#Agenda2014 Indian Manufacturing Sector

Introduction

Manufacturing sector has been the Achilles’ heel of Indian Economy. Its share in national GDP and employment is quite low by comparative standards. Given the centrality of manufacturing sector in the economic performance of ASEAN tigers, this weakness has been both a puzzle and cause for concern. A weak manufacturing sector is particularly problematic as expansion of this sector is essential for absorbing steady influx of unskilled and semi-skilled rural migrants in urban areas and also for meeting the rising demand of white goods that “revolution of rising expectations” entails.

While some weaknesses of manufacturing sector are endemic, stubborn and well-studied, recent growth slowdown is specifically pronounced in this sector. In 2012-13 this sector grew by a paltry 1.3%. It is obvious that any strategy for revival of growth in manufacturing sector should seek to address these challenges in different time-frames. Accordingly this note is divided into immediate and medium term challenges.

Immediate Challenges

Fiscal Consolidation and shoring up aggregate savings

One of the key drivers of Indian growth story and a source of its robustness was an increase in aggregate saving rate. Saving rates peaked at 36 percent around 2006. The reasons of buoyancy were manifold. First given fiscal discipline induced by Fiscal Responsibility and Budgetary Management Act (FRBM) fiscal dissaving was contained. Second, a benign inflation regime encouraged private savings and channelization of savings into financial assets. Finally high profitability of firms was also reflected in the form of increased savings.

All these factors were reversed in the economic environment under new political dispensation, ideologically committed to left-of-center economic policies. Flagship social sector schemes, electoral transfers in the form of loan bailouts and resistance to unpopular decisions like rising the price of petroleum and fertilizer, often in utter disregard of canons of sound finance, has been the hallmark of new political regime. No wonder FRBM provisions were gradually diluted and finally dismantled. With high level of expected inflation, private savings took the form of gold purchase. Finally corporate profitability too dropped sharply.

As a result, there has been a slippage of around 6 percentage points in aggregate savings that is straining investment. One of the immediate challenges therefore is to stabilize fiscal deficit and shore up aggregate savings.

Strong, credible and ethical governance

Indian institutions have recently come under increasing criticism and scrutiny for corruption and sweetheart deals. Corruption results in redistribution of rent from fisc to corrupt politicians and businessman. This redistributive effect perhaps captures the public imagination and is highlighted by media.

There are other subtle effects though. A more important channel through which corruption affects the economy is the distortion of rules and resulting inefficiencies. Consider the case of preferring beauty contests (i.e. discretionary allocation) of scarce resources such as coal and spectrum over more conventional auction route. An auction route is guaranteed to place the resource in the hands of those who can potentially create most value for the consumers and shareholders. Thus auction not only raises the public revenue but also has additional efficiency considerations as well. An arbitrary allocation will have none of these properties; indeed in the worst cases resources can even be hoarded and stopped from being used productively.

Moreover corruption by flouting norms and legal rules also increases the probability of investigation and prosecution. While in a best of all worlds these procedures work flawlessly, in real world they create lots of friction and uncertainly. Decision making, even honest and necessary, comes to a grinding halt.

Additionally in the absence of a strong and credible political center, there is no mechanism to coordinate different ministries and resolve their differences. Consequently as the Advisory Council to Prime Minister noted in its annual review of the economy:

If one were to pick the most important element in play, the principal source of the problem would be the issue of clearances that have stalled projects and undermined conditions for investment, and therefore for economic growth going forward.

Given these complications it is imperative that after the election a decisive, credible and ethical government with commitments to economic reforms is formed. Importance of a strong political center for economic transformation, particularly in manufacturing sector, can never be exaggerated.

Medium Term Challenges

Soft Infrastructure

Modern economics recognizes soft variables such as laws, rules, regulations and procedures as the deeper determinant of economic dynamics. In particular, for thriving economic activities, cost of setting up new business enterprises, winding up etc should be low and contract enforcement must be robust.

Unfortunately Indian experience in all these areas is far from satisfactory. According to the ‘Doing Business’ database of World Bank, India’s procedures are costly and time-consuming. It takes 27 days and 47 percent of per capita GDP to start a new business; benchmark OECD figures are 11 days and 3.6 percent respectively. Similarly it takes 1420 days to enforce a contract, roughly 1000 days are spent in trial and judgment alone; again benchmark figures are about one-third.

Failure is an inevitable part of businesses, particularly when the venture is risky. It is imperative that winding up and bankruptcy procedures are short and swift so that resources do not unnecessarily remain locked up and various claims are resolved as expeditiously as possible. Shockingly, in India it takes about 4.3 years for a business to close down and recovery rate is extremely low (24.3%); again benchmark (OECD) is 1.7 yrs and 70% respectively.

One can multiply such statistics, bottom line is that soft infrastructure in India is lacking in several respects. While it is a challenge, it also presents a low-hanging fruit. Once procedures are simplified and made less complex, Indian manufacturing sector and entrepreneurship will reach a different growth trajectory altogether.

Hard Infrastructure

In terms of hard infrastructure, we have roads, ports, electricity, water and sources of energy such as coal and gas. Abundant and plentiful supply of these is essential for manufacturing success.

Ports in India suffer from congestion, high ship turnaround time, small vessel sizes and outdated custom procedures. Major liners often tend to avoid Indian ports as they’re perceived to be time-consuming. Modern ports established in private sector such as Pipava by Adani group provide one model of expansion and modernization of port sector. There is an acute need of urgent dredging of old ports such as Kolkata which are operating at the sub-optimal capacity.

Perhaps the most critical part of infrastructure is electricity in particular and energy in general. Most of the State Electricity Boards are accumulating financial losses. They hardly have resources to meet their current expenses, leave aside for investing in new plants and technology. Privatization and reforms in this sector have mostly halted. Transmission and Distribution losses are still high and operational efficiency quite low. Availability of electricity at the consumer’s end is erratic and of poor quality. Voltage fluctuations are a common occurrence. An attempt at cross-subsidization imposes extra costs for businesses. It should be borne in mind that modern CNC machines require good quality of electricity. Fluctuations for even a fraction of second typically mean rejection of entire lot being produced. Moreover in an assembly line production such problems are often cascaded to the next level. If India has to emerge as a leading manufacturing hub, in electricity sector it must come up with novel technological and financial solutions. As the example of Gujarat shows, given political will, challenges are not insurmountable even in a democratic setup.

India has a large network of poor quality roads. With a few possible exceptions, Indian roads are patchy, studded with potholes and suffer from land encroachment. Logistical difficulties created by poor roads have the consequence of increasing lead time between receipt of the order and final delivery of goods. Given high level of competition in sectors such as textile and garments, where due to changing fashion there is strong seasonal component in demand and orders are often time-bound, even a slight disadvantage results in quite large losses.

Correcting Factor Market Distortions

Land and Labor are emerging as the main constraints of Indian manufacturing sector. While antiquated labor laws, loaded heavily in favor of incumbents in organized sector labor unions, have prevented consolidation and entry of organized sectors in labor-intensive industries such as garment, toy-making, footwear etc, a new distortion has been created in the form of Land Acquisition, Rehabilitation and Resettlement Act.

Rather than encouraging a voluntary transaction between land-owners and new entrants to labor market and businesses, our regulatory regime works on paternalistic assumptions.

It is important therefore that new politically feasible workarounds should be found for factor markets. Particularly new entrants should be given options to work for companies at less favorable terms rather than foregoing employment in organized sectoring altogether.

Conclusion

“The problem Dear Brutus lies not in our stars but in ourselves that we’re underlings.“

India is blessed with a favorable demographic profile, stable political institutions, rule of law, effective separation of power, a strong and resilient base of indigenous entrepreneurs and a culture that is largely respectful of scientific inquiry and technological advancement. India also has a large, aspirational population that is shifting to secondary sector for improving its fortune. The deep determinants of nation’s development are favorable. There is nothing structural about India’s manufacturing predicament. With right set of policies, entirely within the power of incumbents, its fortune can be changed for good.