Analyzing India’s Manufacturing Growth Trajectory
Adam Smith and much of his liberalist brethren has long back articulated what presently underlies the economic reform philosophy of Indian policymakers- low tax incidence, higher targeting of service delivery, demand-pull growth, and economics of scale. It is generally accepted that higher tax rates with loopholes embedded in exemptions tend to invite corruption and harassment. This has been the rationale behind the rationalization of corporate income tax and the proposed labor law reforms.
Promoting ease of doing business has significant merits of its own. For one, it leads to nudging consumer investment towards financial markets instead of dead weight economic assets such as gold.
But more interesting nuances come up if we analyze industrial growth trajectory of India. As labour intensive and capital scarce market, the strategic inclination should tend towards spreading out the scarce capital resources over the vast range of labour force available. Despite this common-sense analogy, most corporations do exactly the opposite, i.e. they invest heavily in capital intensive and less labor-intensive industries. Just imagine the consequences of it! Heavy capital invested in modernized machinery to eliminate the dependency over labor. The labor, which is ready to work at abysmally small wages up to the level of Rs.100 per day in factories of Begusarai in Bihar. From any perspective or stance, we can ill afford to squander such precious capital by depriving our labor force of two square meals a day.
In typical economic jargon, we have moved from primary to secondary sector, but within the latter, we have jumped directly to Jets(Capital intensive and labour exclusive) by skipping the Jeans (Labour intensive and Capital Exclusive) sector altogether.
A simple cursory look over industrial development data would corroborate the facts. In past decade, the worker to fixed capital ratio has declined from 11% to below 2%. So has the employment growth figures. worker-to-real GDP ratio in the registered manufacturing sector has also declined from 52.2 in 1990-91 to 17.4 in 2009-10, implying that fewer workers are used to produce one unit of product. According to a recent report by the international labor organization (ILO), total employment increased only by 0.1% between 2004-05 and 2009-10 whereas labor productivity grew by over 34% during this period. The key challenge, therefore, is to somehow nudge the corporates towards reversing this counter-intuitive trend.
While falling labor intensity may not be surprising in capital-intensive sectors as firms in these sectors engage in ‘defensive innovation’ and invest in computerization and machines to ward off foreign competition, the decline in labor intensity in the labor-intensive sectors is not what one expects, given that labor is the source of comparative advantage in these sectors.
Manufacturing contributed in 2017 was only about 16% to India’s GDP, stagnating since economic reforms began in 1991. By contrast, in east and south-east Asia, the industry share has exceeded 30–40% while manufacturing is 20–30%. India’s manufacturing share of GDP has not moved up at all, though between 2004–05 and 2011–12 manufacturing employment growth was reasonable (grew by 6 million, using NSS). However, total manufacturing employment has fallen significantly between 2011–12 and 2015–16 by 10 million in just four years.
The key impediments to the establishment of labor-intensive industries are many-fold. But for a developing country such as India, it could be broadly summarized under four buckets. Firstly, there are Draconian and archaic labor laws and related legislation such as the ones which prohibit retrenchment in any industry employing over 100 workers without taking explicit permission from authorities. Now taking explicit permissions from authorities, more often than not, is a mere euphemism for paying hefty fines and bribes and whatnots to the Babus of the day. Such legal provisions nudge the corporates towards capital intensive industries.
Secondly, the economic fabric of the country is so designed that the brunt of any major economic reform is faced by the JETS sector first. This can be clearly illustrated from the debacle of labor-intensive industries in the wake of GST and Demonetization reforms.
Thirdly, there is a marked decline in the global competitiveness of our labor-intensive industries. Major industries such as textile and jewelry are facing stiff competition from countries like Vietnam and Bangladesh, which possess a first-mover advantage in this regard. And the problem gets exacerbated by the fact that even Indian markets have become import-dependent for these products whose industries had initially proliferated domestically, such as leather, textiles, and gems. Similarly, the export basket of our country has been housing larger and larger shares of mechanized goods. Customs duties had been kept significantly lower giving enough leeway to China, inadvertently to flood our markets with their goods.
Fourth, The lack of growth in export-oriented labor-intensive manufacturing along with the emergence of a highly skill-intensive export-oriented segment of the services implied that the patter of structural change in India was atypical and out of sync with other Asian countries. As a result of this, the typical trajectory of growth in India from agriculture to manufacturing was skewed in an abnormal manner.
Moving ahead of the cause-effect analysis, I would like to analyze where did we go wrong in our approach towards policy design. To a large extent, the eco-political philosophy among Indian policymakers has been guided by a reactionist stance. In addition to this, there has been an appreciable tendency to emulate the growth policies of western and south Asian nations, so as to create a beautiful patchwork of ideas with little originality. Whether it is the LPG reforms or the GST law, nearly every major policy has exhibited these tendencies. A strangled economy at the juncture of economic crises required innovative policy design and subsequent course correction. But lack of strong political ownership along with the intertwined nature of our nation's polity ensured this does not take place. The country’s economy became the scapegoat for lack of original thinking and the impregnation of too much democracy in an immature nation.
The standard explanation for why we may observe a fall in the labor to capital ratio is that this is due to an increase in the real wage to the rental price of capital ratio, where the rental price of capital is the product of the real interest rate and the relative price of capital goods.
If we analyze the movement in labor wages in the organized sector and the capital goods installation cost in the industries, we could see that the latter has been targetted and subsidized by the government ever since the LPG reforms were put in place. Yet another innocent culprit was trade reforms that targeted capital goods in particular and brought their prices down over time. One inadvertent consequence of this was the lessening of the incentives of firms to employ workers, and to quicken the adoption of machines in their workplaces, across the board in organized Indian manufacturing.
The much-coveted GST was introduced in our country a bit too late after the complete debacle of labor-intensive industries was attained. The inverted duty structure (IDS), which has adversely impacted manufacturing for decades, means higher duty on intermediate as opposed to final/finished goods, with the latter often enjoying concessional custom duty under some scheme.
The next point of analysis could come from the fact that most labor-intensive manufactures are food processing, leather and footwear, wood manufactures and furniture, and apparel and garments. These product groups account for 50% of manufacturing employment in India (total manufacturing is 60 million of the total employment in India of 475 million in 2011–12). Unfortunately, however, it is the unorganized segment of these labor-intensive manufacturing firms that employ most workers, not the organized segment.
In India, the compound annual growth rate of labor absorption in the informal sector in the post-liberalization period (from 1999–00 to 2004–05) is 2.76 percent, while in the pre-liberalization period (from 1983 to 1988) it was 1.38 percent. The size of the informal sector has increased not only in terms of employment but also in terms of its contribution to total industrial output and total manufacturing exports by the country. Unorganized manufacturing accounts for 80% of employment and 33% of income in the Indian manufacturing sector (RBI), compared to 14% on average in the OECD and 9% in Brazil. Employees do not exhibit job loyalty to a particular firm and employers evade investing in training them because they fear that the time and cost involved in training will be wasted. All these results in the sector’s inability to maintain quality. The growth in exports of unorganized manufacturing products of India has not increased because of the poor quality of products. More than 90% of entrepreneurs and establishments in the manufacturing sector in India fall in the small enterprises' category. More than 80% of employment is generated by small enterprises in the unorganized sector.
Yet another historical policy mistake has been the rate of institutionalizing trade tariff reforms. Reduction of tariffs during the LPG reforms (1991–1998) has been precipitous, from an average rate of 150% to 40% by 1999, and to 10% in 2007–08, especially in manufacturing. Indian manufacturers, unreasonably protected till 1990, were suddenly exposed to competition. A slower reduction would have enabled them to adjust to import competition, upgrade technology, and compete. The sudden onslaught of lower-priced imports decimated many domestic enterprises. Unfortunately, this overexposure gathered momentum as from the early 2000s, free trade agreements with much of East/South-east Asia reduced tariffs further, flooding Indian markets with Chinese and other country products.
With the advent of alternate employment structures and gig-economy, we can see that there is a wide scope for employment generation even in the unorganized sector if it gets properly regulated. In addition to regulations, a gradual but definite change in the “mindset” needs to be inculcated. People should respect work and move away from the mentality of acquiring degrees/certificates to acquiring skills in line with industry expectations to get a job. Academic learning should be integrated with industry exposure through workshops. Secondly, estimating the skill gap and developing the requisite skillsets in the workforce in a phased yet timely manner requires strong collaboration between government, industry, and academia.
A related explanation highlights a range of supply-side factors, such as infrastructural bottlenecks, poor skills and low literacy rates among unskilled workers in India as possible reasons why firms have been substituting capital for labor.
A closer analysis of the issue from a multi-sectoral perspective can suggest a few areas to look forward to. First, logistics cost as in the cost and time involved in getting goods from factory to destination is higher in India than in other countries. Second, labor costs need to be fair but subject to the ceiling such as: a) regulations on minimum overtime pay; b) onerous contributions that ultimately become de facto taxes for low paid workers by trickle-down effects; c) lack of flexibility in part-time work; and d) high minimum wages in some cases. Third, world demand is shifting towards clothing using man-made fibers while Indian domestic tax policy favors cotton-based production, and tariff policy protects an inefficient man-made fiber sector. Finally, India faces higher tariffs in the US and EU, unlike its competitors, an issue it must raise in the WTO.
Finally, I would suggest policy must go beyond the traditional labor-intensive sectors. Electronics are not very labor-intensive as final products. But in terms of the components and supply chain, it is a sector that creates many jobs. The GST, especially its inter-State component, has resulted in a neutralisation of the IDS, which had come to prevail. The resolution of the twin balance sheet problems (of companies being over-leveraged and banks unable to lend due to mounting non-performing assets), together with the Insolvency and Bankruptcy Code, should now open the floodgates for new manufacturing investment.
