While much attention has been focused on the manner in which demonetisation has inconvenienced the general public, the sudden invalidation of 86% of Indian cash may create a short-to-medium-term impact that is brutal for small businesses.

The importance of Micro, Small, and Medium Enterprises (MSMEs) cannot be overstated. According to the estimates of the Ministry of MSME, the sector generates around 100 million jobs through over 46 million units. With 38% contribution to the nation’s GDP, 40% to overall exports, and 45% of manufacturing output, they clearly form the backbone of the economy.

Immediate impact of demonetisation

Where GDP growth moderation due to demonetisation is estimated at 50bps at the lower end to as much as 300bps at the higher end, it can be presumed that the impact on MSMEs will be higher than the rest of the economy due to their greater dependence on hard cash. Their unvirtuous cash cycle begins from an expense base that is almost exclusively cash-based. This then incentivizes the business to earn revenues in cash as well.

This has resulted in varying degrees of disruption in the supply chain of businesses of all sizes. Speaking about the impact in the immediate aftermath, Tex Zippers, Vice President, Mudit Tandon says, “There are hiccups in the supply-chain. For example, we could not find a specific grade of insulation and other material we needed for our products for many weeks after demonetisation in wholesale markets. The other important aspect to consider is the importance of petty cash. As a factory, we frequently have welding, cartage, and tool repair jobs. These are small jobs that are settled in cash and we did not have enough petty cash for this. With our regular suppliers there was no issue, but for odd jobs like these, which can actually stop work at time, we had a problem.”

There are some segments that attract very low rates of tax – mainly essentials and agricultural machinery – and hence these businesses have been dealing in white for a while. The demand seizure, however, would impact even these segments severely. For example, a motor pumps manufacturer who did business almost entirely in white would not have any buyers since farmers who buy his product are not able to sell their produce because the produce traders do not have cash. Others that have preferred dealing in cash to avoid taxes or per force will likely be completely paralytic.

Even in the event that a business has pending orders, execution may prove difficult what with workers lining up at banks all day, day after day to exchange their savings.

On the capital front, the cash crunch may force the businesses to rely on bridge or working capital loans. Due to the inundation of workload at the banks, they may end up relying on more informal channels, thus exacerbating the flow of unaccounted cash.

Going forward

Demonetisation will require a wholesale rethink by participants in the parallel economy. Businesses need to think about first entering the banking system, second digitizing, and third full declaration. Big resets to practices and mindsets will need to happen for this coming as this move does just months before the planned implementation of GST.

Gokul Ferrocast Pvt Ltd, Joint Managing Director, Sunny Ahuja, who is also a prominent member of Belgaum’s business community, feels that demonetization will help the organised MSMEs probably at the cost of the unorganised MSMEs.

“Most bulk and regular purchases were anyway routed through the formal banking system. Since demonetisation has no effect on digital payments, it is business as usual for the more organized players,” says Ahuja.

Undercutting legitimate, competitive businesses through lower pricing via cash dealings will probably end or at least reduce. This will improve the overall competitiveness of MSMEs generally. Enterprises with organized systems and planning processes will make the transition sooner, giving themselves a tangible advantage, thus taking the already substantial contribution of 38% to GDP or even higher.

On the capital front, many MSMEs faced difficulties in credit appraisal before demonetization due to the large volume of unaccounted transactions. Once the initial setback phase is over and businesses streamline their processes and accounting, they will be able to access credit markets more efficiently and at better pricing, thus lowering their cost of funding.

On the labour front there may be some longer term pain. Smaller businesses are dependent on migrant labour, which is frequently moving across India. Many of these workers either do not have proper IDs or have IDs that are not valid in the state in which they work. The lack of income in the immediate aftermath of demonetisation will force them out, thus hurting the business continuity and adding to hiring and training costs.

Secondly, as revenue transactions come into the white sphere, businesses will be forced to change the mindset of labour and help ease their financial inclusion, which will not be easy.

Endemic issues

Endemic issues that lead to generation of cash, need to be addressed. If these are not part of the reform, India may merely be exchanging Rs  1,000 and Rs 500 notes for Rs 2,000 notes, which paradoxically makes logistics of cash transactions at least twice as easy.

Take an example of a business that does transactions entirely in white despite the large cash outgoes on expenses. When a rent seeker like a factory/labour inspector, excise official, or policeman comes by and demands a payout, the business is forced to set aside some cash to service these payments. The most convenient way is to not account for some revenue, which also saves tax and provides the needed hard cash. Can this business owner necessarily be called a black marketer for doing this? This is regarded more as a cost of convenience and is one of the main roots of the black economy. Until this kind of corruption is weeded out, the cycle will just keep reviving itself.

Also, many businesses depended on customers who preferred to pay in cash. Excess unaccounted cash had to be spent away, and quickly. This was a key demand driver for many small manufacturing and trading businesses. Moreover, the demonetisation move has come towards the end of the festive season, the beginning of the wedding season, and just before elections in two major Indian states (UP and Punjab). This is the time when consumption is at its peak in India.

While the much-needed clean-up is underway, we have to also remain cognizant of the big picture relating to small businesses. Even though the transactions of these businesses are unaccounted at the primary level, ultimately they are part of a larger transaction chain that impacts even the white economy. The small sized transport company that shuts shop affects the logistics of blue-chip corporates. The consumption demand that comes from the wages these businesses pay out impacts revenues of the largest FMCG majors.

With this move, MSMEs are now at the crossroads. The surgical strike on black money could uncage this growth animal if it is supported by the spread of digital payment systems and financial inclusion, and mechanisms to end corruption. The surgery could, just as well, also prove fatal.

(By – Ujval Nanavati)

Source: The Economic Times

Image Courtesy: The Financial Express