Has the export-oriented manufacturing model reached its sell-by date for India?

As India faces the challenge of creating millions of well-paying jobs for its rapidly growing working-age population, Devashish Mitra analyses which sectors and what strategies can provide these good jobs. He posits that four factors can help the export-oriented manufacturing model succeed – further labour reforms; the signing and implementation of free trade agreements and establishing special economic zones; and participation in global supply chains. This will allow India to leverage its labour, along with advanced-country technology, to create productive jobs.

With India’s overall per capita income 2.5 to 3 times the average income in its agricultural sector, we can expect the expansion of this sector to create only low-productivity and low-wage jobs in the absence of significant technological breakthroughs. Turning to the service sector: with only 12% of India’s population holding bachelors’ degrees or higher, and with 59% in the primary-school, middle-school and illiterate categories combined, only a small proportion of the population has any chance of qualifying for good service-sector jobs.¹

Thus, India must focus on manufacturing to make any significant dent in the jobs problem. As documented by NITI Aayog (2017), small firms (those with less than 20 workers) employ 75% of all manufacturing workers, but produce slightly over 10% of all manufacturing output. This implies several-fold higher labour productivity in larger firms. Besides, the average wage of a formal-sector manufacturing worker is six times the average wage in informal-sector enterprises, which are generally small, low-productivity², unregistered, and exempt from most labour regulations (NITI Aayog, 2017). Thus, good jobs will mainly have to be created in relatively large firms, and mainly those in labour-intensive industries, since that is where output growth is bound to be accompanied by employment growth. The large scale of production is expected to reap economies of scale, leading to higher productivity and wages.

China’s labour-intensive manufacturing production (of textiles, apparel, footwear etc.) has been concentrated in firms employing 1,000 or more workers. On the other hand, India’s labour-intensive manufacturing is concentrated in firms with under 20 workers, which form a higher share of employment in India’s rigid labour market states³ than others (Hasan and Jandoc 2013). Clearly, there seems to be better exploitation of economies of scale and faster employment growth in states with relatively flexible labour markets, as confirmed by Gupta et al. (2009).

The reasons for concentration of Indian manufacturing in small-scale enterprises include labour restrictions that can be avoided by firms by remaining small; land acquisition restrictions that make it difficult to acquire several contiguous pieces of land from different owners to operate firms at large scales; and low maximum floor-space indices (FSIs)⁴that restrict the vertical expansion of buildings. Poor infrastructure and financial underdevelopment have compounded these problems.

Consequently, India has failed to grasp its natural comparative advantage from labour-abundance, as evident from the recent doubling of import tariffs on entry-level labour-intensive goods⁵. Increases in import duties on electronics and communications devices also show India’s lack of competitiveness in low-skilled labour-intensive input processing and assembly – a sector that has propelled China’s export expansion and growth.

However, this failure does not mean that an approach to job creation based on exports of labour-intensive manufactures is not feasible for India. As discussed above, agriculture and services cannot be engines of job creation and growth. Therefore, giving up on manufactures and their exports is equivalent to giving up on growth and forsaking the creation of good jobs. I argue that there is still hope for an export-oriented manufacturing model – emphasising specifically labour-intensive exports – to succeed for India.

Progress on labour reforms

Firstly, there has been some encouraging movement on labour reforms. Andhra Pradesh, Haryana, Madhya Pradesh, Maharashtra, Rajasthan and Uttarakhand have raised the Industrial Disputes Act (IDA) threshold for firm-employment size⁶ from 100 to 300 workers. This same increase in the threshold has now also been incorporated in the countrywide Industrial Relations Code (IRC), one of four new labour codes that will be implemented soon.

Additionally, Rajasthan has raised the threshold membership for recognition of a union to 30% of a firm’s employment. Going further in that direction, the IRC requires 51% of a firm’s employees to be members in order to recognise a negotiating union, or else a ‘negotiating council’ will need to be formed.

To minimise harassment by inspectors, a unified web portal has been instituted at the central level for the self-reporting of compliance with several central acts (and now also some state acts). Within the portal, there is a built-in algorithm, which looks for inconsistencies in reporting, which, if found, triggers an inspection. The labour codes eliminate duplication of and contradiction between the numerous regulations, while also making them more transparent, as they consolidate regulations. The number of filings and compliances is, therefore, going to be vastly reduced.

With this considerable reduction in regulatory burden on firms, effective costs of employing labour are expected to go down. Hasan et al. (2013) find that in most industries, Indian production was far more capital-intensive compared to other countries at similar stages of development, possibly driven by the higher effective costs of employing labour relative to capital. This could change at least somewhat with the new labour reforms. Flexibility in employment is also expected to be considerably enhanced through the provision of employment of fixed-term labour in the IRC.

Negotiating free trade agreements

The next factor contributing to my confidence in the export-oriented, labour-intensive manufacturing model is some recent progress with free trade agreements (FTAs). After India’s disappointing withdrawal from the Regional Comprehensive Economic Partnership (RCEP)⁷, we are now seeing the beginnings of a new strategy with FTAs that have recently been negotiated, first with the UAE and then with Australia.

The signing of the Economic Cooperation and Trade Agreement (ECTA) with Australia – a country of only 26 million people but one whose economic size is approximately half of India’s⁸ – is not insignificant. Coupled with the fact that Australia’s per capita GDP is seven-fold India’s at purchasing power parity (and 28-fold at the market exchange rate), the ECTA gives rise to a substantial market expansion for Indian producers and exporters. The doubling of India’s exports to Australia, and the consequent creation of a ‘million jobs’ that the government is aiming for through the ECTA within the next five years, will require more than just implementing this agreement. India will have to compete with countries like China and Vietnam, who also have FTAs with Australia. India has a disadvantage with respect to these countries in the form of factor-market rigidities, and lower infrastructure quality, average labour force skills and education. Clearly, those are areas India will have to work on. Competition through this FTA will put some pressure on policymakers to deliver on domestic policy reforms and bring about an improvement in infrastructure and skills.

Finally, an important feature of the ECTA is the tariff cuts on imports of Australian cotton and aluminium. Cotton is an important input in textiles and apparel, both highly labour-intensive, while aluminium is used in many other manufactured products. Clearly, lower input costs can go far in boosting labour-intensive exports.

Setting up special economic zones (SEZs) or autonomous economic zones (AEZs)

Today’s geopolitics, rising wages in China and its recent long-duration Covid-related lockdowns are changing export patterns, and providing new opportunities for countries like India. Nonetheless, it is important to note that none of India’s 250 SEZs (at an average size of 0.3 square kilometres), come close to China’s Shenzhen, which has an area of 1,950 square kilometres⁹. Panagariya (2020) has argued that India needs a few AEZs, each with an area of at least 500 square kilometres, under an autonomous administration.

As mentioned above, the idea of SEZs is not unfamiliar in India, but, as argued in Panagariya (2020) and Jha and Mitra (2020), this idea needs to be scaled up. This would solve the land area problem for large enterprises by relaxing land acquisition regulations and FSIs within these AEZs. Allowing for more flexibility in labour employment decisions within these AEZs would remove fears on the part of employers there that they might be compelled to retain all their workers even if they experience demand reductions in the future, or if some workers are found to be incompetent This flexibility could lead to greater initial hiring of workers and the adoption of more labour-intensive methods of production. Each AEZ will act as a coordinating mechanism for agglomeration, in the form of a cluster of related economic activities, thereby leading to higher productivity through labour market pooling and attracting nearby input suppliers. Easing of capital constraints and infrastructure development through public-private partnerships in these AEZs would be needed. The construction activity of building dorms for workers, roads, office buildings, schools, hospitals, etc. will start creating jobs way before these AEZs are operational (see Jha and Mitra 2020).

India’s role in global supply chains

Next, the current geopolitics, a result of worsening China-US relations, along with rising Chinese wages, provides India (and a few other Asian countries) the opportunity to grab some of China’s global market share of labour-intensive manufactures. There are also reports that the recent long-duration Covid lockdowns in China have prompted Western firms to look for alternative suppliers.

As a result, consistent with recent export data from India, there are informal reports of shoppers in North America observing a recent growth in ‘Made in India’ brand-name cotton apparel in departmental stores. However, high tariffs (of 20-25%) on artificial fibers and fabrics are possibly adversely affecting synthetic-fabric garment exports. Eliminating these tariffs could go a long way in expanding output and employment in this sub-sector as well. So would eliminating high tariffs on final product imports (for instance, the ones in the range of 60-125% on automobiles) that have made this industry inefficient and uncompetitive in the world market.

Policy implications and conclusion

In this context, it is important to note the belief in a mercantilist approach to export promotion often held in policy circles – namely that export promotion and import substitution can go hand in hand – as in the case of Prime Minister Modi’s ‘Make in India’. The impossibility of doing this is a clear corollary of the well-known Lerner symmetry theorem¹⁰. Clearly, when a country produces more for domestic consumption, there are fewer resources left to produce for exports. Also, import barriers – through a reduction in the demand for foreign exchange and a consequent exchange rate appreciation of the domestic currency– make exports more expensive and reduce their volumes sold on the world market. This makes it important and urgent to roll back India’s tariff hikes of the last few years.

Let me end with a rebuttal to something one often hears these days, about the strategy of export promotion for development: that the new nature of production and trade makes it difficult to use exports as an engine of growth and job creation. It leads to the inference that India has missed the bus on this strategy; I strongly disagree. While automation has made considerable progress, it has far from taken over all labour-intensive production. The current method of production fragmentation and offshoring allows for prevalence of numerous labour-intensive tasks in labour-abundant countries, even within the production of goods that are overall capital-intensive. With production fragmentation less common in the case of goods considered labour-intensive overall, a country like India now has opportunities to perform a larger range of productive tasks than before, combining developing-country labour with advanced-country technology, with the potential to create productive jobs. This is what exports through input processing and assembly are all about.

This post is the first in a six-part series on 'The good jobs challenge in India'.

Notes:

This includes jobs such as information technology, IT-enabled services, finance and other business services.
Although 75% of manufacturing labour is employed in small firms, they produce only 10% of output; the remaining 25% labour working in larger firms, produces nine times as much output.
This classification is based on state amendments to Central labour acts and monitoring intensities.
FSI or floor area ratio (FAR) of a building is equal to its total floor area divided by the area of the land parcel on which it is built. Lower FAR values lead to low building height and implies stricter building regulations.
Goods such as beauty aids, watches, toys, furniture, footwear, kites and candles.
This threshold is the upper limit on employment size for firms which are not required to seek government permission to fire workers; above this threshold, government approval is required.
The RCEP is a free trade agreement among a number of Asia-Pacific nations, including Australia, China, Japan and South Korea.
Australia’s GDP at the current nominal exchange rate is US$ 1.33 trillion, and India’s is US$ 2.66 trillion.
One of the biggest Indian SEZs, Mundra, is roughly 64 square kilometres.
In international trade theory, the Lerner symmetry theorem states that import barriers (for instance, import tariff per unit of imports or denominated as a proportion of import value) also act as export barriers.