Government must continue to take steps to reform factor markets and other input markets

The “missing the bus” metaphor made a comeback earlier this week when 15 nations signed the Regional Comprehensive Economic Partnership (RCEP), a mega trade deal, sans India, which opted out of negotiations last year. Indeed, the metaphor is apt for different points in India’s post-Independence economic history. But, not for RCEP. A bus is a means of transport, what matters is the destination. Free trade agreements are a means; the destination is industrialisation, jobs and economic growth. Boarding a bus, which takes you to a destination not of your choice is a folly. The government has chosen wisely.

For critics, this is further affirmation of the Narendra Modi Government’s preference for raising tariffs and trade barriers (ostensibly to promote domestic manufacturing), which they believe is U-turn from the post-1991 consensus on trade liberalisation and a hark back to the failed pre-1991 era. Indeed, it is a challenge to the post-1991 consensus. But it is not a return to the pre-1991 era.

The fact is that just like pre-1991 trade policies did not yield a competitive manufacturing sector, the post-1991 trade policies did not help create one either. The share of manufacturing in India’s GDP has remained stagnant at around 16% of GDP for a couple of decades (having fallen from 19% of GDP post-1991). No country has achieved inclusive prosperity without a robust manufacturing sector (which at India’s level of income needs to grow to beyond 25% of GDP), nor will India. There is a third way on trade policy which follows neither the pre-1991 nor post 1991 consensus.

The world doesn’t work in black and white. Historical experience suggests that few, if any, successful countries followed either completely free trade policies or complete autarky while industrialising. What matters more than trade policy in isolation is an entire gamut of policies which are required for manufacturing to thrive. The key ecosystem requirements are competition and competitiveness.

In the pre-1991 era, competition was given short shrift. Companies were protected from foreign competition through restrictive trade policies and restrictive FDI policies. They were protected from domestic competition by the industrial licensing regime. Competitiveness, in terms of the cost structure of industry, was not given a thought because it did not matter.

The post-1991 policy era exposed domestic manufacturing to competition through continuous trade liberalization and opening doors to FDI. This was done without addressing the dimension of competitiveness. While product markets were liberalised, factor markets were not. The land market was never flexible; the 2013 amendment of the land acquisition law made it harder to acquire land and made it more expensive than in competitor countries. Labour laws, which were extremely restrictive did not allow domestic industry to leverage cheap labour. Capital markets were liberalised on the equity side, but not enough reform was implemented on the debt side or the banking side making access to capital difficult and more expensive than in competitor countries.

At the same time, power, a critical input for manufacturing was provided at high rates to industry to cross subsidise farmers and consumers. Railway freight rates, also an input cost, were set high to cross subsidise passengers. With arms and legs tied, it is hardly surprising that domestic manufacturing failed to compete once trade was liberalised for most sectors. The one success of manufacturing in India, namely automobiles, happened behind continued trade protection.

Many of these structural factors still hamper the competitiveness of Indian industry, whereas RCEP members have a very competitive manufacturing sector. While the Government works at resolving these, some of which are deeply embedded in the political economy, manufacturing needs a level playing field. In this context, the Government’s strategy to raise tariffs moderately across a range of sectors is rational, especially when China actively and non-transparently subsidises critical inputs to industry, flooding India with imports.

It will not lead to pre-1991 type of inefficiencies because domestic competition in most sectors is robust (no licensing) and FDI is free to enter in most sectors. As long as competition is not sacrificed, an effort to improve competitiveness of Indian industry through temporary protection and support is vital for manufacturing to thrive.

In fact, it is encouraging to see the Government use policies like production-linked incentives (PLIs) to boost domestic industry. Since these are inextricably linked to rising production levels, they induce high performance by firms availing of the benefit. They all have sunset clauses, available for not more than five years in most cases. And they are available to multiple firms in the same sector, thereby ensuring competition. Ideally, even tariffs should have a sunset date.

In the meanwhile, the Government must continue to take steps to reform factor markets and other input markets which render manufacturing uncompetitive without protection. Once that is achieved, protection will no longer be necessary. Indian manufacturing will beat the best of the world. But first, it must survive. Abandoning RCEP gives some breathing space for manufacturing to flourish.