How can India become a manufacturing powerhouse?

India’s manufacturing sector has been stagnant over the past 20 years, in terms of contribution to national output as well as employment generation. In this article, Ejaz Ghani locates the explanation in the diverging paths of industrialisation and urbanisation, market distortions pertaining to land and finance, excessive focus on large enterprises rather than smaller, informal ones, and the misconception that services growth is crowding-out manufacturing.

Despite huge efforts made during the last two decades to scale up the Indian manufacturing sector, its growth has been stagnant – its contribution to national output has hovered around 15%, and for employment at less than 12%. As of 2023, its contribution to global manufacturing output is less than 3%, compared to nearly 30% for China, and 16% for the US.

What is holding back the rise of the manufacturing sector? It is not a lack of policy reforms, infrastructure, or availability of workers. Policy reform efforts have been huge, as reflected in improvements in India’s global ranking in the World Bank's Ease of Doing Business index. Investments in physical infrastructure have been increased dramatically. Several policy initiatives – Make in India, Skill India, New Industrial Policy, Production Linked Incentive Scheme, Goods and Services Tax (GST), removing restrictions on foreign investment, and establishing of one-stop shop for clearances for new businesses – have been launched to stimulate the manufacturing sector. Yet, these efforts seem to have failed to bring about the structural change needed to make India a manufacturing hub.

Is it the case that India is yet to remove the structural constraints that have held back growth in the manufacturing sector but not in the services sector?

First, the manufacturing sector has been moving from urban to rural areas to remain cost-competitive. However, it is not able to grow due to poor infrastructure in the rural areas. Infrastructure investments have remained lopsided, with a focus on urban areas. This has helped services, which remain concentrated in urban areas.

The second structural constraint is factor market distortions. The manufacturing sector is more land-intensive compared to services. India is a land-scarce country, with huge distortions in land markets that have raised manufacturing costs.

The third structural constraint is, assuming that large enterprises are national champions, and need to be supported like South Korea’s chaebols¹. But India’s manufacturing miracle is in small enterprises that have expanded in the tradable sector, while the Indian equivalent of chaebols have expanded in the non-tradable sector. India needs to export more to make manufacturing a growth driver, just like the country’s services sector that has become a global powerhouse.

Fourth, concerns have been raised that India’s premature deindustrialisation is a result of crowding-out by the more dynamic service sector. However, empirical evidence shows that the two sectors complement each other. There is no reason why India should just focus on services and ignore the manufacturing sector.

The future of India is bright, and it has not yet lost the global manufacturing race. Free from an ageing population like that of China, Europe and the US, India has the benefit of demographic dividend. It has the largest share of youth in the world, and a rising middle class which has created a huge market and demand for goods. Being a late-comer to industrialisation and urbanisation, it has several advantages in terms of technology and processes that can support green growth. This is also being helped by the global diversification of supply chains and ‘China+1’ policy² being followed. Yet, the manufacturing sector to succeed, the structural constraint needs to be addressed first.

Diverging paths of industrialisation and urbanisation

Conventional wisdom suggests that industrialisation and urbanisation go hand in hand. Policymakers often adopt an active industrial policy to accelerate growth, while also embracing an active urban policy, since industrialisation without urbanisation gets stalled.

India’s industrialisation and urbanisation did grow together in the early 1990s. Manufacturing growth was initially concentrated around the mega cities. But the trends have changed over the last two decades. The share of manufacturing in output, employment, and number of enterprises has declined in urban India and increased in rural areas. This de-urbanisation of manufacturing is a lot starker in the organised sector relative to the unorganised sector.

Conglomerates and large-scale manufacturing enterprises are moving from urban to rural areas due to a combination of factors including search for cheaper land, lower pollution restrictions, less congestion, and other spatial considerations. In China and the US, the manufacturing growth drivers have already migrated from mega cities to tier-1 and tier-2 cities. But the growth drivers in India are still concentrated within urban areas in mega cities. Secondary cities have yet to become engines of growth, and still lack the physical and social infrastructure to make enterprises more competitive, attract new enterprises, and create more jobs. The diverging paths of industrialisation and urbanisation have become a huge constraint to manufacturing.

The de-urbanisation of manufacturing is improving the spatial dispersion of the sector, and this is associated with a more efficient allocation of enterprises between urban and rural settings. Spatial mismatch of the manufacturing sector has declined since the early 1990s, at an increasing pace. Most districts with an initial spatial mismatch have experienced improved spatial allocation – particularly those with good physical and social infrastructure.

The trends in the pace of decline in spatial mismatch also differ across organised and unorganised sectors, and large and small enterprises. The faster pace of reduction in spatial mismatch is primarily driven by small, unorganised enterprises.

With all its promises and desirability, the spatial development of manufacturing across urban and rural areas, imposes unprecedented financial, managerial, political and policy challenges for India. A key policy lesson for India will be to try harder to align industrialisation with spatial development and appropriate infrastructure investments. India needs renewed emphasis on spatial development of secondary cities and rural areas that have the highest potential for growth in the manufacturing sector. India will also need to address factor-market distortions to reduce high costs associated with manufacturing.

Land market distortions

Enterprises need three factors of production – labour, capital and land. Labour-market restrictions have grabbed headlines, but empirical evidence shows that land markets are much more distorted as compared to labour markets (Mitra 2024). The effect of these distortions can be seen in less productive firms accessing more land relative to more productive firms. Land misallocation appears to be at the root of factor misallocation, and accounts for a large share of the observed differences in output per worker in manufacturing. It is estimated that productivity growth could increase by more than 50% in India, if land market misallocation in India could be brought down to US levels (Duranton et al. 2015).

While the policy focus on improving land administration and regulation, and digitisation of land records, is welcome, there are bigger growth benefits that can be derived from shifting the policy focus from reducing land ‘regulatory tax’ (that is, taxing the value of land) to increasing land revenue tax. This will enable more efficient firms to grow faster and increase the budgetary revenue to maximise finance for development, and additional revenues needed for investments in infrastructure, housing, and social programmes.

Financial market distortions

There is an important reason to suspect that land and financial markets are connected. Most bank loans require some form of collateral to guarantee the loan. Due to its immobility, land is simply the best form of collateral (that is, the debtor cannot run off with land). While borrowers can often pledge 80% of land values against loans, for most other forms of fixed investment the loan-to-collateral value ratio is substantially lower (say around 25%). So, if land markets are highly distorted, then it is likely that the finance market is also distorted, given the misplaced collateral channel. This can in turn prevent India from becoming a manufacturing hub.

How has financial misallocation impacted the manufacturing sector? There are several interesting trends observed in India. First, there are huge spatial disparities in access to finance within the country – it is significantly higher in a few leading regions, and very low in lagging states like Bihar and Uttar Pradesh (UP). Second, large firms in the organised sector have much higher access to loans compared to unorganised firms. Over 95% of organised firms in states like Gujarat, Haryana and Rajasthan have access to financial loans, while access to external loans has declined in the unorganised sector (Duranton et al. 2016). States such as Bihar and UP perform poorly in providing external credit support for both organised and unorganised sectors. Third, while the share of plants accessing external loans in the organised sector has increased, it has declined for the unorganised sector. The unorganised segment accounts for nearly 80% of employment and about half of the value of land and buildings held in India’s manufacturing sector. Yet, the value of financial loans reported in this sector is barely 2-6% of the total for the manufacturing sector (Kerr et al. 2016). These emerging trends in land and financial misallocation need more attention to make the manufacturing sector more competitive.

Manufacturing miracles

There are two under-appreciated facts about India’s manufacturing growth. The first is that much of the sector’s employment growth is in the form of informal establishments in tradable sectors – this suggests that growth in traded industries is not due to plants achieving larger economies of scale or shipping goods at a distance (Ghani et al. 2015). Second, large, formal enterprises have expanded in the non-tradable sector.

There are several factors that have enabled the rise of the informal sector: rapid expansion of female business ownership, greater subcontracting, and “push” entrepreneurship (that is, entrepreneurs who start businesses out of necessity rather than growth desires). The development of one-person enterprises is particularly surprising given that we would expect the trade and investment reforms of the 1990s to more strongly impact larger firms, as micro-enterprises are known to face significant hurdles in competing in export and other non-local markets.

The vast informal sector in India affects everything from poverty levels to the allocation of activity in the economy and beyond, so greater insights into its functioning are vital. Industrial policy needs to focus more on how informal firms connect into local supply chains and input-output networks.

Empirical evidence indicates that India has undergone a rapid change from having specialised, undiversified manufacturing districts prior to liberalisation, to a distribution pattern today that more closely resembles that of the US (Ghani et al. 2016).

These trends bring to the fore intriguing issues within the patterns outlined above. Most Indian districts have shown a movement towards less specialisation and greater diversity. However, districts with higher initial specialisation have also exhibited greater manufacturing employment growth. These facts are not necessarily at odds with each other, as much of the growth could have come outside of the initial specialisation industry. It is well-known that Indian government policy prior to the 1991 deregulation promoted industrial placement in less developed locations in the name of distributional equality. These patterns are perhaps showing how this initial, artificial placement unwound itself, with a general movement of regional industry towards a focal point.

Are manufacturing and services friends or foes?

There are rising concerns that India’s more dynamic service sector is crowding-out manufacturing. India’s phenomenal service-led growth in recent decades has generated debate on the role of services vis-à-vis manufacturing as the engine of growth.

Empirical evidence shows that the two sectors in fact complement each other (Ghani 2022). The correlation between manufacturing and services distributions across states is extremely high, with states with a high share in manufacturing also holding a high share of services.

Tamil Nadu and Andhra Pradesh, which capture close to 10% of firm share in manufacturing, are steadily increasing their share in services as well. Cumulatively, the six states of West Bengal, Tamil Nadu, Andhra Pradesh, Gujarat, and Maharashtra are home to about 60% of the total in both manufacturing and services.

The spatial development patterns of the manufacturing and services sectors, however, differ. While both manufacturing and services are highly concentrated in just a few states, this tendency is much stronger in manufacturing. States and cities with better infrastructure and access to markets have grown, while others have been left behind.

India has not lost the manufacturing race

The biggest challenge of India’s economy is to create enough jobs for a 900 million-strong young workforce. If India is successful in doing that, its demographic dividend will yield enormous benefits. If it fails, the weight of such a large underemployed population could bring the country crashing down. India cannot rely just on services alone to create jobs – it needs a much more dynamic manufacturing sector.

India has the benefit of demographic dividend, and it has the potential to win the manufacturing race. The growth drivers are shifting to rural areas. India’s manufacturing sector is spatially spreading from urban to rural areas at a much faster pace than services. The low-density manufacturing districts have the potential to grow at a much faster pace than high-density ones. This dispersion of the manufacturing sector from dense to less dense districts will accelerate structural transformation, improve resource allocation, promote growth of more efficient enterprises, and reduce spatial mismatch.

However, the manufacturing sector has not spread to all districts. Only those districts that have improved their physical and social infrastructure have attracted manufacturing enterprises. Though the spatial evolution trend in Indian manufacturing is like the trends found in China and the US, the pace of spatial spread is much slower in India. The path to industrialisation will be through increased focus on rural structural transformation. Policymakers need to develop physical and social infrastructure investments in rural India, where there is potential for the manufacturing sector to expand.

Reducing factor misallocations is worthy of more attention. Further, policymakers need to focus more on financial liberalisation policies to help break the strong link between distortions in land and loan markets.

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Notes:

Chaebols are family-owned and family-managed business groups with diversified businesses such as manufacturing, services, and non-banking financial services.
The China + 1 policy encourages companies, especially multinational corporations, to diversity their supply chain and manufacturing activities away from China and into alternative destinations.