A lot of Indian hopes were pinned on a successfully negotiation of the Bilateral Trade Agreement with the US, which could potentially catalyse a long elusive take off in Indian manufacturing. Whilst we still hope the talks falling through is just a temporary manifestation of Trump’s unique negotiating tactics and we should still be able to pull through sooner than later. But to emphasise how important this is for India, here’s a guest blog at Noahpinion. Noah Smith had asked ‘Can India industrialise?’ in his blog in 2023. This time he invites Prakash Loungani, the Director of the M.S. in Applied Economics program at Johns Hopkins University and Karan Bhasin, a doctoral candidate at University at Albany, SUNY, who write about what’s holding Indian manufacturing back and what can be done to fix it.
“ The 1991 reforms were successful in in many respects, but the success came with an Indian accent. Unlike East Asian peers, which first industrialized before pivoting towards services, India achieved success in export of high-value services even as it struggled with exports of labor-intensive products. Figure 1 illustrates that the share of manufacturing in India’s GDP has remained relatively flat, even as the services sector expanded significantly from 40% to 60% between 1980 and 2024. India is, therefore, paradoxically, a large labor-surplus economy which but struggles with labor-intensive production but instead specializes in production of high-value services (and also goods such as pharmaceuticals and more recently electronics).”
Indeed, they highlight that India’s failure to boost labour intensive manufacturing hasn’t been because of lack of attempts or political will. They go on to highlight various policy incentives both pre and post liberalisation. They analogise the growth in Indian services alongside policy push for manufacturing as: “let’s say that you visit a restaurant and order a Rasgulla – an Indian desert. The chef assembles all ingredients and prepares the desert but even with the right ingredients ends up with a Crème brûlée. Indian policymakers have been facing the same dilemma as they keep preparing the policy mix for manufacturing, only to find services outshine any success. It is therefore an important question on whether India’s struggles are due to the policy mix – or if there is inherently something that prevents manufacturing from taking off in a country with the world’s largest English-speaking college-educated workforce.”
They begin with the now well accepted impediment to unlock the two key factors of production – land and labour.
“Firms in general respond to economic conditions by cutting back the length of the workweek and laying off workers, but the latter route is essentially prohibited for large manufacturing firms in India….India’s labor norms, particularly those relating to industry have imposed stringent conditions for retrenchment of workers, particularly for firms greater than 300 employees.”
They cite studies why this has led to large segments of the industrial economy remaining informal and depriving themselves of the benefits of economies of scale or embracing capital intensive manufacturing. The latter doesn’t solve the employment problem nor does it lend competitiveness given the historically high cost of capital in India (albeit might be changing at the margin).
More importantly, “…These regulations do not apply to service-based firms, which has therefore allowed such firms to increase in size and benefit from economies of scale. Perhaps, an important policy that can help India’s industrialization efforts would be to do away with such regulations and allow for more dynamic adjustments in the labor market. This would indeed subject workers at big industrial units to business-cycle fluctuations – but an alternative way to insure against such risks would be to devise an unemployment insurance-based social protection policy, as recommended by Duval and Loungani (2019).”
Then the challenge with land acquisition, another politically sensitive challenge: “Conversion of land from agriculture to industry has remained as a challenge in many Indian states. The lack of adequate land for industry has meant much higher cost of land acquisition which locks in a considerable amount of capital for firms. To be fair, there was an attempt at reforming these laws in 2015, but political opposition thwarted the effort. Some states have since then worked on resolving these challenges at their own level. States that have adequate land available for industry have gradually benefitted as they have succeeded in attracting greater investments.”
Thirdly, trade restrictions and protection of domestic industry making them less competitive globally.
“All this while, India’s export of services has grown exponentially. Figure 2 illustrates the steady rise in the share of exports in India’s GDP since the 1991 reforms. Moreover, as highlighted by Noah, India’s overall exports of goods and services in terms of GDP are of the same magnitude as that of China. Even for manufacturing, the sectors that have performed well have been those that focused on export markets and were subjected to greater competition. Subjecting the overall economy to greater competition and ensuring lower duties on critical raw materials will be of essence in allowing India to integrate with existing supply chains.
…Prioritizing a trade agreement with the U.S. is particularly important to eliminate tariff-related uncertainty and strengthen the economic partnership between the world’s largest and oldest democracies. Notably, many of India’s competitors already benefit from preferential trade agreements with the U.S., resulting in lower tariffs compared to the 25% currently levied on Indian exports.”
Finally, the ease of doing business, whilst incrementally better in many respects, still not the most competitive, as seen with the unprecedented FDI outflows in the recent past:
“We point at certain disturbing trends with regards to business regulation. The first is the withdrawal from Bilateral Investment Treaties (BITs). These treaties allowed for dispute resolution in a third-party country – presumably one with a more efficient and well-functioning judiciary. Foreign investors would likely require such protection given the large numbers of pending cases across different levels of Indian judiciary. A direct effect of the decision to withdraw from BITs means lowers Foreign Direct Investment flowing into India. Combined with the pivot towards protectionism, it has meant lesser need for urgent capital allocation by firms – many of which have witnessed record profits and sit on healthy balance sheets. Luckily, there has been some re-think on BITs and on international trade, which would address this issue.
The second issue pertains to the issue of cost of compliance for Indian firms which has increased over the last few years. Stringent Know Your Customer norms (KYC) to remove anonymity of money have been introduced as a part of anti-corruption measure. Statutory powers of agencies that investigate economic crimes and tax authorities have expanded to restrict tax evasion. These measures, while important, can often lead to an assault on individual rights particularly in a system where grievance redressal would be delayed in a clogged judiciary. There is a need to reassess and reevaluate these powers given the prospects of their misuse. India’s investors, even if willing to invest might be reluctant given the regulatory landscape.”
The authors finish with this recipe for India’s industrial success: “Perhaps the best ‘masala mix’ to achieve a successful manufacturing base would be to let the state treat manufacturing just as services: that is, to just let them be.”
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