of MSMEs Changed?

The primary criticism of the former definition was that it was outdated – after all, it was crafted 14 years ago. The classification does not take into account how the economy has changed since then or even the increase in price index of plant and machinery equipment.

Another reason for the revision, as pointed by the Finance Minister during her press conference, was to encourage MSMEs to grow and expand without fear of losing the benefits you are entitled to as an MSME. “With the revised definitions, they will not have to worry about growing their size and can still avail benefits,” Sitharaman said.

How has the policy change been received? While there was appreciation for the long-pending revision, there was also confusion over why an additional criterion (annual turnover) was added when it could have been made the sole parameter, thereby not making things more complicated. Moreover, a complaint against the old definition was that investment is not a reliable metric to measure since data regarding this is not easily available. But it has remained a parameter in the new definition.


What Kind of Businesses Come Under MSMEs?

Under the Manufacturing vertical, any business that is involved in the manufacturing and supply of goods and products are considered MSMEs (of course, they also have to fulfil the investment and turnover requirements). Such businesses would include processed food, electronics, furniture, textiles etc. 

Under the Services vertical are businesses involved in providing certain services to customers. These services can include many things from photocopying and beauty parlours to electronics repair and IT.

To ensure that a business claiming MSME status - and, therefore, benefits - deserves classification as one, the Government uses the National Industrial Classification Code (NIC Code). This document has a list of manufacturing and services activities each of which has a unique code that must be mentioned when a business applies to register as an MSME.


How Important are MSMEs?

Now that we know what MSMEs are, let’s understand why they are important. Are they actually the “backbone” of the economy as everyone says they are? Well, the Government just set aside ₹3.7Lcr ($49bn) aside for MSME support amidst the COVID-19 crisis so that should tell you something about their indispensability. But let’s dig deeper.

Let’s take a look at some statistics. According to an RBI report, they contribute c. 45% to India’s manufacturing output, more than 40% of exports and its share of the GDP is over 28%. The sector also employs more than 111m people – so, over 23% of the labour force.

The sector is also vast. There are more than 63m MSMEs in India – the second-largest number in the world after China. Most of the enterprises (over 99% of them, in fact) are micro set-ups.

Together, these businesses offer a wide array of products and services, ranging from traditional medicines to hi-tech items. Backbone of the economy, indeed!


What are the Challenges Faced by MSMEs?

Just as they are vast and crucial, MSMEs are also greatly fragmented.

As mentioned earlier, more than 99% of MSMEs are micro enterprises. These can often be businesses led by one or two people – and these micro establishments are more often than not unorganised, cash-dependent and not tech-savvy.

Moreover, as a paper by the Confederation of Indian Industry (CII) noted, even in the organised MSME sector growth has been hampered as “technological obsolescence and financing problems have been associated with the sector since long.”

Then there’s data. There is no reliable repository of MSME-related data on stats like number of MSMEs, associated workforce and sectors, financial performance, credit history, loans sanctioned, loans repaid, collaterals etc.


Will Banks Lend to MSMEs?

All the above challenges - lack of formalisation, cash-dependency, technological handicap and data deficiency - combine to cause another challenge: that of credit. To grow, businesses need credit, which can be borrowed from banks, but banks’ enthusiasm for lending to MSMEs has gradually eroded in recent years due to challenges faced by the sector and the risk of loans turning bad down the lane.

Vast numbers of MSMEs also make use of informal channels of credit, which can be less efficient and more costly. Barely a third of MSMEs’ lending requirement (i.e. ₹12Lcr ($156bn) out of ₹36Lcr ($468bn) is met through regular banking channels (commercial banks, NBFCs etc.) as per the International Finance Corporation.

As of January 2020, the MSME sector’s bad loan ratio stood at 12.5% (of which micro enterprises was at 9%), increasing over the previous years despite there being an overall decline in commercial lending NPAs in the same period. (Ironically this is still much lower than 17%-18% NPAs for large corporates, on average.)

Why is this an important point? Because if MSMEs are to get back on their feet in the coming months, banks will have to lend. The ₹3Lcr ($39.9bn) loan facility the Government revealed? Those are mainly credit guarantees given to banks by the Government. The banks would still need to underwrite.  

Such harsh structural forces would continue to suppress their potential, with or without a pandemic or stimulus in the background.


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