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Unmade in India

The manufacturing bottleneck is created by restrictive labour laws, skills mismatch

Updated: January 25, 2014 9:19:28 am
The manufacturing bottleneck is created by restrictive labour laws, skills mismatch (rEUTERS) The manufacturing bottleneck is created by restrictive labour laws, skills mismatch (REUTERS)

The ambitious National Manufacturing Policy (NMP) seeks to make India a global leader in manufacturing. Unveiled in 2011, the NMP envisions that the share of manufacturing will increase from the current 16 per cent to 25 per cent of the GDP by 2022, besides creating 100 million new jobs. The policy emphasises the establishment of Chinese-style mega-industrial corridors, national investment and manufacturing zones and connecting major commercial centres, like the seven industrial cities being planned along the Delhi-Mumbai freight corridor.

It is hoped that these industrial clusters will promote small and medium enterprises (SMEs) by addressing coordination problems and leveraging economies of scale —  facilitate common forward and backward linkages, lower fixed costs, simplify regulatory clearances, provide policy certainty, etc. However, we need to remember that much the same concept has been an integral part of India’s industrial policy for nearly five decades, with limited success. The NMP may therefore have to be complemented with economy-wide reforms that seek to relax several other binding structural constraints.

In this context, the work of Harvard University Professor Ricardo Hausmann helps shine more light on India’s manufacturing challenge. In brief, a country’s capabilities are encapsulated in the products it makes. Countries grow not by making more of same products, but by moving up the manufacturing value-chain, from their current products to other, usually more complex products. But this structural transformation is easier between closely related product categories, or where there are complementarities in the required capabilities. In simple terms, a region making air-coolers will find it easier to move into making other consumer electronics than one involved in food processing.

Hausmann’s team has constructed a “product space”, which is a network of relatedness among all possible products in the world. A country’s product space — while reflecting the products made by it and how they relate to each other — also represents the opportunities available to move up the value-chain. Based on a comprehensive cross-national time-series database of all products exported by countries, they find that India’s current product diversity endows it with the best opportunities for structural transformation among all countries. But an analysis of changes in India’s export basket in 1998-2010 reveals that far from upgrading to more complex products, as peers like China have done, Indian manufacturing has been stagnating.

The signs are everywhere. Manufacturing’s share in the GDP has remained stationary at 15-16 per cent for more than three decades now, far lower than the 25-35 per cent that characterises the East Asian economies. The sector’s share in employment had declined to 10.5 per cent by 2009-10, eclipsed by construction as the second-largest employer after agriculture. A Planning Commission report reveals that half of the 48 million-net non-agriculture jobs generated in 2004-12 were in construction, whereas manufacturing contributed just 5 million. A McKinsey study claims that more than half the country’s 1,000 largest manufacturing firms did not return their cost of capital in the 2006-10 period.

So what is constraining India’s manufacturing sector? As several recent studies show, India’s massive informal economy — which generates more than half the GDP and employs nearly 85 per cent of non-agricultural labour — highlights a major resource misallocation problem. It is well established that the major share of industrial growth and job creation comes from the growth of small and highly productive formal firms. Informal firms are less productive, poorly managed, stay small, use less capital and create low-paid jobs. Further, small formal firms do not grow out of informality, and hardly any formal firms have ever operated informally.

As evidence from India, the 2005 Economic Census shows that the 7.7 million self-employed and informal manufacturing firms with a 56 per cent share in employment, account for an average of 1.5-2.5 workers, whereas the 0.6 million formal firms employ the remaining 44 per cent at 20 workers per firm. A study by the International Finance Corporation, which compared the relative sizes at start-up of 35-year-old firms in India, Mexico, and the US, found that during this period in India, the size declines by a fourth, in Mexico the size doubles, and in the US, it is 10 times larger.

Clearly, there is something about India’s business environment that encourages small informal manufacturing enterprises and discourages the expansion of formal firms. A differential diagnosis through cross-national comparisons with countries at a similar level of economic development shows that apart from infrastructure bottlenecks, credit constraints, high tax rates and compliance costs, excessive bureaucracy and pervasive corruption, restrictive labour regulations and inadequate supply of skilled manpower are possible factors holding back manufacturing.

Aggregate credit supply trends do not reveal credit constraints faced by SMEs. IMF estimates show that commercial bank loans outstanding to SMEs were just 5.96 per cent of the GDP in 2012, the lowest among large emerging economies. India has consistently hovered near the bottom of the World Bank’s Doing Business indicators, reflecting a business environment that is worse than even its South Asian neighbours and many African economies. A labyrinth of nearly 250 state and Central labour market regulations, most prominently the Industrial Disputes Act (IDA) 1947, places onerous restrictions on the management of work conditions and labour layoffs. Firms prefer to stay below the threshold of 100 workers and hire less productive contract labour to avoid attracting the provisions of the IDA.

A 2012 McKinsey report points to a skills supply-demand mismatch — an excess supply of unskilled labour, inadequate supply of medium-skilled labour and poor work-readiness among those entering the workforce. Seventy per cent of the workforce has primary education or less, nearly double that of other major emerging economies, and just 10 per cent have received some form of skill training, compared to 70-90 per cent elsewhere. Multiplicity of taxes, high tax rates and compliance costs may be among the easier challenges to address.

In a country of India’s size and diversity, these constraints bind in varying degrees across sectors and regions. None of them are amenable to simple solutions. Many require fundamental structural reforms, often long-drawn, led by multiple departments and both Central and state governments. Most importantly, some of them cannot happen without consensus among at least the major political parties.


The writer is an IAS officer, batch of 1999, and a graduate student at the Harvard Kennedy School, US. Views are personal

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