Micro, small, and medium enterprises (MSMEs) are the backbone of India’s economy. They account for about one-third of the economy, and more than 60% of employment. In manufacturing, professional services, and information and communications technology (ICT), they generate about 40% of value added in the economy.
A new McKinsey Global Institute (MGI) report, ‘A microscope on small businesses: Spotting opportunities to boost productivity,’ highlights the vital role of MSMEs. In the 16 economies studied—both advanced and emerging—MSMEs account for two-thirds of employment in advanced economies and almost four-fifths in emerging ones—as well as half of all value added. They also inject dynamism into economies. Globally, about one in five of today’s very large companies scaled from being MSMEs at some point after the year 2000. But in India, it is only one in 10.
But MSMEs struggle with productivity in comparison with large companies. Today, India’s MSMEs are only about 25% as productive as large companies, compared with 29% in other emerging economies, the MGI report finds. In fact, the productivity of India’s MSMEs lags by more than 50% compared to that of large companies.
Raising productivity is the optimal route to healthier incomes and business resilience. In a world beset by uncertainties and a move by some companies to realign their manufacturing and services footprints to build resilience, raising the game of MSMEs is a priority.
For the growth of India’s economy, therefore, raising the productivity of its MSMEs is vital. Narrowing the productivity gap between MSMEs and large companies could boost India’s GDP by approximately 10.5%.
The question is how. Prioritising efforts would help. Our research shows that productivity performances and dynamics differ across sectors—and some offer more potential to create value. Globally, the largest share of GDP from improving their MSME productivity ratios is in sectors like retail and wholesale trade, and manufacturing, which have the most output. In India, they offer more than 40% share of value added.
Prioritising sectors and sub-sectors that represent sizeable value, like ICT, legal and accounting, chemicals, pharmaceuticals, etc., would make sense in order to concentrate efforts and use available resources effectively.
A key part in tapping the potential lies in strengthening networks and interactions between MSMEs and other firms. It is notable that business-to-business MSMEs have a 40% lesser productivity gap than business-to-customer MSMEs.
When small businesses work with large companies, their productivity and that of their larger partners benefit. For example, automotive MSMEs gain operational proficiency through systematic interactions with productive original equipment manufacturers (OEMs), and small software developers benefit from talent and capital ecosystems seeded by larger companies.
And the benefits flow both ways. In two-thirds of the sub-sectors studied, the productivity of MSMEs and large companies is in lockstep. This interdependent relationship is even more pronounced in manufacturing, where productivity levels of MSMEs and large companies are correlated across countries, in about 80% of the 24 sub-sectors analysed. This has important implications for how to approach MSMEs’ relatively low productivity. Governments have tended to tackle it by creating incentives, quotas, or protections to tilt the balance towards either smaller enterprises or, indeed, larger ones.
But our evidence of the win-win dynamic, where the productivity of both MSMEs and large companies goes hand-in-hand, suggests a different approach is merited—creating the right economic fabric for all companies. So beyond conventional policies focussed on MSMEs, efforts should include strategies to build “collective productivity” by strengthening networks and interactions between large and small businesses.
Big firms can help MSMEs in their networks to build digital and R&D capabilities as well as an ability to develop the skills of their workforce. By showing lenders that an MSME is part of a settled network, large companies can help that MSME gain access to finance. For their part, MSMEs can proactively pursue relationships not only with large companies but with each other. An OECD study of SMEs operating in Asean economies found that they perform better when they are allied with large enterprises, and also when they strike partnerships with other MSMEs.
In India, some of the highest potential to create value lies in sectors and sub-sectors where large companies are highly productive and where building networks between MSMEs and large companies can help. Other high-potential sub-sectors are those where both small and large firms lag behind on productivity. In these cases, policy that aims to help both together, including, for instance, a transparent and fair regulatory framework, combined with action to improve infrastructure, such as reliable logistics networks, access to basic utilities like uninterrupted power supply, and the availability of 5G, would be a way forward.
Pulling this off is not easy and requires granular understanding of MSME productivity in order to tailor approaches. The potential is sizeable, but efforts to capture it need to be thoughtful and targeted in a way that can create a win-win for all companies—small and large.
Anu Madgavkar is a Partner and Kanmani Chockalingam is a Fellow with the McKinsey Global Institute. Views are personal