Why tariff hikes won’t protect domestic manufacturers

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Published: February 7, 2020 4:55:26 AM

Tariff protection without a trade policy driven by reduction cost of doing business in India has the danger of making us less, not more, competitive

tariff hikes, domestic manufacturers, FY21 Budget, corporate tax rates, China, trade deficit, GDP, MFN tariff The rationale given is to protect local manufacturers, and give a boost to Make in India.

The FY21 Budget announced tariff increases on a range of household products and appliances as part of a trade policy to restrict ‘unnecessary’ imports. Many of these imports are from China, India’s widening trade deficit with which has caused the government concern. The rationale given is to protect local manufacturers, and give a boost to Make in India. This comes soon after the cutting of corporate tax rates to make them globally competitive, especially with ASEAN countries like Vietnam, with which India is competing for investments. Despite a range of policy initiatives, the manufacturing share of India’s GDP remains stubbornly ‘stuck’ at around 15%. While India is not alone in imposing higher trade barriers post the 2008 financial crisis, it is one of the most aggressive users of anti-trade notifications. WTO estimates that India’s average MFN tariff is the highest among major economies.

I don’t contend that India should refrain from using these measures to protect its interests. Data supports the government view that our regional trade FTAs didn’t have a positive outcome for local industry. While overall volume of trade increased, imports increased faster. But, my fear is that by going back to a more protectionist stance, we may be in danger of shooting the messenger instead of addressing the lack of global competitiveness of many parts of India’s manufacturing sector. The worst-case outcome will be if we become comfortable again with the high tariff protection regime and discredited policy of import substitution of the 1960s to 1980s, which had made India a low-innovation, high-cost manufacturing economy.

Let us understand the ‘message,’ starting with tariff hike. Most of these ‘unnecessary’ imports, like toys, small plastic parts, small furniture, etc, are made by private Chinese SMEs, which operate in a hyper-competitive environment in a country with rapid increase in wages, and not by subsidised, large state firms. Indian SME suppliers are unable to compete with them, despite the additional cost of transportation from China, even though they do not lack a large-scale local market as these products mostly cater to the mass segment. Further, despite the tax cuts to make India a more attractive manufacturing investment destination, Vietnam is attracting a major share of the large capacities shifting out of China, despite India’s much larger domestic market as an attraction. As a result, Vietnam’s manufacturing exports are growing rapidly while India’s are stagnating or declining.

The message is clear. The important link connecting both these contexts is simply the lack of competitiveness at both ends of the spectrum—Indian SMEs in local market are being outpriced by their Chinese competitors, and large scale manufacturers find themselves outpriced in the global market by plants in Vietnam (and several other countries, e.g., Bangladesh for textiles). This is not to say that we don’t have any globally competitive SMEs or large manufacturing companies, but these are more the exception than the rule. And, unless we address this essential poor global competitiveness, we face the danger of falling into the high tariff protected, import substitution, high-cost manufacturing mindset of the 1960s and 70s.

So, what should we do? I have two observations to offer. First, I do think that a trade policy favouring local manufacturers is a legitimate policy lever (if allowed within WTO rules) as long as there is clear understanding within the industry that these tariff increases are temporary and they have to improve their cost competitiveness during this period of high tariff imposition. From past experience, we can see that this strategy has helped build the only two globally competitive manufacturing sectors we have in India—automotive, and pharma. Both these industries developed in the 1980s and 1990s; since then, we haven’t been able to add even one more industrial sector (not counting ITES) to this short list. The highly competitive automotive industry developed in India by harnessing a protectionist policy regime of a phased manufacturing program (PMP), with private sector’s entrepreneurial enterprise. Similarly, the pharma industry developed where a protectionist patent policy (India’s interpretation allows local firms to develop innovative, cost-efficient processes of of-patent molecules) combined with the genius of local entrepreneurs, who knew that they have a window of opportunity before this liberal interpretation of patent regulations will come under pressure from global pharma giants. In both sectors, industry players knew they had to become globally competitive while the protectionist policy lasted, and they did.

Clearly, we need a game-plan for global competitiveness along with the tariff protection and tax cuts. And that is my second observation. While the NDA government has initiated several major policy reforms—GST, focus on EoDB, infrastructure development, setting up a logistics department, etc—to support the manufacturing sector, we have to ‘change our game’ and put global competitiveness at the centre of our industrial policymaking to ensure that our trade, investment, and industrial policies are synchronised, with one overarching objective—global cost competitiveness of the Indian industry. Without this, individual policy initiatives will not deliver the full benefit to the industry.

So, how do we achieve this? By measuring India’s rank, and then having a clear roadmap to improve it. The only measure of this is Cost of Doing Business (CoDB), which has to be built on (i) factor costs, (ii) cost of, and access to capital (especially for SMEs), (iii) regulatory compliance costs, and (iv) other factors of global competitiveness that go beyond EoDB. Only by developing such a measure that brings together the comprehensive set of factors that drives CoDB, and then using this metric to inform our policymaking, can we improve our global cost competitiveness. The importance of having such a metric comes out if we compare CoDB for Vietnam and India to understand why manufacturing investors prefer the former. The comparison shows that, interestingly, India and Vietnam don’t have hugely different factor costs. India is most disadvantaged on government and regulatory costs, and speed of decision (for Chinese investors, a cultural affinity and proximity to Chinese infrastructure is also a factor in choosing Vietnam). This is also where Indian SMEs are most disadvantaged vis-vis China as they are unable to navigate cost-effectively the over 1,980 central and state regulations for manufacturing companies (as per a recent FICCI report).

India needs a more globally competitive manufacturing sector. Tariff protection without a clear endgame has the danger of making us less, and not more, competitive. Supporting this trade policy with a CoDB-driven industrial policy that sets a time-bound plan to improve our ranking to the top-five will be critical if we want to achieve our aspiration of becoming a global manufacturing hub.

The author is Managing Director & Senior Partner, Boston Consulting Group. Views are personal

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