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Definition of SME

SME stands for Small to Medium Enterprise.

MEDA SME Definition

Small & Medium Enterprises are defined as follows, as approved in SME Policy 2007

Enterprise Category Employment Size (a) Paid Up Capital (b) Annual Sales (c)

Small & Medium Enterprise (SME) Up to 250 Up to Rs. 25 Million Up to Rs. 250 Million

SME Definitions used by various institutions in Pakistan

Institution Small Medium

SME Bank Total Assets of Rs. 20 million Total Assets of Rs. 100 million

Federal Bureau of Statistics Less than 10 employees N/A

Punjab Small IndustriesCorporation

Fixed investment. up to Rs. 20 million excluding land andbuilding N/A

Punjab Industries Department Fixed assets with Rs. 10 million excluding cost of land

Sindh Industries Department Entity engaged in handicrafts or manufacturing of consumer or producer goods with fixed capitalinvestment up to Rs.10 million including land & building

State Bank of Pakistan (SMEPrudential Regulations)

An entity , ideally not being a public limited company, which does not employee more than 250persons ( manufacturing) and 50 persons (trade / services) and also fulfills one of the followingcriteria:(i) A trade / services concern with total assets at cost excluding land and buildings up to Rs 50million.(ii) A manufacturing concern with total assets at cost excluding land and building up to Rs 100million.(iii) Any concern (trade, services or manufacturing) with net sales not exceeding Rs 300 millionas per latest financial statements.

SME Definitions in selected Asia Pacific Economic Cooperation (APEC) member countriesEnterprises exporting up to US$2.5 Million a year are considered Small by the State Bank of Pakistan

Country Sector Employment Other Measures

AustraliaManufacturing Less than 100 employees

Services Less than 20 employees

CanadaManufacturing Less than 500 employees

Services Less than 50 employees

China Varies with Industry Usually less than 100 Employees

Indonesia Less than 100 employees

Japan*

Manufacturing Less than 300 employees 100 million assets

Wholesaling Less than 100 employees 30 million assets

Retailing-Services Less than 50 employees 10 million assets

KoreaManufacturing Less than 300 employees

Services Less than 20 employees

Malaysia Varies (for SMI) Less than 75 employees (Different for BumiputraEnterprises) Less than RM 2.5 million

Philippines Less than 200 employees P 40 million assets

Singapore Manufacturing less than S$12 million fixed assets

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Services Less than 100 employees

USA Less than 500 employees

In the given scenario Small and Medium Enterprises (SMEs) are considered to be one of the principle driving forces in the economic development of Pakistan. Anecdotal

evidence suggests that despite the decline in the large sector growth rate, SME sector hasmanaged to grow at an average above 8% since they are relatively flexible and can adaptquickly to changing market demand and supply situations. Their ability to generateemployment and to diversify economic activity can make a significant contribution toexports and trade, create employment as well as alleviate poverty in Pakistan.

Why SME important for economic growth

Small and medium-sized entities are contributing the lion share to economic growth also in anycountry They produce 68% of all exports are from sme. Which is much more than in other countries.

IMP L I C A T I ONS O F MONE TA RY P O L I C Y FO R SME S

The monetary transmission mechanism is a process through which monetary policyactions affect the ultimate policy goals i.e. output and inflation. Due to considerable lagsbetween monetary policy shocks and their effects on policy variables, it becomes crucialto forecast the possible impact and extent of monetary policy actions on the realvariables. Interest rate channel is the most extensively discussed and recognizedmonetary policy transmission channel. The fundamental nature of this channel makes itnot only relevant to the economy at large but also serves as an important medium of transition in SME sector. Transmission through this channel hinges on the relationshipbetween changes in the policy rate and short term nominal interest rate and subsequentlylong term real interest rates. Shifts in long term real interest rates affect aggregateconsumption, business investment and other components of aggregate demand.

Tightened monetary policy over the last few years kept on increasing the policy ratewhich caused upward shifts in the yield curve. Cost of financing has gone up due tohigher long term interest rates which constrains investment in SME sector.

Credit channel transmits those changes in monetary policy that affect firms tendency toborrow money as well as banks capacity to lend money. Such policy changes arecontrolled by the structure of financial system and its regulation. SBP, in consultationwith relevant stakeholders, is undertaking a detailed review of existing PrudentialRegulations for SME Financing. This review is an attempt to facilitate SMEs access tocredit by proposing separate definition and regulations for them. Exchange rate channelinvolves policy-induced changes in domestic interest rate, their impact on exchange ratewhich subsequently affects the aggregate demand through foreign financial flows and netexports.

The efficacy of this channel is highly dependent on sensitivity of exchange rates tomonetary policy shocks, the extent of economys openness and responsiveness of foreign

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inflows and net exports (including exports of SME sector) to the changes in exchangerates. Furthermore, changes in exchange rate have an impact on the domestic price of imported production inputs (raw material etc.) and in turn affects the cost of productionof SMEs which are mainly dependent on imported raw material.

Developments in Monetary Indicators

Governments record borrowing of Rs. 216 billion from The State Bank in the first 70days of the current fiscal year raised Net Domestic Assets (NDA) of the banking systemwhich, being one of the components of money supply , consequently increased M2.

Increased government borrowing restricts the scope of SME sector in particular andprivate sector in general to gain from the available credit. This link can also besubstantiated by the above mentioned trends of monetary indicators. Furthermore, risingSME sectors nonperforming loans (NPLs) also encourage risk averse banks to prefer government borrowing requirements over SME sectors investment.

Inflation Trend

Already fragile macroeconomic outlook has further been hit by devastating floodscausing serious implications for macroeconomic growth and stability. The rise in MoMFood Inflation to 5.1 percent and MoM Consumer Price Index (CPI) Inflation to 2.5percent in August 2010was predominantly due to floods as it caused disruption in thesupply chain of food items and was above the average MoM growth (during Ramadan inprevious five years) in Food and CPI Inflation which are 1.6 percent and 1.1 percentrespectively. In October 2010, MoM food and CPI inflation fell down to 0.1 and 0.6percent respectively. Raw materials, fuel and electricity are the major production inputsused by SME sector. These production inputs are mainly covered under the non foodbracket of CPI inflation and Wholesale Price Index (WPI) inflation, which in contrast tofalling CPI food inflation increased to 1.1 and 4.2 percent respectively in October 2010,which increases SMEs cost of production. According to SBP the average YoY CPIInflation for FY11 is projected to come down between 13.5 and 14.5 percent. On theother hand, likely increases in electricity prices and increasing government borrowingsfrom SBP together with introduction of reformed GST make expected inflation evenmore uncertain.

IMP L I C A T I ONS O F F I S C A L P OL I CY FO R SME S

Stabilization policies (monetary and fiscal) have a significant role in combating thechallenges of economic growth and price stability. Monetary policy represents thedecisions regarding the optimal level of money supply and interest rates while fiscalpolicy is associated to taxation and spending decisions of the government. Although thescope of this document is by design exclusive to the monitoring of fiscal policy changesand their impact on SME sector,Over the last five years, slow revenue growth and higher expenditure led to higher fiscaldeficit. Consequently, fiscal policy had been shifting largely at the cost of development

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expenditure. Revenue balance is the difference between the total revenue and currentexpenditure and corresponds to governments savings or dis-savings behavior. Thereshould be sufficient amount of total revenue to at least finance the current expenditures Inorder to reduce the fiscal deficit, the government needs to generate higher revenuespredominantly through an efficient tax system rather than curtailing development

expenditure.

SME Sector related Fiscal Policy Shocks

There are two broad categories of fiscal policy shocks, Taxation and GovernmentSpending. In order to monitor SME Sector related policy shocks, relevant changes under each category need to be examined.

TaxationFollowing are the relief measures announced in the Federal Budget 2010-11 that can helpSMEs reduce their cost of production inputs to some extent:

Reduction of customs duty on crude palm oil from Rs.9, 000/MT to Rs.8, 000/MT todecrease cost of vegetable ghee and oil. Reduction of duty on raw materials for laundry soap and detergent to provide relief togeneral public. Exemption of customs duty on import of fully dedicated LPG buses and dispensingequipment to encourage use of cheaper environment friendly fuel. Exemption of customs duty on import of raw materials/ components for energy savinglamps to support its local manufacturers. Exemption of customs duty and sales tax on rice processing machinery to boost valueaddition and export of rice. Reduction of duty on raw materials of leather industry to encourage leather exports. Reduction of duty on raw materials of glass industry to make them more competitive. Reduction of duty on secondary quality tin mill black plate for manufacturers of tinplate to reduce their manufacturing cost. Exemption of duty on milk filters to support dairy industry. Withdrawal of restriction on adjustment of FED paid on beverage concentrate is aimedat attracting new investment in beverage industry and reducing the prices of aeratedwaters in the country. Reduction of advance tax on monthly industrial and commercial electricity consumptionfrom 10 in FY10 to 5% in FY11.

5% tax credit for a company in the year of its enlistment in any registered stock exchange in Pakistan. On the other hand, some revenue measures which may havenegative impact on SME sector are as follows: Enhancement of tax rate for small companies from 20% in FY10 to 25% in FY11. Rise in withholding tax on imports from 4% in FY10 to 5% in FY11. Rise in the rate of sales tax from 16% in FY10 to 17% in FY11. Introduction of 10% FED on air conditioners and deep-freezers. Increase of FED on Natural Gas from Rs. 5.1 per MMBTu in FY10 to Rs. 10 per MMBTu in FY11.

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Government Spending

Government spending is another fiscal tool that is used for policy adjustment.Government expenditure comprises of two distinct strands i.e. current expenditure and

development expenditure. Development expenditure is further divided into two strands;Public Sector Development Programme (PSDP) and other development expenditures.SME related development expenditure is largely covered under PSDP throughprogrammes/ projects undertaken by various government ministries and departments. Thechanges in PSDP expenditure most relevant to SME sector are largely being focusedhere. This degree of relevance has been inferred on the basis of Ministries/Departmentsdirect involvement in SME related PSDP projects

As evident in the table above, the overall size of Public Sector Development Programme(PSDP) for 2010-11 is Rs 663 billion that is 30% above the revised estimates 2009-10while the PSDP size for SME sector related divisions has decreased. The forthcoming

provincial legislation of the draft of Reformed General Sales Tax (RGST) which is anattempt to restore original form of GST distorted by exemptions along with rehabilitationof flood affected areas are going to influence governments fiscal stance. Therefore,budget 2010-11 is prone to a revision in its revenue and relief measures as well as itsallocation of government expenditure. These revised estimates may provide completelyopposite inferences. Corresponding to the available estimates, SME sector may benefitfrom the proposed tax credits and reduction and exemption of duties however these relief measures may also be outweighed by the governments revenue measures such asenhancement of tax rate for small companies, withholding tax on imports and sales taxalong with reduction in SME sector related development expenditure.

R E F O RME D G E N E R A L S A L E S T A X B I L L (RGS T ) 2 0 1 0 & SMES E C T O R

Stagnant Tax-to-GDP ratio has brought forth a dire need of undertaking a few revenuemeasures. There is no second opinion on the subject of implementing a broad-basedmodern form of sales tax on goods and services so as to increase countrys tax revenues.The original SalesTax Act 1990 was designed on the basis of recognized value added taxation principlesdue to which this tax regime is often phrased as GST in VAT mode. Unfortunately, thisAct had been distorted and restricted to a narrow base through political compromises andrevenue constraints in the shape of ever-expanding exemptions, special

regimes, multiplicity of rates and several other deviations from international bestconcepts and practices. Since the introduction of Value Added Tax (VAT) triggered apolitical hullabaloo and disagreement among various segments of the country, it has beenproposed to rely on the value added tax doctrines in the original act and broaden the taxbase by integrating exempted sectors and imposing a uniform sales tax rate, instead of multiple rates. The Cabinet has approved the Draft to table the Reformed General Sales

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Tax (RGST) Bill for discussion and approval of the Parliament. This bill, if approved,will replace the present Sales Tax Act, 1990. Pakistan, SME-related tax reforms in thebill need to be highlighted in specific and are as follows:

A uniform sales tax rate of 15 percent has been proposed, instead of rates ranging

between 17 and 26 percent. GST will replace the existing regimes of sales tax and excises on services and apply onboth at import and local supply stages. Annual uniform exemption threshold is proposed to be enhanced from Rs. 5 million toRs. 7.5 million to keep small businesses including small traders / retailers / cottageindustry out of mandatory tax compliance. Local consumption of sectors like textile (including carpets), leather, dairy products,surgical and sports goods has been subjected to tax that is, in one way or another, goingto affect the SME sector. Correspondingly, agricultural inputs (e.g. pesticides etc.) andagricultural machinery have also been proposed to be taxed. GST will be levied only on value added component of each stage of the supply chain

and there is a provision to adjust the tax paid at preceding stages in the supply chain dueto which net tax incidence remains as a single stage levy. Automatic input tax adjustmentfacility leads businesses towards voluntary registration so that they can benefit fromsuch adjustments and improve their cash flows. This is going to encouragedocumentation and self compliance of small and medium businesses. Exemptions on certain goods and services have been kept intact and include basic fooditems (e.g. wheat, rice, pulses, vegetables, fruits, live animals, meat and poultry) andedible oil. Despite an enhanced uniform annual exemption threshold and automatic taxadjustment led incentive for documentation and self compliance, the aforementionedreforms also have some repercussions for the SME sector. RGST on inputs and serviceswill increase RGST on inputs and services will increase the cost of production andservices e.g. raw material, logistics, electricity, gas, communication, leasing and bankingcharges etc. It will lead small and medium size manufacturers and wholesalers to increasetheir prices which will affect the end consumer. Most of the sectors brought under this taxbracket are based on SMEs and tax on their local consumption will directly increase their prices. The sectors under discussion are textile (including carpets), leather, dairyproducts, surgical and sports goods. Looming and stitching sectors of textile industry aremainly SMEs and also vulnerable to RGST imposition. Moreover, governments inabilityto release previous tax refunds and export rebates raises concerns about the smoothclearing of GST refunds. In case of delays in tax refunds, the exporter or entrepreneur invalue-added sectors such as textile will face shortfall in working capital. On the other hand, cost of financing working capital is also rising as mark-up rate is continuouslyincreasing. These issues together with increased utility tariffs and cost of raw materialswill eventually reduce the industrial output and subsequently exports volume. Balance of payments will also be disturbed by the ensuing export curtailment. The SME sector, byand large, lacks the complete documentation of tax returns and therefore is unable toavail tax adjustments right away. Although it promotes documentation, the proceduraldelays in registration may lead to serious cash flow bottlenecks The imposition of RGSTis currently under debate among policy makers and major

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Stakeholders. While there may be differing points of views on the issue, the inevitabilityof broadening the countrys tax base and increasing tax revenues cannot be denied.

ABOUT SME O B S E RV E R

In the absence of any specific mechanism for provision of such practical informationto businesses and in particular to small and medium enterprises, the SME Observer would serve as a handy tool. The publication includes sections on SME Trade, PriceTrends, Raw Materials and Macro Economic Policies with specific reference to SMEs.As a business intelligence tool the publication would be useful for entrepreneurs,providing information on business input costs and trends, export markets and keyeconomic indicators, such as interest rates, government expenditure and taxation.We are hopeful that the analysis presented in SME Observer will be useful for policymakers, academia and entrepreneurs