Report of the Expert Committee on Small Enterprises

THE PREMISES: The Expert Group recommends that the guiding principle of the future course of small scale enterprise (SSE) development policy should be their accelerated growth and competitiveness. Hitherto, the accent of small enterprise development policy was infant industry protection predicated on the assumption that new enterprises cannot withstand predatory competition from large companies Moreover government focus has exclusively been on small-scale industries. The concept of the small-scale sector should now be widened to include small-scale business and service enterprises. The principle of protection of fledgling enterprises at the stage of their formation will remain valid in the future as well Beyond their initial state of development, incontrovertible evidence exists of the capacity of SSEs to survive competition from large companies in India and elsewhere in the world. SSEs typically survive on the strength of their flexible managements, prompt response to market demands and customised products. SSEs should, therefore be expected to fend for them selves aided by a supportive business environment. A change in the orientation of the policy for SSEs is inescapable since other domains of economic policy in the country have been liberalised.

MECHANISMS OF PROMOTION: In consonance with the stated goals of growth and competitiveness of SSEs, the Expert Group recommends that the policy of protection be replaced by promotion as the cornerstone of future policy. Adequate supply of credit, services, technology assistance, infrastructure and low transaction costs are the hallmarks of the proposed strategy for promotion of SSEs. This can be achieved by developing a variety of linkages between enterprises and their support institutions, partnerships between the private sector and the government, greate-information flows and by streamlining the legal an institutional framework.

FOCUS ON CLUSTERS: The centrepiece of the new approach is an increasing public private partnership in setting up support systems for small scale enterprises. Such public private partnership would thrive particularly in clusters of small scale enterprises. Agglomeration of SSEs is a source of informational economies, accretion of skills and economies in infrastructure development. As a matte of fact, spontaneous growth of over 300 clusters has already taken place in the country mostly unaided by the state. This growth has been fuelled by access to domestic and international markets and cheap labour. However, further progress in clusters is hamstrung by decrepit infrastructure, environmental degradation, technological obsolescence and meagre skills of the workforce. World wide experience confirms that growth in clusters can be buttressed by institutional development, and aided by the abundant provision of services and infrastructure development. The thrust of the future policy for SSEs should be to bolster growth in existing clusters by redirecting current investments in regional development (i.e. backward areas) to such centres of growth which are spreading to less developed regions. The Export Group therefore recommends that state governments identify the existing SSE clusters and then promote new types of organisations which are joint ventures between the state governments or local authorities and business associations in these clusters.

The Experts Group recommends that the 9^th Five year Plan should include funds to be provided for funding and running these organisations on this basis. The Clusters Small Enterprise Associations (CESAs) should be autonomous and the government should only support them if the local business associations are willing to provide some level of matching funding. The level of matching funding would have to differ between different locations depending on the size and strength of clusters.

DEVELOPMENT ROLES FOR CENTRAL AND STATE GOVERNMENT: The Expert Group is proposing that policy support must be broadened from the current support of only small scale industries to all small scale enterprises. Historically, the Central government has taken the initiative to foster an array of institutions that have catered to the needs of the small scale industry. Subsequently, the state governments have created an administrative infrastructure to address the needs of the SSEs in the future, therefore, the development of SSEs should be largely the responsibility of state governments. The development of SSEs is an aspect of regional development that is best pursued by state governments. The Central Government’s tasks should be confined to policy formulation, legal and institutional development. In view of the expanded coverage of the small scale sector to include business and service enterprises, the Expert Group recommends that the responsibilities of the Department of Small Scale Industries and Agro Related Industries be expanded to cover all small scale enterprises. Accordingly, its nomenclature should now be changed to "Department of Small Scale Industries and Business Enterprises" Other residual tasks such as data collection, linkages between SSEs and universities and co-operation between Indian and overseas clusters can also be the domain of the Central Government. In particular, the Central Government needs to restore confidence in the quality of statistical information currently ridded with contradictions. The Expert Group therefore recommends that the Central Statistical Organisation and the Ministry of Industry from a group to improve the quality of statistical information on small scale industry as well as to identify additional needs of the industry and other users of this information.

REVITALISING DISTRICT INDUSTRY CENTRES: District Industry Centres will play a pivotal role on account of the regional focus in small enterprises development. So far they have been ineffective due to administrative overload inflicted by a gamut of regulatory functions. The Expert Group therefore recommends that a completely new look be taken on the functioning of the District Industry Centres in order to make them more promotional rather than regulatory. DICs need to be redesigned as autonomous District Enterprise Promotion Agencies (DEPAs) with participation from business associations, government agencies, banks, etc. DEPAs should help weave a web of relationship between clusters and their support institutions and be the conduits for flow of information for dissemination to SSEs. DEAPs can be supported by local councils which will be forums for participants in SME development such as business associations banks etc, to air their views on contentious issues and to discuss problems. The newly proposed DEAPs must have a special focus on the assistance of tiny units.

CORPORATION OF GOVERNMNT EXTENSION AGENCIES: Over the last four decades, the Central Government has sponsored a myriad organisations for the delivery of business services to small enterprises. In recent years, private sector consulting firms have emerged to meet the same needs. Whereas government institutions are either unable to keep pace with modern technological developments or are incapable of prompts delivery, private companies are preferred for their speedy response even though their price is higher. The Expert Group therefore recommends that government extension agencies be corporatised. They should also specialise in a few core activities to develop their competitiveness. Government should facilitate the transition by part funding the corporatised institutions. Similarly, enterprises should have the option of sourcing services from the private sector with part funding from the state. It is recommended that SIDBI open a special window for the funding of technical consultancy organisation and other business support services aimed mainly at small scale enterprises.

ABOLISH RESERVATIONS: One of he most important planks of the policy for the development of small scale enterprises has been the reservation of products which can be manufactured only by them. The existence of reservation policy has also provided an illusion to the government and the country at large that adequate protection/promotion was being provided to small scale industries. Past experience leads to the conclusion that reservation does little for the promotion of small enterprises and play only a negative role of keeping out large enterprises. This policy is now inconsistent with the current trade reform which allows the free import of the large majority of goods and most of the remaining consumer goods can be imported under special import licenses. In any case, the large majority of products manufactured by the small scale sector are not reserved at all. Conversely, a large number of reserved products are either not manufactured at all by the small scale sector or their sales turnover is insignificant. On the other hand, the opportunity cost of the reservation policy is extremely high since important sectors like light engineering and food processing have not been able to grow due to the limitations imposed by it. Moreover, the pace of expansion of exports in such important sectors as textiles and leather is threatened because India I unable supply large enough volumes of adequate quality within the required delivery time. The problem will be accentuated when quantitative restrictions on imports in developed countries, such as those under the MEA, are withdrawn. The Expert Group believers that this is the most powerful argument for the abolition of small scale industry reservations forthwith. The existing small scale units as well as new entrants in these industries must be provided an opportunity to investment in appropriate size and technologies to be able to compete with imports in the coming years. It is therefore, imperative for future export growth to remove such smal scale industry reservations so that adequate new investment and technology upgradation take place in these industries and that existing units are allowed to upgrade.

It is on all these considerations that the Export Group has concluded that the policy of reservation be entirely abolished. We have considered the option of a phase abolition

{PAGE 3 OF 246}

in order to give time to industry to adjust However, in view of the overwhelming evidence that the reservation policy is now serving no purpose in the promotion of the small scale sector, we are recommending a complete abolition. However, the government must make simultaneous transitional arrangements to assist small scale units affected by this dereservation.

Transitional Arrangements for Small Scale Industries Affected by Dereservation: The Expert Group recommends that the Ministry of Industry should immediately set up a joint mechanism between the government n industry representatives to identify specific industries/items in which small scale units are likely to be affected by the proposed dereservation. These are perhaps among the 68 reserved items which accounts for more than 80% of the total value of production of reserved products. Subsequent to this identification the geographical areas where such affected units are concentrated could also be identified. The Expert Group recommends that the government should provide annual resources of the order of Rs. 500 crore over the next five years, thereby totalling Rs. 2500 crore, to the Ministry of Industry for providing the proposed support. These resources would be used to leverage greater resource from SIDBI, banks and other financial institutions to provide concessional funding in terms of equity support an interest rte concession to such units for expansion, technology upgradation, modernisation and training. It is also suggested that, as a transitional measure for a period of 5 years, fiscal concessions may be extended for existing units which manufacture reserved items. For such units complete exemption may be granted upto a turn over of Rs. 50 lakh, partial exemption for turnover between Rs. 50 lakh and Rs. 1 crore. The elisibility turnover limit may remain for these units at Rs. 3 crore.

Raising Investment Limits: First, the definition of the small scale enterprises (SSEs). Incentives, credit facilities, and promotional facilities should then be available to all small scale enterprises. To begin with, the concept of the SSE sector, should include all business enterprises in the service sector which provide services to industrial enterprises. Taking into account all these factors, an investment limit provide services to industrial enterprises. Taking into account all these factors, an investment limit of Rs. 25 lakh for tiny units is adjudged to be most appropriate. For small scale enterprises, the there should level should be immediately raised to Rs. 3 crore for the same reasons.

Excise Incentives for Graduating Tiny and Small Scale Unites: Some, modification is required, as already suggested for units that currently manufacture reserved items. Second, some modification may also be made to remove the disincentive for tiny units to grow beyond their investment limits. It is therefore proposed that tiny units which graduate beyond the investment limit of Rs. 25 lakh be permitted a higher total exemption limit of turnover to Rs. 50 lakh, for a period of 5 years after crossing the tiny sector investment limit. Similarly the total turnover limit of Rs. 3 crore may be expanded to Rs. 5 crore after the SSI crosses the proposed new investment limit of Rs. 3 crore, but only for a period of 3 years from such graduation. In ordr to encourage franchising, ancillarisation and to promote closer complementary links between small scale enterprises and large scale enterprises, it is recommended that excise exemption withdrawn earlier for branded goods should be restored.

RESTRICTURING OF FINANCIAL SUPPORT

The financial system also need to be reformed to increase access of small scale units to term loans and working capital and to lower the costs of credit. Available evidence suggests that the access of small scale enterprises to credit is generally inadequate. The existing institutional structure for delivering credit to SSEs needs a through overhaul. State Finance Corporations(SFCs) and State Industrial Development Corporations (SIDCs) have suffered from very poor recovery rates. Moreover, they have also been characterised by heavy political and bureaucratic interference in their functioning. Further, as a result of interest rate deregulation and the poor recovery rate of financial institutions lending to SSEs, the cost of credit for small enterprises has risen as they are considered risky propositions. The Government had appointed the Nayak Committee to review the credit requirements of SSEs. The Expert Group endroses the recommendations of the Nayak Committee and urges the RBI to implement them. In particular, all effort must be made to achieve the prescribed target of providing working capital of a minimum of 20 percent of the projected turnover of small scale enterprises.

Restructuring of SFCs and SIDCs: It is nevessary that the distinction between term lending and working capital institutions be done away with and banks and SFCs increasingly get into making composite loans. The Expert Group recommends that the IDBI in association with SIDBI devise a new scheme to revitalise SFCs and SIDCs. The approach should be to make these institutions autonomous by reducing government equity to less than 50%. The rest of equity could be held by other financial institutions, commercial banks, private banks, including industries and other private interests which have particular interest in the specific states.

Specialized Commercial Bank Branches and Local Area Banks: The Expert Group further endorses the plan for local area banks and specialised branches of commercial banks to service the needs of SSEs. A special emphasis should be given to this scheme so that special training for appraisal, evaluation and monitoring can be given to the staff in these branches. These local area banks can become the storehouses of information about credit risk of investment in small enterprises in their region. The costs of credit will decline if banks and financial institutions can increase the rate of recovery of loans. Therefore, the mechanisms for credit recovery should be strengthened by community guarantees, credit rating and creation of date bases on the credit record of companies. Now that commercial banks are also allowed to do term lending, these special branches must provide term loans and working capital to the small scale enterprises within their jurisdiction. The Expert Group recommends that the Reserve Bank of India should promote the speedy establishment of these local area banks in the districts where SSI clusters have been identified. The Expert Group also recommends that the Reserve Bank of India should initiate action to provide support for special training schemes for the staff of these new local area banks so that appropriate expertise is built up quickly in these new financial institutions. The Expert Group recommends that the Board composition of these LABs would benefit from the participation of representatives from local business associations.

Reducing Credit Costs for SSEs: Extending credit ratings Services to SSEs: The Expert Group recommends that SIDBI in co-operation with the national credit rating agencies should promote the establishment of local credit rating agencies in the identified SSE clusters. This would require some level of equity participation by existing financial institutions including commercial banks and the national credit rating agencies. The government could provide a small seed fund to help in kick starting this process. We, therefore, recommend that cluster associations be allowed to stand as guarantors an their co-operation should be enlisted for this purpose.

Other Fundings Sources for SSEs : Other sources of financial can also be tapped if the 24 percent ceiling on equity participation by large companies and foreign direct investment in SSEs I removed. The national equity fund would function much better if it is disbursed by local base of venture capital funds can be increased considerably if Flls are allowed to invest in them and private pension funds and insurance companies are allowed in the country. The Limited Partnership Act, if it is implemented, would also enable access to an additional source of funds and skills brought forth by management partnerships. The Delayed Payments Acts has not been too effective so far in helping SSEs collect their dues. A more practical approach would be to encourage a bills culture and to expand factoring services. We also recommend that in the annual accounts of large companies, information be provided on a statutory basis on the extent of accounts payable to small enterprises. The Expert Group recommends that the Department of Company Affairs explore this possibility.

Addressing the Credit Needs of tiny Enterprises: For ensuring that the tiny sector is not bypassed by the commercial banking system, the Expert Group proposes that it should earmark a minimum of 70 per cent of the priority lending allocated to the small scale sector to the tiny sector. To help those entrepreneurs without sufficient collateral towards procuring bank loans, it is suggested that a Revolving Collateral Reserve be created at the intermediary level.

INTEGRATED SUPPORT SERVICES: Support institutions for SSEs in India are largely government owned and do not roved a package of services. International experience suggests that technical assistance, market assistance and information have to be available as a package to have the desired results. Moreover, enterprises should have the choice to access services from the source most suited for them and not just state-sponsored institutions. Government should withdraw from direct delivery and partly fund the cost of services accessed from the most efficient source. Technological support is an obvious need of clusters since they have so far survived on the strength of low prices. The main reason for slow technological progress is that clusters do not have access to related infrastructure for testing, quality control etc. It is, therefore, suggested that assistance institutions preferred by industry. Since small companies cannot by themselves finance large expenditures, research associations will be an effective means to pool together resources for research and development. New technology can be effectively commercialised in incubation centres and science parks. Training of manpower has to also take place to enhance human capability to absorb new technology. East Asian countries have successful experimented with training schools jointly sponsored by large companies, small companies and the government. Private participation is a more effective means to transfer skills from one firm to another. Tax waivers should, therefore, be available for private sector investments in training institutes.

SUPPORT FOR TECHNOLOGY DEVELOPMENT IN SSEs

The Expert Group recommends that the government should provide funds to the Bureau of Industrial Standards (BIS) in the Ninth Plan to fund a special exercise for providing technology support to SSEs to achieve prescribed technical standards.

Financing for Technology Upgradation : The Expert Group proposes that the scope of the existing TDMF Scheme of SIDBI which is presently linked to 25% export obligation be enlarged to cover all modernisation proposals including those which involve the improvement of capabilities and competitiveness in the domestic market. Further assistance should be provided out of this fund to support service institutions / enterprises engaged in technology transfer, technology-oriented research and development and the like. To encourage increased availment by SSEs under the scheme, the assistance under TDMF could be provided at a concessional rate of interest. SIDBI and other financial / banking institutions which opt to take up this scheme may be compensated for such soft lending under a Special Revamped Scheme for Technology Development and Modernisation of SSEs. This assistance would be particularly relevant to tiny units.

Support for Research and Development: Once again, the Expert Group is of the view that such services could be provided most effectively through institutions based around clusters of similar industries so that they are able to specialise as well as reap economies of scale. The Expert Group recommends that the government should establish fund(s) at both central and state level in order to design schemes which provide matching funds as incentives to clusters industry associations to establish the required technology support institutions. The Expert Group recommends that the Department of Science and Technology initiates a new scheme in the 9^th five-year plan to from R&D associations based around identified clusters of industries which may be identified as those which are in urgent need of technology upgradation. At least 10 such clusters should be identified within the first year and the aim should be to establish at least 50 such industrial R&D associations for assisting SSEs, within 5 years. We recommend that these links between these existing technical institutions and existing industries on the one hand, and with the new proposed technology support institutions could best be forged by the national level industry associations through their members.

The Expert Group recommends that a National Research Institute for Small Scale Industries be established it is proposed that this institutes should be promoted jointly by the central government and apex industry associations.

Training: Technology upgradation in the small scale sector will throw up large requirements for training of entrepreneurs, managers and employees. The Ministries of Industry. Labour and Education should set up a special Task Force to work out the modalities for a special training scheme for SSEs and provision should be made in the Ninth Five Year Plan for the provision of seed capital for this scheme which must be designed to elicit equivalent contributions from the private sector. The Expert Group also recommends that state government should make provision for matching funds to be provided for establishing skills development centres.

Marketing Asistance : The Expert Group suggests that on the lines of Marketing Development Assistance Fund set up earlier in EXIM Bank with World Bank assistance, a fund be created and operated through SIDBI for assisting a targeted SSE exporting units numbering around 5000 in the 9^th plan period. The Expert Group also recommends that a suitable mechanism be evolved to promote marketing outlets specialising in marketing the products manufactured by the tiny sector. Efforts may also be made to develop common brand names for such products. We do, in fact, have a few such successful initiatives in India by NGOs like Sarva Shanti Ayog (SASA), Calcutta ad Orissa Rural ad Urban Producers’ Association (ORUPA). Franchising must be promoted as a concept.

INFRASTRUCTURE DEVELOPMENT IN CLUSTERS: In the future, integrated development of infrastructure will be essential in industrial estates. Moreover, the convenience of doing business in industrial estates can be considerably enhanced if they are supported by high quality services. The Expert Group therefore recommends that both central and state governments redirect their existing growth centre and other infrastructure development schemes to the infrastructural development of existing SSE cluster. The Expert Group recommends that the private sector be encouraged to develop industrial estates as infrastructure projects. The State should from State Industrial Park Authorities to facilitate the entry of the private sector. These agencies would have to formulate the regulatory framework for entry of the private sector into industrial park Authorities to facilitate the entry of the private sector. These agencies would have to formulate the regulatory framework for entry of the private sector into industrial parks. Government should also share the risks of large investments in infrastructure to facilitate their rapid development. The decayed industrial centres in some of the major industrial cities can be reused for the development of SSEs. A major source of delay in the implementation of infrastructure projects is the acquisition and sale of land so obtained. This problem can be solved if landlords are granted development rights to benefit from the upside potential of project development. Government can also contribute land in its possession in lieu of its share of equity in infrastructure development projects.

Business Associations As Partners: The participation of business associations is critical if private investment in infrastructure is to be successful. Recent experience suggests that progress in infrastructure projects is often stalled because of conflict of interest issues. Greater participation of business associations will help to avert such problems. In recent times, some business associations have shown an inclination to participate in social projects and this should be encouraged by the Government. The government, particularly at the state level must initiate action to activate the city / cluster level business associations so that they can participate actively in the many activities recommended in this report. The Expert Group recommends that the Ministry of Industry should initiate a programme of technical assistance from the European Union or other bilateral sources to bring this about.

INSTITUTIONAL N LEGAL INNOVATION: The Expert Group recommends a separate law for small enterprises. The objective of the law would be to define the small enterprise sector and outline the broad framework for the promotion of the sector. A new single business law called the "Basic Law for Small Enterprises" should be enacted.

End To Inspector Raj: A major restructuring of social legislation is essential to lower the transaction costs of doing business for SSEs. Currently, the inspector raj thwarts small enterprise. The single law for small enterprises should help to reduce the number of officials visiting factories. Furthermore, employers should have the option of voluntarily paying a change for medical insurance an public provident fund in exchange for a waiver from corresponding public schemes. Similarly, the labour laws should be waived for enterprises employing up to 50 workers with power and 100 without power if employers agree to pay for unemployment insurance. To the extent that certain kinds of social and regulatory legislation is necessary for social welfare, a certain amount of inspection would have to continue. The Expert Group recommends that transparency be introduced in such inspection arrangements. Inspectors for different laws could be "clustered" and then inspection of units made on an open random basis, on random drawing of units in defined clusters. Finally, environmental targets should be determined for an entire cluster and business associations held responsible for implementing them in the best manner possible.

Monitoring of The New Policy Approach : Expert Group recommends that the Ministry of Industry set up a Steering Committee under the chairmanship of the Industry Minister to oversee the evolution of the new policy approach suggested.

PREFACE

The Department of Small Scale Industries and Agro & Related Industries constituted an Expert Committee on Small Enterprises in Decembr 1995 (see Annex P. 1)

Shri S.A.T. Rizvi, Development Commissioner, Small Scale Industries, was a member until December 16, 1996 and was then replaced by Shri K.V. Irniraya, who succeeded him as Development Commissioner. Shri J.V. Shetty resigned as Member of the Committee on September 1, 1996 when he retired as Chairman and Managing Director of Canara Bank. Shri Brahm Dutt Joint Secretary, Ministry of Industry was co-opted as member of the Expert Committee effective October 28, 1996

The Expert Committee held a series of meetings at New Delhi and in various state capitals through its existence. The Committee held consultations with representatives of state governments and of industry associations in all the regions of the country. The Committee would like to place on record its appreciation for the hospitality provided by the governments of Tamilnadu, Gujarat and maharashtra for arranging these meetings during its visits. The merchant’s Chambers of Commerce, Calcutta, the Indian Merchant’s Chamber in Bombay, the punjab Haryana and Delhi Chamber of Commerce and Industry (PHDCCI) in New Delhi, the Tamilnadu Tiny and Small Industry Associations, Chennai, and the Gujarat Chamber of Commerce and Industry, Ahmedabad graciously organised the Committee’s interaction with representatives of industry associations in their respective regions and provided warm hospitality. The Committee found its interaction with state government representatives, both at the political and official levels, to be extremely enlightening. We benefited greatly from their practical experience in the promotion of small scale enterprises. The representatives of industry associations provided first hand information to the committee on the problems being faced by small scale enterprises and indications for their solutions.

We would like to record a special debt of gratitude to Dr. C. Rangarajan, Governor, Shri R. V. Gupta, Deputy Governor, Reserve Bank of India an their colleagues for having found the time to meet with the Expert Committee and share their views with us.

I would like to particularly record my appreciation for the generous support given to the Expert Committee through out its existence by Shri Brahm Dutt. Joint Secretary, Department of SSI&ARI in the ministry of Industry. He was ably supported by Shri M. Sahu, Director, Shri Beni Ram, Under Secretary and Shri S.Hariharan, Section Officer in the Department of SSI&ARI.

The Committee was fortunate to receive the assistance from the National Small Industries Corporation (NSIC) in making all arrangements for its visits to Calcutta, Mumbai, Ahmedabad and Chennai. Shri M.Ahmed, Chairman and managing Director, NSIC was extremely generous in placing at the committee’s disposal the services of his organisation’s staff and resources. We would like to acknowledge the assistance received from Shri Rajiv Bhatnagar, Shri O.P Sharma, Shri N.S. Padmanabhan, Shri S.K. Ahluwalia, Shri H.C. Sharma, and Shri S.P. KAINTH of the NSIC during its various visits.

The Office of the Development Commissioner (Small Scale Industries) is the key organisation at the central level looking after the interest of small scale industries. Shri S.A.T. Rizvi and Shri K.V. Irniraya shared their views and experience with the Committee and generously provided additional support from the staff. We would like to acknowledge the help in particular of Shri C.S.Prasad, Additional Development Commissioner, DC(SSI) and Shri Raju Sharma, Director, who provided specific contributions regarding the existing policy framework for Small Scale Industries Special assistance was also received from Dr. (Mrs.)V.S. Bharucha, Economic Adviser, Ministry of Industry for the work on extreme focus products identified by the Ministry of Commerce.

Secretariat an research support was provided to the Expert Committee by the National Council of Applied Economic Research under the direction of Dr. Rakesh Mohan. In his capacity as member Secretary of the committee Dr. Rakesh Mohan contributed extensively both in terms of ideas and policy initiatives to be undertaken. His interactions with the local industry associations specially contributed towards evoking positive responses from the non officials. His knowledge of economics and the experience in the Ministry of Industry was extremely valuable for the work of the committee. The Expert Committee has deeply appreciated the very scholarly research contribution of prof. Deepak Mazumdar in providing the theoretical base for support of small scale enterprises and in the analysis of the structure and performance of small scale industries. Shri K.R.Pandit has provided meticulous research and overall support to the Expert Committee’s work in the NCAER. His particular contribution has been in documenting the various aspects of policy on reservation of items for Small Scale Industries, Computerisation and software assistance has been provided by Mrs. Kiran Dutta and Shri Ashok Kumar thakur. A special word of appreciation goes to Shri Ajay Kumar Gupta and Shri Rakesh Kumar Srivastava for performing the arduous task of word processing in this relatively large report an organising the collation of its various segments. I would specifically like to thank to Shri Niral Maru of SEBI who made the final production of this report possible through the use of his specialised information technology skills. Mrs. Simi Kumar Chawla provided overall organisational assistance at the NCAER. Shri Kishore Jethanandani has provided us the benefit of his critical, writing and editing skills wothout whom it would have been difficult to compile this report.

I would also like to acknowledge special contributions by the member of the committee Dr. H.C. Gandhi, Dr. Shailendra Narain and Dr. V.G. Patel provided major contributions in arriving at many of the policy recommendations for credit policies for the small scale sector an special support needed by the tiny sector Dr. Mashelkar has contributed to the ideas regarding the technology upgradation requirements of small scale industries. Prof. J.C. Sandesara contributed to the analysis of structure and performance of small scale industries. I am extremely grateful to all the members of the Expert Group for generously giving their valuable time to the work of the Expert Committee.

It is my hope that this report will contribute to a significant improvement for the policy support required by small scale enterprises in the country. I hope that our recommendations would receive adequate consideration by the government and would be debated widely by the general public.

Abid Hussian

Chairman

Annex p.1

F.No. 13(24)/95-SSI(P)

Government of India

Ministry of Industry

Department of Small Scale industries

and Agro and Rural Industries

New Delhi , 29^th December, 1995

ORDER

An elaborate set of policies, programmes an institution has evolved over the past four decades for providing government support for the promotion of small industries in India. The Government have in the meantime implemented a programme of economic reforms including industrial and trade policy reforms whose objectives have been to eliminate bureaucratic control and protectionist measures, allow greater play to the market forces in shaping entrepreneurial decision making and promote competition. Globalisation and change in technology are also emerging as the major forces that will modify and mould the environment for small business an entrepreneurship over the next decade and beyond, Small enterprises in many barriers of the service sector, are fast emerging as provider of employment and contributors to exportdevelopment which necessiates reconsideration of the view that the policies for small enterprise development should concentrate on the manufacturing sector. It is thus, necessary to address the need for reforms in the existing policies and design new policies for small and medium enterprises (SME) development which will facilitate the growth of viable an efficient enterprises that can adjust to technological change and remain internationally competitive.

It has, therefore, been decided to constitute an "Expert Committee on Small Enterprises" which will go into these issues in depth and make is recommendations to the Government. The Committee will consist of the following:

1. Shri Abid Hussain Chairman
(Former Member
Planning Commission)

2. Dr. R.A.Mashelkar Member
Director General
Council of Scientific
And Industrial Research

3. Shri H.C. Gandhi Member
(Former Secretary, Technical
Development, Ministry of Industry
Government of India)

4. Shri J.V. Shetty, Chairman and Member
MD. Canara Bank

5. Dr. J.C. Sandesara, Hony, Professor Member
Department of Economics, University
of Bombay

6. Dr. V.G. Patil, Director Member
Entrepreneurship Development
Institute, Ahmedabad

7. Dr. Sailendra Narain Member
Managing Director
Small Industries Development
Bank of India

8. Shri S. A. T. Rizvi Member
Development Commissioner
Small Scale Industries
Government of India

9. Dr. Rakesh Mohan Member-Secretary
Director General
National Council of Applied
Economic Research

To examine the promotional and protective policies and direct assistance programmes for small industry development, assess their impact and efficacy and in the light of international experience and recent economic policy reforms, suggest appropriate changes with the objective of creating an efficient viable and dynamic small enterprise sector in the Indian economy.

To review the definitions, legal framework and the heterogenous composition of the small industry sector and make recommendations for bringing about changes as may be appropriate for the realisation of the objectives outlined above, and in particular advise if the different segments of the small firms (such as village industries and modern small industries) may be covered by the same policy package or separate sets of policies may be prescribed keeping in view their different characteristics and requirements.

To examine the efficacy and desirability of the small industry reservation policy, assess its impact on the growth of small enterprises from the point of view of viability, efficiency, competitiveness and exposure to technical changes and progress and make appropriate recommendations.

To advise, in the light of international experience, it the small enterprise development policies should be restricted to the manufacturing sector or these should also cover small enterprises in the business and service activities.

To examine the present arrangements and sources for the collection, compiltation, dissemination and analysis of the date on small enterprises with a view to assessing their quality, consistency and reliability and make appropriate recommendations.

To review the present institutional arrangements for the transfer and dissemination of technological and technical information to small and medium enterprises (SMEs), assess the quality of the available advisory and extension services, xamine the necessity and possibility of placing these more and more in non-governmental organisations and private service (constancy) sector and make appropriate recommendations.

To examine the existing institutional arrangement and the polices and programmes for meeting the long term and short term financial requirements of the small enterprises examine their effectiveness, particularly in meeting the requirements of the innovative and technology oriented firms and the first generation entrepreneurs and in the light of the practices followed and instruments adopted in other successful economics, make appropriate recommendations.

To view the impact of various fiscal policies and tax concessions on small enterprise development examine their role in enabling the small firms to exploit their potential and grow into medium/large enterprises and make suitable recommendations.

To examine the impact of various regulatory laws and procedures such as the labour laws, the Factories Act, the Industrial Disputes Act and the Environment Protective Act on the small forms and the ability of these enterprises to meet various requirements under these laws and procedures and make appropriate recommendations.

To consider and make recommendations on such other matters as the Committee considers relevant for small enterprise development including changes in legislation where necessary.

The Committee will adopt its own procedure of work and may take evidence from any interested party, as deemed proper. It should submit its report to the Government within three months.

BRAHM DUTT,

Jt Secy.

Chairman’s Introduction

The small scale sector occupies an important place in the country’s economy. The existence of small scale units is essential to encourage to encourage the spread of industrial entrepreneurship throughout the country. It is therefore necessary for the small scale sector to be provided a proper environment for growth an efficiency. The objective of policy for Small Scale Enterprises (SSEs) must be to nurture such an environment.

For setting this objective, it much be recognized that there is an organic growth potential gets developed in the right policy environment, this potential gets developed. Further the imperatives of market and technology enable a healthy small scale operation to grow into a medium scale unit just as a medium scale unit becomes large, and a large national company aspires to emerge a an international business. There will always be industrial activities which are best done in the tiny, small or medium units rather than in large units. An efficient industrial system is so organised that the interlinkages between the small, medium and large sectors are mutually reinforcing and not competitively erosive.

The existing framework of policy support for the small scale sector evolved essentially in the environment of the 1950s an 1960s and then continued until the present time. The economic and social framework was quite different at the these policies were designed. Almost all industrial activity was controlled by the industrial licensing system; trade was controlled through the export import control system; foreign investment and technology were heavily controlled as well. In this framework, since industrial activity depended on the attainment of different government approvals, mostly at the central level, it was particularly difficult for small industries to enter into the industrial sector. At the time same, during the 1950s, and 1960s, during the first two decades after independence there was a great need to encourage entrepreneurship which had been kept dormant during the colonial era, Government activity was also marked by missionary zeal and different kinds of extension activities in both he rural and urban areas were started successfully by government agencies.

In such a framework it was logical to provide support for small scale industries on a protective basis by providing subsidies, concessions, small scale industry reservations and direct government support to SSI units. The basic structure of industrialisation has evolved over time and therefore the policy framework for small scale industry policy needs to change alongwith the new economic and social framework which now exists in the country.

We now have to recognise that government over time has become more bureaucratic and rule bound and can no longer be characterized as mission oriented. Many of the earlier systems for supporting small scale industries have instead emerged as bureaucratic bottlenecks which tend to restrict their growth rather than helping in their entry or in their expansion. The new framework for supporting small scale industries must therefore be much less dependent on the government and be more market oriented. Such a framework should derive support from non official sources and derive its strength from market imperatives.

The basic accent of India’s policy for small scale industries has been defensive, aiming to insulate the small-scale sector from the dynamics of competitive growth. In the world of today, such insulation is not practicable.

To begin with, the definition of a small-scale unit is in financial and not economic terms. Not only is that definition misplaced but in these times of inflationary pressures it soon becomes meaningless as assets become more and more expensive. In fact, a common practice, as a consequence, consists of dividing up assets between different small units. Indeed, quite often these latter exist only on paper undermining the futile basis of such policy.

Again, instead of focusing on areas that should be the province of the small scale sector by economic rationale, the SSI policy has traditionally concentrated on exclusive reservation of activities for this sector. In this process, it has lost sight of the simple but determining logic of a market system that it can not make business sense for a large company to do anything that can be done more competitively by a small unit. A policy of exclusive reservation for small-scale industry therefore is at best unnecessary and at worst inefficient.

Much of the existing policy framework was designed to assist individual units. These units were seen as free standing units with little relationship to others. Thus direct services were provided to individual units through government agencies, through fiscal incentives, and through financial subsidies. With the success of many of these measures the small scale sector has expanded greatly and it is no longer possible for the government to provide direct individual assistance in the way that has been done in the past. With the changes that have taken place in economic policies since 1991 many of the older restrictions no longer exist. Few clearances are required from the central government level. Consequently some of the biases against small scale industries have been removed. A great deal of entrepreneurship has emerged in the country. They now need to be nurtured for growth. The new policy framework must recognise this new economic environment and should now be designed to be much more promotional rather than protective.

India being such a large country the existing centralised approach can no longer be effective. The states will now have to handle most of the programmes of polilcy support for small scale industries. In addition, states also have to recognise the existence of concentrations of small scale units in readily identifiable areas and design their support programmes accordingly.

Small scale enterprises will continue to need exceptional support in terms of financial resources, technological development and infrastructure. It is much easier to organise such support systems in clusters where industries of similar characteristics exist together to reap the benefits of agglomeration economics. State governments will have to explore innovative ways of creating public private partnership with industry associations, business associations, and others to provide the kind of support that small scale industries need. The Expert Group’s recommendations have been based on this general view of the small scale sector.

This report presents a comprehensive analysis of the economics of small-scale industries in general terms, followed by a detailed look at the Indian case. In Chapter 1 the basic theoretical case for policy interventions to promote the development of SSE’s is presented having regard to the working of factor markets in developing countries. The general directions of interventions suggested by this analysis are outlined in Chapter 2 and the need to move away from the traditional Indian policy of reservation is stressed.

We have then examined the Indian experience in terms of policies and outcomes. Following a discussion in Chapter 3 of major policy measures adopted to help SSEs in India, Chapte 4 draws on a variety of available statistical sources to present a comprehensive view of the SSE sector in India, and how it has evolved in the last three decades. We discuss the size and growth of the SSI sector, its regional distribution, as well as the evidence on its relative efficiency. The next chapter traces the implications of the new economic environment for SSIs and provides pointers to the kind of policy changes that should be made in Chapter 6 we provide an analysis of the shortcomings of the existings policies and recommend the new directions that policy for small scale enterprises should take.

I. THE CASE FOR POLICY INTERVENTION TO PROMOTE SMALL SCALE ENTERPRISES

1.1 Introduction

The arguments advanced in the literature for promotion of small-scale enterprises (SSE) involve both certain desirable characteristics of such enterprises (e.g. their labour intensity and related positive distribution effects, their flexibility, their potential contribution to decentralization, their promotion of entrepreneurship etc,) and a common belief that that under normal market conditions either too few, or the worng combination of resources will be employed in such enterprises it is important to distinguish between the reasons why one hopes to see a flourishing small scale industry (SSI) sector (having to do with its positive features) and the need for sector specific support programs. Such programs are necessary if an when market imperfections may impede the sector’s full flowering in the sense that the size of the sector is below the ‘optimum’ which might be reached in the absence of such imperfections. It markets and more general policies worked adequately, SSI might live up to its potential without any special support programs.

The basic imperfection which might lead to a less than optimal size of SSI lies in the area of factor markets – of both labour and capital. It is argued below that in most economics – and in developing countries in particular – capital market imperfections are more basic to the non-optimal size of the SSI than labour market imperfections. The factor market distortion argument developed in section 12 might suggest that the correct inference to be drawn from the discussion is that the problem of less than optimal size of SSI is best tackled by confronting it at its source – enacting policies to remove capital market distortions. This is indeed that first best solution, but it will emerge from the discussion in this section that the reasons for capital market segmentation are such that they are hard to remove through direct interventions. Hence the need to adopt supportive policies for SSI development as a second best solution.

The argument is extended to considerations of distribution of income, and we conclude that equity objectives provide additional support to the argument based on efficiency objectives for selective policies of assistance to SSI. We then explore some additional reasons for promoting SSI growth over and above the basic reasons based on factor market imperfections.

While the basic argument for supporting SSI is established in the following three sections, we then turn to a cautionary note about indiscriminate support of SSI. Efficiency and growth objectives economies of scale or attaining technical efficiency. The discussion in this section points to the adoption of policies of support which enable SSIs to exploit available opportunities for efficient economic performance and growth.

1.2 The Factor Price Distortion Argument

It is commonly argued that, for various institutional reasons, labor used in large enterprises (LEs) is priced well above the levels at which it is used in small enterprises (SEs). At the same time capital is generally much cheaper for the larger firms it might appear that the price differences for the two factors between LEs pull in opposite directions and would compensate each other, so that the relative profitability of the two types would not be greatly affected. However, we shall now develop the argument that price differences affecting the use of capital are much more important in affecting the relative costs of factors than the differences in wages per worker. If this is the case, there are two ways in which the economic outcome left to itself would be produce a sub optimal situation from the efficiency point-of-view first, the SSI sector which uses more labour and less capital per unit of output will have relatively higher costs and hence have an over-all size in the economy which is less than optimal. Secondly, if the price of labour facing large firms is too high compared to the true economic (opportunity) cost of labour, and the price of capital too low, then large firms would be using a higher ratio of capital to labour than would be socially optimal.

1.21 Why Capital Market Segmentation is More Important

The basic reason why differences in the price of capital are more important for the cost structures of large and small enterprises than the differences in wage per worker is that a higher wage facing the large firm could be, and is generally compensated for by higher efficiency of the workforce – so that the wage cost per efficiency unit of labour is much less than the observed difference in the price of capital. Labour is a factor of production, which can be applied at varying quality levels. Large firms with higher wage could, at least upto a point, attain higher efficiency of their workforces through better selection and also internal skill formation. Capital or finance, however is a factor of production without this extra dimension to its supply. A rupee is a rupee and there is nothing to compensate for the higher cost of a rupee available to smaller firms.

In fact, in some scenarios it might be more appropriate to hypothesize that it is not the institutionally determined higher wage, which causes the capital-labour ratio, and hence labour productively to be higher in large firms, but rather the line of causation runs the other way round. Capital market segmentation makes the price of capital relatively low for large firms, and this encourages a higher capital intensity and labour productivity – which is its turn enables the large firm to pay higher wages per man and select a body of workers more appropriate to its organizational style nd skill requirements.

1.22 Non-Institutional Factors Causing Labour Market Segmentation

While both labour legistation and trade union action have been an important part of the urban labour market scene, more so perhaps in South Asia compared to other parts of the continent, it would be extreme and unhistorical to suggest that the origin of labour market segmentation could be found primarily in these types of institutional factors. Detailed studies of labour markets and their evolution in developing countries have suggested that a number of factors, other than labour legislation operate singly or in combination to cause wage levels in the large scale sector to be set at higher levels than in the small scale sector. These can be listed as follows:

Large factories, acting on their own, try to select a stable body of workers with strong firm attachment to industrial work, and they were prepared to pay a wage premium to attract this workforce. There I a wide variety of migrants from the rural areas seeking work in the urban labour market. Factories in the formal sector would prefer to attract more stable migrants, who are attached to urban work and tend to settle in town with their families for a long time. They would be prepared to pay a higher wage to attract such migrants with a higher supply price, because their higher productivity over the long run would more than compensate for the higher wage. Small enterprises make greater use of the unstable labour with high turnover because in their case the stability-efficiency relationship for the workforce is much weaker. They use much less expensive, often second-hand, machines which need less training to use, and whose cost of damage from misuse is less.

Large firms often want labor which is not just stable, but also which is attached to the individual firm. Skill development and efficiency of the workers are often firm-specific, and large firms interested in long-run productivity might be prepared to pay a higher wage relative to their competitions in order to develop their own body of committed workers.

A third group of factors is the high labour productivity in large firms which enable the firm-specific labour force to claim a share of the profit or rent created. The motivation of an exclusive labour force can only be sustained if management is sympathetic to profit sharing ideas. At the same time such a body of workers, tied to the enterprise is extremely suitable for unionisation, and in fact in many cases management has been known to encourage unionisation in the interest of industrial stability. A telling piece of evidence suggesting that productivity differences rather than labour legislation are ata the heart of wage differences by firms size comes from a detailed study of wage differentials carried out in Mumbai in 1979. It was found that after accounting for human capital attributes and other considerations, the importance of the employment size of the enterprise for the earnings level of the workers was very large, as was the extent of the differential – workers in the largest factories (1,0000+) earned twice as much as those in small estate establishments, and three times as much as casual workers. But contrary to expectations the boundaries of the Factories Act did not distinguish the high and low wage sectors. Earnings per worker went up with increasing size classes even within the "factory sector" i.e.. the firms covered by the prevailing labour legislation. Only at the employment size of 500-999 workers did the earnings level seemed to have reached a plateau. Evidently there are factors other than institutional wage determination which play a significant role in the wage-size relationship. Attention should then focus on the explanation of difference in labour productivity between large and small firms. When we begin to do so we must bring into consideration the segmentation in the market for the other major factor of production – capital.

1.23 Capital Market Segmentation

Capital market segmentation is a natural outgrowth of some basic characteristics of the economy. First, the administrative, selection and insurance costs of loans from the banking system have pronounced economies of scale with respect to the loan size. The information cost for assessing an SSE project is often a substantial lump sum amount which works out much cheaper per unit of credit as the size of the loan increases. In addition, the ready availability of relevant data might be a problem for SSEs. Secondly, the size of acceptable collateral which reduces lenders’ risk obviously increases with firm size. For small firms, particularly newly established ones, the only security available for a potential lender is its personal credit evaluation of the entrepreneur himself. Formal lending institutions are unlikely to have easy and reliable access to detailed information about a small entrepreneur. Thirdly, the unequal distribution of wealth and savings implies that the supply of potential capital from ‘friends and family’, which figure prominently in the financing of small enterprises is necessarily limited.

Because some of these factors causing capital market segmentation are endemic to the working of modern societies – both developed and developing – most economies have adopted various measures to intervene in the financial sector to make capital more easily available to SSEs. However, as the problem has very deep roots, such measures have by themselves been inadequate. Governments have generally been induced to supplement policies of financial market intervention with more direct measures to promote the SSEs. Some of these are reviewed in the next chapter.

To say that capital market problems take precedence over those of the labour market is not to deny that the latter are without importance. Unions and labour legislation have in recent years increased the level of wages facing LEs beyond the levels established by economic forces )Little, mazumdar and page, Chapter 7; lieberman 1990). At the same time job security legislation has sought to protect workers in LEs from lay layoffs and plant closures (ILO-STAT 1996). It might appear at first sight that these institutional pressures in the labour market redresses the balance against SSEs arising from capital market segmentation, but if they do so, they do it in a distortionary way by inducing LEs to be even more capital intensive – further away from the socially optimal capital – lbour ratio.

Furthermore, an important way in which such developments in the labour market damage the healthy growth of SSEs is by acting as impediments in their vertical mobility. SSEs might be wary of growing beyond a threshold size which would bring them under the purview of labour legislation or subject them to union pressure. They might lack the financial resources to graduate to the higher capital intensity needed. Also, while established LEs might over time be able to develop a system of labour utilization which increases labor efficiency to compensate at least partly for the higher wages, SSEs might not be able to bear the costs of transition while the more efficient labour system is being developed within the firm but they are still required to pay the higher wages. Job security legislation, while it encourages subcontracting to SSEs, adds to labour costs and reduces the turnover of efficient LEs. This reduces the opportunity for graduation of efficient SSEs as much as it discourages expansion of more competitive LEs.

1.3 The Distribution of Income Argument

Considerations of equity would strengthen the general direction of the conclusion reached above. There are three ways in which an economy with a larger presence of SSEs would have a more equal distribution of income:

smaller units with a lower capital-labour ratio would generally have a larger share of value added accruing to the workers;
entrepreneurial income could be expected to be more widely distributed; and
the typically large wage differential between the small and large firms implies that when the former have a larger share in total output, more of the income accruing to labour goes to lower wage groups, i.e. there is a more equitable distribution of labour earnings.

The last point s particularly relevant in the light of the discussion above about the nature of wage differentials between SSEs and LEs. It was argued that the difference in the efficiency wage would generally be much smaller than the difference in wages per worker. Take a hypothetical example where the difference in wages per worker is completely offset by differences in worker efficiency – whether through the employers adopting a selection process of workers acting on their own or reacting to institutionally imposed wage differentials. In this case there is no difference in wage cost per efficiency unit, and there is no problem of allocative inefficiency as far as the labour market is concerned. But left to itself the economy will be split between an LE sector with a relatively small workforce of high efficiency and high wages, and a large SE sector in which a large portion of the manufacturing workforce will be employed at low levels of efficiency and wages. This scenario presents a highly unequal distribution of labour earnings. Equity considerations require that SSEs should be promoted. But a point of some importance should be noted here. The distribution of labour earnings will not be improved if the SE sector merely expands horizontally at the unchanged level of earnings. It is important that there is increase in labour productivity and / or upward mobility of the SSEs so that a larger percentage of the labour force cound graduate to the middle rungs of the earnings distribution. Thus promoting development of SSEs for its won sake without regard to its potential productivity is self-defeating. Growth of inefficient SSEs is undesirable from the point of view of both equity goals within the manufacturing sector (and the urban labour market), and of increasing output and its growth rate. We shall come back to this point late in the Chapter. But for the moment let us look at some other arguments which have been advanced for the encouragement of the SE sector.

1.4 Other Reasons for Promoting SSEs
1.41 Product Differentiation

There has been some emphasis on the idea of product heterogeneity and product differentiation within the same broad ‘product group’ as an additional reason for the coexistence of small and large firms. Even when firms of different sizes produce ostensibly the same product (for example, a bar of washing soap), the qualities which are contained in different brands of soap will differ markedly. Small firms generally cater to the low income groups and will, therefore, tend to concentrate on brands which emphasize basic product attributes such as cleaning power over more cosmetic properties such as fragrance. Simple technologies could be more appropriate in the production of he basic attributes meeting with demand from low income consumers. Small or micro enterprises may be able to use such technologies successfully with low capital-labour ratios, while larger capital intensive firms which cater to the high income segment of the market may use more mechanised technologies to produce the attributes demanded by the wealthier consumers. On the other hand, small enterprises sometimes produce luxury products, making intensive use of skilled labour, which essentially cater to the luxury segment of the market and which the large firms cannot supply. Elements in the market structure, such as monopoly pricing, advertising and barriers to entry, accentuate product market segmentation which increases the economic distance between large and small firms. It is possible that in many lines of production, this type of product market segmentation helps to perpetuate industrial dualism.

It has sometimes been argued that the welfare of low income groups is best served by promoting the ‘low quality’ products, without the additional attributes. This, it has been argued, would not only meet the basic needs of poor consumers, but the less mechanised techniques used in the manufacture of these products would produce more income for the very same consumers because of the higher labour intensity of such techniques. However, if the products made with less mechanised techniques are priced cheaper, then they would obviously be bought by poor consumers. Therefore, the argument for further intervention can then only be that such groups should be induced to buy more of such products, or not so poor groups should also buy these products. But before they embark on such a course of intervention policy markers should be aware of the full implications of this argument. First, it is tantamount to paternalistic overriding of the principal of consumer sovereignty. It is in effect being argued that the low income consumers, if they are buying products with additional attributes which the more mechanised processes can supply at higher prices, they do not know what they are doing, and policy makers know better about what the poor people’s preference ought to be. Secondly the protection of non-mechanised technique, beyond the point which market prices support, perpetuates outmoded technology and lead to general technological stagnation in the economy. Clearly these types of protection do not prepare the economy for international competitiveness. Lack of technological progress leads to slower growth of productivity and wages in the long-run hence hurt the welfare of low income earners whose interests are supposedly being promoted.

It is possible to admit one specific exception to the above argument. The luxury attributes being produced by more mechanised techniques might be priced more competitively because the cost of capital and finance is lower for the larger mechanised establishments as discussed at length above. The financial market intervention is supposed to correct for this capital market segmentation. Additionally, excise taxes on luxury goods have been always been accepted as a legitimate fiscal tool of redistribution provided it is not overdone.

1.42 Flexibility

An advantage adduced more frequently in the last few years is that small firms are better able to adept to changing, and sometimes disruptive, economic circumstances. The 1970s and 1980s have produced several shocks demanding a flexible response from industrial firms. According to some authors, traditional mass production units have been less successful in this regard than have small establishments based on a modern version of the craft principle that ‘flexible tasks and machines augment the craftsmen’s skill’s and ability to produce ever more varied products’ (Schmitz 1982:4).

The most influential work embodying these ideas is that by Piore and Sabel (1984). Their paradigm of successful ‘flexible adjustment’ comes from the recent appearance in italy, Germany and Japan of a ‘new’ type of industrial unit: flexible, small, and better able to respond to the challenges of the last two decades than the giant plants of the older industrial countries like the United States.

In particular, the development of a vast network of very small enterprise is impressive, spread through the villages and small cities of central and northern Italy. These little shops range across the entire spectrum of modern industry, from shoes, ceramics, textiles and garments to motorcycles, agricultural equipment, automotive parts an machine tasks. The firms perform an enormous variety of the operations associated with mass production, excluding only the kind of final assembly involved in the automobile production line’ (Piore an Sabel 1984).

Average size varies by industry, but is generally extremely small, with shops of ten workers or fewer not uncommon. The flexibility which has been viewed as a hallmark of Taiwanese small firms certainly seems to fit this pattern (Levy 1991). Although there is considerable anecdotal evidence from other countries, organized information remains limited.

It should be noted that the flexible and quick response to changing economic conditions which is often the special advantage of SSIs is much more feasible in an economy which is undergoing liberalization. The importance of this point could then be expected to increase in the Indian conditions, and will be strengthened with better access of business to information technology.

1.43 Contribution Export Potential

Chen (1986) concludes that the experiences of Japan, Hong Kong, South Korea, Singapore and Taiwan suggest that a strong and viable small industrial sector is necessary for successful export oriented growth. In the early stages of manufactured export growth, small-scale industry can play a significant role since products are labour intensive, there are rapid changes in demand, due in part to world economic fluctuations, and output growth is demand driven. Small firms have the advantage of law overheads and the capacity to respond quickly to changing conditions. There is a growing international preference for high quality personalized items, often skill-intensive, in place of mass-produced ones. Such products require flexibility, which often gives the smaller firm the advantage.

According to Beng (1988), a reliable supporting sector has been important in attracting high technology foreign investment to Singapore. Otherwise the foreign firms either would have to bring in their own subcontractors or import foreign workers, neither of which was in line with the long term objectives o government policy. In Japan, and more recently in Hong Kong, Singapore, Taiwan, and elsewhere, subcontracting with small producers has allowed the export sector to keep costs down an flexibility high. Small firms’ absorptive capacity can also be an important determinant of technology transfer, in Singapore, for instance, a major channel involves skilled personnel, previously trained by a multinational company, who then take up employment in smaller local firms or start their own (Beng 1988).

The Indian experience of SSIs has not been disappointing as far as the export potential is concerned. But as with the recent Asian developing countries just mentioned the continuing success of this sector will depend on their ability to move into technologically more advanced and sophisticated product lines. The ‘flying geese’ paradigm of industrial growth is as applicable to SSIs as to large-scale industries. Traditional industries with low levels of technology reach their peak and unless enterprises graduate to new generations of products the dynamism of growth slows down.

1.44 Other Economic and Social Advantages

Small-scale industry is also expected to perform better than larger firms in two other areas: contribution to decentralization and the fostering of entrepreneurship. Support for SSI has often been based in part on the hope of reducing the excessive infrastructure and social costs associated with large assembly plants and large urban agglomerations. Ho (1979, 1980) contrasted the regional dispersion of industry in Taiwan (with its prominent SSI sector) with Korea (with its dominant large firms). In general, it appears that very small (mainly household) enterprise is much more widely dispersed, including a fairly high density in rural areas, than are small-medium plants (World Bank 1978).

Another major objective has been the promotion of a widely based class of small entrepreneurs. We refer in a succeeding chapter to the case of Taiwan where, at the outset of the period of export-led industrialization, Japanese trading companies led the way by promoting subcontracting and exporting through a network of small and medium manufacturers and export traders.

1.5 The Need for Selectivity in SSE Promotion

The arguments considered so far have implicitly assumed that all firms – large or small – are equally efficient in the utilization of the factors of production, though they might be using different combinations of capital and labour due to factor market distortions. But there are two classes of situations in which this assumption might not be valid.

1.51 Economies of Scale

Clearly the case based on allocative efficiency will be dampened if there are sufficiently strong economies of scale in production. The claims of large scale industries since the Industrial Revolution in Europe have been based on the importance of increasing returns to scale in mechanised production, and have been strengthened by the development of "Fordist" industries of mass production. More recently, as mentioned above, recent developments in technology and the market for consumer goods have to some extent devalued the older sources of increasing returns. Industrial economists are talking about a "third industrial revolution" which has ushered in an era of technology and market specialisation which favour a much smaller optimum size of the firm even in the developed economies. It is important to make the point here that in some line of industry economies of scale would be important and to impose administrative controls on the expansion of large units in such industries with a view to promoting the small scale sector would be welfare reducing. This is obviously a matter for empirical investigation. In any case this underlines the danger of blanket policy measures which seek to promote small-scale units without reference to the production technologies in individual industries. Equally, the argument strongly supports the need for the formulation of support policies for SSEs which does not discourage growth. Policies which merely seek to protect SSEs err on the side of encouraging stagnation and ultimately high costs for both producers and consumers.

1.52 Technical Efficiency

While allocative inefficiency arises when a firm is operating at a point on its production function which is inappropriate at the optimal factor price ratio prevailing in the economy, technical inefficiency arises if the firm is operating below the production frontier i.e. if it is not attaining the maximum level of production which it is in fact enjoying. Only a few firms in any group of firms we consider would in fact attain or be close to attaining maximum technical efficiency. The average productively per unit of factor input of the firms in the group being considered would be below the level of the maximum achieved by the firms at the frontier. The ratio of the average to the ‘frontier’ productivity is an index of technical efficiency for the group. When we say that small firms as a group have higher technical inefficiency than large firms, we hypothesize that the index of average to ‘frontier’ productivity for the small, after allowing for the appropriate ratio of capital to labour, will be lower than that for the large. Clearly this is a matter for empirical investigation which can be undertaken with firm level analysis of micro data. But even if such analysis reveals higher levels higher levels of technical inefficiency for small firms, it does not signal policy conclusions biased against the small scale unless we examine the causes of the higher incidence of technical inefficiency.

For example, such inefficiency might be caused by general conditions of the economy which make it difficult for small firms to obtain necessary inputs or marketing services. Thus small firms are often hampered by the absence of reliable, continuous sources of raw materials or electricity. This was particularly important in the earlier license / quota regime in India.

More generally, small firms as a group might suffer from technical inefficiency relative to larger enterprises if one more of the following factors are present in an important way:

competition between firms of large and small sizes, and within forms of each size group is weak;

there is limited vertical mobility among small firms due to institutional or policy related factors, so that small enterprises do not have either the opportunity or incentive to graduate towards more productive modern "best practice" technology; and

there is little incentive for modern large scale enterprises to transfer their superior "know-how" to smaller firms working for them as ancillary units. In our review of the Indian policies to the small-scale sector we would indeed have occasion to point out that these policies were often conceived and implemented in a way that created some of these problems.

1.6 Conclusions

This chapter has argued that there is a strong case for adopting support policies which would encourage the development of SSIs beyond the point which the sector might attain left to free market forces. From the point of view of allocative efficiency, equitable distribution of incomes and several desirable objectives of healthy social and economic growth, we have seen that the size of the sector would be less than optimal in the absence of such policies.

The argument developed above on factor markets suggests that the apparent ‘distortion’ in labour markets could be exaggerated if one just looks at the difference in earnings per worker in small and large firms. This is because large firms could and generally do develop a workforce of higher efficiency to suit their specific organisational needs, so that the wage cost per efficiency unit of labour is not nearly as great. On the other hand, capital does not have an extra dimension in quality, and hence the significantly higher price of capital available to small firms constitutes a genuine disincentive.

The appropriate solution to correcting this important disadvantage to the small scale sector is to intervene directly in the market for finance to remove the impact of capital market segmentation. But, as will be pointed out at greater length in the next chapter, most governments have found that only a limited amount can be achieved through policies impacting directly on the financial structure. This is because capital market segmentation is endemic to the working of most economies, and is particularly serious in developing countries with their relatively weak financial institutions.

There is thus a case for direct support for the small scale sector to bring it nearer to its optimal size in the economy. Some of these measures are discussed in the next chapter. But it is equally clear from the discussion above that support policies would be self defeating if they merely aim at protecting the existence of small enterprises. All the objectives of policy require that the measures enacted to promote SSEs must aim at their development - which implies they must be encouraged to grow.

II. POLICIES TO PROMOTE SMALL SCALE ENTERPRISES

Given that the development of small – medium enterprises is desirable on both allocative efficiency and equity considerations, particularly in the new technological and market scenario, what are the major policy instruments available to governments to promote the small-medium sector? A conclusion was reached at the end of the last chapter that policy instruments need to be developed which do not just protect SSEs indiscriminately, but which help then develop in a dynamic and changing environment. This wold result in more efficient firms which are able to exploit the opportunities for growth Further, these instruments must ensure that firms with different efficiencies and potential for growth derive differential benefits from the assistance which is available. This implies that such instruments should have a general and pervasive in impact, rather than be specific to particular industries or groups within the SSI sector.

The reservation of specified product line for the small scale sector has been central to Indian policies for development this sector. In India, policies based on reservation have persisted in the manufacturing sector over a long time, and India is almost unique in its dependence on and persistence with such policies. A large number of product groups – defined at a fairly detailed level using the National Industrial Classification Code – are reserved for the exclusive production by SSEs which are defined on the basis of value of fixed investment in plant and machinery. Once a product line is reserved, those firms with levels of investment exceeding the SE limit are restricted to the level of production equal to their installed capacity at the time of reservation. This method of fostering the growth of SSEs was first introduced in 1967 and the list of items has been progressively increased until today it comprises a total of around 830. The value of the limit in plant and machinery has been increased over time in nominal terms but the increase in value of this limit after allowing for inflation has been small.

This line of approach had its value in the initial stages of encouraging the SSI sector. Large numbers of new SSI units were encouraged to establish themselves and protected from competition from the large-scale sector. But the problem with the continuation of such policies is that it is not sufficiently discriminatory in favour of small enterprises which show potential for growth. Industry based policies of reservation overlook the fact that small enterprises which show potential for growth Industry based policies of reservation overlook the fact that small enterprises is not confined to specific product lines, and that their importance in different product groups are constantly changing. In vie of this, there is a need to implement polices for the development of SSEs which are generally and have a pervasive effect in the sense that all small enterprises, no matter in what product groups, could potentially take advantage of the assistance measures available. Secondary, it is important that such policies do not discourage the growth of small into medium enterprises.

2.1 General and Pervasive Policies to Encourage SSEs

In many instances the removal of bias in policies discouraging the small – medium sector should help considerably. The regulatory framework, including elaborate licensing procedures affecting outputs, inputs, and urban land rights, has been widely discussed as severe constraints on the Latin American literature (e.g. de Soto) and is relevant to Asian countries, although perhaps to a smaller extent. A large literature has focused on the impediments to SE success which come from trade and foreign investment policies which are implemented. It has frequently been concluded that the protective structure has been biased against SSEs in the sense that effective protection rates are higher for those industrial sectors where the SE share of output is relatively low (Pitt 1981 for Indonesia; von Rabenau 1976 for malaysia; Anderson and Khambata 1981 for the Philippines). The era of import substituting industrialisation, with its regime of rationing of foreign exchange for importers of machinery and material inputs, an overvalued exchange rates which reduced the effective price of capital equipment, has been traditionally viewed as a source of bias against SSEs. But in more recent years, when export promotion policies (import tax drawbacks, special credit facilities, other tax breaks based on the level of exports, etc) have been used as a substitute for lower exchange rates, the performance of the SE sector might have been adversely affected, since such assistance is less accessible to them for more less the same reasons that quantitative restrictions are biased against them (Bruch and Heimenz 1984; Marsden 1984). Similarly, policies to encourage direct foreign investment, would favour large firms, because lumpiness of investment and the high management cost of dispersal are likely to encourage foreign investors to enter the LE sector.

Protective macro-economic policies have particularly hurt SSEs in creating scarcity of good quality raw materials for these units. While LEs get access to raw materials at low regulated prices (in some cases on account of their export potential), SSEs have to scramble for materials in the open market. This is one, though not the only reason for SSEs producing at the lower end of the quality scale.

In the Indian context, in spite of the concerns With SSE development in government policies there are many instances of both regulatory and macro polices being discriminatory to the small sector. The Committee on Simplification of Procedures for SSIs appointed by the Ministry of Industry (the Mhapatra Committee) pointed out that a small scale unit had to deal with about 20 Departments of government both Central and State – and that an entrepreneur had to interact with 50 inspectors. They ranged from Labour laws to Environmental, Excise and Developmental regulations some of them actually meant to provide subsidised services to SSEs. While large units can assign special staff for the purpose of filing returns to numerous bodies, the burden is quite disproportionate on small entrepreneurs. It has been mentioned above that a major item in the cost structure of SSEs is often the payments to a large body of inspectors who need to be induced to look the other way.

Of the Asian countries for which we have information, Hong Kong comes closest to a free market model of development. It is observed that "within the proclaimed laissez faire environment in Hong Kong the government does not seem to have a policy towards manufacturing not to mention any policy towards the SSIs" (Beng 1988:58). An obvious hypothesis emerging from the Hong Kong experience is that, in the absence of the usual sort of policy biases which protect both capital and labour in large firms, the most successful enterprise size for an export oriented economy would be in the SME range (under 100 workers), and the wage and productivity differentials with respect to larger unites will be small. It might be objected that the compact geographical size of the colony is unique and does not allow for generalisation to other types of countries.

Industrial units are much more spatially dispersed in Taiwan. The important role played by SMEs in this economy needs to be studied more carefully. Like Hong Kong the adaptability of relatively small units seems to have been an important contributor to overall export success. The role of financial institutions in helping the SME sector in Taiwan is an important element of their success. Taiwan developed a widely distributed structure of manufacturing enterprises, many of which had low start-up capital like in Hong Kong. One study has stressed the importance of government supported financial institutions specialising in "Venture capital" lending in this process (Scitovsky 1985).

The most command widely used supply side intervention to support the SME sector is the program of subsidised credit put in place by governments with or without the help of multilateral or bilateral donors. The World Bank has championed SME lending projects for almost a decade. Typically a central development bank of the borrowing country acts as the wholesale borrower for these loans and as a lender to commercial banks which retail them against a guarantee given by the central development bank. Although these schemes have had a positive effect on the promotion of enterprises outside the corporate sector their cost-benefit ratio varies enormously, and it is not altogether clear that the potentially most efficient enterprises or groups of enterprises are helped most. The conclusion which emerges from the evaluation of such schemes is that such programmes are generally successful if they are backed up by associated programmes of technical and marketing assistance. A further relevant point is that the provision of subsidised credit is meant to address the problem of capital market segmentation which makes the cost of capital relatively high for SSEs. Accordingly its success depends very much on the effectiveness of other policies to help develop the financial structure which provides easier access to finance for SSEs. In the absence of such developments in the banking and other lending institutions, government efforts to provide subsidised credit can only have a limited effect and are likely to get stalled.

One of the major ways in which economies with a substantial presence of large scale industry have successfully developed a small sector component is subcontracting. Japan is, of course, the most cited example, where in spite of powerful economic and institutional factor s favouring LEs, small industrial units have continued to provide a large share of employment and value added in manufacturing (43 percent of the former and 28 percent of the latter in the mideighties, with small units being defined as those with less than 50 workers). Many of the large units in several branches of industry found it profitable to contract out some parts of the production process to smaller firms. The economic logic of vertical subcontracting lies in the fact that economics of scale are important in some areas of the production and marketing process, and not in others. It is significantly helped by the flexibility which is introduced in the use of labour. The Japanese labour system in large factories is that of lifetime employment so that fixed costs of labour are very much reduced by passing on the burden of demand fluctuations to subcontractors.

The last point is of relevance to many countries of Asia which have had to cope with increasing job security of factory workers due to institutional and economic pressures. While subcontracting is obviously the most efficient way of increasing greater labour market flexibility, its successful development is critically dependent on large firms being able to transfer the know-how for quality production to the ancillary units, and to build up a relationship of healthy co-operation rather than dominance. The experience in several Asian countries has not been very satisfactory from this point of view. In countries and sectors like garments, in which some elements of production are "put out’ to small, often household enterprises, the labour market system is better described as "casualisation" to take advantage of depressed wages and working conditions. Skill formation is minimal among the subcontractors, who have little hope of branching out in other activities led by the parent company.

One country which has successfully developed its sub-contracting in recent years is Korea. "In 1990 probably half of the output of small establishment was subcontracted. The radical change in industrial size structure wrought between 1975 and the early 1990s was partly a result of the changing composition of industrial output by sector but was also directly sought by policy, with a view to spreading the fruits of industrial growth more widely" (Berry 1996, basing himself on Baek 1992 and Cho 1995). The process was helped by the post-1987 changes in labour behaviour with rising worker militancy and labour costs, even as Korean industry faced increasing competition

v. An important point to mention in the context of subcontracting is that the nature of indirect taxation might have an important effect on the growth of the subcontracting system. If the revenue system depends on excise taxes based on the gross value or quantity of the final product, firms will be discouraged from subcontracting out part of their operations. A system of MODVAT / VAT taxation (taxing value added at each stage of production) would remove the disincentive to subcontracting.

While subcontracting involves vertical inter-firm co-operation, much interest has been expressed recently on the development of horizontal small-small co-operation. The idea that networks or "clusters" of mainly small firms, interacting themselves through specialisation and sharing of services, have been the key to the success of many industrial areas in developed countries, dominates the discussion of clusters. In a well-known work Piore and Sabel (1984) urgued that the vitality of small firms in the "Third Italy" lay in the co-operative competition among communities of enterprises, and on the broad skill of the labouring communities.

In the Asian context favourable note has been taken of Trippur, a district in Southern India which became a major centre of cotton knitwear for both the export and home market in the decade after 1975 (Cawthorne 1995). In spite of considerable competitive rivalry among the large number of small-medium firms there was dense inter-firm linkages in production, sings of collective activity involving sharing of information about markets and design capability, and external economies reaped from the growing market for outputs and inputs, including labour. Cawthorne, however, makes the pertinent point that Tiruppur had been an industrial cluster for a long time before it embarked on its recent dynamic phase. This dynamism "is to a large extent a function of its having successfully entered export markets for high volume / low-to-medium quality knitwear goods…This suggests perhaps a more general point, that it is not clustering per se which makes for industrial success, but clustering in a propitious macroeconomic context" (Cawthorne p.54). One might add that plocy

Help on the demand side of the market is probably more fundamental. Governments may provide some assistance in providing services which help the economics of clusters, but the major effort has to come from the entrepreneurs’ own initiatives, in Asia as in Italy. The role of the government would be to make provisions for assistance – financial, technical and marketing – which will be available to all members of the "cluster". Furthermore central provision for labour training, control of pollution and other control facilities carries important external economies, and hence can be provided more economically in "clusters"

A major role of institutions like subcontracting and "clusters" is to facilitate the provision of technology support for SSEs. It has already been remarked that financial assistance – such as directed credit facilities – have often had only limited effect in India and elsewhere because of the lack of suitable measures to follow up on the credit measures with technical help. Officials concerned with banking operations are generally not the most suitable or knowledgeable in the provision of technical help. But without active support in this area SSEs, even if they get financial help, tend to get mired in low levels of productivity with little potential for growth. It is not clear that public agencies are the ideal bodies to carry the brunt of transferring technical know-how to SSEs. The more successful cases of development in this area, in Italy as in Taiwan, have come from trade and manufacturing association who are near to changing market conditions. Nevertheless public support is needed in the encouragement of such activities, particularly in the early states. Of special interest is the constitution of funds earmarked to helping the organisation of contacts between potential suppliers and customers through trade fairs, periodic visits and so on.

A continuing concern in the literature on urbanisation in developing countries has been the problem of over – expansion of large urban conglomerations, and what are called megacities. Even with the spiralling costs of real estate and money wage costs which such developments entail, external economies enjoyed by firms locating in these areas encourage continued concentration of private capital and investment. Enough has been said in the migration literature to show that excessive rural - urban migration or an uncontrolled migration of people in search of "city lights" is not the basic problem. Rather it is the distribution of public capital – investment in infrastructure, and services like health, education and utilities – which favours large conglomerations, and this in turn raises the marginal productivity of private capital and labour in these areas leading to a concentration of both capital and labour. The implication of this type of urban concentration for poverty alleviation and the development of the sma

Report of the Expert Committee on Small Enterprises

Chairman Abid Hussain

Chairman
Abid Hussain