Ease of Doing Business? From incorporation to listing, how regulatory burden is stifling MSME development

A study by RBI has found that the majority of the banks do not go beyond 25 per cent (in priority sector lending) for MSME credit. (Image for representation)

• By Kanishk Maheshwari and Anuj Chaudhary  

Ease of Doing Business for MSMEs: In June 2020, the Government of India amended the MSME definition with an objective to push MSME growth. It’s been a year since then and despite the reclassification, MSME development still remains challenging. Regulatory bottlenecks faced by them continue to stifle their growth. MSMEs account for 99 per cent of all the firms in the country. As per the 73rd round of the National Sample Survey, there are approximately 63.4 million MSMEs in India employing 111 million people. 99 per cent of these firms belong to the Micro sector. The previous MSME census identified approximately 36.2 million MSMEs. While the number of MSMEs has almost doubled since then, the share of micro-units has remained the same. Most firms in India continue to stay small. This is primarily due to the limited opportunities to grow amid the regulatory burden of MSMEs that is restricting their size.

MSMEs face their first obstacle during the incorporation stage itself. While the government has made significant progress with making incorporation itself paperless and faceless, opening a new bank account is still a key challenge. For opening a bank account in India, MSMEs still need a physical letterhead along with the traditional rubber stamp. The board members are then required to manually sign the letterhead. The same banks then will need MSMEs to go paperless while dealing back with them. Once incorporated, the MSMEs should get registrations (again not fully paperless) under diverse acts from the state government agencies. To circumvent these obstacles, MSMEs entities then prefer to run as ‘sole proprietorships’ in India. 

MSMEs face their next predicament when they have close to 10 employees on their payrolls. Employees State Insurance Act (ESIC), 1948 requires that firms with 10 or more employees must mandatorily register and make monthly payments for the social security of their employees. While the process is online, monthly returns followed by unscheduled inspections discourage firms to hire more employees.  ESIC rules prescribe imprisonment of the owners in case of failure to comply with the regulations.  

These provisions instill fear in the mind of small units. If we look at the data on the number of employees employed by an MSME, one will find it converging towards 10 employees especially for micro-units. Similarly, firms must obtain registration within one month of employing 20 persons or more under the Employees’ Provident Funds and Miscellaneous Provisions Act (EPFO), 1952. MSMEs prefer to hire individuals on a contract or temporary basis to minimize their regulatory burden posed by ESIC/EPFO requirements. There is very little incentive for firms to increase their size unless they are looking at significantly more than just 10 employees. 

In case the unit aspires to grow, accessing finance/loans is the big obstacle they need to overcome. The central bank in India has accorded MSMEs a priority sector and has directed banks to prioritize 40 per cent of the Adjusted Net Bank Credit (ANBC) to priority sector including MSMEs. The guidelines also require banks to allocate 7.5 per cent of the ANBC to micro-enterprises.

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A study by RBI has found that the majority of the banks do not go beyond 25 per cent (in priority sector lending) for MSME credit. Perhaps mandated lending does not seem to work, and it seems that pursuing MSME is not at the core of commercial banks’ business strategy. The study also identified sudden changes in regulations and government policies as one of the primary reasons for MSMEs turning Non-Performing Assets (NPA). Therefore, MSMEs continue to be underserved in the country. 

Public Sector Banks (PSBs) account for more than 50 per cent of the overall MSME lending in India. The PSB MSME loans are still largely collateral-based. Commonly, banks require land/property documents of the owner as the collateral for the loan. However, despite possessing these documents, loans are not granted in several cases owing to a mismatch with government records. The ownership details are either not updated or don’t reflect the right owner in government records due to clerical errors. MSMEs have to hire a lawyer to physically visit the land/property records office to update the records as no lender is willing to underwrite the loan. 

MSMEs in India prefer to stay away from the capital markets due to the huge regulatory burden imposed by the regulator. While both NSE and BSE have introduced dedicated exchange for MSMEs, very few companies prefer to get listed. Out of 64 million MSMEs in India, only 342 are listed on the BSE SME exchange and 112 (less than 1/3rd) have migrated to the mainboard. The number of companies on NSE Emerge is even lower than that on BSE Exchange. While the regulator, SEBI, has relaxed few compliance norms for SMEs such as half-yearly submission of results instead of quarterly, firms still elude capital markets. Listed SMEs need to comply with SEBI, RBI, and Companies Act regulations that encompass a high regulatory compliance cost. 

Consistent increase in regulatory obligations has a compounding effect on firm growth, especially for small firms. Obtaining Udhyam Registration and registering under Startup India does provide certain benefits to MSMEs. However, they are both voluntary and few have registered themselves under these initiatives. Approximately 3.5 million MSMEs (5 per cent of total MSMEs) have obtained the Udyam Registration as of June 30, 2021. For MSME development, government agencies must push digitalization and focus on regulatory easing to reduce the burden.

Kanishk Maheshwari is Managing Director at Primus Partners and Anuj Chaudhary is Private Sector Development Specialist at multilateral organisations such as World Bank Group and Asian Development Bank. Views are the authors’ own.