October 27, 2014 7:00 pm JST

Ranjit Goswami: Capital shortage will hobble India's manufacturing drive

India's Mangalyaan Mars probe, which recently entered orbit around the red planet, has focused world attention on a "Make in India" campaign launched by Prime Minister Narendra Modi in August. The new push sets the goal of expanding the country's manufacturing base on a scale that would establish it as a rival to China. No one can dispute the success of Mangalyaan, which was entirely made in India, and is clearly a triumph of Indian technology.

     However, India's goal of becoming a global manufacturing power is challenging for a country where the cost of capital is very high, and the value added per worker very low compared with other Asian countries that specialize in making physical goods.

     After World War II, the U.S. quickly became the manufacturing powerhouse of the world -- in the 1950s it produced half of the world's goods with only 6% of its population. Western Europe, especially Germany, and Japan also built large manufacturing sectors, followed in the late 1970s by other East Asian countries, notably China.

     Many factors were at play, including wage levels, worker productivity and the skills of the available workforce. But all these countries shared a significant competitive advantage as they expanded their manufacturing capacity: The cost of capital was either lower than competitors or -- in the case of China -- not significantly higher, and compensated for by other factors such as scale and the availability of a skilled workforce.

     India, under Modi, is seeking to replicate East Asia's achievement without any of its advantages. The country has been down this path before. In effect, Modi's Make in India campaign is simply a rebranding of earlier manufacturing policies such as the National Manufacturing Competitiveness Program of 2005-06, and the New Manufacturing Policy of 2011. That would not matter if the earlier policies had delivered. They did not: The promised millions of new jobs, and the forecast increases in manufacturing as a proportion of gross domestic product, did not materialize.

     In a globalizing world, other factors have arisen. The cost paid for goods after transportation to the end-destination has become more important than the cost of production. Strong physical infrastructure, leading to efficient and effective integrated supply chains, determines the competitiveness of any national economy aspiring to be a global manufacturing powerhouse, and requires huge state investment. India's infrastructure is notoriously disheveled, and while the government is rightly committed to improvements, it will be many years before this deep competitive disadvantage is overcome. Some of the country's supply chain infrastructure still bears characteristics of the last century, and public infrastructure has been crying out for huge investment for decades.

     India also faces a major problem in its abysmally low productivity, or gross-value-added per manufacturing worker. Nearly 89% of the 50 million or so jobs in India's manufacturing sector -- approximately just half of the number of equivalent jobs in China -- are in informal and unorganized low-productivity sectors.

     The glut of sub-scale and low-productivity manufacturing in India, compared to that of China, becomes clearer when one notes that 84% of manufacturing employment in India is in companies with fewer than 50 employees, compared to just 25% in China. Value-added per manufacturing worker, in this category, is less than 10% of China's level. More than 50% of manufacturing workers in India manage without electricity.

     The minority of manufacturing workers employed in bigger companies is more productive: value addition per employee in the organized sector is more than 15 times that of the family workforce sector. Yet there are simply not enough such companies -- the organized workforce accounts for just 11% of the manufacturing workforce, compared with 57% for the family sector. It is no wonder that China's manufacturing valued-added nominal GDP is more than 11 times that of India's.

India's bottom line

India's biggest problem, however, remains the cost of capital. The level of gross domestic savings, currently running at 26% of GDP, according to the World Bank, is just over half of China's 51%. The rate is far below the investment needs of the nation. Combined with high fiscal and current account deficits, and supply-side constraints in domestic-consumption, this has resulted in persistent depreciation of the Indian rupee, along with high retail inflation -- both of which raise the cost of capital for businesses seeking to modernize and expand.

     All this means that India's capital stock per worker is among the lowest in the world. There has been an improvement lately in both the capital-to-labor ratio and the ratio of fixed-capital-to-labor -- which jumped by more than three times in the period between 1990-1991 and 2009-2010 -- albeit only in the tiny organized manufacturing sector.

     India's gross capital formation rate is inadequate to absorb even a small fraction of the 1 million additional workers entering the job market every month; in fact the challenge is to convert the existing 44 million manufacturing workers in the unorganized sector from extremely low productivity to high productivity, which requires a huge infusion of capital.

     Up to now, the excessively high cost of capital has prevented significant expansion of organized manufacturing, while infrastructure development has often been a loss-making proposition. The weighted average cost of capital has often been higher than the return on invested capital, resulting in an accumulation of non-performing assets in banks.

     There is one reason for optimism. Global food prices have hit a four-year low, and the prices of industrial commodities are subdued because of growth concerns in much of the developed world. Both developments have helped to reduce India's inflation rate, which fell to 6.46% in September, the lowest since January 2012.

     If the downward trend persists, the central bank will be able to reduce interest rates, thus ameliorating the competitive disadvantage of higher costs of capital. That would be a necessary condition for a surge in Indian manufacturing output, but it would do nothing to resolve many of the other issues that hold back the sector.

     The expansion of manufacturing in India is also likely to face headwinds from slower global growth and the deflationary outlook in much of the world, which will hurt critical blocks of the global economy and reduce demand for manufactured exports from India.

     The good news for India is that most issues, such as the poor state of public infrastructure, and the impact of archaic labor laws, are within the country's capacity to resolve. The bad news is that repeated attempts to expand manufacturing in the past have failed, in part because these issues were not addressed.

Ranjit Goswami is Dean (Academics) of the Institute of Management Technology Nagpur. IMT Nagpur is a leading private business school in India.

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