SMEs are the backbone of exports from India, especially of manufactures and increasingly of services if the source of value addition is taken into account. Indeed manufacturing in the ‘original sense’ is very much an SME business. The reasons are not far to seek.

Late industrialisation in a situation of ‘labour schism’ gives rise to a much larger role for the SMEs, and India is at the phase where functionality of economic growth demands that the the sector grow fastest of all others—large, and tiny household firms. The latter being vestiges of the pre-industrial world and surviving only because there is disguised employment, are destined to die out (except the few who are able to cater to niches) with the passage of time. Indeed, they have all but vanished in East Asia and their survival in India reflects the relative slowness of manufacturing growth in India (8% or so versus more than 15% or more in Thailand and China for example) and the nature of the same being less labour absorbing than in these countries.

Chambers of commerce and industry, including those of SMEs, ill understand the situation. All they about is lack of labour flexibility. While it is true that the labour flexibility for large firms is nowhere near what East Asian large firms enjoy, flexibility has improved very rapidly over the 90s, with growth itself being an important influencer. Most important, like Japan (which also had a ‘schism’ in the labour market) labour flexibility is to be sought in the SMEs and here there is almost total flexibility. Thus links between large small in the form of vendor development, OEM, contract manufacturing, technology transfer, etc have the potential to combine the competitiveness of the large with the factor cost advantage of the small to bring out India’s potentially awesome competitiveness in manufacturing. Unfortunately the focus on ‘labour reform’ has taken the attention away from the errors in policy.

Even today the manufacturing, and more so the SME sector, is subject to negative effective protection rates in many industries especially those with much potential. Tariffs on inputs like steel (until recently) plastics and energy continue to be much higher than on the finished goods. Unfortunately, few industry associations understand effective protection and discrimination and are still caught in the license raj paradigm of asking for “concessions” on apologetic terms. Similarly, huge energy cross subsides (oil and electricity) hit SMEs hard in their exports.

Zero vatting (of both central and state taxes) is not total in India since all duties paid cannot be reimbursed unless it takes the form of credit. More important, since the ‘taxes’ on energy take the form of cross-subsidies there is no recourse within the current fiscal framework for this large distortion. Compensations for higher energy prices have to take place since there is no end in sight for the mess in India. Any compensatory move here has to be WTO compatible, which is not easy.

Perhaps the biggest constraint arises out of the management of exchange rates. The exchange value of the Chinese reminibi (as also the Thai bhat) is structurally undervalued, relative to the equilibrium-priced rupee. This has made the export profitability of Chinese industry many times its domestic sale profitability and lead to the emergence of the Chinese manufacturing powerhouse over the last two decades. Now Chinese output is nearly perfectly elastic with exports growth at over 23% on a sustained basis.

The Indian response can be potentially even better as the years from 1993 to 1997 would show. Even if we forget structural undervaluation for now, the real effective exchange rate has appreciated since 1993-94 substantially to hurt exports, especially SMEs. This has restricted India’s exports to more of ‘absolute advantage’ products and services—software, BPO or diamond polishing and low-end textiles.

At a macro level, competencies and capabilities systemicaly follow exports hence the importance of policy. Unfortunately, the RBI is wedded to pricing the rupee such that the current account (including remittances of the order of $25 billion) deficit is not too large, and taking cognisance of portfolio inflows. This makes remittances (and increasingly the export of absolute advantage products like software and diamonds) impose a ‘Dutch disease’ on SME’s comparative advantage and competitive products, slowing down the growth of its exports.

Current high world demand has been positive for our SMEs, but with the exchange rate being aggressive, exports could have grown at over 30% per annum and many SME sectors could have seen even larger East Asian like rates. Labour productivity growth in SMEs is of the order of 4% and in large firms about 6-7% per year is eminently feasible. This means that manufacturing has to grow substantially in excess of these rates for labour to be absorbed. Only demand stands in the way. The other constraints have been exaggerated. Exchange rate aggressiveness is entirely WTO compatible, and completely non-distortionary.

Unfortunately few industry associations understand the same to make it their pitch and many even harbour the illusion that it is market determined, allowing the RBI to be ultraconservative.