SME Exchange in India: A Way to Inclusive Development1 Be faithful in small things because it is in them that your strength lies

Mother Teresa

Abstract SME sector is always a matter of concern as it is considered to be one of most important sectors for overall economic growth and development. There is a need of alternative channel to provide capital to SMEs with minimal cost. SME exchange can be a great source to support the enterprises not only with capital but also with better accessibility to the information. The development of SME exchange can pave the way for inclusive growth. Keywords: SME exchange, capital, inclusive growth. SME in India: A Synopsis Small and medium enterprises (SMEs) play a very decisive role in economic growth which they pave with employment generation, enlargement of entrepreneurial skills and contribution to overall industrial production. They have their own indigenous technology as well as modern expertise with which they produce a vast range of items. While talking of their contribution to the larger economy, this segment credits the entire country with over 45 percent (approx) of the total industrial production, 9 percent (approx) in the GDP and employing nearly 69.54 million people by engaging through about 29.81 million units spread across the length and breadth of the country. Figure-1 shows some facets about MSMEs contribution to the economy. It is found that after 2005-06, the MSMEs (micro, small and medium enterprise) grew more aggressively in terms of number of units and overall employment generation (figure-2). As a result of which their contribution to industrial production and GDP also took an upward shift. It is also manifested that the total production by MSMEs is consistent with steady growth since the early 1990s, but both the production as well as exports have hastened up from 2000 onwards. Amidst several factors, the new government policy introduced in 1999 is considered to be the prime one.

The article is written by Mr. Sudhanshu Gupta and Mr. Debasish Maitra, fellow participants of the Institute of Rural Management, Anand (IRMA). The authors can be reached at guptasudhanshu01@gmail.com and debasishmaitra@gmail.com respectively. The corresponding author is Mr. Debasish Maitra.
1

Figure 1. Contribution of MSMEs to Total Industrial Production and GDP

50 45 40 35 30 25 20 15 10 5 0

PercentageShare

TotalindustrialProduction GrossDomesticProduct (GDP)

Source: MSMEs Annual report 2010-11, Ministry of Micro, Small and Medium Enterprises Figure 2. Performance of MSMEs by different indicators
120 100 USDbillion 80 60 40 20 199 199 199 199 199 199 199 199 199 199 200 200 200 200 200 200 200 200 200 200 0 80 70 60 50 40 30 20 10 0 Units (mill) Production ($ bill.) Export($bill.)

Source: Handbook of Statistics on Indian Economy (Reserve Bank of India) 2010-11 Are SMEs Born Sick? - Causal Agents More than often not, it is imagined that small enterprises are born sick. Eventually within a very short period of emergence they die out. Pinning down to find different causal agents which determine their fate results into various reasons. According to the Third Census of Small Enterprises conducted by Ministry of MSMEs in 2001-02, the reasons which have been identified are tabulated in table-3.

Table 1. Reasons determining sickness of SMEs S. no. Reason for sickness/ incipient sickness Proportion of sick/ incipient sick units* Total Small Regd. Small Unregd. Industries Small Industries 1 2 3 4 5 6 7 8 Lack of demand Shortage of working capital Non-availability of raw material Power shortage Labour problems Marketing problems Equipment problems Management problems 66 % 46 % 12 % 13 % 5% 36 % 11 % 4% 58 % 57 % 12 % 17 % 6% 37 % 9% 5% 69 % 43 % 12 % 12 % 4% 36 % 12 % 3%

Industries

*The total may exceed 100 percent as some reported more than one reason. Source: Report of Working Group on Rehabilitation of Sick SMEs, RBI (Reserve Bank of India).

Highest percentage of units opined that their sicknesses are due to lack of demand followed by shortage of working capital, followed by marketing problems. Rests have received low to moderate responses. 1. Lack of demand: SMEs face most of the time the lack of market for their products because they either start producing the same products with which the local markets are already saturated. The problem lies in too many enterprises chasing too small market. They should be given training on how they can access the global markets and target new markets. In this aspect technological up-gradation is very much necessary so they can remain informationally advanced. 2. Need of Capital: To start up any venture, they need adequate and timely fund. Failing of which jeopardises their business. Table-4 illustrates the declining trend of credit to small enterprises as a percentage of banks gross bank credit.

Table2. Credit flow to SMEs and Gross Bank Credit Medium and Large 29,463.8 32,567.4 34,464.8 47,033.6 49,442 70,460.8 91,846.4 115,885.8 145,129.2 177,078.6 221,010.2 278,349.4 Gross Bank Credit 75,025.4 85,832.4 96,549.8 124,011 145,684.4 199,957.6 280,968 360,248 440,960.2 520,365 608,001.4 733,470.8

($ millions) Medium and large/GBC 39.27% 37.94% 35.70% 37.93% 33.94% 35.24% 32.69% 32.17% 32.91% 34.03% 36.35% 37.95%

Year

Small 10,563 11,200 11,440 12,079 13,171 14,918 18,242 23,582 26,540 33,799 41,280 45,820

Small/GBC

1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

14.08% 13.05% 11.85% 9.74% 9.04% 7.46% 6.49% 6.55% 6.02% 6.50% 6.79% 6.25%

Source: Handbook of Statistics on Indian Economy, RBI(Reserve Bank of India), 2010-11 It is apparent that sectoral lending to medium and large enterprises has upward sloping. However, when lending to medium enterprises is dissected from medium and large and clubbed in micro and small enterprises it is found that out of total gross bank credit, MSMEs occupy only 10.9 percent both in March 2009 and 2010. Whereas large enterprises alone occupy 28.8 percent and 31.48 percent in March 2009 and 2010 respectively (RBI data on deployment of bank credit by major sectors). It is also much difficult for banks to measure risk of default while lending to SMEs. Banks receive many proposals for new small and medium enterprises through KVIC (Khadi and Village Industries Commission) and PMRY (Pradhan Mantri Rojgar Yojana) which involves a good amount of subsidy. This increases moral hazards among the entrepreneurs who only want bank credit to enjoy the subsidy

without any business attitude. This in a way discourages banks from lending them as there is a chance of falling in the trap of adverse selection. 3. Marketing Problems: It is linked to the problem of positioning their products in the

markets. Most of the SMEs either do not know branding, product promotion and other marketing strategies or they just ignore them thinking that these require capital and do not pay off. Nevertheless, these are as much needed as capital to scale up both horizontally and vertically. Advantages: Core and Peripheral The core advantage of the SME exchange is that it will enable small and medium enterprises to raise capital from public sources and improve their capital structure. It will make them less dependent on banks and other financial institutions. The issue of capital structure has been greatly studied by many economists. The two dominant theories that explain structure are pecking order theory (Mayers and Majluf 1984) and trade-off theory (as first proposed by Krus and Litzenberger 1973). Pecking order theory suggests that internal financing is preferred over external source of financing as information asymmetry exists between managers and the investors in the market. The least preferred source is equity financing as it generates higher adverse selection costs. However, since long SMEs in Indian context have already been depending debt. They become gradually constrained to mitigate the deviation from the target leverage which is deemed as their favourable capital structure. Debt has benefit of tax but the costs of financial distress containing both bankruptcy cost of debt and non-bankruptcy cost are attached to it. So, depending on only debt as external source causes them to reap decreasing benefits by incurring increasing marginal cost as the level of debt increases. In a way, the option of equity would give them opportunity to decide on trade-off while making choices between debt and equity (trade off theory).The equity will complement to debt and would strengthen SMEs balance sheets by reducing the level of leverage. The opening of SME exchange would enable various small and medium enterprises to generate equity capital for their burgeoning need. In most of the IITs (Indian Institute of Technology) and IIMs (Indian Institute of Management), incubation centres are being opened where idea of business are nurtured and incubated before taking them to the final phase. While academia is making big effort towards cultivation of more enterprises, this new initiative would spur their growth by bringing them in the exchange platform. The opening up of new capital market for SMEs will mobilise the idle capital reserves remained as savings in the economy

and accelerate capital formation in other sectors too. It will make funds available on a continuous basis, thus rendering more liquidity. It is also argued that capital market provides better avenues for investment than others as entry and exit barrier are lesser. The experience of Dhirubhai Ambani is inspiring one, who managed to create equity cult among Indian middle class. After getting no response from banks for more capital, he decided to go public by offering shares. Eventually, Indian shareholders increased from one to four million between 1980 and 1985 (Das 2002). Apart from core advantages, some peripheral advantages include that the SME exchange will give many small and medium entrepreneurs the lens to look at bigger and wider image of the global market. As they will be under the network of many investors, hence, they can come to know about cost, product and service better to hone their competitive advantage. Investors will always look for earning more return on investment thus; will transfer the knowledge of market information faster. The search cost of information will be significantly reduced. As they will become public, the information about their performance now be better accessed by suppliers, other partners would increase their social capital. The exchange based trading will also help SMEs to merge to capture more market share as the information become more available and accessible. Professor David Birch, a former professor of MIT and now with Cognetics Inc, suggested that there are three kinds of business entities; elephants, mice and gazelles. The elephants are the large fortune 500 companies. Enterprises like small retail shops, restaurants and services are mice. The gazelles are small but grow very rapidly through innovation and provide millions of jobs (Das 2002). Shri Mahila Griha Udyog Lijjat Papad is a striking example of gazelle started with very small but expanded widely. They all started with $1.6 in 1959 and over the period of time they became an organization with more than $178 million turnover of which $7.2 million are from exports. SME exchange will support the efficient and competitive baby firms to become gazelles in future. Performance of Small Cap and Mid Cap Indices To understand the small and medium capitalised companies in the financial market in India, small cap and medium cap indices at the both BSE (Bombay Stock Exchange) and NSE (National Stock Exchange) are analysed to look at their performance. Both the BSE and the NSE innovated with mid cap and small cap indices to mirror the behaviour and performance of medium and small segments.

For small capitalised companies the BSE has mandated minimum criteria like minimum postissue paid up capital of the company should be $0.6 million, the minimum number of investors should be 1000, the turnover of the company should be $0.6 million in each of the preceding 3 of the 12-months period. While the NSE has laid out the requirement criteria like 3 years track record of positive net worth, companies should demonstrate a trading frequency of at least 90 percent in the last six months and should not constitute individually more than 5 percent free float market capitalisation of the universe. The eligibility criteria set for small capitalised companies at the BSE can be comparable to the criteria set for SME exchange, with some relaxations to the SMEs. Hence, performance of small and medium capitalised companies can be indicative if not exhaustive to make conjecture about SMEs. Figure 3. Growth of CNX Midcap and Small cap Indices
12000 10000 IndexValue 8000 6000 4000 2000 0 CNXMIDCAP CNXSMALLCAP

Source: National Stock Exchange, India

Figure 4. Growth of BSE Midcap and Small cap Indices

16000 14000 12000 IndexValue 10000 8000 6000 4000 2000 0 BSEMIDCAP BSESMALLCAP

Source: Bombay Stock Exchange, India

Table 3. Comparison of performance among Nifty, Sensex, BSE Mid cap, CNX Mid cap BSE Small cap and CNX Small cap Year Return (%) Avg. Daily Avg. Daily Volatility (%) Sensex 1 year 3 years 5 years -28.29 32.62 -52.81 1.32 1.58 1.90 BSE Midcap 1 year 3 years 5 years -41.69 15.85 -118.13 1.16 1.47 1.73 BSE Small cap 1 year 3 years 5 years -55.31 -5.59 -144.26 1.22 1.54 1.74 -0.22 0.06 -0.02 -41.69 17.83 -0.06 -0.17 0.06 -0.01 -36.95 24.80 -79.96 -0.11 0.06 0.09 -28.16 31.16 -48.74 1.32 1.57 1.89 CNX Midcap 1.15 1.40 1.72 CNX Small cap 1.28 1.46 1.75 -0.17 0.06 -0.01 -0.15 0.06 0.01 Return (%) Return (%) Avg. Daily Avg. Daily Return (%) Nifty -0.11 -0.06 -0.01

Volatility (%)

Source: Auhtors estimates

It is evident from fig-3&4 that both the indices of medium cap and small cap are growing. At the BSE the small cap index is growing above the mid cap index. It is found that the performance of small cap index at both the BSE and the NSE are poorer than sensex and nifty. The 1-year return is more negative in case of small cap indices than mid cap indices, sensex and nifty. Small and mid cap companies also suffer from greater amount of loss during any crisis. However, the risk component of small cap companies is very much comparable with sensex and nifty. It is also true that unlike sensex and nifty the small cap and mid cap indices are not very old, so they need more time to mature. Sensex and nifty comprises of large companies with high market capitalisation while small cap and mid cap companies are with much lesser market capitalisation, yet they provide positive and relatively good returns (3-years) when compared to sensex and nifty. It indicates that small and mid cap companies are able to attract investors. Regulatory Structure in India and Other Countries The success and sustainability of the SME exchange depends on the synergy among SEBI (Securities and exchange board of India), the exchanges (NSE and BSE) and the participating investors. While SEBI is trying to bring SEBI has made it mandatory to invest in minimum trading lot of $0.002 million along with 50 minimum numbers of investors. In a way it would deter other small investors from participating in SME exchange. But it is argued that this requirement is necessary to protect small investors from loss. However, it has to be overhauled properly that SMEs do not cook up their accounting data as already they have been given the relaxation only to report their half-yearly results in place of quarterly results without any feasible reason. In addition to this, SEBI has also relaxed the rule of reporting profitability. Now SMEs are only needed to report their profits of any of the 3 years of preceding 5 years instead of only preceding 3 years. These all may discourage investors as these will also fuel their pre-occupied notion that SMEs are not transparent. SEBI may think of including corporate governance in the listing requirements to promote transparency and accountability of the firms. Monitoring rather than restrictions are necessary. Much

restriction will lower the process of listing and increase the cost of transaction. However, it has been decided that on BSE platform the post-issue face value of paid up capital should not exceed the limit of $2 million and firms with paid up capital between $2 million and $5 million can list them either on SME exchange or main exchange, but there are no initiative from the regulators and exchanges ends to ensure the transparency and good governance of SMEs. The requirement of $20 million net worth for the exchanges desire to open SME

exchange is again a question casts doubt on SEBIs willingness for this renewed initiative. Recently a SEBI committee headed by Bimal Jalan recommended minimum net worth of $ 20 million for all stock exchanges. But this should be relaxed for the exchanges interested in SME sectors. It seems to be anti-competitive and unviable. If risk management component, a determinant of net worth, is assigned off to other agencies then exchanges can shy away from holding so much net worth (Parekh 2008). Table 4. Comparison of minimum requirements and performance of various SME Exchanges Name of Exchange Net Assets/Revenue/Profit ability Minimum Requirements Share Capital /Market Cap SME BoardChina ChiNext Profit of $47 mill./3 Share years capital$47 mill Profit of $16 mill./2 Share years capital$47 mill ACEMalaysia No. min requirement No. min No. min requirem ent 200 127 $ 1.6 bill 116 $0.9 billl. 281 $118 bill. 646 $ 428.6 bill. No. Performance of No. of Listed Total Market Companies Capitalisation

sharehol ders

requireme nt

CatalistSingapore GEMHong Kong AIMLondon

Sufficient

working -

capital for 12 months Trading record of 2 Market years, Cash flow of cap-$13 $26 mill./ 2 years No. min requirement mill. No. min No. min 1253 requirem ent 200 2154 $70 bill $100 bill 100 168 $11 bill.

requireme nt

TSVXCanada

$0.2-0.74mill.

net -

tangible assets $0.5 mill revenue, if no

then future prospects of revenue, 12 months working capital MothersJapan $13 mill net assets, $1.3 mill net profits/2 years Source: Shenzen Stock Exchange China, Bursa Malaysia, Singapore Stock Exchange, Growth Enterprise Market Hong Kong, Alternative Investment Market London, Toronto Stock and Venture Exchange Canada, Tokyo Stock Exchange. A comparison of eligibility requirements and performance of various SME exchanges are presented in table-4. It is evident that in most of the cases minimum requirements are relaxed to encourage investments. AIM-London and ACE-Malaysia relaxed up to no restriction of minimum number of shares and minimum number of shares to be in the public hands. It also ensured the presence of nominated advisers to advise the small firms about the pros and cons of market regulations (Ghosh and Purohit 2009). The performances in terms of number of companies listed and market capitalisation are quite notable. Most of exchanges were set up in 1990s and soon they picked up the momentum. Even in small country like Malaysia, it has been able to enlist good number of companies while few companies have been eventually graduated to the main exchange. In India, SEBI has taken a good initiative by making a mandatory market making for all scrips being traded on the SME exchange at least for three years. On the other hand, it has not much talked about how the market makers like merchant bankers and other investment bankers responsible for underwriting would charge the premium for underwriting on behalf of SMEs as the risk of adverse selection and moral hazard is more here. SEBI needs to create some alternative arrangement to look after the liquidity and other regulatory requirements once the market makers will disengage themselves. The crucial role of financial Public Relations (PR) firms are also to be considered to publicize the issue of new small and medium enterprises for better subscription. SEBI should think of policies to increase institutional participations like Mutual Fund companies can be directed to include SME segments in their portfolio ,and rating agencies as well as analysts can be given directives to analyse companies belong to this segment. To encourage giving services to this segment at much lower cost should be complemented with some incentives to the service providers (Banerjee, 2006). 300 176 $158 bill

The new SME exchange initiative evokes the failure of our past attempts towards establishment of the same. The sink of Over-the-Counter Exchange of India (OCTEI) and IndoNext (BSE) are also the reasons which are raising eyebrows against this new initiative. The reasons of failure were many namely, high cost of transaction, cannibalistic competition from big brothers like NSE and BSE, lack of will and improper timing etc. Nevertheless, bitter experience should not impede the dawn of new idea. It is only to be thought over that past mistakes are not repeated this time. Market microstructure should be improved. Bid-ask spreads should be monitored to reduce the transaction costs. Promoters interests, institutional participation, more number of companies and margin systems are some important things should be addressed this time (Banerjee, 2006). This time the minimum number of shareholders has been relaxed unlike IndoNext where companies should have minimum 500 shareholders. The consideration of dual listing this time will help to move the thinly traded companies from the main platform to the SME platform and vice-versa. It has to be believed also that OCTEI was built up in 1990 when India was already reeling under the regime of liberalisation rendered it difficult to succeed. During that time India was not so efficient in trading and monitoring. Of late various systems based technological up-gradations would make it comparatively easier for the new one to succeed. Conclusion The intention to build SME exchange is a welcome step from the SEBI. It can be a fulcrum to foster the growth and development of SME sector not only by unlocking the door to raise capital but also by improving their management practices, governance structure and access to information. Although today it looks pale and questionable because of our past experiences but can become of great significance if it is followed with integrity. When small and mid companies are growing and are becoming able to attract investors, so a positive future prospects can be held for SME exchange. A simple but sincere policy is warranted to help the financial market towards a competitive outcome for SMEs with no entry barrier or benefits to the participants with concentrated market power. A good muddling of policy with practices can transform this better into reality. Every step has to be examined and monitored carefully for successful implementation. SME exchanges have been successfully established by many countries while we failed in the past. So, finding the gap and factors or enablers for their success have to be understood before going forward. It would give cues the way SME exchange should be dealt with in Indian context to pave the way for Inclusive Development.

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