India’s growth story for the first quarter of this financial year shows that the manufacturing sector played a key role in blunting the impact of the second Covid-wave.
"Manufacturing and construction were the key drivers of the pickup in GVA growth, whereas on the expenditure side, private consumption and investment powered the turnaround in the GDP performance. Nevertheless, all of these sectors remained well below their pre-covid levels," said Aditi Nayar, Chief Economist with ICRA Ltd.
Manufacturing which grew by 49.6 per cent, fell 36 per cent in the same period last year. This would be music to the ears of our policymakers, who are acutely aware of the importance of the sector if India’s is to bounce back quickly to the path of double-digit growth.
The country’s exports over the past decade have been hardly impressive, hovering around $300 billion. As percentage of GDP, it fell from 17% in 2011 to 12.4% in 2018. And its share in world merchandise exports ranged between a meagre 1.5% to 1.7% over the same period.
How can India turn the table?
First, can India swing the shift in its favour by scaling up domestic enterprises to cater to this new demand from global customers? Second, can it attract a higher share of investments from global companies, while also bringing in technology and building local supply sources? For both, action on the ground gives rise to optimism. As for the first, there is the growth seen in specialty chemicals industry, of more than 25% compounded over the past five years. For the second, there is the government’s production-linked incentive (PLI) scheme in segments like mobile manufacturing and IT hardware that has attracted foreign investors. Sixteen proposals including three manufacturing partners of Apple — Hon Hai (Foxconn), Wistron and Pegatron — selected by the government committed to invest a cumulative sum of around Rs 110 billion to manufacture mobile phones worth Rs 10.50 trillion over the next five years. Last year, despite being a pandemic year, investments of Rs 13 billion materialised on the ground and produced goods worth Rs 350 billion in the first five months till December 2020, according to the ministry of commerce and industry. Samsung and Rising Star, and local players Lava, Bhagwati (Micromax), Padget Electronics (Dixon Technologies), Optiemus are some of the companies waiting to invest.
Can this initial momentum turn the tide in favour of Indian manufacturing decisively? The second wave and the cascading effect on economic activity has most certainly dampened business confidence. “Investments are delayed, but they are not off the table. Before the second wave of pandemic, we saw several companies from Japan, Korea, Germany and US, who were in discussions with potential Indian partners, spanning areas such as auto components, energy equipment and capital goods. The business models range from contract manufacturing, technology licensing to manufacturing JVs,” says Suvojoy Sengupta, partner, McKinsey & Co. Although there are concerns about demand destruction, the bigger worry is the government’s ability and willingness to walk the talk in terms of putting incentives on the table.
The Centre’s ambitious scheme laid out last year involves rolling out Rs 2 trillion-worth of incentives over five years beginning FY20 to 13 key sectors, such as mobile handsets, pharmaceuticals and medical devices. Totally, nine PLI schemes have got cabinet approval so far. The first three were approved in March 2020 and these were followed by another 10 schemes in November 2020. Of these, the previous three schemes have been notified, and six of the 10 have been approved by the Cabinet.
A Credit Suisse report in November 2020 stated that the scheme will add 1.7% to Indian GDP by financial year FY27 and highlights that bulk of the additional $144 billion sales across 13 sectors will be exported, thus shrinking the country’s trade deficit by $50 billion. India’s trade deficit stood at $98.56 billion for FY21 and $15.24 billion for April 2021. Last fiscal, manufacturing constituted 17.4% of India’s GDP, little more than 15.3% from two decades ago in 2000. By comparison, Vietnam’s manufacturing sector more than doubled its share of GDP during the same period.
India’s manufacturing sector woes are deep rooted, with ease of doing business low and cost of doing business high, making companies uncompetitive compared with peers in other nations.
In India, the auto sector serves as a good playbook. Maintaining high import tariff, India was able to attract global companies to invest in the country as well as drive localisation. Thus, the industry was able to become globally competitive and now exports of automobiles and auto components totals about $25 billion even as tariffs have systematically declined.
As for mobile handsets, there is already skepticism about whether component manufacturing will shift to India. Currently, 90% of mobiles sold in India are assembled here, but most components are still imported, which translates into a value addition of less than 10% by the mobile assembly and testing units. Unless the sub-assemblies and discrete components (components that go into subassemblies) shift production, and some of these components are localised, the assemblies will not stick. Assembly lines are largely modular and can be easily shifted overnight, and these will typically shift to where return on investment can be maximum. Though the government has asked the handset manufacturers to define what level of localisation they will achieve, it is still not binding on them to do so.
The problem is more acute when it comes to IT hardware because India has zero tariff, which means there is no incentive for companies to set up capacity here. “On top of that, the IT hardware market globally has been flat for the past six years, meaning there is enough capacity in the world already. Therefore, companies are less motivated to come and invest,” says George Paul, CEO, MAIT. But IT hardware is of strategic importance, for computers are at the heart of all critical infrastructure from power and telecom to passenger vehicles. “The outlay has to be a lot more and so should be the incentives,” says Paul.
Incentives aside, the global experience in relocating capacity has not been encouraging. While Vietnam has been hugely successful in attracting foreign investments, its effort to grab a share of component manufacturing has met with little success, and that says a lot.
Pharma’s small-scale problem
In pharmaceuticals, India already has a fairly strong formulation business with 12% global market share. The current incentive plan for APIs is critical, to bring back some of this manufacturing back and ensure the supply chain for our formulations business is protected. We cannot afford a situation where drug intermediate and API supplies are disrupted, because if that arises, the axe will fall not just on generics exports but also on domestic medicine supplies.
But replacing China here is tricky considering the scale they have already built around several products, and their pricing policy wherein, with depreciated facilities, they can really crash prices. “If we can’t meet Chinese scale and price or the strengths of the developed world, then we won’t offer any real benefit or incentives for the developed world to seriously source from or outsource to India,” says Raja Ram, former managing director of Sigma Aldrich India, now Merck KGaA.
The India pitch
FDI inflows grew 9.3% to $81.3 billion in FY21. Nearly 60% of the total investment came from Singapore, US and Mauritius. Nearly half or 45% came into computer software and hardware industry, but much of this came into digital ventures rather than manufacturing. This highlights the real problems of doing business in India.
“Entry and exit are probably now easy but living through business is far more difficult in India,” says Janardhanan Ramarajulu, vice president, regional head, South Asia and Australia, Sabic. He echoes the sentiment of most corporate chieftains in India. What he is talking about is not only the cost of logistics and inventory, but the additional establishment costs required to deal with bureaucracy.
Except Vietnam, where wages are about 10% lower, India continues to have the advantage of cheap labour but lags far behind in productivity. China is 3x costly and other countries such as Indonesia and Thailand also have higher wages. Compared with India, manufacturing productivity in Indonesia is 2x high; in China and South Korea, productivity is 4x higher, according to McKinsey data.
Apart from upskilling the workforce and transitioning to more value-added categories, domestic companies will have to work on building scale and trustworthiness. In fact, at the heart of the problem facing Indian manufacturing companies is return on capital. According to McKinsey, over the past four years, from 2016 to 2020, sectors that saw healthier return saw an increase in invested capital; but out of the top 1,000 manufacturing companies, 700 earned a return that was less than their cost of capital in 2018.
Partly, the low return is from structural factors such as high cost of credit, power and infrastructure, and inefficient logistics, all of which escalate operating expenses — these are what the government now is compensating for through the PLI scheme. But the other big reason is the lack of scale. “The small, fragmented companies that make up some value chains cannot operate productively, let alone at peak efficiency; cannot innovate quickly enough to keep up with competitors; and cannot command price premium because they lack strong brands,” notes Sengupta.
Considering the lead China has established and how other competing nations have grown in specific value chains, existing spaces are extremely competitive and taken. Snatching away share from others will be challenging, since every export-oriented nation not only wants to protect its own turf, but also wants a piece of the slice China may yield. Sure, the PLI scheme is a good start to regain ground in manufacturing, but it will only buy us some transition time.