Small-business risk sharing can deliver inclusive economic growth

This budget will be no exception. It will hold clues about the intent of the government, particularly after a competitive election. In particular, it would be important to understand if the policies are in tune with the changing world and can support long-term growth that benefits a wide section of the population.

The budget presents a critical opportunity to address one of the most pressing challenges:

managing risk. Over the last few years, we have seen risks to the global and Indian economy emanating from various sources. The Global Risks Report published by the World Economic Forum earlier this year highlights that significant short-term and long-term risks remain. 

The upcoming budget provides a chance to support the economy and people in mitigating some of these risks—at both the macro and sectoral levels.

At the macro level, India’s central bank has done a reasonably good job by maintaining sensible monetary policy. Macroprudential policies are a work in progress. In the fiscal policy space, indications are that the government is consolidating, which will help in managing global shocks. 

Where the government has fallen short is in helping firms, particularly small and medium enterprises, mitigate various risks. As I have pointed out in one of my previous articles, the gross fixed assets of small firms fell by 11.5% in 2023. According to a response in the Rajya Sabha filed by the government, the number of MSMEs closing down in 2022-23 was the highest in four years.

An inability to cope with risks is a big factor. Moreover, this only paints a partial picture, because no data captures how many businesses did not even start because of elevated risk levels. This manifests in the country’s private investment slump, though. 

The government’s response has been to come up with various loan schemes, but that has not helped precisely because they cannot adequately mitigate risks.

What can the government do?: To address this critical issue of risk, the government should consider creating an investment fund that takes equity positions in small and medium businesses and new ventures. The key here is scale. While the individual investments made may be small, if such a scheme is implemented on a large scale, aggregate risk would become manageable, as it would amount to risk sharing.

This approach would democratize access to equity funding, allowing a broader range of entrepreneurs to benefit from risk-sharing mechanisms previously available only to a select few who have access to avenues such as private venture capital funding.

Availability of such equity capital would not only make funds available to small businesses to expand, but because risk is shared, the loss to individual business owners would be lower. This will change the expected returns and encourage more people to start businesses. 

As a result, aggregate private investment is likely to go up. The high interest rate regime we currently face makes borrowing costly, and small firms often have limited capacity to increase leverage.

The proposed government-backed entity that infuses equity into small firms could address both these issues, reducing the cost of capital and increasing their borrowing capacity. This is also likely to boost employment—one, by incentivizing more individuals to start their own ventures, and two, through newer jobs generated by these businesses.

Implementing this proposal, however, is not without challenges. The government will need to carefully design the selection criteria for businesses eligible for equity investment. Transparency in the selection process will be crucial to prevent misuse and ensure that the funds reach deserving enterprises. The government will also need to have clearly defined exit rules.

But such a fund can have a powerful impact. Consider a small business that produces steel frames for rooftop solar installation in a tier-2 city. Such a venture is unlikely to generate any interest from a VC firm, but could now access the capital needed to purchase new equipment and expand operations. 

This not only boosts the individual business, but also contributes to local employment and economic growth. Multiply this effect across thousands of SMEs nationwide, and we begin to see the transformative potential of this approach.

As we look towards Budget 2024, the focus must be on creating an ecosystem that nurtures SMEs by investing in them and sharing risks. By reimagining risk management for SMEs and coupling it with widespread investments in them, we can lay the groundwork for higher private investment, increased employment opportunities and sustained, inclusive growth over the coming decades.