China Plus One: Address challenges to help India’s manufacturing to benefit

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China Plus One strategy of diversifying manufacturing and production to new locations has gained momentum since the pandemic. Supply chain disruptions amidst COVID-19 lockdowns, rising labour costs and growing strategic concerns around the concentration of production, have provided a fresh impetus to this shift.

Multinationals are looking at alternative destinations for reducing their reliance on manufacturing in China. India is emerging as a viable alternative, given some of the inherent advantages like a large labour pool with a demographic advantage, a growing consumer market along with government’s policy focus on ramping up the manufacturing base.

Many policy initiatives and reforms have been announced with the objective of increasing the share of manufacturing in gross value added (GVA) to 25 percent. In 2019-20, the sector contributed 17.1 percent of GVA and exports accounted for 20.7 percent of the total manufacturing output. According to the World Bank, India’s manufacturing sector as a proportion of GDP remains much below the world average as well as most peers.

The Make in India campaign has set a growth target of 10 percent for the Indian manufacturing sector over the next decade. Growing at that rate, its share could reach 25 percent of the GVA by 2030, making India a manufacturing hub with a large export base. However, that would require addressing some of the challenges which have kept India’s manufacturing sector relatively stagnant.

Several policy initiatives taken by the government to develop a low-cost manufacturing base have helped place India at the cusp of a capex cycle. A few critical ingredients for that take-off are in now place – capex orientation of the central government spending along with policy focus to enable private investments, improving health of the banking and corporate sectors, and the ongoing normalisation post-pandemic that’s helping to improve capacity utilisation levels in the manufacturing sector.

Policy Push

The central government’s investment orientation through public capex in infrastructure is creating an enabling environment to crowd-in private capex. Various policy measures have also been announced post the pandemic in addition to measures already undertaken. These include a corporate tax regime rationalisation, simplification of the labour laws, implementation of the goods and services tax (GST) to create a common national market and liberalisation of the foreign direct investment (FDI) regime with opening up of sectors like defence and space.

Under the production-linked incentive (PLI) scheme, fiscal incentives worth Rs. 1.97 trillion for 13 critical sectors, over a 5-year period, have been announced to boost domestic manufacturing and exports. That is likely to draw in foreign and domestic investment in these sectors. New technologies are getting a push under this scheme.

A PLI scheme for the fabrication of semiconductors, announced in December 2021, with a fiscal incentive of Rs 760 billion, is already drawing interest from domestic and foreign companies. A thrust towards green energy, with a target to reach an energy mix comprising 50 percent renewable energy by 2030, would see a greater generation of clean energy.

Improving roads, ports and railways network under the National Infrastructure Pipeline and PM-GATI Shakti scheme would close the logistics infrastructure gap and help improve productivity and export competitiveness. In the auto sector, a policy focus shift towards electric vehicles (EVs) is expected to provide a tailwind to investment in the sector.

Fourth Industrial Revolution

India’s manufacturing sector is also well placed in the backdrop of the world going through a fourth industrial revolution (IR-4). India’s advantage in the information technology service sector is expected to benefit the adoption of IR-4 technologies such as the Internet of Things (IoT), cloud computing and analytics and artificial intelligence (AI) for smart manufacturing.

A well-developed public digital infrastructure with growing internet penetration and the launch of 5G services would help facilitate large-scale adoption of IR-4 in the manufacturing sector, which is yet to happen. Technology intensity of India’s manufacturing sector is likely to increase over the next decade as new technologies like 3D printing, renewable sources of green energy, new modes of transportation and improving digital infrastructure help develop a smart manufacturing ecosystem capable of customised industrial production.

However, scaling up manufacturing to a size where it is globally competitive abounds with challenges. Main challenges include low participation in the global value chains, low expenditure on research and development (R&D), gaps in the physical infrastructure and skill shortages in the labour force along with low labour force participation.

Participation in global value chains (GVCs) allows a greater share of world trade through backward and forward integration into the complex global supply chain for various manufactured products. Backward participation refers to the role of a country in assembling with low domestic value addition to exports, while forward participation refers to climbing up the ladder with increasing domestic value-added content in foreign exports.

As per an analysis in the June 2022 RBI bulletin, both backward and forward participation of India has improved over the period of 1995-2018, but it remains low. Between 1995-97 to 2016-18, India’s forward participation in global value added of exports increased from 0.6 percent to 1.6 percent, while backward participation increased by a meagre 0.5 percent. In comparison, China’s forward participation increased from 2 percent to 8.4 percent over the two time periods.

Addressing Challenges

In order to engage more in the global supply chains, a rationalisation of tariff levels and non-tariff barriers is required.  Downward adjustments in average import tariff levels, which remain higher than other emerging market economies (EMEs), can help in enhancing competitiveness and higher participation in GVCs. For instance, as per the WTO, the trade-weighted import tariffs in India have remained largely unchanged from 7.2 percent in 2010 to 7 percent in 2020, while that in China have come down from 4.6 percent to 3.4 percent. India could look to rationalise its trade barriers on a reciprocal basis, especially with countries and regions where FTAs are being negotiated.

India’s infrastructure gaps vis-à-vis other emerging economies have been a major drawback in enhancing the competitiveness of the economy. While India has witnessed impressive growth in several infrastructure sectors such as national highways, ports and installed electricity generation capacity, per capita investment in infrastructure is the lowest in the world. As per the estimates of the Global Infrastructure Hub, India needs to invest 6 percent of its GDP to close the infrastructure gap by 2030, from the current rate of 4.6 percent.

To step up infrastructure development, access to litigation-free low-cost land, faster and efficient environmental clearances and viable financing and monetisation mechanisms are needed. The National Infrastructure Investment Pipeline, with a proposed investment of over $1 trillion and a focus on improving the transport infrastructure in the country, holds promise in this area.

Quality of labour, rigidity in the labour market and low participation rate in the labour force stand in the way of favourable demographics and absorption of excess labour from the agriculture sector into the manufacturing sector.

As per the Periodic Labour Force Survey (2019-20), three-fourths of the population has educational qualifications only up to the secondary level, which is categorised as unskilled and low-skilled. Only 9 percent of the population has a graduate or post-graduate degree.

Manufacturing in the IR-4 era would require upskilling of the labour force, particularly with a growing potential for automation. Moreover, the labour force pool needs to expand. The labour force participation rate in India is the lowest among major economies. About 42 percent of the population of the country constitutes the labour pool, with women’s participation at a low of 22 percent.

According to the World Bank, India ranks 178 among 187 countries in terms of female labour force participation. Employability, appropriate skills for a particular job, is less than 50 percent. Hence the quality must improve through investment in education and health, along with higher participation, especially of women.

Labour laws too have been an impediment in the past to absorbing workers in the manufacturing sector. A simplification of 29 central laws into four labour codes and the inclusion of fixed-term employment contracts providing flexibility to firms to hire workers according to the economic cycle would benefit the industry. Creating a wider formal social security network and reskilling programs would help further in terms of creating a flexible labour market.

Finally in the context of the IR-4, where the technology intensity of the manufacturing sector would play a critical role in successful adaption, increasing focus on R&D would be needed. India’s R&D expenditure as a percentage of GDP was 0.7 percent in 2018 as per UNESCO estimates, compared to 2.1 percent in China, 1.2 percent in Brazil, one percent in Russia and three percent for most advanced economies. With smart manufacturing being the hallmark of the IR-4 era, India’s strength in digital technologies would have to be supported by higher investment in R&D, both by the public and private sectors along with developing the knowledge base of the labour force.

In conclusion, India is well placed to benefit from this growing trend of China Plus One strategy, especially in this era of the fourth industrial revolution which brings together technology and manufacturing. With some major structural reforms undertaken over the last 10 years, and with India standing as an economy with a stable macro-economic, external and policy environment, it is an opportune time to address the impediments holding back the manufacturing sector.

Gaurav Kapur is Chief Economist, IndusInd Bank Ltd. Views expressed herein are personal.