The Hindu Business Line : Industrial policy options

Steel coils being readied for export_ Industry can grow only if there is adequate demand, and demand has to be stimulated by public investment in both infrastructure and agriculture.

I RECENTLY came across a seminal contribution to the ongoing debate on economic reforms in India, written by a bright economist, Dr R. Nagaraj of Indira Gandhi Institute of Development Research.

In a perceptive article to the Economic and Political Weekly (of September 5), he has analysed what happened to industrial growth pre- and post-reforms and what can be done to revive it. That the rate of growth declined in the 1990s is brought out clearly from the data. He analyses the possible causes and suggests solutions. His contribution deserves a wider attention.

India's manufacturing sector currently accounts for about 17 per cent of real GDP, 12 per cent of total workforce and close to 80 per cent of merchandise exports. In the past half century, this sector has grown at nearly 6 per cent per year, nearly one-and-half time the growth rate of domestic output.

The annual trend rate of growth during the last two decades is close to 7 per cent, a break from India's colonial past, although relatively small compared to the scorching rates of growth of other countries in Asia.

For 1980-2000, comparable figures are China (12.8 per cent), Indonesia (10.2 per cent), Korea (9.4 per cent), Malaysia (11.2 per cent) and Thailand (9.8 per cent) as against our 6.8 per cent.

Dr Nagaraj compares the growth rates of India's manufacturing sector in the 1980s and the 1990s. The Table is of interest:

The deceleration in the 1990s appears substantiated by the figures, though not strictly in terms of statistical tests of significance.

An analysis of the detailed growth figures is more rewarding. The capital goods sector grew at 6.7 per cent during 1981-98 and at 5.7 per cent per year during 1992-98. The overall trends hide significant variations in individual industries.

Within capital goods, production of passenger cars went up sharply in the period, representing an annual growth of 15 per cent during the two decades.

What suffered was the manufacture of basic capital goods, such as machine tools. Output of domestic metalworking machine tool manufacture in 2001 dropped by 14 per cent, the fourth year of decline since 1997. The machine tool industry stagnated at a time when the industrial investment boomed.

Evidently, much of the incremental demand was met by imports. The import-consumption ratio doubled from 29 per cent in the early 1990s to 56 per cent in 1995. No wonder, Ashok Desai graphically described the reform-led reduction of import tariffs as leading in the 1990s to the "massacre of machine building".

It is important to note that in contrast to the 1990s the 1980s saw a substantial increase in public investment, particularly in infrastructure, power being the main beneficiary. It also saw a step-up in public investment in agriculture. Both these contributed to the higher industrial growth pattern.

Dr Nagaraj notes that one of the benign consequences of the reforms was the reduction in prices of capital goods, thanks to the abundant imports and lower tariffs. This has led, no doubt, to the capital stock becoming more productive.

There has also been an accompanying growth in the construction sector, thanks to relaxed supply conditions of steel and cement. Employment in the construction sector doubled from 2.3 per cent of the total workforce in 1983 to 4.4 per cent in 1999-2000.

Dr Nagaraj notes that contrary to reformers' expectations, labour-intensive manufacturers did not gain. Removal of import substitution bias was expected to lead to a strengthening of exports of labour-intensive manufacturers. This has not happened.

The share of the unregistered sector (the smaller units) in the total manufacturing gross capital formation halved from around 45 per cent in the mid-1980s to less than 20 per cent by the end of the 1990s.

Dr Nagaraj points out that industry invested heavily in the expectation of an expanding market following liberalisation. As things turned out, increase in demand did not fructify. Output growth proved to be smaller than projected.

Dr Nagaraj notes that investment in the unregistered manufacturing was also hurt by high interest rates in the critical early years of reform. Further, banks resisted lending to the productive sectors for various reasons, including fear of pursuit by various agencies.

They preferred to lend to the government. Dr Nagaraj notes that bank credit to the small-scale sector declined from over 16 per cent in the 1980s to less than 12 per cent a decade later. Commercial banks have had little incentive to lend to small units. This is an obvious flaw in the reform process.

Dr Nagaraj attempts to answer the question why manufacturing growth has slowed down since the mid-1990s, in spite of reforms being implemented. One view, attributed to Ashok Desai, is that the credit squeeze of 1996 and as part of reform rise in interest rates throttled the boom of 1995-96. But, as Dr Nagaraj points out, the interest rates have since then softened and the credit flow resumed. Why then the continuing pause in industry until recently?

Dr Nagaraj does not quite agree with those who plead for more reforms as a solution to the problem. He cites a more fundamental flaw in policy for the current slowdown.

In his view, and he has the support of eminent economist W. Arthur Lewis in this, what limits the size of the manufacturing sector in countries like India, is the productivity of farmers whose marketable surplus is exchanged for manufactures. Apropos this, K. N. Raj has interesting observations, which Dr Nagaraj quotes:

"Private consumer demand in a country such as India depends to a large extent... on how things go in the agricultural sector. If output and income in this sector are rising rapidly, consumer demand for both agricultural and non-agricultural products can also be expected to increase rapidly, the latter being even more than the former since higher proportions are generally spent on non-agricultural products as levels of income rise.

"Output and incomes in the agricultural sector need not of course always rise together since the effect of sharp increases in output could well be to lower the prices of agricultural products more than proportionately; this is in fact an important factor governing agricultural income in some regions of the country characterised by serious year-to-year variation in climatic conditions and water supply."

Sukhamoy Chakravarty, another perceptive economist, has also argued that while the long-term constraint in a developing economy is one of supply of savings and investment under specific circumstances, aggregate demand could become a binding constraint for growth.

The answer then lies in increasing aggregate demand through public policy. This, suggests Dr Nagaraj, has to come from autonomous public investment in infrastructure, which helps create demand for industrial goods as well as release infrastructural constraints.

He states that econometric evidence also supports the view that public investment in India crowds in private investment instead of displacing private investment. It is also essential to speed up public investment in agriculture, so as to help increase rural productivity and generate rural surpluses.

The slackening of industrial growth since the mid-1990s cannot be cured by the simplistic adoption of more reforms on the conventional model. What is needed is an increased focus on public investment on infrastructure and greater attention to agriculture.

Dr Nagaraj anticipates, and answers, the critique that financing can present a problem. He believes that in the Indian context, public investment in infrastructure may actually have benign effects on the fortunes of public sector enterprises, which are at present underutilised and may help, instead of hindering fiscal balance. Besides, the Shetty model of public-private partnerships can ensure a safe financing paradigm, without cluttering the fiscal balance. In this context, one cannot do better than quote the eminent economist, Dr Mihir Rakshit in support of this rather unconventional view:

"Even in mainstream economics, it is recognised that the fiscal deficit cannot be a primary policy parameter, but is the outcome of the working of the entire system... (in) India almost all industrial units producing heavy machinery, equipment and basic metals belong to the public sector; and the wage bill in the large majority of these enterprises constitutes a fixed rather than a variable cost in the short and medium run.

"This implies that (i) an increase in the demand for fixed capital goods met from domestic sources raises public sector savings by an almost identical amount; and (ii) the value of the investment multiplier is close to unity. Thus even the short-run effects of public consumption and investment on aggregate demand are quite different."

Thus, while reform is necessary, reform is not all. More and more reform of the same type may not solve the problem of industrial slowdown and restore growth. Dr Nagaraj's suggestions, supported by a thought-provoking analysis of facts and figures, deserve consideration at the highest level.

Aggregate demand in the economy has to be "grown" by the properly articulated policy of increased public investment, without falling a prey to mantras of fiscal stability.

Industry can grow only if there is adequate demand and demand has to be stimulated by public investment in both infrastructure and agriculture — ironically enough, a throwback to the unreformed 1980s.

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