Demonitization & GST
Courtesy: Economic Times ET Rise
The micro, small and medium enterprises (MSMEs) sector is of special significance for the Indian government, expecting it to offer higher employment opportunities by 2020. The sector forms a key component of the government's 'Make in India' and 'Skill India' programme.
The advent of the Goods and Services Tax (GST), meanwhile, brought with it expectations and debate about its impact on the domestic economy. These continue even after three quarters since the implementation of GST. In this context, it is most pertinent to study the impact of GST along with other policy initiative, that is, demonetization, on the MSME sector.
To state the obvious, both measures have had a significant impact on the sector. Even though the impact of demonetization was largely ironed out by mid-2017, the introduction of GST brought with it a fresh wave of challenges, especially for the informal sector. Along with the initial confusion and infrastructure glitches that took some time to stabilize, there were reports of delays in receiving Input Tax Credit (ITC), which directly affected the MSME industry. The advent of GST also affected supply chains, notably where small traders acted as suppliers of intermediates to larger manufacturing companies.
As Dun & Bradstreet, we can access our proprietary database for hard data that measures impact. From that perspective, the data on MSME is still unfolding. Moreover, since the GST filing data is yet to become publicly available, any estimation at this stage would be inaccurate. In addition, with most MSMEs not being listed entities, their monthly or quarterly business performance filings are also largely unavailable.
Nonetheless, in the absence of such data, we still have access to related parameters to assess the impact of the twin economic measures. The factors discussed below can help in assessing the effect of GST and demonetization on the MSME sector.Reduced Liquidity due to Daily Sales Outstanding (DSO)
Our database indicates that the DSO for small enterprises was around 70 days in 2017, as against 58 days for large enterprises. MSMEs typically have a high dependency on trade receivables, depending upon how a particular segment operates. The sector makes most payments (such as wages) on a daily, weekly or monthly basis.
Hence, high receivables periods directly affect the working capital of most firms in the sector. D&B data shows that the trade receivables scenario for micro and small companies has deteriorated, following demonetization and GST. For micro and small companies, around 70% of trade receivables were open for more than 90 days during Q1 2018 as compared to just 45% during 2015. In case of large companies, these percentages remained flat at around 55%.
While the delay in trade receivables impacted all the companies in the MSME sector, the export segment took most of the hit. As per the Government's directive for the new tax regime, exporters are to receive 90% of the input tax refund within seven days of filing their returns. There had been significant delays in receiving the ITC, however, which adversely affected the working capital of firms. This scenario affected the liquidity positions of small and medium-scale exporters more than it did their larger counterparts.
Consequently, export growth moderated during May-August 2017 period as compared to previous period - a pattern not observed in other emerging Asian economies. This is consistent with the fact that we know that exporters faced implementation glitches during the GST implementation period. It also implies that sectors with high working capital requirements could have been hit more severely due to non-refunds than those with low working capital requirements. Increased cost of compliance and an evolving refund mechanism resulted in a spike in working capital needs of exporters. Further, labor-intensive sectors were hit even more as a result of note ban.
In the six months following implementation of GST, bank credit to MSMEs went up by 3.7% during the August 2017-January 2018 period as against a decline of 3.7% during April 2016-July 2017 due to shortfall in working capital funds. Further, the Dun & Bradstreet CFO Optimism Index, Q4 2017, indicates that the percentage of CFOs cited need for raising short-term funds stood at a six-quarter high during the July-September 2017 quarter.
Increased cost of borrowing: higher spread over G-sec yield
The transition to the GST regime affected the MSME sector more than any other, since its players lack compliance infrastructure to map their outstanding inventory with tax invoices. Furthermore, its weak credit profile and risk weightages attached to it by banks, pushed it closer to higher credit change options from the non-banking finance segment.
The difficulty that MSMEs face in accessing finance is an impediment to their global competitiveness. It is estimated that the lending rate to MSMEs in India varies broadly between 11% and 18%, depending on credit history and the type of loan. This also compares unfavorably with the interest rate scenario in other economies. Further, credit to the MSME sector in India has been low because banks are understandably more risk averse at this time.
According to the Dun & Bradstreet CFO Optimism Index for Q4 2017, the percentage of CFOs, who said that the cost of funds would go up during the July-September 2017 quarter (immediately after GST implementation), was the highest over the last six quarters.
The construction and consumer durables sector faced the biggest brunt during the GST transition. This was due to the nature of their business, respective margins and credit profiles.
Declining Sales volume of MSME sector
We have witnessed a period of demand moderation across sectors. This scenario affected the MSME sector more than others, due to various systemic issues. The sector, especially small and mid-scale export units, were already facing challenges prior to demonetization and GST. Over the last few years, the sector was impacted by the global economic slowdown, owing to its exposure to the export markets of the US and Europe.
Vulnerable businesses which lack pricing power took the demand downturn harder because of high transaction costs and procedural delays (during GST implementations period). This led to high fixed costs that they were unable to control. D&B data shows that sales volume in the MSME sector declined by 0.2% during FY17, as compared to a positive growth of 7% for large companies.
To help the sector, largely spread across rural and semi-rural India, the Government should offer an initial phase of handholding and on-ground support. More favorable export policies and adequate funding support from banks are required. Banks should also take initiatives for prudent credit relaxation for better segments of MSMEs.
Brighter days ahead
Once all businesses register themselves on the GST platform, the economy will benefit from the advantages of better compliance and better transparency. The ease of doing business in the country will improve, attracting domestic as well as overseas investments. It is already back to business as usual for large companies, and we expect to return to our growth trajectory by this quarter. The cause of concern, however, is the MSME sector, which is yet to recover from these recent policy changes.
We think that the fast-tracking of GST refunds for exporters through active intervention by the government would ease the working capital constraints, thus allowing the exporters to fulfill their delayed export orders.
As MSMEs become accustomed to a larger compliance climate, a better level of preparedness and discipline in conducting business will gradually be a part of operation. With the government's commitment to strengthen MSMEs on all fronts, we expect the current challenges to stabilize and gradually take a positive turn to fulfill the nation's 'Make in India', 'Skill India' as well as 'Startup India' visions.