India’s growth success has been driven by service-producing industries that mostly employ relatively skilled labour . Even within the manufacturing sector, India tends to specialise in relatively skill- and capital-intensive activities. This is despite the fact that that India’s true comparative advantage lies in unskilled labour-intensive activities. Slow growth of industries that mainly employ low-skilled workers has caused manufacturing as a share of GDP to remain constant at about 16-17 per cent during the two decades of economic liberalisation. The share of manufactures in India’s merchandise exports declined from 72 per cent in 1991 to 63 per cent in 2008. By contrast, in China in 2008, manufacturing accounted for 34 per cent of GDP and 93 per cent of merchandise exports.

Why is this lack of unskilled labour-intensive manufacturing a problem for future growth in the Indian economy?

Today, a large and growing share of international trade consists of intermediate and unfinished goods shipped from one country to another to combine manufacturing or services. This is what has driven growth in the East Asian economy.

This type of trade is the result of the increasing interconnected production processes that form a vertical trading chain stretching across many countries, with each country specialising in particular stages of a good’s production sequence. China, through specialisation in labour-intensive processes and product lines, has successfully integrated its manufacturing sector with global production networks. This phenomenon, often referred to as vertical specialisation, is an important factor in its export success. Vertical specialisation has also increased growth in newly industrialised Asian countries. But vertical specialization is not a phenomenon restricted to East Asia alone. Between 1970 and 1990, as Hummels, Ishii and Kei Mu-Yi point out, growth in vertical specialisation-related exports accounted for 30 per cent or more of the growth in overall exports of 10 OECD and four emerging market countries

Because it lacks labour-intensive industries, India lags behind other fast-growing Asian countries in integrating domestic manufacturing with the global vertical production chain. India’s import substitution policy regime created a bias in favour of capital- and skill-intensive manufacturing, and the reforms have not been comprehensive enough to remove this bias. Although policy changes have gone a long way toward easing barriers to the Indian market, multiple barriers preventing non-viable production units in the organised manufacturing sector from exiting the market remain. These barriers primarily have their source in India’s rigid labour and bankruptcy laws, and discourage firms from investing in manufacturing in India, as they mean that foreign firms fear being locked in to a cycle of diminishing returns. If India continues to discourage vertical specialisation, it will find itself stagnating as it is locked out of global supply chains.

A lack of openness to foreign direct investment (FDI) is another problem that afflicts the Indian economy. Inward FDI has been instrumental in integrating China’s manufacturing with the global vertical production chain. Vertical FDI represents the international fragmentation of production process by multinationals, and involves locating each stage of production in the country where it can be done at the least cost. Vertical FDI was initially concentrated in South Korea, Taiwan, Hong Kong, and Singapore. After the mid-1980s, as wage levels in these countries (in relation to labor productivity) began to rise, vertical FDI shifted to China and other Asian countries, including Thailand, Indonesia, Malaysia, and the Philippines. Currently, the bulk of the FDI flows to China and other East Asian developing countries are vertical in nature. According to the 2003 World Investment Report, FDI has contributed to the rapid growth of China’s merchandise exports at an annual rate of 15 per cent between 1989 and 2001. In 1989, foreign affiliates accounted for less than 9 per cent of total Chinese exports, but by 2002 they provided 50 per cent.

In contrast, inward FDI into India is primarily horizontal (market-seeking) rather than vertical (export-promoting). FDI has been much less important in driving India’s export growth, accounting for less than 10 per cent of manufacturing exports. What explains the fact that India has been attracting horizontal rather than vertical FDI while the opposite has been the case for China?

For one thing, there exists a powerful incentive for multinationals to undertake horizontal investment as Indian tariff rates, despite the reduction since 1991, remain relatively high, and horizontal investment seeks to avoid tariffs. In addition, trade is necessary for vertical FDI, and trade costs are high in India because of inefficient infrastructure, burdensome regulatory environment, and poor trade facilitation. Finally, India’s labour laws hobble labour-intensive manufacturing in general and vertical FDI in particular. An India that finds itself unable to attract vertical FDI will find itself unable to grow as fast as others.

The grand idea of India building ‘self-sufficient industry’ is meaningless in the current landscape of international commerce, where countries engage in trade by specialising at the level of distinct product lines and processes. What is important is the creation of an environment that encourages entrepreneurs to search and identify opportunities in the vertically integrated global supply chains of various industries. Labour market reforms, investment in physical infrastructure and efficient trade facilitation are crucial if India is to become a manufacturing powerhouse.

Veeramani Choorikkadan is a visiting fellow at Crawford School of Economics and Government, ANU, and Assistant Professor at the Indira Gandhi Institute of Development Research, Mumbai.

 

This is an article from the most recent edition of the East Asia Forum Quarterly: ‘Next generation on Asia’.