International trade, domestic labour laws and India’s manufacturing sector

  • Blog Post Date 22 September, 2014
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India has a multitude of restrictive labour laws and these have been found to adversely affect economic performance of manufacturing firms. This column illustrates how the impact of trade liberalisation on the domestic manufacturing sector depends on labour laws. It contends that more flexible labour laws will enable India to compete better in global markets.

There are approximately 200 labour laws in India currently, including 52 Central Acts (Bhagwati and Panagariya 2013). The key regulation is the Industrial Disputes Act (IDA) that requires firms employing more than 100 workers to seek permission from their respective state governments in order to retrench or lay off workers1. Restrictive labour regulations make labour adjustments by firms very difficult and lead to rigidities in the Indian labour market. Since these laws apply to registered firms above a certain threshold of employment size (number of employees), they encourage firms to stay informal and small.

Since ‘industrial relations’ is a concurrent subject in India’s constitution, state governments have been able to make their own amendments to the IDA, even though it is a central (federal) Act. In addition, the implementation of labour laws lies with the states. Thus there is some amount of variation in labour-market rigidity across states.

Labour regulations and economic performance of firms

There is, by now, considerable evidence that the economic performance of the formal manufacturing sector varies across states and improves with labour market flexibility (Besley and Burgess 2004). Hasan, Gupta and Kumar (2009) find that states with relatively restrictive labour regulations (pro-worker) have experienced slower growth of labour-intensive industries and overall employment. Hasan and Jandoc (2013) find that the share of labour-intensive firms employing 0-9 workers is much higher in restrictive labour regulation states as compared to other (pro-employer) states (about 60% versus 40%); the reverse is true for firms hiring 200-plus workers (roughly 10% versus 25%)2. Dougherty, Frisancho Robles and Krishna (2014) show that total factor productivity in firms in labour-intensive industries as well as in industries with highly volatile demand (requiring frequent input adjustments) were on average about 11-14% higher in the states with less restrictive labour laws compared to others.

Thus, one could infer that labour regulations are stunting the growth of labour-intensive firms. This is further supported by the fact that labour-intensive enterprises are not growing despite major reforms in India’s trade and Foreign Direct Investment (FDI) regimes, ending of small-scale reservation in labour-intensive industries, de-licensing and the expiration of the Multi-Fibre Arrangement3 (Bhagwati and Panagariya 2013). The small size of labour-intensive firms prevents them from reaping economies of scale. This is a channel through which labour regulations lower India’s comparative advantage in labour-intensive manufacturing. Not surprisingly, Das, Wadhwa and Kalita (2009) find that unskilled labour-intensive sectors such as food and beverages, apparel, textiles, furniture etc. have had a constant or even a slightly declining share in Gross Domestic Product (GDP) over the last two decades, while skill-intensive and capital-intensive industries such as automobiles, petroleum, refining, engineering good, telecommunication, pharmaceuticals, finance, software, etc. have grown much faster and have increased their shares in India’s exports from 41% in 1990-91 to 65% in 2007-08. On the other hand, India has been losing world market share in apparel slowly to Bangladesh and quite rapidly to China.

How do labour laws influence the relationship between trade liberalisation and performance of domestic manufacturing?

Restrictive labour regulations prevent firms from making the required adjustments to their inputs in response to shocks to demand and technology. In the presence of trade, this can handicap domestic firms relative to firms in countries where labour market rigidity is not a problem. The realisation of the beneficial effects of trade requires both substantial amounts of inter-sectoral labour reallocation as well as intra-sectoral labour reallocation across firms within an industry. Both types of labour reallocation are constrained by restrictive labour regulations. Panagariya (2001) argues that such regulations raise effective labour costs and constrain the scale of production as the laws apply to firms above a certain threshold level of employment. This prevents firms from reaping economies of scale and being competitive in the world market. These laws also discourage firms from employing a large number of permanent workers, and hence they tend to employ more casual or contract workers, who have limited incentive to learn on the job and acquire firm-specific skills.

I, along with Beyza Ural, examine the impact of trade reforms on productivity of firms in India, and how this varies across states with varying degrees of labour market flexibility (Mitra and Ural 2008). Using industry-level data for the 15 major Indian states for the period 1988-2000 from the Annual Survey of Industries (ASI) and the Asian Development Bank, a productivity increasing effect of trade reforms is found across all states, with the impact being 33% greater in the relatively more flexible labour market states. Qualitatively similar effects are also found in the case of employment, output, value added, capital stock and investment. With regard to the informal manufacturing sector as well, trade liberalisation boosts employment, output and value added (Ahsan, Mitra and Sundaram 2013). However, in this case the impact is greater in the rigid labour market states (as compared to the flexible labour market states) for informal enterprises with more than five workers. Thus, these findings indicate that the growth of formal manufacturing that is constrained by restrictive labour regulations is picked up to a certain extent by the informal manufacturing sector. There is also some evidence here of outsourcing of production activity from the formal to the informal sector (Ahsan, Mitra and Sundaram 2013). Overall, there seems to be complementarity between formal and informal production activity both through the forces of agglomeration and outsourcing.

The relationship between trade and labour regulations can be further understood by looking at the impact of the latter on factor (input) intensities, since it is factor intensities in combination with factor abundance that determines comparative advantage and specialisation under trade and, in turn, the gains from trade. Using cross-country industry-level data mainly from the United Nations Industrial Development Organisation (UNIDO), I, in collaboration with Rana Hasan and Asha Sundaram, find that labour market imperfections, arising from restrictive labour regulations, are associated with an increase in capital intensity in the various industries of the manufacturing sector, in particular unskilled labour-intensive industries and industries whose demand and technology are volatile enough to require frequent labour adjustments (Hasan, Mitra and Sundaram 2013a). Thus, such regulations limit the gains from trade based on factor-abundance driven comparative advantage. In particular, hiring and firing regulations, minimum wage regulation and unemployment benefits are found to drive the result that higher regulatory burdens associated with the labour market are associated with higher capital intensity. Since India has relatively restrictive labour regulations, India uses more capital-intensive techniques of production than predicted by its level of development (Hasan, Mitra and Sundaram 2013a). Interestingly, in a large majority of manufacturing industries, India uses more capital-intensive production techniques than does China. These industries include paper and printing, leather, rubber and plastics, chemicals, non-metallic minerals, base metals, metal products, electrical equipment and instruments, petroleum etc.

Next, I move to a relatively recently identified set of channels through which trade impacts the labour market. Rodrik (1997) has argued that trade reforms, by allowing cheaper imports of inputs that might be substitutes for the services of domestic labour, makes labour demand more elastic (more responsive to changes in the price of labour). Rodrik (2013) goes on to argue that this increase in labour demand elasticity resulting from trade liberalisation will mean a lower bargaining power for workers as well as greater volatility in wages and employment for given volatility in productivity. Using industry-level data for the 15 major Indian states for the period 1988-1997, I, in collaboration with Rana Hasan and KV Ramaswamy, find that trade reforms led to a statistically significant increase in the labour demand elasticity, with this elasticity and the increase in it (due to trade liberalisation) relatively greater in states with flexible labour markets (Hasan, Mitra and Ramaswamy 2007)4.

Most models of unemployment suggest that a decline in workers’ bargaining power is likely to bring about a reduction in unemployment. I, along with three of my research collaborators, find evidence for an unemployment reducing effect of trade liberalisation in states with flexible labour markets, with roughly 37% of the actual unemployment decline being possibly attributed to trade liberalisation (Hasan, Mitra, Ranjan and Ahsan 2012). In addition, a decline in the bargaining power of workers and in particular labour unions could shift incentives such that greater effort receives bigger rewards. This can be productivity enhancing and can ultimately lead to an increase in wages. Furthermore, a decline in the bargaining power of labour can unleash political-economy forces that could bring about reforms in labour regulations. While greater labour demand elasticity will mean greater transmission of the volatility in productivity into wage and employment volatility, the more important and likely effect in a rapidly growing economy is the greater transmission of productivity growth to wage and employment growth.

Implications and policy recommendations

Restrictive labour regulations have held back the performance of India’s manufacturing sector, especially in labour-intensive industries, thereby preventing a labour-abundant country like India to take advantage of its factor abundance-driven comparative advantage in labour. Thus, labour regulations constitute a major binding constraint on India’s industrialisation and economic development. Reform of these labour laws is, therefore, of paramount importance. Indian labour laws do not offer flexibility in hiring and firing of workers required to support firms in an open economy competing with firms across the globe. Especially in labour-intensive industries, Bhagwati and Panagariya (2013) argue that there is much greater flexibility available to employers in China, Vietnam, Bangladesh etc., where large-scale apparel firms are very common. As result, they suggest a tighter definition of retrenchment which excludes from this definition; the downsizing in response to a shrinking demand or a change in technology or non-confirmation of a worker on probation. Furthermore, they argue that labour laws should be modified to allow greater flexibility in moving a worker across tasks for which he/ she is qualified. Further, multiple unions within a firm should be disallowed as it can lead to messy situations resulting in huge productivity losses. Other suggestions include minimisation of costly paperwork due to the requirement of filing information with the state labour department.

Since workers in the formal manufacturing sector are politically well organised, the changes suggested above are viewed by some as politically not feasible. However, this constraint should not be taken as given. As noted above, greater openness to international trade leads to a decline in the bargaining power of workers. Also, there is evidence to show that greater import competition arising from trade reforms has resulted in de-unionisation in the form of shrinking union membership as well as declining union presence (as a result of declining rents to be shared between workers and employers as well as possibly a decline in the bargaining power of workers) (Ahsan, Ghosh and Mitra 2013). These developments should lead to an erosion of the political power of formal sector workers which, in turn, can make labour market reforms politically more feasible. As these reforms take place, workers will probably realise that they are the biggest beneficiaries of such reforms. This should lead to greater political support over time for these reforms. At present, employers are reluctant to hire workers since they know that, due to the severe firing restrictions in place, they will get stuck with them even if they turn out to be incompetent or if demand shrinks.


  1. Other key labour laws are: (i) Industrial Employment (Standing Orders) Act: This makes modifications to job descriptions and inter-plant transfers within a firm (with more than 100 workers in some states and more than 50 in others) extremely difficult, if not impossible. (ii) Trade Union Act: This allows any seven workers within a firm to form a union, thereby leading to the possibility of multiple unions within a firm, a potentially difficult situation for employers. Unions have the right to strike and represent workers in legal disputes with employees. (iii) Employees' State Insurance Act, Factories Act, Employees' Provident Fund and Miscellaneous Provisions Act, Minimum Wages Act, Maternity Benefits Act etc.: These become applicable at other threshold employment sizes and apply to various kinds of establishments (Bhagwati and Panagariya 2013). They stipulate minimum work conditions and benefits that further increase labour costs for employers. (iv) Contract Labour Act: This regulates and restricts the use of contract labour, preventing firms from easily substituting permanent workers with contract workers to reduce the cost of labour regulations. For certain tasks, the use of contract labour is not allowed.
  2. Hasan and Jandoc (2013) do a similar comparison between high- and low-infrastructure states and do not find anything as striking as in the above comparison. They also show that while employment in the Indian apparel industry is concentrated in small firms (employing less than 9 workers each) it is concentrated in very large firms (each employing more than 2,000 workers) in the Chinese apparel industry.
  3. Under the Multi-Fibre Arrangement quotas were imposed on the imports of textiles and apparel from developing countries by developed countries. This arrangement started in 1974 and expired in 2005.
  4. While Slaughter (2001) was the first to investigate the labour demand elasticity increasing effect of trade for the US, I along with Pravin Krishna and Sajjid Chinoy, investigated this relationship for a developing country – Turkey – in 2001. While Slaughter finds somewhat mixed results, varying across types of labour and not very robust after accounting for variations across time, the impact of trade liberalisation on labour demand elasticities in Turkey turned out to be insignificant.

Further Reading

  • Ahsan, Reshad N and Devashish Mitra (2014), "Trade Liberalization and Labour's Slice of the Pie: Evidence from Indian Firms", Journal of Development Economics, 108:1-16.
  • Ahsan, R N, A Ghosh and D Mitra (2014), ‘International Trade and Unionization: Theory and Evidence', Department of Economics, Syracuse University.
  • Besley, Timothy and Robin Burgess (2004), "Can Labour Regulation Hinder Economic Performance? Evidence from India", Quarterly Journal of Economics, 119(1): 91-134.
  • Bhagwati, J and A Panagariya (2013), Why Growth Matters: How Economic Growth in India Reduced Poverty and the Lessons for Other Developing Countries, Public Affairs, New York.
  • Das, D K, D Wadhwa and G Kalita (2009), ‘The Employment Potential of Labour Intensive Industries in India's Organized Manufacturing', ICRIER Working Paper 236.
  • Dougherty, S, V C Frisancho Robles and K Krishna (2011), ‘Employment Protection Legislation and Plant-Level Productivity in India', NBER Working Paper No. 17693.
  • Gupta, Poonam, Rana Hasan and Utsav Kumar (2008), "Big Reforms but Small Payoffs: Explaining the Weak Record of Growth in Indian Manufacturing", India Policy Forum, 5(1):59-123.
  • Hasan, R and K Jandoc (2013), ‘Labour Regulations and Firm-Size Distribution in Indian Manufacturing', in Bhagwati, J and A Panagariya (eds.), Reforms and Economic Transformation in India, Oxford University Press, New York, NY, 15-48.
  • Hasan, Rana, Devashish Mitra and K V Ramaswamy (2007), "Trade Reforms, Labour Regulations and Labour Demand Elasticities: Empirical Evidence from India", Review of Economics & Statistics, 89(3): 466-481.
  • Hasan, Rana, Devashish Mitra, Priya Ranjan and Reshad N. Ahsan (2012), "Trade Liberalization and Unemployment: Evidence from India", Journal of Development Economics, 97(2):269-280.
  • Hasan, Rana, Devashish Mitra and Asha Sundaram (2013a) "The Determinants of Capital Intensity in Manufacturing: The Role of Factor Market Imperfections", World Development, 51:91–103.
  • Hasan, Rana, Devashish Mitra and Asha Sundaram (2013b), "What Explains the High Capital Intensity of Indian Manufacturing?", Indian Growth and Development Review 6(2):212-241.
  • Krishna, Pravin, Devashish Mitra and Sajjid Chinoy (2001), "Trade Liberalization and Labour-Demand Elasticities: Evidence from Turkey", Journal of International Economics, 55:391–409.
  • Mitra, Devashish and Beyza Ural (2008), "Indian Manufacturing: A Slow Sector in a Rapidly Growing Economy", Journal of International Trade and Economic Development 17(4):525-560.
  • Panagariya, A (2001), ‘Rigid Labour Laws: A Minor Barrier to Growth?', The Economic Times, 26 September 2001.
  • Rodrik, D (1997), ‘Has Globalization Gone Too Far?', Institute for International Economics, Washington DC.
  • Slaughter, Matthew (2001), "International Trade and Labour-Demand Elasticities", Journal of International Economics, 54(1): 27–56.
  • Sundaram, A, R Ahsan and D Mitra (2013), ‘Complementarity Between Formal and Informal Manufacturing in India', in Bhagwati, J and A Panagariya (eds.), Reforms and Economic Transformation in India, Oxford University Press, New York, NY, 49-85.
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