Should you be investing in Indias manufacturing outsourcing story

Updated: Nov 14 2004, 05:30am hrs
It is an interesting exercise to look at yourself from an outsiders perspective. Dr Marc Faber, the economic historian who is also popularly referred to as the prophet of gloom and doom, at a recent session organised by CLSA Asia-Pacific Markets decided to view the world from Chinas eyes.

Here are two interesting takeaways from his presentation:

The strength of the US economy is riding on higher debt and a withdrawal from this state of excesses could be very painful.

A strong US dollar will help China destroy the US manufacturing sector while our Hindu neighbours will do the same to the services sector - to the extent outsourceable.

India seen as a services player

One clear indication from the above is that India is seen as a global player in services, but there is not much recognition of its manufacturing sector capabilities. The other interesting aspect is that riding on US demand growth may not be prudent in the long-run, given the risks perceived, and a conscious focus on Europe and other emerging markets might prove beneficial. On this count, India is fairly comfortable as a large part of its manufactured exports in several sectors like textiles and automobiles are either to the EU or neighbouring countries. For India, US is a big export customer of cashew (48%), marine products (33%), spices (25%) and processed minerals (25%). The key segment this could have implications for is readymade garments (26%). But as with the pharmaceuticals and IT services, there is still significant room for growth in the near term in this segment, more so with the expected phase out of quotas next year. Besides leading players in these sectors have already started diversifying across geographies.

But what is equally and perhaps more important to note is that India is seen more as a market for goods and a supplier of services. The entry of most global auto companies into the country, to ride the growth in domestic demand, is seen as a pointer to Indias being viewed as a big potential consumer of goods. In fact, several reports and studies have pointed to the emergence of China and India as big consumption economies in the longer-term.

For India, a favourable demographic profile, higher employment and incomes provided by the services sector - IT, product after-sales and retailing and logistics - are seen as the drivers for consumption growth. Auto industry players confess that their first priority is the domestic market. A look at the share of exports across key emerging sectors, viewed from an outsourcing potential perspective, provides an indication of the dominance of the domestic market in their sales mix (See table). Besides, engineering exports, which grew 41% last year are seen growing at around 27% this year, forecasts Centre for Monitoring Indian Economy (CMIE). When one views this against the scale of IT services exports and the rate of growth in the sector, it does make one wonder if the manufacturing outsourcing story, barring a few sectors like pharma, isnt over-played.

Infrastructure a bottleneck

Among the reasons why the Indian IT services sector has been able to post healthy year-on-year growth has been its relatively low dependence on the state of the physical infrastructure in the country. Besides, with the opening of the telecom services to private sector players and significant investments by them, the telecom infrastructure has improved significantly.

On his second visit to India, Stephen Roach of Morgan Stanley, made some interesting comments (in his personal capacity) based on his observations. Heres the short of it:

He is worried about Indias fixation on a manufacturing-led development strategy that remains constrained by a glaring infrastructure gap, sub-par national saving, and a serious shortfall of foreign direct investment.

A more illustrative comment on the infrastructure front was his rating the Mumbai-Pune expressway as B-minus by Chinese standards. His comment on our infrastructure: not only does it risk crimping the efficiencies of supply-chain management and nationwide delivery capabilities, but it raises serious questions about the transportation requirements of a dynamic export sector.

The comment when seen in light of the poor quality of road infrastructure, delays at ports and the insufficient and high-cost power supply in the country puts our competitiveness in perspective. To think that the Silicon Valley of India doesnt even have an airport that can handle the flood of international traffic headed for the city or the rooms to accommodate all those who visit, unless they book well in advance, is a telling fact.

But a better indication of the impact of Indias poor infrastructure is available in a study by ICRA Advisory Services for the Society of Indian Automobile Manufacturers. The report, which focuses only on the automobile sector, indicates that the poor infrastructure leads to a cost disadvantage for Indian manufacturers of 3-4% vis--vis Malaysia, 3% compared to Thailand and about 2-3% vis--vis the Philippines. And we are only talking about the ASEAN countries here.

The other point that Roach makes about a manufacturing sector led growth is that it has not led to any significant increase in employment generation. He points to the fact that most manufacturers have enhanced productivity and efficiencies by adopting more capital-intensive processes. His argument is that Indias strength lies in its qualified / skilled, low cost manpower, which is not the true driving force for capital-intensive manufacturing.

To counter this, industry sources say that despite the infrastructure bottlenecks Indian manufacturers have been able to compete in the overseas markets. Some also point to the infrastructure issues being overstated, but the fact remains that unless a significant improvement on this count does take place, it would eventually take its toll on the manufacturing outsourcing business.

Already, several industrialists complain that it costs them more in time and money to transport goods within the country, than it does to ship them overseas. Besides, the ICRA study indicates that power and fuel costs in India, a key input for most industries, are also on the higher side.

A recent trend among large Indian companies who have opened their minds to global sourcing, production and marketing has been their venturing out of the country for growth. And these are not just to find new markets. Bharat Forge and Sundram Fasteners decided to set up facilities in China. Mahindra (M&M) has also entered the land of the dragon by acquiring interest in a tractor unit with an eye on exports. Two-wheeler players are looking to invest in facilities in countries like Indonesia and drug makers are on a buying spree in Europe. What this points to is the fact that commercial interests will now dictate business decisions and a love for the motherland need not translate into new investments in the country.

And governance an impediment

But infrastructure is not the only issue constraining competitiveness. Says a leading economist, A significant improvement in GDP growth is unlikely till we overhaul the current governance structure. There are hidden costs that any business has to bear for operating in the country.

An industrialist rues that his senior executives spend more time dealing with the government than they do on driving the business. It is not surprising, therefore, that most players in the textiles sector have decided to opt for freedom from the inspector raaj (excise payments), and this along with a level playing should place them in a better position to compete globally.

However, there are others who argue that red-tapism is gradually taking a backseat and point to the competition between states for investments, as a positive development in this context. Still, the government needs to act fast on issues like an exit policy and labour laws to attract the required foreign direct investments (FDI) into the country and its fund starved infrastructure sector.

FDI is seen as a big source of capital for infrastructure projects. The Planning Commissions steering group on FDI (NK Singh committee) had recommended a host of steps - regulatory reforms, institutional changes and raising of sectoral FDI caps - to attract foreign capital flows. But several of these issues are still hanging fire. Another example of slow progress in the infrastructure sector is the Vallarpadam Container Terminal Project, which has seen almost no progress on the ground for almost five years now.

So buy the company not the country story

The message for investors, therefore, is to focus not on sectors, but on large companies in sectors where global product outsourcing is likely. These companies with their ability to compete (despite odds like poor infrastructure), their established credential overseas and larger resources should find a way to grow (either in India or through overseas investments) and exploit the global sourcing opportunity.