Subir Gokarn: Start-up questions

The current recovery in manufacturing, though encouraging in certain ways, has some pitfalls

With the Indian economy growing at over 8 per cent during the first six months of 2005-06, concerns about bottlenecks and constraints are understandably fading into the background. Everybody knows what the problems are, but they don't seem to be spoiling the party for now, so why keep singing the same old tune? The Prime Minister's assertion that a growth rate of 7.5 per cent over the next four years was possible even in a business-as-usual scenario, made during his address to the India Economic Summit last week, strengthens the perception that the economy is generating sufficient momentum from a combination of powerful, positive drivers and is, therefore, becoming less and less dependent on what the government might or might not do.

As reassuring as this optimism is, it does raise certain issues. Many people would say that sustained 7.5 per cent growth is perfectly acceptable. If this can indeed be achieved without engaging in the difficult political battles that any significant reform measure entails, why bother? A message of comfort targeted at foreign investors is, unfortunately, equally a message inviting complacency amongst domestic political constituencies.

But, let's keep in mind that there is no such thing as perpetual motion. Any system needs regular infusions of energy to continue to function. Over the last fifteen years, this energy has come from the series of reforms that various governments have implemented. Their combined benefits have been particularly visible over the last three. The dividends of past reforms may well continue to accrue over the next few years. That expectation is presumably the basis of Dr Singh's optimism. However, this is by no means guaranteed.

Energy is always draining out of the system; it does so at faster or slower rates, depending on external conditions. In the absence of continued infusions through further reform, economic performance is vulnerable to these external forces. "Business-as-usual" may well look fairly comfortable today, but the environment could change for the worse any time. If that happens, 7.5 per cent could end up being quite unrealistic. The point is that 7.5 per cent could be either the result of deliberate action or good luck. The impact of actions will endure, while the impact of luck could change directions overnight.

Take the specific case of the manufacturing sector, which has been performing rather well over the last three years. In the first half of this year, it grew at about 10 per cent, accelerating beyond the 9.2 per cent it achieved in 2004-05. Three and a half years of sustained growth and still accelerating? Obviously, some energy is being infused into the system. But, do we have any indication as to whether this will sustain?

In my view a good indicator of how much energy is being infused into a sector is the number of new firms entering the marketplace. It reflects both the current and the future health of the sector in a variety of ways. It shows that entrepreneurs see the potential for growth and profits in the activity. It brings fresh, new ideas, technology and practices into the sector in a way in which the mere expansion of existing firms would never do. It increases the competitive pressure on existing players, compelling them to be more efficient. But, going beyond these benefits, in the current Indian context, new businesses are likely to be a major driver of employment growth.

So, given the generally positive scenario in the manufacturing sector, are large numbers of new businesses being set up? Unfortunately, this is a rather difficult question to answer directly. The mere registration of a new entity is not enough; it must obviously create some assets and begin producing for the benefits listed above to accrue. There are significant limitations in quantifying effective start-ups. However, a couple of alternative approaches allow us to at least establish a pattern over the last few years.

To create an appropriate backdrop for the analysis of new business formation, it is useful to divide the reform period after 1991 into three segments: 1992-93-1997-98, which was a period of relatively rapid growth in the manufacturing sector; 1998-99-2001-02, when the sector slumped; and 2002-03 and beyond, representing the current industrial expansion.

Beginning with public limited companies, as reported in the Centre for Monitoring the Indian Economy's Prowess database, in 2005, there are 5,162 such companies engaged in manufacturing. Of these, 1,094 companies were incorporated in the first period, clearly reflecting the post-reform euphoria in business and the investment boom that it engendered. In other words, about 21 per cent of the companies currently active in this category were set up in the first years after the reforms.

In the second period, the downturn in manufacturing activity was clearly accompanied by a slowdown in new business formation. Only 168 of the firms on the list currently were incorporated between 1998-99 and 2001-02. However, even as the sector turned around in 2002 and continues to do well, there was apparently no corresponding recovery in new business formation. Only 27 of the companies on the list were incorporated between 2002-03 and 2004-05.

It is often argued that public limited companies are hardly representative of the manufacturing sector as a whole. The Annual Survey of Industries (ASI), published by the Central Statistical Organisation of the government of India, gives us another perspective on the new business formation issue. It enumerates "establishments", essentially individual factories, as opposed to "companies", so there are some difficulties in interpretation, but the vast majority of companies in the country run only one establishment.

Between 1992-93 and 1997-98, 25,373 establishments were added to the population, representing almost 19 per cent of the units operating in 1997-98. Between 1998-99 and 2001-02, however, the total number of establishments went down by 7,004. In the third period, data for only 2002-03 were available. These indicate that the attrition continues, with 592 units dropping off the list.

Given the emphasis I place on new business formation, these patterns do not look good. It's quite possible that there is some good in them""consolidation and rationalisation between existing companies and establishments, for instance. If this is the case, benefits will accrue, but not indefinitely. However, patterns could reflect the relatively unattractive investment climate for manufacturing in the country. If so, they reinforce concerns about the stagnation of reforms and the energy drain that it implies. The bottom line is that the more new businesses contribute to growth, the more sustained and durable it will prove to be.

The author is chief economist, Crisil. The views here are personal