Mitigating MSME Distress

I wrote substantial part of this blog a couple of days back. I would have completed it before noon on 23/08/2019. I held back and waited for Finance Minister Ms.Nirmala Sitharaman’s announcement. My original couple of paragraphs read thus.

“One does not know the impact of abolition of Article 370 and Article 35.  It may be good or bad, time will tell.  However, something else has happened, which is really good for the country.  The Government of India has come out of its denial mode and has indeed acknowledged that the economy is in serious trouble. 

In Article 370 deliberations, one did not see Ms. Nirmala Sitharaman.  This is because she was having a series of meetings with various groups of people on the problems of Indian economy and the measures to be taken for reversal and speedy growth.  This is quite heartening.”

Well, FinMin has created all the sound bytes the Industry wanted to hear. She has fully taken care of the grievances of Dalal Street Gamblers. She has taken care of problems of Venture Capital and Private Equity Investors. Large cap companies also will be happy. But there is nothing much for key employment generators except the optics. Directionally speaking, Government is still barking the wrong tree.

"20100517-BP" by Chris Piascik is licensed under CC BY-NC-ND 2.0
Photo Courtesy: “20100517-BP” by Chris Piascik is licensed under CC BY-NC-ND 2.0 

Well, the first tranche of ‘Industrial distress alleviation programme’ has been delivered and Dalal Street is bound to be happy. We can expect to save a few thousand jobs. But who are the real job providers? Agriculture, Real Estate, Infrastructure and MSME. If North East monsoon is good and the Industrial package announced by Finance Minister takes off, there would be GDP growth. The same jobless growth of UPA II. Still worse, really. Gap will widen, some formal high paying employment will be added and informal employment will be the biggest casualty.

Need of MSME

Real Estate, Infra and MSME are the non-agri sectors that provide informal employment and keep the society peaceful. This was systematically dismantled. Laudable as it may be, this Government takes a moral high ground. They don’t like cash (as in black money). They don’t like corruption, they say. They declared war on black money targeting the wealth creators that the Finance Minister lauded profusely.

Granted, compliance, tax payment and being on the right side of the law are not long suits of God fearing Indian psyche. Waging a war on it can hardly be a bad idea but successive actions ended up isolating MSME, Infra and Real Estate, the real employment providers.

By late 2015 Real Estate showed signs of slipping and the inventory started piling up, just like cars today. Government wanted to cleanse the system. Introduced Voluntary Disclosure Scheme and then followed it with Demonetisation in November 2016. The Industry is limping, to be benevolent. Lot of MSME players closed shop and with that went scores of unorganised jobs. Infra companies also tanked.

Next is GST. Even today, after two years, MSME is running from pillar to post to comply. Flavour of the season now is annual return. Lot of MSMEs are fighting to comply. MSME is slowly but surely getting finished. Soon only organised players will operate. GDP Growth will happen but there will be shrinkage in unorganised labour. I am skipping Real Estate and Infra in this post and concentrating on MSME.

"GDP" by Got Credit is licensed under CC BY 2.0
Photo Courtesy : “GDP” by Got Credit is licensed under CC BY 2.0 

What we have razed down is a very vibrant sector of the economy. Number of MSMEs is over Rs.6 crores.  Number of employees in MSMEs is atleast about 15 crores.  MSME’s share of GDP is about 25% and its share of export is close to 50% and MSME creates about 12 crore jobs. Bank lending is about 25 lac crores. Make no mistake, more than 50% of this will be rendered NPA and the whole sector is in jeopardy.  This is a systemic failure that needs radical solution.  Expert committee on MSME produced a report in June 2019. The report listed the problems, but unfortunately, applies cream and plaster and hopes for the best. Barking the wrong tree continues.

Finance Minister made a passing reference to this report. MSME in India is categorized by out moded and dilapidated definition based on investment in plant and machinery.  More successful world has classifieds its MSME based on turnover or number of employees or both.  We hope to move in this direction and keep turnover as the basis.  Expert committee report has sought to correct this and we should classify our MSME based on turnover.  I think we can call less than Rs.10 crores is micro, Rs.10 crores to Rs.75 crores is small, Rs.75 crores to Rs.500 crores is medium. This would pretty much cover 90% of non agricultural financial activity.

But what has it got to do with trying to discipline the sector to comply? Noncompliance, black money, gaming banking sector, non payment of taxes… Wealth creators operate in an ecosystem. When they are continuously penalised when rest of the ecosystem goes scot-free, it is an unfair situation.

Need of MSME

Apart from entrepreneurs themselves, Taxman and tax collection mechanism, The Chartered Accountants, who are the auditors of SME, Bankers who are pathetic in credit management are all responsible. No one is affected, just the Wealth Creator the Finance Ministry salutes. I am passing tax terrorism up in this blog since the FM acknowledged it in no uncertain terms. But she confined herself to Income Tax. With the advent of GST, erstwhile Excise Duty officers and state VAT officers are available to hound the wealth creators. It is a open secret that the wealth creators were distributing wealth at every step of the way during compliance – at the time of return filing, assessment, audit and dispute resolution. They are now faced with faceless assessments. (Pun intended). What if the assessing officers want to be personal wealth creators? Diluting the statutes will result in business going to the old ways. Making tax administrators to exercise restraint may or may not yield results. FM has a daunting task ahead. I can only wish the Government good luck. For the record, generally, they are never brought to books. It is only the wealth creator who takes all the fury.

Need for MSME
Need of the Hour

Let’s look at the contribution of Chartered Accountants.

Chartered Accountants certify the accounts.  Year after year knowing fully well, the numbers portrayed in the accounts has got nothing to do with the reality.  They give a few disclaimers and the prominent among them are “We have relied on the certification given by the management and we have not verified the inventory”,  “The company does not have practice of confirmation of book debts and the realizability of the receivables is accepted based on the management’s opinion”, and “Fixed assets are stated at cost and the company does not have the practice of verifying the fixed assets”.

These sweeping generalizations resulted in the auditor having no opinion on roughly 90% of the assets of the company.  And then comes the famous certification of the auditors.  “The Books of Accounts of the company give true and fair view of the state of affairs of the business”. This is not all.  In quite a few cases, we have seen the auditors save tax by manipulating numbers.  There may be a really good year in business and the company may have received a bumper profit.  However, the tendency of the Chartered Accountants is to keep the profitability ratios within the trend, i.e., if the company made the profit of 4% in the previous years, they would want to show 4.1% in the current year, even if the actual profit is 15%.  They have iron-grip over the clients, and they don’t let them grow since they may go out of their hold. Audited financial statements have become such a mockery that no one believes it. Yet, only the entrepreneur is being questioned for every action and reaction of everybody else.

Need of MSME

Let’s turn our head towards bankers. Today, the bankers are not taking decisions even in the most deserving case. We cannot blame them.  They know that the accounts they are looking at hardly contains any facts.  They also know how they managed to not treat an account as NPA largely out of corporate compulsions of the banks.  Bigger loans got the blessings of Chairmen of banks and political bosses.  Sanctioning of smaller loans kept the bankers happy. Managing the loans from being classified as NPA was the name of the game.  Additional loans were given to slipping advances, i.e., they used to give more loans and use the proceeds to re-pay loans.  They used to re-schedule it.  They used to take it to corporate debt re-structuring mechanism and classify all these loans as performing assets. They simply want to get away from accountability.  None of the past deeds of the bankers have any bearing on them and they have gone scot-free too.  End of the day, only MSME suffers.

Does this mean, entrepreneurs are angels? No. They have their share of the sin. This is a systemic failure. Targeting only MSME for cash cleansing and compliance will only bringing down the economy. DeMo, GST and strict compliance drive have achieved just that. That’s why I believe a one time amnesty scheme to clean up Balance Sheets is in order.

Understanding the working of MSME will give credence to amnesty scheme. Wealth creation and greed are separated by a very thin line. It is here the problem starts,

At the start of the business, in the past, project reports were prepared.  25% used to be the equity and the balance was through bank debts.  In order to meet the 25% margin, often, equipment cost, building construction cost etc., used to be over stated.  The entrepreneur paid part margin to the bank and the bank to pay the full invoice to the supplier of Plant and Machinery / construction contractor.  The vendor in turn gave back the excess cash and the entrepreneurs rotated it back again for the margin.  So, promoters’ skin in the game was less than what it actually is stated in the books of accounts. Again an all round immorality perpetuated for decades. Don’t just blame the entrepreneur.

MSME entrepreneurs generally don’t have clear understanding of long-term funds and short-term funds.  If a machinery is broken down, it is replaced from the Cash Credit Account right on the same day.

And then there were planned diversion of funds in the form of purchase of non-core assets – expensive cars, land and building with an eye for appreciation… One has to understand the effect of all these. A few case studies will prove the point.

Need of MSME
Need of the hour

The tale of a paper company:  This company promoted by a paper trader who can sell paper very easily went down south with all these problems.

Successful paper trading (newsprint, white sheets and notebooks) has induced an ambition in the promoter to have a recycled newsprint factory.  He went ahead with the plans and all ingredients for a manufacturing startup were in place, for e.g., overstating of estimated project expenses.  The company has taken cash credit by hypothecation of stocks and book debts.  A small property was also purchased.

This required more loans. Increase in loan requires over statement of stock and book debts and showing more profits. After all, cash credit loan is a function of Inventory, Debtors and Profits. The actual stocks were much less than what is shown in the books, actual receivables were much less than what is given in the books.

In other words, year after year systematically, real liabilities were created balancing them with fictitious assets.

The real business, however, was growing and was quite profitable.  So, the time came for expansion and every year loan component was more. Banks wanted more and more securities.  Initially personal properties were given. Subsequently.  The property that was brought with cash credit was given.

A new project report was prepared for doubling the plant capacity and to utilize the steam for production of electricity.  As always time and cost over run ate the project viability and pushed the estimated cost.  So, the revised plan had to be drawn on and validated for techno-economic feasibility.  The margin of the promoter was obviously met by working capital.  The net result of all these is the company is now in NCLT, despite the fact the company is capable of selling newsprint worth Rs.100 crores with the gross margin of about Rs.10 crores. Receivables and book debts total about Rs.100 crores in the books, the actual amount is anybody’s guess.  It may not be more than Rs.25 crores.

Need of MSME
Need of the hour

The tale of software Exporters Most of the export-oriented software companies routinely overstate the Balance Sheet.  This is actually the reason why bankers don’t give loans to software companies that easily anymore.

In this case exports do not have Bill of Lading since no physical product is exported.  It makes it lot easier for these companies. STPI registration legitimises the whole thing. They take bank loans over stating the sales.  They have a branch office in America and western countries.  Money is sent to the subsidiaries ostensibly for their maintenance.  This money is rotated through shell companies only to be replaced by more loans.  Their sin is they were busy developing software products using working capital.  In reality, they were paying salary to develop software products financed by working capital by showing non-existent sales and recovery. Satyam is a star example. They were not alone. Many such companies have got busted in the recent times. Many more will be busted in the coming days.

We can give many examples. Whether it is ‘brick and mortar’ or it is ‘click and computer’, methodology is same and the result is same. This is the state of Indian SME and they constitute 90% of the companies.

Now it is quite easy to provide sermons to the entrepreneurs, point finger at them and crucify them.  This is considered cleansing, and this is what is going on.  Net result is hundreds of employees lose their jobs with each company going down. 

It’s lot easy to take moral high ground, but the ground realities were very different.  Corruption was considered a norm.  The banker-enterprise relationship was like that of a marriage under Hindu Marriage Act before thirty years.  No matter what banker or entrepreneur did, they were destined to live together.  There was all round corruption.   No one had any qualms about generating ill-earned wealth.  While rest of the eco-system is going scot-free, the SME entrepreneurship has become a casualty.  Tightening of NPA norms, Companies Act 2013 and the bankruptcy legislation have affected only SMEs while rest of the eco-system has gone scott-free.

Need of MSME
Need of the hour

Think about it.  Starting with License Raj, we were having an immoral eco-system.  Trying to clean this has resulted only in endangering SMEs.  The question here is not morality.  The question is survival of a sector, which was contributing 40 to 50% of the exports of the country, producing 25% of the GDP and employing 40% of labor. 

We have introduced de-monetization, breaking the cash economy the SMEs were thriving in and providing employment.  We have introduced GST to bring about transparency and collection.  Compliance takes enormous effort for the SME’s.  Prior of demonetization, we have been introduced voluntary disclosure scheme.  We need to have a separate scheme for cleaning the Balance Sheet.  One simple method will go a long way in rejuvenating the economy.

Roughly 90% of the Balance Sheet have camouflaged and incorrect numbers.  This has to be cleaned once for all.  All enterprises should be allowed to clean up their books once.  This may result in reduction in drawing power in bank loans.  All the excess borrowings should be converted to a ten-year loan with concessional interest.  Differential fresh funding should be provided for, wherever required.  This does not require money, just postponement of NPA declaration. Money has already been given based on wrong Balance Sheet. This is the single most important economical reform needed at the moment. Hope Government thinks about it.

5 Replies to “Mitigating MSME Distress

  1. As a small time bank manager, I strongly agree with your observation on balance sheet and our feeling on the truth behind the figures.

    MSME loans given to MICRO after the introduction of MUDRA has made small time bankers stay away from small borrowers.
    We always feel threatened by providing a collateral free loan we may invite trouble to our PF and action by bank against Quick Mortality and staff accountability. (சொந்த செலவில் சூன்யம்)

    Hope right persons in right places understand what you have conveyed and actions do follow.

  2. All said above are true. Totally agree!
    1) But, I doubt the Government / bank will allow the Companies to clean up their Balance sheet to bring to real numbers. That will be a bold step!
    2) But, the rest of the world gets practical faster and converts loans that are not paid on time to maximum of 30-year loans at affordable / discounted interest rates.
    3) Lending business is risky like any other. So, before lending, banks are supposed to make sure on all factors. Once given, tightly monitor with close quarters with competent professionals. If companies truly fail, the bank should quickly get practical and restructure the loan rather than practically killing the company and filing legal cases against the owners.
    4) Competency of Govt. banks’ officials is very poor. They don’t understand business. Most of the time, they try to save their skin while taking views/decisions. Bank’s approach of scapegoating the concerned officer is also very unique to Govt. banks in India only. Concerned officer would have approved after getting HO or Zone’s approval. Still he will be the scapegoat. That is also unfair. All of these happens in India only.
    5) Let us take an example of Anil Ambani’s empire. Since he is saved by his brother, things are going ok now. The day he goes NPA and he is helpless, all agencies will be behind him find out how he misrepresented or how he cheated the banks. Take the example of Jet Airways. Why the same agencies have to wait until NPA to investigate if he has cheated the banks? Wrongdoing irrespective of prompt payment or not has to be punished, isn’t?
    6) Prevention is better than cure! Don’t let the corruption happen and then later try to punish. In the process you lose company assets and bank gets nothing!
    7) Government should just focus on compliance, governance such as RBI. They should get out of banking business as they unduly use Government powers when industries fail. If NPA, they just file legal case 100% to protect their skins. This doesn’t happen anywhere in the world. If large exposure, banks to save their skin (whether any illegal involved or not) just refer to CBI/ED. They take the default judgment that the business owner is a culprit and arrest them. Onus is on the business owner to prove he is innocent, which happens after 15-20 years. So, his life/family everything is gone.
    8) As per RBI norms, NPA restructuring process is a bad word. Rest of the world just take decisions quickly and save the existing business too!
    9) I hope Ms. Nirmala Sitharaman is able to see the other side of the story rather than just seeing it from Govt. perspective!

    1. Thanks for taking time and posting a detailed and meaningful reply. This change would take effort. Would probably necessitate amendment to multiple statutes. Hope Government looks at it seriously.

  3. Very well worded Mr Gopalan.
    You have brought out the true picture very crystal clear.

    It’s not that the Officials and various Stakeholders don’t ubderstand the game being played. But unless we change the entire rules across all stakeholders (CAs, MSMEs ) being a part of WHOLE, things will continue like this.

    I believe the definition being proposed has already become outdated. We should see how smaller economies in East Asia define their SMEs. Their is a need to look at Micro in a totally different perspective and not along with Small and Medium – if we really want Make in India, Made in India and foreign JVs to succeed in India.

    With no synergies between Ministries – Banking / MSME and various others it’s almost a case of the left and right hands of MS Dhoni attempting different things behind stumps.
    The potential of our country makes me hope that soon realisation for correct synergies to be built, will set in amongst all.

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