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A make in India conundrum

How much we make will depend on the interest rate, how much is exported will depend on the exchange rate.

Written by Vinay Bharat Ram |
Updated: February 9, 2015 12:17:39 pm
India should look to manufacturing for its internal market. India should look to manufacturing for its internal market.

RBI Governor Raghuram Rajan’s remark in his December 12, 2014 Bharat Ram Memorial Lecture on “Make in India, Largely for India” caused a lot of controversy. Arvind Panagariya argued in favour of export-led growth for India, as was the case with South Korea, Taiwan, Singapore and Hong Kong, especially given the vast pool of unskilled labour in India that can be adapted to low-wage products like garments, shoes and sports goods.

Rajan’s argument is based on the premise that the kind of economic growth that favoured Chinese exports to the US and Europe is slowing down in those countries and is likely to remain so in the foreseeable future. Therefore, India should look to manufacturing for its internal market.

Both Rajan’s and Panagariya’s arguments fail to get the complete picture. Panagariya seems to want to use exports as a driver of employment generation for our vast pool of unskilled and semi-skilled labour, overlooking the fact that a large and growing volume of our exports now comprises of engineering goods, pharmaceuticals, software as well as components and semi-finished goods wherein skilled labour is required. While textiles and traditional items are still a significant part of our export basket, real growth will come from the aforementioned categories.


This brings us to Narendra Modi’s campaign for “Make in India”. It is a laudable objective, but it needs to be understood in all its dimensions. To begin with, a modern product like an automobile, a white good or a machine is seldom manufactured at one go. They use components and sub assemblies put together to get the final product over time. Irrespective of whether a foreign firm brings in FDI or an Indian firm sets up a manufacturing facility, the process will begin with making simpler components and gradually move to more complex ones.

The question is what proportion, in terms of components and sub assemblies of the final product, should be made indigenously and what proportion imported. This is largely determined by the foreign exchange rate, assuming the interest rate and other cost factors as given, except in the case of defence items, which are produced based on strategic objectives. How so?

Let’s take the example of China that, over decades, kept its exchange rate in relation to the US dollar artificially high. This resulted in a barrier to the import of wholly built-up goods like automobiles and others, made not just in the US but also other developed countries. Consequently, automobiles in knocked down form as well as other semi-finished goods were imported by China mainly through FDI and assembled using cheap indigenous labour.

Again, the process of moving from the manufacture of simple to more sophisticated components or import substitution took place in China.

RBI Governor Raghuram Rajan. RBI Governor Raghuram Rajan.

Another notable example of a similar phenomenon is when, in the 1980s, the Japanese yen appreciated exorbitantly vis-à-vis the dollar, owing to Japan’s growing trade surplus. This was also the time when their cars had become hugely popular and were in great demand, especially in the US. The exchange rate of the yen vis-a-vis the dollar, however, acted as a barrier. Japanese firms then had no option but to set up assembly plants in the US and utilise cheap American labour and components to make cars for the American market.

Cheap American labour? Yes, you heard right.  This is what the exchange rate can do. So, is Modi’s dream of “Make in India” going to be fulfilled? Or should we say, Rajan’s suggestion of “Make in India for India”?

Modi’s dream can, of course, be fulfilled — except that the barrier at this point in time is not the exchange rate but the interest rate. Despite a steady fall in the rate of inflation, both wholesale and retail, the interest rate is exorbitantly high. The real rate of interest, which is the nominal rate minus the inflation rate, is in the range of 7 to 8 per cent, which in most countries would set off alarm bells if it exceeded 3 per cent. The recent rate cut, though small, is a welcome development, provided it is followed by further rate reductions.

The question, however, is why Rajan took so long to initiate it. To get an answer, we must go to the root. The University of Chicago, Rajan’s alma mater, which gave to the world some of the greatest monetary economists like Friedrich Hayek, Milton Friedman and, later, Robert Emerson Lucas, Jr. Lucas postulated the “theory of rational expectations”, which says that people are generally rational and using past experience and current knowledge, they can make an accurate forecast about the future, thus leaving little or no room for uncertainty. In other words, the future is probabilistic and measurable as opposed to uncertain.

Given such a frame of mind, someone in Rajan’s position could well say that, based on past experience and current knowledge,
we can make a probabilistic model of the future and this model tells us that inflation will rise or remain unstable. One wonders if the falling oil and commodity prices were actually factored into the falling inflation rate, or were they “black swans”?

Manmohan Singh, the chief guest at the Bharat Ram Memorial Seminar and a Keynesian, who could well represent both Cambridges, in the UK and Massachusetts, would most likely say that knowledge is seldom perfect and the future is uncertain and, therefore, not amenable to rational measurement.

Furthermore, human sentiment and certain “animal instincts” — not necessarily rational — drive markets and investment behaviour. He would also say as a Keynesian that the negative impact of high real interest rates on growth, employment, capacity utilisation and investment should be unacceptable in both human terms and in terms of “Make in India”. Further, even if deficit financing were to be undertaken to encourage investment, this may not be objectionable as it could lead to greater employment, demand and, eventually, higher tax revenue.

To sum up, how much of what we make is exported or sold domestically will depend upon the exchange rate; and how much we make will depend upon the interest rate, ceteris paribus.

The writer is an industrialist and visiting professor of economics at IIT, Delhi

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