How the levy of Import Duties can help MSMEs in 2018 (The less obvious reasons)

In late 2017 after a long wait green shoots have appeared in stock market earnings, giving hope that current high market valuations may finally be sustainable. The bad news is that 2018 brings with it an expectation of an increase in crude and other commodity prices key for Indian Industry.

This is very bad timing for the economy, particularly small industry which is already reeling from demonetization and GST and is very sensitive to raw material prices.

Among finished goods listed above, the Government of India has also recently imposed duties on steel and cooking oil. I am not sure if these protectionist moves can be termed as a case of central planning overreach or a timely intervention but there are both obvious and less obvious reasons to why a levy of import duties now is critical to protecting small companies.

Globalization as a cause of NPAs

This is a controversial statement but if crime is looked through the lens of intent Essar, Jindal and Bushan Steel did not intend to default on their loans. In other words, manslaughter is not murder. They were not guilty of causing NPAs.

Capacities were being built by these steel makers with the intent to expand business – easy access to loans was just a covenience they enjoyed thanks to political patronage and poor lending controls at banks.

Then the slowdown in steel prices happened. A duty on steel at that point in time may have helped insulate industry and banks. But Chinese steel was dumped in India impacting the turnover of the companies and making them non-viable. The capacities these companies built gathered rust and banks that had financed them took an enormous hit on asset quality.

Credit Situation for MSMEs is tight

A result of the NPA situation is banks are not in a position to lend or are not willing to lend to MSMEs. This raises the cost of capital for MSMEs who must rely on internal accruals to finance growth. Internal accruals in turn depend on their margins which will be under pressure if 2018 sees a major uptick in commodity price inflation.

Operating Leverage is a Necessary but not Sufficient condition for MSMEs to thrive

Lets admit that most MSMEs are involved in downstream value chain activities and commodity businesses. This in turn means their margins are low and are highly dependent on raw material prices as they have little pricing power with their buyers and little bargaining power with their suppliers.

Operating Leverage is one key competitive advantage they can hope to build in their commodity businesses but a major percentage of their costs is still variable.

To give an example – Plastiblends (NSE: PLASTIBLEN), which advertises itself as India’s largest manufacturer and exporter of Colour & Additive Master Batches and Thermoplastic Compounds for the Plastic Processing Industry has 80% of its cost structure as variable costs – its margin being highly dependent on the price of crude. Plastiblends has the highest economies of scale of any plastic master-batch manufacturer in India and even then it has a huge sensitivity to raw material prices.

In a scalable business the average cost of creating the products and/or services fall as the volume of its output increases.

But in the case of rising commodity prices, Operating Leverage will not be very useful for such companies as each additional unit produced will cause an increase in average costs, irrespective of capacities at hand. (Even if somehow they can borrow at reasonable cost of capital from the reluctant banks to build sufficient capacities).

Since smaller MSMEs cannot retain their margins in the face of increased raw material prices they will not be able to transition to becoming larger players like Plastiblends, or even worse, will not be able to survive. This is obviously a very bad scenario for Indian MSMEs and the job market.

Final Thoughts

ROIC or Return on Invested Capital is a degree of attractiveness of a business. ROIC is described as the operating margin multiplied by asset turnover. In other words, the two components that define a company’s fitness are the ability to charge a high spread between price and actual cost, and the ability to generate sales from a small base of invested capital. Import Duty helps protect ROIC of MSMEs by removing competition from cheap import substitution, so if the spread cannot be maintained in a scenario of raw material inflation – the sales of MSMEs atleast can be sustained.

Alibaba didn’t grow in a vacuum, neither did Maruti Suzuki. Government protectionism helps create large home grown industries but for MSMEs under Make in India it may well be a matter of survival.

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