The emerging order post Covid-19 is an opportunity for India to emerge as an alternative investment destination to China, believes Prime Minister Narendra Modi. Wake up “the sleeping giant”, Modi urged a gaggle of chief ministers recently.
The US, locked in a fierce trade war with China, certainly believes it’s a possibility. “India can quickly become a favourable jurisdiction for more of the industrial activities that are happening currently in China,” the US Department of State reportedly said a couple of weeks ago.
Indeed, the need to derisk the global economy in the new world has sparked off a global debate on diversifying supply chains away from China. But cold, hard economic reality suggests that India will find it tough to snatch business from China in a meaningful way.
The US-China trade war has provided a window of opportunity to India. In 2018, China held a 65% share of US imports from low-cost countries in Asia. By Q4 2019, this had dropped to 56%. But, of the volumes that shifted from China to competing Asian destinations in 2019, almost half (46%) was absorbed by Vietnam, a fourth (27%) by Malaysia, and only 10% moved to India.
Even as some firms are keen to shift from China, it is debatable they will choose India. India’s only advantage over China has been labour costs and that is unlikely to be a game changer in an era of automation.
It would be naïve to expect global firms to desert China when they operate out of a destination that boasts of one of the most efficient supply-chain ecosystem. A multitude of free-trade agreements (FTAs) also ensure duty-free access to inputs for firms with bases in mainland China, an advantage which would be hard for India to replicate.
Also, as speed and adaptability to change replace labour costs as the mantra to withstand competition, near-shoring becomes more relevant. This explains why exports from high-cost locations like EU and Japan increased amid the recent trade wars.
Its factories stand out by their sheer scale of operations, underpinned by robust supply-chain efficiencies. Manufacturing demand globally has been weak for years together and factories are getting automated at an unprecedented pace, both of which are a deterrent for the rise of India. Many of India’s concerns are attributable to legacy issues and so it will need to discover its own strengths to make a mark on the global manufacturing map.
When Prime Minister Narendra Modi visited headquarters of Tesla Motors at Pao Alto in 2015, expectations were high as it is the flag bearer of high-tech manufacturing. But the joy was short-lived. More than three years later, Elon Musk tweeted: “For other countries, we pay in part for the local factory by selling cars there ahead of time. Also, gives a sense of demand. Current rules in India prevent that. Maybe I am misinformed but I was also told that 30% of parts must be locally sourced and the supply doesn’t yet exist in India to support that”.
In short, Tesla didn’t have a business case for setting up a plant with high localisation in India. The problem of higher duties and demand isn’t, however, unique to Tesla. The No. 1 luxury car brand, Mercedes, sold a mere 14,000 units in 2019 compared to nearly 700,000 in China. Martin Schwenk, CEO of Mercedes-Benz India, said the main inhibitor is a policy environment with high taxation (almost doubling the price), lack of FTAs, and absence of harmonisation standards (local testing adds to time and regulatory cost).
Another hurdle Schwenk cited was the low demand for luxury cars in India compared to China. “If we had one model selling 25,000 units annually, deeper localisation and even exports could be thought of. However with the kind of volumes India is churning out, exports are unviable. Moreover, we need to import parts with high duties while exports also attract duties as India doesn’t have FTAs with many countries,” he added.
Consider Tesla’s China journey to get an idea of what the country delivers for companies.
Tesla’s China subsidiary was incorporated in May 2018 and its huge plant started deliveries in December 2019. Tesla Gigafactory at Shanghai is reportedly manufacturing 3,000 electric cars per week in May 2020 despite having to shut down its other factories.
It could be a very profitable venture and the plant built with a capex of USD2 billon could generate revenues of USD15 billion. It has a more streamlined production line compared to its existing plant in California.
About 30% of the parts now used by the Shanghai facility are sourced locally with plans to increase that to 100% by the end of 2020.
Robust local supply chains also bring in technology. In May 2020, Reuters reported that Tesla will source batteries from Chinese maker CATL, giving a boost to CATL’s – and China’s – LFP battery technologies, distinct from the NMC technology which is popular in the west.
Who benefits from tariff wars between the US and China?
The rising importance of technology in manufacturing is evident from the fact that the biggest beneficiaries of the US-China trade wars were the European Union followed by Mexico, Japan, and Canada.
As shown above, China’s supply chain is integrated with Asia’s electronic supply-chain economies of Malaysia, Philippines, South Korea, and Taiwan. China constitutes half their overall exports, which are in turn shipped to every country in the world.
China has entered into 24 FTAs globally, of which 16 are fully operational. Besides, Beijing has also signed bilateral trade agreements with ASEAN (2002), the Eurasian Economic Union (2018), and 18 other countries globally, besides being a party to 127 bilateral investment treaties and is now trying to lead the Regional Comprehensive Economic Partnership (RCEP) agreement.
A manufacturing hub
Drawing on its trade links and control over global supply chains through FTAs, China has emerged as a manufacturing hub, with an annual output of USD4 trillion. A large global superior market share facilitates unparalleled economies of scale and swift responses to changing customer requirements. Further, its sharp focus on research and development (R&D) spends, at around 3.5% of GDP, overshadows India’s miniscule 1.5%.
It is hardly surprising that China leads in the manufacturing of a wide range of – from steel and toys to consumer electronics and next-generation technologies. India pales in comparison with our manufacturing output being USD412 billion or just 10% of what China has achieved.
India finds it difficult to enter FTAs as Indian industries fear loss of market share to these countries that are more competitive. Larger players like the steel and tyre industry often seek duty protection while in certain other sectors, such as electronics, solar panels, and lithium-ion batteries, Indian industries are unwilling to invest.
India’s strengths offset by its weaknesses
According to UNCTAD World Investment Report, India received FDI flows worth USD43 billion in 2018, which is 6.2% of gross FDI flows to South Asia and next only to China and Singapore. However, the country lags others on the metric ratio of FDI flows to total capital stock where smaller peers score much better. For instance, Vietnam, which ranks below India in ease of doing business, is also fast catching up with India in exports, buoyed by FTAs and easier connectivity to global manufacturing hubs. The Communist country keeps workers on a tight leash. Taiwan, Thailand, and Malaysia are others making huge strides in FDI inflows which brings in technology support for production.
India lags in ease of doing business
Despite overall rank having improved to 63, India lags its Asian peers in time to start a business, property registrations, contract enforcements, insolvency resolutions, etc. This has a great bearing on how India is perceived which, in turn, influences firms’ decisions to relocate.
To be sure, India is more cost effective in terms of both labour and capital. India’s labour productivity fell by 4.78% in 2019 while its incremental capital output ratio (ICOR) has been stagnant at 4.25 since 2017. However, China has been unproductively using its capital with ICOR steadily rising from six in 2015 to eight by 2019. This means more capital required to produce a unit’s worth of output. This is attributable to China’s massive investment-led growth strategy which reduces the marginal efficiency of investments, delaying return on investment or ROI.
A natural question follows: What prevents a firm from taking advantage of India’s superior labour and capital efficiencies?
The villain in the piece is low demand. While India’s consumption story has slowed over the last five years, China’s case is the reverse with smart recovery in auto sales in April being a testimony.
Stagnant manufacturing demand, unutilised factories makes capex tough.
Manufacturing activity has been stagnating across the globe. It doesn’t make sense to shift base to India merely due to factor productivity gains when demand has practically vanished even before the outbreak of the pandemic. Now that Covid-19 has struck, new factories would become ‘sunk-costs’.
In a muted global economic environment, the only reason then why companies would relocate would be to cut costs. In fact, this has been the genesis of the Asian tiger economies that achieved significant economic growth riding on the manufacturing surge after World War II. However, the services sector has been growing exponentially since 2000, resulting in a falling manufacturing share in GDP. It would suffice to say that there could be little felt need now to shift manufacturing locations due to lower growth.
Automation and speed makes near-shoring more attractive
Automation has increased productivity. Declining value addition of labour due to artificial intelligence and robotics is true of Tesla factories in China and the US, semiconductor fabrication plants in Taiwan, the newly set-up Volkswagen and BMW facilities, or the lithium-ion giga factories of CATL. This implies that humans are needed only in sectors where they outperform a machine, which in India’s case would mean low-end products like stitching, weaving, etc. and not a BMW or a Volkswagen where automation is huge and India lacks comparative advantage.
Moreover, emerging technologies will ensure that the marginal cost of production is practically zero for developed economies, obviating the need to look elsewhere for cost efficiencies.
The bottom line
Established players originally preferred China as it meant lower costs. It excelled on this count to such an extent that it helped firms expand their markets at home and abroad. The formidable supply chain was the key, supported by regulatory continuity and solid infrastructure.
Chinese exports also stand out for their high share of high-tech exports. Electrical and electronic equipment made up 43.6% of its exports amounting to a staggering USD1 trillion. No wonder wherever you are on the planet, your mobile phones, laptops, consumer durables, or even mobile networks are heavily reliant on China.
Market leadership is one of the hardest things to build and once achieved it is difficult to break. The scale and specialisation act as a huge deterrent for a potential entrant.
Whether we like it or not, Covid has made economies more inward –looking and instilled a de-globalisation attitude. India can indeed attract some parts of the global value chain in manufacturing as political pressure mounts on the west to reduce dependency on China. Even some Chinese firms would like to diversify production to other countries to offset high tariffs and expensive labour.
As we have highlighted in many of our earlier pieces, India needs to upgrade its cranky infrastructure on a war-footing to attract global manufacturers. It also needs to usher in land reforms to make it easier to acquire land by businesses. Meanwhile, a major irritant compared to peers has been an inadequately trained labour force. Hardly 5% of India’s graduate pool is employable. This needs to be redressed through greater industry-academic interfaces. Political, bureaucratic, and legal systems are not business-friendly, driven by generalists and lack of consistency. The inefficiencies work to the advantage of incumbent power centres and are, therefore, intractable.
However, India’s knowledge-based economy surged and now generates a quarter of its organised corporate-sector employment. It drew on its huge educated labour force that had nowhere else to go. In a sense, India was able to turn the disadvantages into an opportunity. In manufacturing India needs to demonstrate a couple of success stories to make its mark globally. Unfortunately, it is nowhere in the game and has a negative image in many parameters. Moreover, the pandemic and resulting loss of man days and depressed income levels could lead to social unrest, turning the situation worse.
The silver lining is that given India’s puny share in global trade, even a small step can make a huge difference. This unprecedented crisis can be positively used to propel the political and business class to break out of their inertia.