Make in India essentials

Written by Gulzar Natarajan

December 29, 2014 

The more important concern is the difficulty faced by informal firms in accessing credit. But this is more a matter of informality than access to credit.

The prime minister has declared his goal of “Make in India” with “zero defect” (quality) and “zero effect” (on the environment). As a vision statement, there could not be anything more appropriate. But walking the talk is, arguably, the challenge.

India’s manufacturing has been a puzzle. Since the late 1970s, even as its peers in East Asia have greatly diversified into manufacturing, the sector’s share has stagnated at around 15 per cent of the GDP. It is not that past governments have not tried to revive manufacturing. For decades now, not just the Centre, the states too have had an industrial policy. At some time or the other, many states have even pursued it vigorously. Some of these policies have also been well designed. But the results have been universally disappointing.

This alone should be adequate to chasten us about the task at hand. The revival of our stagnant manufacturing sector is arguably the biggest economic challenge India is facing. Unfortunately, the problem is complex and intractable, demanding several, often diffuse, sets of solutions.

So what is holding back India’s manufacturing? The potential candidates are obvious, though their relative importance is contentious. Sorely deficient infrastructure, inhospitable business environment, corruption, poor quality of human resources, problems with access to timely and adequate credit, difficulty of getting land, high burden of taxation and restrictive labour regulations would figure prominently on any list.

In an ideal world, public policy would be tailored to address all these problems. But in the real world, governments have limited resources and face serious administrative and political limitations. Further, many of these are intimately linked to the country’s stage of development.

One way to prioritise among them is to do a differential diagnostic of the various constraints facing the sector to identify those primarily responsible for holding back manufacturing growth. In other words, such binding constraints are those factors whose relaxation generates the greatest bang for buck. This approach was popularised by economists Dani Rodrik, Andres Velasco and Ricardo Hausmann in the early 2000s and has since been embraced by many countries across the world in designing their industrial policies. In their own words, growth diagnostics is simply “a strategy for figuring out the policy priorities”. Simple as it sounds, in the context of India’s manufacturing sector, it is a formidable exercise. Here is a simplified diagnostic analysis of the sector.

Infrastructure tops the list of most surveys on doing business in India. In particular, chronic deficiencies in transportation and power impose prohibitive costs and lower business competitiveness. Multiple enterprise surveys have identified electricity as the biggest constraint. Further, India lags behind on every measure of transport connectivity. Though there have been considerable recent successes spurred by private participation, much needs to be done.

Credit access for small and medium enterprises (SMEs) is a concern even in developed economies. Interestingly, among the ten parameters in the World Bank’s Doing Business Survey (DBS), India scores best on access to credit, better than its emerging market peers. Other surveys also confirm this. The more important concern would be the undoubted difficulties faced by informal firms in accessing credit. But then, this is more a matter of informality than access to credit.

Scarcity of land and skilled labour have already started troubling businesses, though it is difficult to describe them as binding constraints. Consider land: Over the last decade, several states have generously allocated massive amounts of land, virtually free of cost, for the establishment of manufacturing facilities. But, pointing to constraints that go beyond land, only a minuscule proportion of these investments have materialised.

Our poor human resource quality — 70 per cent of the workforce is educated up to the primary level or lower, though only 10 per cent has received some skill training — is likely to emerge as a constraint in the days ahead. However, work of economists like Aashish Mehta and Rana Hasan finds little evidence that the skills gap is a binding constraint. It is more likely that businesses are unable to hire skilled workers at affordable wages. A more sustainable strategy to bridge the “employability deficit” is to fix the quality of school education.

The regulatory hurdles are equally onerous. India has some of the most restrictive labour regulations. But evidence on growth in the manufacturing sector from states that have eased hiring and firing regulations is, at best, mixed. In any case, a gradual reform process on this is afoot and given its politically contentious nature, this could be the best strategy forward. A bigger constraint may be labour-related taxes, as pointed out by Manish Sabharwal in these pages (‘Pains of the pay cheque’, IE, November 25). They not only impose prohibitive costs on employers but also an unbearable burden on employees, thereby forcing both sides into informal contracting.

High taxes erode business competitiveness. The 2015 DBS reveals that Indian firms’ total tax obligations are among the highest. A multiplicity of indirect taxes raises both the tax burden as well as administration costs. Fortunately, the rationalisation of indirect taxes through the proposed goods and services tax should significantly address this. In any case, our less-than-encouraging experience with tax concessions, the core of numerous Central and state industrial policies over the years, does not lend credence to the view that taxation costs are a binding constraint.

Finally, we have the business environment. Here, I am referring to the interface with various organs of the government in accessing transactional services — procuring land, starting a business, getting utility services, enforcing contracts, resolving insolvency and recurrent routine contact. As numerous studies and surveys show, corruption and harassment plague these transactions. It has an even more pernicious effect on incentives.

Such hostility encourages businesses to start and remain informal, thereby perpetuating India’s overwhelmingly dominant informal sector. All the aforementioned constraints bind with much greater force on informal firms. It also discourages expansion of small business, a major source of job creation, reflected in the “missing middle” of India’s firm-size distribution. While many of these transactions can be eased by simplifying the regulations concerned, their implementation would run into state capability and related governance problems.

Apart from all these, sound macroeconomic policies are necessary to create a low-inflation, low-interest rate and high-growth environment that is essential for the country’s global manufacturing competitiveness.

In conclusion, labour taxes, infrastructure, and the business environment appear to be binding constraints on the revival of India’s manufacturing sector. However, given the huge size and vast diversity of the country, a diagnostic for each state may be a more prudent strategy. In any case, instead of big-bang reforms, sustained efforts in multiple directions, which cumulatively generate large effects, are required to relax these constraints so that we can realise the goal of making in India.

Natarajan is an IAS officer, batch of 1999. Views are personal

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