India, explained.

Components at the air conditioner factory of Haier Appliances India Ltd, in Greater Noida, India (Anindito Mukherjee/Bloomberg via Getty Images)

Trading up can unlock India’s industrial potential

Three foundational flaws in trade policy are holding the country back from becoming the next manufacturing powerhouse.

Srijan Shukla

5 June 20235 min read

Since India moved away from its socialist economy in 1991, it has had many transformative successes, but its biggest failure continues to be the absence of a robust manufacturing sector. Even over the past decade, as global production gradually moved away from China, India’s manufacturing as a share of its GDP declined. A combination of legacy constraints and the inability of successive governments to develop an efficient industrial policy meant that the country’s manufacturing sector could never take off like has occurred in other parts of Asia. However, another oft-overlooked constraint is India’s outdated trade policy.

India’s tariff protections have certainly fallen from the mind-numbing average most-favoured nation tariff rate of 125% in 1990–91, dropping to 13% in 2013–14, yet bouncing up to 18% a few years later. But this embrace of import liberalisation is only part of the story and misses the broader trade policy’s adverse effects on India’s ability to industrialise.

Over the years, India has come to be seen as a “party pooper” when it comes to trade negotiations. Whether this entails India blocking agreements at the World Trade Organisation or walking out of Regional Comprehensive Economic Partnership (RCEP) negotiations at the eleventh hour, or a general hesitation towards signing new free trade agreements.

However, there has been a shift lately. India has signed new agreements with United Arab Emirates, Mauritius, and an interim deal with Australia. It is actively negotiating new agreements with the United Kingdom, European Union, and Canada.

Yet even with the uptick in electronics exports from India in recent years – with smartphone assembly by Apple and Samsung in the country, a product of the government offering export subsidies through its scheme of Production Linked Incentives, which offer about $25 billion of incentives for manufacturers across 14 sectors – this has not been sufficient to usher in an industrial revolution, especially of the kind seen in South Korea or Taiwan.

Rather, India’s trade policy has three foundational flaws, which include a design problem, a political economy problem, and a capacity problem.

A good industrial policy is premised on the idea that policymakers need to keep tweaking based on performance – not just a carefully thought-out set of tariff and non-tariff barriers and just waiting for some manufacturing magic to happen.

The most fundamental flaw in India’s trade policy is the design of its tariff structure. It has an inverted duty structure, which means that tariffs on intermediate goods are higher than they are on the final goods. In a world where most production happen through Global Value Chains (GVCs), goods constantly move in and out of a country before the final product is assembled, and then exported or consumed. If India wants to integrate into GVCs, it needs to begin by reducing tariffs on intermediate goods.

Policymakers in India seem to think that India shouldn’t just be a centre for global goods assembly, but the necessary inputs should also be sourced from domestic firms. But it is unrealistic to assume that Indian firms – which have practically no experience of competing in GVCs – would magically become productive enough to start supplying inputs to the most productive multinationals in the global economy. It took China several years to reach the point where it now accounts for a quarter of the value added in an Apple iPhone.

Here the developmental experience of Taiwan could be instructive for policymakers in New Delhi. In its initial stage of industrialisation, Taiwan had relatively low tariffs on inputs required by its foreign-owned exporting factories, and sourced all inputs from abroad. Eventually, this changed, and Taiwan started sourcing all the required intermediate goods from its domestic producers. To do so, it had to ensure that its domestic suppliers become productive enough to compete internationally.

A further problem is India has consistently signed “shallow” trade agreements. The common feature among all post-war successful cases of industrialisation has been a steady flow of foreign direct investment (FDI), and consequently, a share of global production. And today a majority of FDI is made by select champion multinational enterprises, which dominate GVCs. In this global political economy, trade agreements are no longer just about trade liberalisation. Rather, they are much “deeper”, and include extensive chapters on areas such as investment protection, intellectual property rights, competition policy, and other domestic regulations, demanded by multinational firms as means of regulatory easing and investment protection in offshore countries.

India’s agreements don’t necessarily include these extensive chapters. Even its recent agreements with Australia and UAE are not particularly deep. Now given most FDI would come from developed economies, how India negotiates its ongoing agreements with say the European Union, United Kingdom and Canada becomes vital.

Indeed, as reports suggest, demands are being made of India in the ongoing negotiations to agree to comprehensive chapters on a plethora of domestic regulatory policies. Effectively, the Indian government now must decide where to give up its sovereign rights over some domestic policies in return for those essential FDI inflows and GVC integration. With RCEP earlier, at its core the agreement was about rationalising “rules of origin” across all industrial states in Asia. And India’s absence from it acts as a disincentive for firms looking at India as a location for moving their production. Even this would require signing on to trade-offs.

From there follows industrial policy. A good industrial policy is premised on the idea that policymakers need to keep tweaking based on performance – not just a carefully thought-out set of tariff and non-tariff barriers and just waiting for some manufacturing magic to happen. After initial policy interventions have been made, the performance of the targeted sector or firms would determine the future policy design. A highly misunderstood aspect of industrial policy is that it ignores market mechanisms. On the contrary, a good industrial policy intervenes in the domestic economy to kickstart a “virtuous cycle” of industrialisation but then relies on market mechanisms to sustain it.

For this feedback loop to work, India would need to build the state capacity which can carry out this dynamic industrial policy framework, much like the Ministry of International Trade and Industry did in Japan. No country has managed to industrialise without a working industrial policy. And no country has had a successful industrial policy without a government that didn’t have the administrative capacity to steer this complex exercise.

About the author

Srijan Shukla

Srijan Shukla is an Associate Fellow with the Security Studies Program at the Observer Research Foundation, India.

Topics

India Trade & investment