Why Informal India cannot be 'Atmanirbhar' India

Atmanirbharta, or self-reliance, has been a holy grail for the Indian economy. In its present avatar, the idea hovers around increasing competitiveness and growth of the manufacturing sector, and rightly so. The manufacturing sector in India has been bypassed by the tentacles of economic growth over past three decades, with services sector heralded as engine of growth with a high share in output and employment.
 
This might just be the right time for India’s manufacturing sector to exhibit a coming of age, with thrust on competitiveness. Competitiveness arises from productivity differentials, which, in turn, are a function of firm size, especially in manufacturing. Larger firms are more productive with higher value added per capita, and higher levels of sales and output per employee. Formal status is another empirically established characteristic of productive firms across countries. World Bank’s micro and informal enterprise surveys show that for India the wedge between value added per employee in a registered and unregistered firm is 35 per cent, that between a small registered firm and a large firm is 68 per cent, and that between a large registered firm and an unregistered firm is 212 per cent.

 
This differential is due to large, formal firms’ access to external finance, and use of more capital per labour. These firms with economies of scale are often run by better educated managers, and employ specialised staff for specific functions, resulting in better internal processes, and customer outreach, allowing these firms to generate sustainable productivity differentials to achieve competitiveness.
 

Indian manufacturing, however, is characterised by a high share of fragmented informal organisations. National Sample Survey Office (NSSO) data reveal that the share of informal employment is as high as 95-98 per cent in sectors such as textiles, leather and furniture. Other potential export sectors like industrial machinery, specialty chemicals, food products and fabricated metals have 60-85 per cent share of informal employment. There are 19.67 million micro, small and medium enterprises (MSMEs) in manufacturing, employing 36.04 million people. The share of micro enterprises, among MSMEs is almost 99 per cent.

 
The antimonopoly regulations and stringent labour laws practised over years have ensured that the average Indian manufacturing firm remained small in size. The romanticism around employment-generating and cost-cutting characteristics of these informal firms have made us believe that informality is forced by excessive cost of regulation. It is important to start acknowledging that these firms may be unproductive, run by lowly qualified managers, unable to function efficiently and, therefore, out of formal structure. The notion that economic growth will generate returns for these firms, bringing them into formality has not worked so far. Nor is there much empirical support for the hypothesis of registration alone increasing their productivity.

 
Shift to a formal status would typically mean additional costs of paying taxes, adhering to safety norms, and providing additional employment benefits to workers. All these are genuine costs. Any estimation of loss of revenue to the exchequer due to tax evasion, loss of lives and project assets due to non-compliance with safety norms, and loss of productivity due to non-provision of social security to employees, is sure to bypass the loss of profitability to informal enterprises.
 
Regulation and productivity need not be mutually exclusive. Supporting informal businesses is desirable from social perspective. Initiatives to keep them afloat and make them increasingly productive are welcome. However, thrust of the self-reliance movement undoubtedly has be to on designing regulatory systems conducive to creating large firms with a clear competitive edge.

 
Failure to separate ownership and control by family-owned large businesses is another proven impediment to competitiveness. Ceding control to professional managers with independence to run the operations and plan for growth-enhancing strategies benefits these businesses. Loyalty and bonding relationships in the family provide intangible resources such as trust and goal congruence promoting competitive advantages, especially when weak legal structures impair contractual enforcement and good governance. However, altruism within extended families makes it difficult to discipline underperforming members of the family, hurting firm performance.
 
Ample macroeconomic evidence suggests that limited access to capital constrains productivity growth in developing countries. Ownership of banks by the government has resulted in hampered credit allocation as there is a conflict of interest between social objectives and the running of an efficient financial system. Implicit government guarantee weakens their incentives to pursue operational efficiency. They are prone to evergreen non-performing loans and keep insolvent borrowers afloat. Slow in adopting new technologies to improve the efficiency of financial intermediation, public banks are more susceptible to distress than private banks. Their investment in government securities reduces availability of loans to the private sector. Designing regulations to prune these hydra-headed institutions is vital in pursuance of self-reliance.

 
‘Atmarnirbhar’ development requires organisations that can benefit from scale economies, entrepreneurs who take risks and grow those organisations, independent professionals who have the skills that can support technological progress and productivity growth, and banks that understand the hazards of providing credit and that diversify their risks while financing growth. It requires regulating and unleashing the power of markets and holding back the temptation to use the state to direct scarce resources towards centrally-handed-down goals.
 
Prof Errol D'Souza is IIM Ahmedabad director, and Prof Ashtha Agarwalla is Associate Professor at Adani Institute of Infrastructure Management