Industrial Policy - a lesson from India | Daily News


Industrial Policy - a lesson from India

If industrial policy is to work, it must be tied  to targets, limited in duration and withdrawn if targets are not met

Industrial policy (IP) is defined as the strategic effort by the state to encourage the development and growth of a sector of the economy. It refers to “any type of selective intervention or government policy that attempts to alter the structure of production toward sectors that are expected to offer better prospects for economic growth than would occur in the absence of such intervention” (Pack and Saggi, 2006) .

In layman’s terms this means giving government support (tax breaks, subsidies and protection from imports) to help a particular segment of industry to grow. Everybody wants the country to grow, so why should not the government help a particular industry and therefore the country?

The idea is to support targeted businesses to “learn by doing”, to help them acquire the skills and know-how to reach a competitive position. For example, sector may be protecting by tariffs until it can catch up to the levels of advanced firms. This may be termed a “pro-business” approach.

The alternative approach is for the government to play the role of facilitator, simply improving the overall business environment; simplifying regulation, easing procedures, reducing taxation which we may term a “pro-market” approach. The difference between the two approaches is that while one supports only targeted sectors, the other helps all businesses. The ultimate aim of the two is the same, to improve productivity and thus growth.

The rationale for IP is that certain industries cannot immediately meet international competition, therefore needs some support until they reach such a level. If a firm is unable to compete internationally it means it is probably less efficient than its competitors, so it needs support until it reaches a competitive stage. It is essential that it does reach such a stage because endlessly sustaining weak firms is a permanent drain on resources.

This is important because the key to growth is productivity-higher output per worker is what supports higher wages. Rising incomes only result from rising productivity. If productivity stalls so will lifestyles.

“A country’s ability to improve its standard of living over time depends entirely on its ability to raise its output per worker.” (Krugman)

Pro-business policies have an advantage, from the perspective of the business in that they have will always benefit the selected businesses (subsidies and protection will increase returns to owners). The impact is quick-because it helps a business directly. The catch is that unless there is improvement in productivity there is little benefit to the economy. This may sound strange – surely if a business is doing better, the economy must be doing better too? This is not necessarily the case because pro-business policies carry certain costs. The economy as a whole will benefit only if the overall benefits outweigh the cost. What are these costs?

For example if subsidies were being granted to a business, they would be paid out of tax revenues so revenues will be diverted from other welfare projects to the selected businesses. Some welfare measures would need to be sacrificed to support the business. If protective taxes were raised, it would increase the price of imports and allow local products to command a better price. The business benefits and this measure does not cost the taxpayers anything, but consumers would need to pay higher prices. In this case the business is actually being subsidised by the consumer.

Therefore while pro-business policies help business, they lead to a certain welfare losses in the rest of society. Therefore good policy requires that the two interests must be balanced; the losses are worth carrying only if it translates to improved productivity. For this to take place the policy must be well-designed. It will make sense to support an industry that demonstrates improvements in efficiency and reaches a globally competitive position but support to a business that continually lags behind is a waste of resources.

Therefore, the support needs to be conditional; tied to achieving targets (eg export volumes) and be available only for a limited time. If the industry shows little likelihood of reaching the target it would be better to withdraw the subsidy and give it to another industry or give relief to consumers or taxpayers, depending on the financing of the subsidy.

India’s contrasting approaches in trying to build an automobile industry illustrate the pros and the cons.

In the 1949 India decided to support a local car industry so it banned imports of cars and from 1953 prohibited local assembly of cars unless they had a minimum local content. GM and Ford who were assembling vehicles in India decided to exit. Hindustan motors, which had been assembling the Morris Oxford indigenized the vehicle and launched it in 1957 as the Hindustan Ambassador.

India did succeed in building a domestic car industry but it was small and the quality was unsatisfactory. To develop the car component industry they restricted it to the SME sector. Components began to be produced locally, but were of low-quality. Until the 1980’s the Indian car industry continued to turn out products that were little changed from those of the 1950’s.

In the 1980’s they tried a different approach. Instead of closing the industry to foreign participation they opted to allow Suzuki to start a joint venture.

Suzuki would have access to the protected Indian automobile market which had tariffs in the region of 85% but to be able to sell in this protected market, Suzuki first had to make the Maruti-Suzuki car with 60% domestic content within five years. This meant Suzuki had to make a significant investment in improving the organizational capabilities of Indian Tier 1 and Tier 2 component producers to meet the domestic content target and yet produce a car that would be of higher quality than existing Indian cars like the Ambassador. There were additional reasons for not compromising on quality, including the reputation risk for the global Suzuki brand. The design of the financing here clearly created strong incentives and compulsions for effort because Suzuki had no interest in drawing the process out and every interest in completing it quickly.

Moreover, there was a very strong likelihood that without fulfilling the domestic content requirement the company could be excluded from the domestic market for contract violation. This threat of exclusion was a condition that could be plausibly enforced because Suzuki had no domestic political allies.

The design of policy was (a) tied to performance targets (b) would be withdrawn if they are not achieved. The case of Maruti Suzuki is a good example of a well-designed structure.

The industry was also complex enough to offer sufficient gains from learning. If support is given to a basic industry there is not much know-how that can be transferred.

“Not surprisingly, the result was a very successful transfer of organizational capabilities, with the rapid development of a broad group of component manufacturers who later became the foundation of a globally competitive Indian automobile industry”.

Therefore if industrial policy is to work, it must be tied to targets, limited in duration and withdrawn if targets are not met.

This creates the incentives for the business to strive to achieve the efficiency required. The policy needs to be administered by independent technocrats –otherwise businesses that cannot meet the targets will simply lobby politicians to continue the subsidy, derailing the objective.

During the years 1957-80 the open ended protection to the automobile industry succeed in producing the Hindustan Ambassador. Once the subsidies were tied to performance a real transformation occurred. In 2016, India was the World’s 6th vehicle manufacturer with a total production of 24 million units and the 5th biggest passenger vehicle market. The sector accounted for 7.1% of the country GDP, 27% of industrial GDP, 54% of manufacturing GDP and employed 19 million people.

For industrial policy to work, both carrot and stick are needed.

The writer is an independent consultant

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