Capital goods need a policy overhaul

Swathysree SS / Parthapratim Pal | Updated on April 22, 2019

Pivotal The capital goods sector plays a critical role in driving manufacturing growth   -  metamorworks

The ‘mother industry’ is mired in slowdown. Inverted duties and pitfalls of export promotion schemes need to be fixed

Data released by the Ministry of Statistics and Programme Implementation show signs of a sharp decline in industrial activity in February 2019. The IIP growth numbers suggest that the production of manufactured goods in February 2019 is only about 0.1 per cent higher than in February 2018. This may be a sign of stagnating demand, and it should be a matter of concern for policy-makers.

More importantly, the data also show that there is an 8.8 per cent contraction in the output of the capital goods sector. This is the second month in a row when production of capital goods has contracted. The January 2019 IIP numbers also show a 3.2 per cent decline in the production of capital goods.

The capital goods sector is important as it provides critical inputs like machinery and equipment to a broad set of user industries which are used directly or indirectly in the manufacture of goods and services. There is growing evidence that the Indian capital goods sector is becoming less self-sufficient and is relying more on imports to meet domestic demand.

India is a net importer of capital goods with a widening trade deficit. In the total non-petroleum and oil imports of India, capital goods emerge as the second largest import category. Up to January of financial year 2018-19 , the share of capital goods imports in the total non-petroleum and oil imports of India was 28 per cent whereas the share of exports is 12 per cent.

India’s export performance in the capital goods sector has also been modest. India’s share in global exports is a meagre 0.6 per cent and is the 25th largest exporter. A trend analysis of the last 10 years’ gross exports of capital goods shows a rising trend, but the export volume is meagre vis-a-vis imports, especially in comparison with China.

The Central government has come up with measures like National Capital Goods policy and ‘Make in India’ to enhance the productivity and competitiveness of the capital goods sector. The government is also planning to leverage the FTAs (free trade agreements) to boost capital goods exports.

Trade pacts

However, an analysis of India’s export destinations and import sources indicate that trade agreements are unlikely to bring much benefits for the Indian capital goods sector. India’s major export destinations of capital goods are developed countries like the US, the UK, Germany, and France, and Gulf nations like the UAE, Saudi Arabia and Kuwait with whom currently India does not have any FTAs.

However, our primary import sources of capital goods include South-East Asian nations like South Korea, Japan, the Philippines, Malaysia, Sri Lanka, Thailand and developed nations like the US, Germany, France, Canada, the UK, and Italy. India has existing trade agreements with most of these South East Asian nations and negotiations on new trade agreements like RCEP are going on.

Foreign trade policy (2015-2020) recognises that though trade under FTAs is increasing, imports are rising faster than exports and India could not utilise the trade agreements with Japan, Korea and ASEAN nations entirely to its advantage. India’s export of capital goods to RCEP nations is modest when compared with our imports.

In 2017-18, RCEP nations accounted for 91 per cent of India’s trade deficit in capital goods, of which China alone accounts for 64 per cent. Thus, with the growing wave of protectionism across the globe, India should be defensive about the capital goods sector as opening up of the domestic market beyond MFN (most favoured nation) level will increase the threat perception for the sector.

From the import side, while the government is pushing up MFN rates to incentivise domestic value addition and Make in India, liberalising vis-à-vis the RCEP countries, especially China, does not sound like a consistent policy.

The capital goods sector is considered the mother industry of the manufacturing sector for the critical role it plays in driving manufacturing growth through inter-sectoral linkages. Capital goods are carriers of embodied technology-enabling diffusion of innovation and thus enhancement of productivity across user industries both in the manufacturing and non-manufacturing sectors.

A robust capital goods sector is vital for strengthening national manufacturing capabilities and creating employment opportunities. Recognising the strategic importance of this sector, consecutive governments have come up with a plethora of measures — National Manufacturing Plan (2012), Make in India (2014) and National Capital Goods Policy (2016) are but a few — to enhance the productivity and competitiveness of the sector.

However, the contraction in capital goods output, as seen in the recent IIP numbers, and the increasing reliance on imports by user industries for their requirements indicate that the policy measures have not yet delivered any results. Thus, it is about time to address the fundamental issues affecting the critical sector.

The government’s plan to leverage FTAs to boost the export potential of capital goods will be fruitful only when our domestic producers are on par with their counterparts across the world in terms of competitiveness.

The way forward

To emerge as a globally competitive capital goods producer in the era of smart manufacturing and swiftly changing technologies, it is imperative that India promotes technological upgradation of domestic producers of capital goods. The government may also focus on addressing issues like inverted duty structure and the unintended consequences of export promotion policies like zero duty on import of capital goods and import of second-hand machinery which affects the competitiveness of domestic capital goods producers. Attracting foreign direct investment with appropriate technology may be another way to boost this sector.

On a more long-term note, recent trends suggest that strong and disruptive changes are imminent in manufacturing technologies across the world. These changes are likely to fundamentally alter systems of production, management, and governance in the manufacturing sector.

India may consider adopting strategies to leverage its strength in information technology and take advantage of this new era of industrialisation which is likely to affect the capital goods sector in a major way.

The authors are with IIM Calcutta

Published on April 22, 2019

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