A defining feature of economic development is the reallocation of labour from subsistence agriculture to manufacturing. To shed light on this process, this column analyses Karnataka’s Industrial Areas (IAs) programme that facilitated the establishment of industrial firms in rural areas. It finds that IAs caused a large increase in the number of firms and employment with substantial spillovers to neighbouring villages, and triggered a classic ‘structural transformation’ of the economy.

Creating non-agricultural employment opportunities is a top priority for governments in developing countries, and India is no exception. Governments can and do create public works programmes, though generally to assist the poorest households. Far more challenging is designing policies that encourage the private sector to create high-quality non-agricultural jobs, particularly outside of urban centres. In order to improve policymaking, it is crucial to know what factors are holding back private sector investment in rural areas, and what governments may do to relieve any such bottlenecks.

Theoretically, the presence of abundant low-cost labour should attract firms to shift production to rural areas, especially in locations in close proximity to urban centres. While there has been substantial growth in the rural manufacturing sector, its progress has been halting and highly uneven, with much of the population remaining in agriculture. One possible explanation for this is that the rural labour force may simply lack the necessary skills for manufacturing employment. Another possible impediment is the notoriously poor quality of India’s infrastructure, particularly in rural areas. Yet another possibility is rooted in the need for coordination to achieve agglomeration economies. Each of these potential factors has very different policy implications, but their relative importance remains poorly quantified.

Karnataka’s ‘Industrial Areas’ programme

In recent research, we shed light on this issue by analysing a two-decade (1991-2011) effort by the Karnataka government to stimulate industrial activity in rural areas through the creation of Industrial Areas (IA) (Blakeslee, Chaurey, Fishman and Malik 2017). IAs belong to the broad category of ‘place-based’ industrial policies that are common in both developing and developed countries. Unlike other place-based policies, such as special economic zones (SEZs), IAs do not offer far-reaching financial incentives to attract firms. Instead, IAs focus primarily on providing the necessary land and basic facilities for engaging in industrial production. Due to regulatory barriers in India to establishing industrial operations on lands zoned for agriculture, the plots of land made available within IAs have the potential to attract private firms at relatively low cost to the government.

If successful in attracting large industrial firms, IAs may generate formal employment opportunities for the surrounding populations as an alternative to informal cultivation or wage labour. For this potential to be fulfilled, however, firms must choose not only to locate in IAs, but also to recruit workers from the local population, which cannot be taken for granted. For example, an insufficiently skilled local labour force may either dissuade from setting up within the IAs, or lead them to recruit the bulk of their workers from elsewhere. For this reason, the effects of place-based policies have been mixed, even in developed countries.

Karnataka’s IA programme provides an attractive setting to investigate the effectiveness of place-based programmes with relatively modest incentives. The richness and geographic resolution of our data (collected from Karnataka Industrial Areas Development Board (KIADB), along with Demographic and Economic Censes) allow us to answer questions such as: What types of firms are attracted to such sites? Whether firms create employment for local populations? What is the social impact of such programmes? What are the impacts on agriculture? Are the benefits widely shared, for example by women and scheduled castes?

Our analysis tracks medium- to long-term changes in the structure of the local economy that occur due to the establishment of an IA. Since IAs form in different years in different location, we can isolate the impacts of regional economic changes from the impact of the IA itself. Here is what we find.

Impact

First, in the village in which an IA is set up, we see dramatic changes in the composition of the labour force, with employment in manufacturing jumping by 70-80%. We also find similar impacts on employment in nearby villages, with effects that gradually diminish in strength and become statistically insignificant around 4-5 kilometers from the IA. IAs are successful in drawing firms that recruit local workers, though they also employ a large number of non-local workers.

Second, we find that there is a remarkably large increase (50%) in the number of small enterprises in the areas surrounding an IA. A variety of factors may explain this outburst of entrepreneurialism. For example, the infrastructure or services created for IAs could be utilised by other firms. Alternatively, firms established within IAs may create demand for secondary factors of production and thus stimulate the creation of firms that can supply them. Another way could be through demand channels, with the increase in local incomes driving demand for local services, such as transportation, restaurants, and retail.

Our evidence suggests the intriguing possibility that the increase in entrepreneurial activity is driven by a relaxation of credit constraints. First of all, many of the newly created small firms are commercial farms, indicating that local agricultural sector seems to be shifting to more formal, market-oriented cultivation. Second, the effects are bigger in villages that did not have bank branches before IAs came up. Both of these suggest liquidity constraints could be at play, with households using the income from manufacturing employment to establish small firms.

These results are striking. They suggest that merely relaxing zoning laws to allow firms to set up in rural areas can trigger a far-reaching transformation of the local economy that involves a simultaneous shift of workers out of agriculture and a commercialisation of the agricultural sector, as well as a broader expansion of entrepreneurial activities. While the results do not in any way diminish the importance of other factors, like infrastructure for industrial development, they do suggest that the relatively low skills of rural populations, and the overwhelmingly agricultural nature of the rural economy, do not constitute a substantial impediment to the expansion of the rural manufacturing sector under the IA programmes.