Prime Minister Narendra Modi had announced policy support to make India aatmanirbhar or self-reliant. The package includes a rational tax system, simple and clear rules-of-law, good infrastructure, capable and competent human resources, and a strong financial system. Let us focus on issues that would act as an impediment to achieving this goal.
Take the case of a product supplied by three types of entities — foreign supplier, trader and MSME. For all three of them, the basic cost is assumed to be 100 units.
From the perspective of MSMEs, there are four policies that would have a detrimental impact on them.
Import duty exemption
The stated objective of import duty exemption is to help large industries reduce their input cost and promote manufacturing. This makes logical sense when there is no alternative MSME supplier and when the final product is made only for export.
Let’s us assess how this policy discourages technology development and indigenisation
The foreign supplier sells the foreign goods. The trader merely imports them and sells to the industry. The MSME, following the Prime Minister’s call for aatmanirbhar, is planning to indigenise the technology and supply to the industry. Naturally, the firm has to start with small level of indigenisation and eventually take it to 100 per cent. Let’s assume the various stages as 10, 50 and 80 per cent. There is hardly a high-technology product that is 100 per cent indigenous. Let’s see how large industry treats each of the suppliers.
Assume that all the three types of firms are equally productive and efficient and their input costs are same. For 100 units as input cost, let’s look at the real cost due to this policy.
For a foreign firm selling to a large industry or shipyard, since the import duty exemption is in place, there is no additional cost and, therefore, the cost remains 100 units. For the Indian trader, again there is no effective import duty since the shipyard will facilitate high-sea sale and, therefore, the cost remains 100 units.
Now let’s look at the MSME that has started with 10 per cent indigenisation and aims to reach 80 per cent. There is no import duty exemption for the components that are imported by this firm, hence 15 per cent basic duty as additional cost will add up on its 90 units (90 per cent is imported). The additional cost that this MSME has to bear is 13.5 units (15 per cent of 90 units). Assuming that the remaining 10 per cent cost is comparable, the real cost for this MSME is 113.5 units. This MSME would be wondering what would be the cost if it achieves 50 per cent indigenisation. Simple, it would be 107.5 units and the same cost drops to 103 units when it achieves 80 per cent indigenisation.
The above costs clearly shows how the incentive structure works. Shipyards would love a foreign supplier or a trader of a foreign supplier. The moment the MSME thinks of indigenisation its cost shoots up. This will eventually drop to the similar level of the foreign supplier or trader only if MSME achieves close to 100 per cent indigenisation. No doubt that 100 per cent is a great goal, but which firm will take this step if the start is so tough?
The second detrimental policy is payment terms. Policy-makers think that the biggest issue a start-up or MSME faces is getting clients. They think that by giving exemption on turnover criteria for start-ups to win a project/tender the problem is solved. They are mistaken. The biggest issue is financing of the project. The skewed payment terms, especially of Central government departments, defence establishments and PSUs, is the bigger problem.
Most of them under various ministries keep the payment terms such that supplier gets paid 100 per cent after delivery. This becomes an issue mainly when the product is custom built and when it takes time, say six months, to make.
In most cases getting banks to finance the project is an issue and this prevents start-ups/MSMEs from taking up bigger projects. Even if they manage to get finance, the Indian supplier stands to lose vis-a-vis the foreign one. The key factor is that the MSME get collateral-free credit at 15 per cent compared to 5 per cent or lower for foreign suppliers. The spread is 10 per cent.
Let’s take the aforesaid case of a custom-made product, whose timeline for supply is six months. Now compare the different suppliers. For a foreign supplier, the cost of finance is 2.5 per cent of product cost (six months @ 5 per cent), i.e., 2.5 units.
A trader who merely acts as a representative of foreign firm is like a foreign supplier. An MSME with ownership of the product and taking the supply risk will have higher finance cost. For such a firm, the cost of finance is 7.5 per cent of product cost (six months @ 15 per cent), i.e., 7.5 units.
In comparison, most State governments follow stage-wise payments against milestone achievements and there are multiple milestones in a project. At every stage, the payment is slightly lower than the value of the product in that stage. This simple measure ensures that both the need for working capital as well as finance cost of the project is lower.
Difference in payment timing
It is strange how Central government and defence establishments get away with differential payment terms between foreign and Indian supplier.
For a foreign supplier, the Letter of Credit (LC) is made one month before the item is shipped from their factory.
The same product if it is made by an Indian MSME, the same government client would make the payment one month after the product is delivered.
For the product with six-month timeline for delivery discussed above, there is a three-month difference in timeline between payment to a foreign vendor/Indian trading company and an MSME manufacturer.
From the cost angle, the additional financing of three months @ 15 per cent is 3.8 units for MSME.
The MSME who thinks of aatmanirbhar is having its competitiveness against foreign suppler further lowered by this difference in payment timing.
A foreign supplier would be paid in euro, and the Indian MSME, in rupees. The MSME that is trying to indigenise would still have to import components. To cover the exchange rate risk, the MSME will have to resort to currency hedging. It is about 3 per cent for six months coverage.
At 10 per cent indigenisation, the MSME would be importing 90 per cent of the materials. So, the additional cost will be 3 per cent of 90 units — that is, 2.7 units. For an MSME with 50 per cent indigenisation, the currency exchange cost will 1.5 units and similarly for MSME with 80 per cent indigenisation the cost is 0.6 units.
Now if we add all the costs we get real cost for each supplier.
The total spread between a foreign supplier and an MSME who embarks on indigenisation is 25 per cent. Because of these factors, government departments and PSUs would prefer a foreign supplier or a trader of a foreign supplier. MSME cannot think of attempting bigger projects. Even if they do, the import duty exemption, payment terms, differences in payment timing and payment currency would kill their competitiveness. How will aatmanirbhar be achieved?
The writer is Founder CEO of Navalt Solar Boats, XShip Analytics, Navgathi Marine