Manufacture or service: Must we choose?

This debate is futile in India's development journey

The structural transformation followed by most developed countries, and those that developed later like Korea and China, and now Vietnam, was to first industrialise and then develop services, shifting millions out of agriculture. In India’s case, this structural transformation became lop-sided. India suffered what Dani Rodrik called “premature de-industrialisation”, with the share of industry peaking in 2008 at around 32 per cent of gross domestic product (GDP), and then falling to around 25 per cent of GDP. In contrast, India did remarkably well early on in services, especially IT-related, and now also in health care and e-services. This has led some to argue that India should pioneer a new service-led growth model and should not waste its energy and resources on industrialisation. 

But we need both. India is a large, highly diversified country with a massive pool of employable individuals at various levels of education and skills. While a small set, with engineering degrees benefit hugely from the rapid growth in high-end services and is in short supply, a large mass of people with basic school education needs low-skill manufacturing jobs. The lack of such jobs has meant that an increasing number of people are either stuck on the farms — where employment has in fact increased by almost 60 million in the last five years — or form the large mass of unemployed youth in urban and peri-urban areas. It also explains why female labour force participation remains low. With 8-10 million people entering the workforce every year and a large stock of unemployment, the service sector alone, despite all its success, will not be able to employ so many people — especially from rural areas with only a school-level education.

To productively employ these people, India has no choice but to also revive its industry. However, India’s industrial strategy, involving import protection and a five-year production-linked incentive (PLI) scheme that “picks winners” and provides subsidies of 4-6 per cent to initially 12 and now expanded to 17 sectors with a bill of around $27 billion, may not be the right solution. Import protection will not only take us back to the bad old days when consumers paid high prices for shoddy products, but the costs today are much higher in a world where global and regional value chains play such a key role in global trade and manufacturing. And lest you think that wars and pandemics have reduced the role of global value chains — they are back — with an even bigger role than before (see Figure 1). India must find ways to become a part of GVCs, and high tariffs — especially on intermediate products — don’t help.

The PLI scheme has catalysed some success in mobile phones, where production and exports from India have expanded rapidly. Greater efforts to attract more investment in chip manufacturing and IT hardware are underway, but several targeted sectors have seen no interest at all. A plan to restrict laptop imports, presumably to encourage local manufacture, which would ironically have hurt IT service exports, has been fortunately postponed twice but remains on the table. In any case, PLI-induced investments will not create the scale of employment needed, especially in low-skill manufacturing. Success can come from unexpected places. To cite one example among many, India now produces globally award-winning whiskey and gin, reducing imports, increasing exports, and creating jobs. No one could have predicted that, certainly not bureaucrats.

More fundamentally, we must analyse why reviving Indian manufacturing requires the PLI subsidy. The answer is that the costs of doing business for industry remain very high. Infrastructure is improving, but using it remains costly. Petrol prices are 50 per cent higher than in China and other competitors and diesel prices 20 per cent higher because of government taxes and cesses to generate revenue to pay for schemes like the PLI.  India’s rail freight charges are three times higher than in China and arguably the most expensive in the world. Electricity prices for producers are 30-40 per cent higher than those in China and other competitors.

Furthermore, labour laws make hiring in any firm with more than 10 workers onerous, making labour-intensive manufacturing in India less attractive. Industry prefers to either become more capital-intensive or avoid the labour laws by employing daily labour, often in less productive activities.  Land, India’s most scarce resource, is very poorly used and exceedingly costly to acquire. More than 40 per cent of India’s population remains stuck on the farm, with almost 70 per cent in marginal farms — locking up land unproductively. India’s floor area ratios are amongst the lowest in the world, leading to inefficient urban sprawl. And while borrowing rates for capital have come down, they remain higher than China and other key Asian competitors. Without addressing these issues, the subsidised sectors will surely lobby for extending the PLI scheme beyond the five-year period and clamour to maintain import protection.

The IT industry, health care, and e-commerce are less affected by these factors and have, therefore, in comparison thrived. But the huge success in back-office outsourcing that triggered the IT-based growth in services could now be under threat from artificial intelligence (AI). According to a recent IMF report, India remains less prepared than many G20 countries to deal with AI (see Figure 2). Nevertheless, India should push ahead and deal with the AI threat and use its pioneering digital stack to generate new startups and encourage other services like tourism, which are employment-intensive.

 

As Swami Vivekananda said, “We enter the world like a gymnasium to make ourselves strong.”  Going forward, we need a smarter trade and industrial policy — not subsidies and tariffs —  that will make India more competitive and prepared to deal with new challenges. And the issue is not manufacturing vs services, we need both to thrive. We need to fix the fundamentals that determine the costs of doing business, not rely on temporary fixes, to make India an advanced economy by 2047.

The writer is distinguished visiting scholar, Institute for International Economic Policy , George Washington University, and co-author, “ Unshackling India” Harper-Collins 2021, Best New Book in Economics , 2022 Financial Times