Sudhanshu Ranade

Chennai, June 8

DESPITE the pride of place accorded to it from the beginning of planned industrial development in the mid-1950s, the domestic capital goods industry is not faring too well.

Its products are unable to compete on price and/or quality with China, Korea and Taiwan, leave alone more advanced countries such as Japan, Germany and the US except by making price concessions, which further compound the cost disadvantage.

Export transactions costs are among the highest in the world. High transaction costs also result in inordinate delay in fulfilling export contracts. This leaves the industry almost completely reliant on the domestic market.

As a result of the emphasis on broadbased heavy industrialisation from the mid-1950s, the capital goods industry produces a wide range of products; almost all major capital goods are domestically produced.

The flip side of this, however, is that the industry lacks depth, because it is unable to reap economies of scale on the basis of the finite domestic market. Even countries with an advanced capital goods sector do not produce the entire range of capital goods, but instead focus on select segments or sub-segments.

There is a close correlation between the growth of the capital goods industry (accounting for 9-12 per cent of total value added in manufacturing) and the overall growth of the Indian industry, says the PricewaterhouseCoopers study on Competitiveness of the Indian Capital Goods Sector; the executive summary of which is available online at the Web site of the Department of Industrial Policy and Promotion of the Ministry of Commerce and Industry.

A related determinant of the demand for capital goods is gross domestic investment, of which the industry accounts for a constant share of 17-21 per cent.

On the supply side, the output of capital goods is determined by investments and by capacity utilisation. There is a close interconnection between these two inasmuch as large investments are necessary to bring available capacity in line with the type of demands made on it. However, investments have in fact declined, with the decline in the relative profitability of the capital goods sector with respect to other sectors. Raw material price indices have risen faster than the price index for machinery produced by this sector. It is difficult for manufacturers to pass on the rise in prices to customers, but some manufacturers have tried to get around this by resorting to value-engineering techniques for efficient raw material usage and cost reduction.

While there are a few firms close to the international frontier in terms of product design capability and process technology, technological capabilities of most players are extremely limited. The country has a number of high quality R&D institutions, but industry-institute interactions are few and far between.

Indian firms are prevented in achieving high levels of precision due to lack of supporting process technologies, such as precision measuring, material engineering and process control. Even in the numerous cases in which Indian capital goods are functionally at par with equipment made elsewhere in the world, they rank poorly so far as the finish is concerned.

Labour in the capital goods sector is highly cost competitive, says the PwC study, even after discounting for low labour productivity. However, since labour costs account for only 7-21 per cent of total factor usage, this by itself does not make much of a difference.

Indian capital goods manufacturers have working capital requirements as high as 45 per cent of net sales (as against a global benchmark of 15 per cent). Meanwhile, interest rates in India are well above those prevailing in China, Korea and Taiwan. A further problem is that it is becoming increasingly difficult for the industry to source capital. Bank credit to the engineering sector steadily declined from 20.3 per cent of the share of total bank credit to all industrial sectors in 1990 to 9 per cent in 2000. With bearish capital markets and a mere trickle of FDI inflow into the sector (except into the electrical machinery segment) the sector has been further crowded out of project funding opportunities.

Inland transport is slow, although the railroad density is among the highest in the world. The cost of electric power is comparable to that in other nations but the reliability is poor. Many capital goods firms have set up their own power plants to find a way around this problem. This has added to costs.

Some advantage is derived from clusterisation in certain segments such as foundry and electronics, while engineering consultancy services have benefited from accumulation of expertise and advanced tools. However, ancillaries and supporting industries are unsatisfactory in terms of technical capability, quality and delivery.

In pre-VAT times, the Indian capital goods sector faced high rates of indirect taxes (excise, octroi, sales tax) compared to taxes faced by capital goods sectors of other countries. The cost disadvantage due to this was as high as 24 per cent in certain cases.

Meanwhile, zero-duty imports for products like refinery, fertiliser etc puts the domestic capital goods industry at a clear disadvantage. This problem is further accentuated by the import of second-hand machines.

(This article was published in the Business Line print edition dated June 9, 2005)
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