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Preliminary. Economic Reforms and their Impact on the Indian Manufacturing Sector: Competitiveness, Exports and Employment Eckhard Siggel, Department of Economics, Concordia University, Montreal e-mail: [email protected] This paper has been prepared for the 14 th World Congress of the International Economic Association in 2005, Morocco. Research assistance was provided by Jade Haddad.

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Page 1: Reform impact on industry competitiveness, exports and ...web.hec.ca/scse/articles/Siggel.pdf · Competitiveness, Exports and Employment Eckhard Siggel, Department of Economics, Concordia

Preliminary.

Economic Reforms and their Impact on the Indian

Manufacturing Sector: Competitiveness, Exports and Employment

Eckhard Siggel, Department of Economics, Concordia University, Montreal e-mail: [email protected] This paper has been prepared for the 14th World Congress of the International Economic Association in 2005, Morocco. Research assistance was provided by Jade Haddad.

Page 2: Reform impact on industry competitiveness, exports and ...web.hec.ca/scse/articles/Siggel.pdf · Competitiveness, Exports and Employment Eckhard Siggel, Department of Economics, Concordia

Introduction

The reforms of the Indian economic system are wide-ranging in terms of policy areas and

sectors targeted. In this paper we focus on the large-scale manufacturing sector as

recorded by the Annual Survey of Industries (ASI). The policy areas that affect this

sector most strongly, by creating incentives and disincentives, are policies regulating

imports and exports, the exchange rate, the interest rate, as well as changes in the

regulatory framework directed towards industries. Unfortunately not all of these reform

components can be quantified. Therefore it is difficult to unambiguously attribute the

changes in growth of value added, employment and exports to changes of specific policy

variables. An attempt is made, however, to isolate some of the observable changes and to

relate them statistically to the measurable changes in policy variables.

Our approach is to use the available quantitative evidence of changes in trade

policy (rates of protection), in exchange rate policy (the real exchange rate), in interest

rate policy (the market and shadow rates of interest), together with output and cost data

from the ASI, during the study period (1987/88 to 1997/98), and to relate observable

changes in competitiveness, comparative advantage, exports and other variables to the

changes of these policy variables. The definition of the study period as well as the choice

of manufacturing as representative of the modern sector, were dictated by the availability

of the data for the chosen method of analysis.

We concentrate on the reforms undertaken in the aftermath of the 1991 crisis and

their subsequent effects on the performance of the manufacturing sector. There is an

ongoing debate in the literature (as well as in political circles) as to whether these effects

can be attributed to reforms implemented in the pre-1991 era and if the reform movement

as a whole actually started with those initial steps taken throughout the 1980s. Rodrik

(2002) argues that tentative measures taken under the Rajiv Ghandi government of the

1980s led to disproportionately high growth, while the reforms undertaken in and after

1991 had a far smaller impact with respect to GDP growth. Panagariya (2004) refutes

this argument and argues in favour of the 1990s reforms stating: “Growth during the

1980s was fragile, highly variable from year to year, and unsustainable. In contrast, once

2

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the 1991 reforms took root, growth became less variable and more sustainable with even

a slight upward shift in the mean growth rate” (Panagariya, 2004, p. 5).

Panagariya goes on to argue that despite the 1980s reforms’ limitations in terms

of scope and vision, they differed markedly from the “isolated and sporadic”

liberalization measures implemented throughout the 1960s and 1970s, and can therefore

be seen as forerunners to more “systematic and systemic” reforms of the 1990s. In

providing this argument, Panagariya draws on support from Ahluwalia (2002, p. 67), who

stated that “while the growth record in the 1990s was only slightly better than that in the

1980s, the 1980s growth was unsustainable, fuelled by a build-up of external debt that

culminated in the crisis of 1991.”

Srinivasan and Tendulkar (2003) provide an export-oriented view of the reforms

undertaken in the 1980s by stating that the increase in Indian exports over the 1980s

reform era was due (mostly) to an exchange rate depreciation attributed more to

exogenous forces than to “explicit policy reforms aimed at reducing the trade barrier”.

1 Reform incidence: a view from the manufacturing sector

First, we provide evidence of the reform incidence as it affects the industrial sector. In the

area of trade and industrial policies we record the rates of nominal and effective

protection as well as their changes over the study period. Similar observations are made

later about foreign exchange and interest rate policies.

1.1 Trade and industrial policy reforms

In the area of trade and industrial policies, the reforms included first the elimination of

quantitative restrictions, which had formerly affected most industries. However their

elimination was not completed until the year 2001. This policy change meant that

protection shifted entirely, but gradually, to the import tariff. The second important

change is the reduction of tariff rates and the resulting change in the structure of

3

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protection. Both policy interventions were accompanied by a host of other changes in the

regulatory framework and in particular the industrial licensing regime.

In order to measure the incidence of such changes it is necessary to observe the

price changes of domestic prices relative to the corresponding free-trade or border prices.

This is necessary because the main effect of quantitative restrictions, such as quotas, on

the incentive structure is to raise the domestic price relative to the free-trade price. This is

a very difficult task and has been undertaken systematically only in a few countries and

by few governments or expert agencies.1 A recent study by Pandey and associates (1998)

of price-based rates of protection is available for India and has been used here for the

purpose of quantifying the trade reform incidence as well as our computations of

competitiveness indices.

Table 1 : Nominal (NRP) and effective (ERP) rates of protection in manufacturing 1987/88 1997/98 Change in1

Industry NRP ERP NRP ERP NRP ERP Food products 1.3549 1.4666 0.3596 0.3909 0.2654 0.2666 Bever.& tobac. 1.5000 1.6318 0.5985 0.9288 0.3990 0.5692 Textile industry 1.3549 1.5168 0.3753 0.4239 0.2770 0.2795 Garments 1.4093 1.3931 0.4635 0.5141 0.3289 0.3690 Wood products 1.3530 1.4395 0.4500 0.5782 0.3326 0.4016 Paper & printing 1.5979 1.6123 0.3465 0.3627 0.2168 0.2250 Leather products 1.4500 1.4641 0.3854 0.4223 0.2658 0.2884 Rubber, plastic, petrol. & coal 1.4123 1.5151 0.3809 0.5027 0.2697 0.3318 Chemicals 2.0156 2.5922 0.3532 0.3827 0.1752 0.1477 Non-met. min. 1.4561 1.5144 0.4217 0.5134 0.2896 0.3390 Basic metals 1.7456 2.5916 0.3249 0.3674 0.1861 0.1418 Metal products 1.6215 1.5641 0.3519 0.3740 0.2170 0.2391 Machinery 1.4148 1.3660 0.3367 0.3362 0.2380 0.2461 Transport equip. 1.2996 1.1903 0.3927 0.4186 0.3022 0.3517 Other man. ind. 1.4905 1.4780 0.3933 0.4081 0.2639 0.2761 Average 1.5096 1.6088 0.3976 0.4678 0.2634 0.2908 Notes : 1 NRP97/98/NRP87/88 and ERP97/98/ERP87/88

Source : Pandey et al.(1998)

1 The World Bank has undertaken studies of nominal and effective rates of protection based on price controls in various countries in the 1970s and 1980s. One of the few countries, in which government agencies undertook such studies is Mexico (ten Kate, 1985)

4

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Based on this study the following picture emerges of the structure of protection

and its changes between 1987/88 and 1997/98. Table 1 shows that for manufacturing as a

whole nominal protection declined from 151 percent in 1987/88 to 39.8 percent in

1997/98, a reduction of about 74 percent. Effective protection declined from 160.9

percent in 1987/88 to 46.8 percent, a reduction of about 71 percent. The reduction of

protection was most dramatic for the chemical and basic metal industries: 72 and 74

percent, respectively, for NRP and ERP.

Panagariya (2004) provides us with a more detailed perspective on the incidence

of tariff reductions undertaken after the June 1991 crisis. According to WTO (1998), as

surveyed by him, the import-weighted average tariff rate stood at 87 percent throughout

the 1990–1991 period, with the highest at 355 percent. Tariff reform was undertaken

through effective reductions in the number of tariff bands and a consistent compression

of the top tariff rate falling to 85 percent in the 1993–94 period, 50 percent in the 1995–

96 period and finally 25 percent in the 2003–04 period.

As far as regulatory policies for the manufacturing sector are concerned,

Panagariya (2004) outlines the effectiveness with which the July 1991 “Statement of

Industrial Policy” sought to (and did) eliminate investment licensing and entry

restrictions on companies under the purview of the Monopolies and Restrictive Trade

Practices (MRTP) act. Throughout the 1990s reform era, and following the July 1991

“Statement of Industrial Policy”, all investment licensing (irrespective of amount) was

abolished across all sectors except 18 (outlined in Annex II of the policy statement and

later reduced to five), the public sector monopoly was limited to eight sectors (listed in

Annex I, and selected according to security and strategic considerations), and pre-entry

inspection of investment decisions of MRTP companies along with provisions relating to

mergers, takeovers, and amalgamations were repealed.

5

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1.2 Foreign exchange policy

Perhaps the most powerful policy instrument with regard to the incentive regime is the

exchange rate. Countries adhering to a fixed exchange rate regime have a tendency to

function with a misaligned exchange rate. Fixed exchange rates become misaligned when

the fixed rate is not periodically adjusted to the differential between domestic and foreign

rates of inflation. Trade liberalization often goes in tandem with liberalization of the

exchange rate, which implies letting the price of foreign currencies be determined by

supply and demand. The Indian reforms of 1991 and consecutive years also included such

a re-alignment of the rupee.

The July 1991 reform package included a devaluation of the rupee by 22 percent

against the dollar, driving it from Rs 21.2 to Rs 25.8 per dollar. Following this

devaluation, the government introduced a dual-exchange rate system in February of 1992,

allowing importers to fully operate on the open foreign exchange market while exporters

were authorized to sell 60 percent of their foreign exchange at open market prices while

the other 40 percent were sold at the lower official price (Panagariya, 2004). Within one

year the exchange rate was unified.

The degree of misalignment can be computed using the real exchange rate. In

other words, rather than observing a shadow exchange rate and the divergence of the

market rate from the shadow rate, one infers the degree of misalignment by observing

domestic and foreign price changes, by computing the real exchange rate over time and

by identifying a base year in which the misalignment was known to be minimal.

The shadow exchange rate and the implicit rate of currency overvaluation are

estimated here using this method based on the real exchange rate. It is assumed that the

year 1994, in which the exchange rate was unified and the rupee was made fully

convertible on the trade account, was a year of minimal misalignment; it is taken as

benchmark year, in which the real exchange rate index equals 100. The real exchange rate

depreciated between 32 and 53 percent between 1987/88 and 1994, depending on which

price index is chosen2. This, together with the assumption of zero misalignment in 1994,

2 Using wholesale prices, for which the inflation differential is largest, the real exchange rate depreciated by 32 percent, while using the GDP deflator leads to real depreciation of 53 percent. Using consumer prices,

6

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implies that in 1987/88 the rupee was overvalued between 48 and 113 percent. We are

using an intermediate rate of 60 percent as the rate of currency overvaluation in 1987/88,

which is close to the rate based on consumer prices.

One could argue that this rate may overstate the real overvaluation because the

exchange rate may have overshot its target in 1994 and may have been undervalued after

several years of strong nominal depreciation. This is unlikely, however, because the

rupee continued to depreciate in real terms in 1995; it appreciated somewhat in 1996, but

depreciated again in 1997 and 1998, returning to its benchmark value of 100 in the latter

year.

Using the real exchange rate based on the hypothesis of well-alignment in 1994,

the rupee was then roughly at par in 1997/98. Using wholesale prices, it may even have

been slightly undervalued at 4 percent. The elimination of currency overvaluation implies

that Indian industries became more competitive by this aspect of external policy reform.

1.3 The price of capital and foreign investment

One of the main targets of policy reform is the price of capital and the access to foreign

capital markets. To the extent that the capital account is liberated, the price of capital is

increasingly determined by the international interest rate, such as the LIBOR. Capital

account liberalization is usually the last step in financial reforms. In the earlier stages of

reform, the price of capital remains a domestic variable and tends to be influenced mainly

by the state of the financial sector, the degree of financial repression and the interest rate

policies of governments.

India’s reforms have included financial reforms, which have had the double effect

of reducing the domestic cost of capital and opening the country to foreign capital

inflows. The domestic price of capital is measured here by the lending rate, which was

lowered from 16.5 percent in 1987/88 to 13.8 percent in 1997/98. The shadow price of

capital is computed here as the LIBOR adjusted for the inflation differential between

the real depreciation was 40 percent. The exchange rate used in this calculation is the one of rupees per SDR, and the foreign price indices relate to the industrial country aggregate as reported by the IMF (IFS, current issues).

7

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India and OECD countries. It remained fairly stable at around 11 percent (11.5 percent in

1987/88 and 11.3 percent in 1997/98. Therefore, the interest rate premium paid by Indian

investors has been reduced by 2.5 percent, and this reduction may considered as an

indicator of financial liberalization.

More important than the cost of capital, however, may be the influx of foreign

investment, which also occurred under the reforms. Its potentially great importance stems

from the fact that it comes bundled with foreign technology whenever it is direct and

long-term investment. In 1987/88 foreign direct investment was literally non-existent in

India, but it started to flow in by 1991 and reached a total of about three billion dollars in

1997/98. Unfortunately, we have no information on the amount of foreign direct

investment received by each industry in the manufacturing sector.

The 1991 reform package called for abolishing the 40 percent threshold on

foreign direct investment, and empowered the Reserve Bank of India to approve equity

investments of up to 51 percent in 34 industries through the development of an automatic

approval concept, Panagariya (2004)3.

2 Changes in competitiveness and comparative advantage

The reduction of protection observed during the study period has certainly had the effect

of increased competition from foreign imports, which in turn induced firms to cut costs.

Such cost reductions can result from shedding redundant workers, by adopting new

production processes, which usually require new investments, and/or by increasing the

efficiency of capital and other input use. Successful cost reductions should then result in

greater competitiveness, both in the domestic market, vis-à-vis imports, and in export

markets. The purpose of this section is to examine how the competitiveness of industries

has changed during the study period. It is of particular interest to see whether the

observed changes have also led to an increase of comparative advantage.

3 A comprehensive list of the concerned industries is listen in Annex 3 of the July 24, 1991 “Statement of Industrial Policy”, Government of India

8

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2.1 The measurement of competitiveness

Competitiveness is measured here by three unit cost ratios developed and applied in

several earlier studies (Siggel, Ssemogerere, 2004; Cockburn et al., 1999), including one

on India in the 1980s (Siggel, 2001)4. The first ratio, UCd, which we consider to be an

indicator of domestic competitiveness, is the ratio of unit costs to the output price, both

measured in domestic, possibly distorted, prices. Since unit costs differ from the domestic

price only by excess profits, this indicator is simply a measure of profitability in the

protected domestic market. It differs, however, slightly from the rate of return, because

own capital enters into the unit costs with its opportunity costs at market prices.

The second unit cost ratio, UCx, is an indicator of export competitiveness. It

divides the full unit cost at domestic prices by the free-trade price. This indicator tends to

regularly exceed unity because the unit costs include tariff margins of all traded

intermediate inputs, while the output price does not.

The third unit cost ratio, UCs, is an indicator of comparative advantage. It divides

the unit cost in shadow prices by the shadow price of output. The indicator is similar to

the Domestic Resource Cost (DRC) ratio, which is well known in the literature. UCs,

however, measures full costs, whereas the DRC ratio, applied at the firm or industry

level, uses value added and thereby ignores the contribution of intermediate inputs to

comparative advantage.

2.2 Improved domestic competitiveness

Under trade liberalization and globalization, industries are normally expected to become

less profitable in the short run because their (shrinking) protective price margin on output

is usually more important than the one on traded intermediate inputs. However, when the

reduction of import restrictions is accompanied by real currency depreciation, the

combined outcome can be the opposite. This is the situation we observe in Indian

manufacturing during the study period. The real depreciation of the exchange rate, which

4 The method is briefly explained in the appendix.

9

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eliminated the substantial overvaluation of the 1980s, had the consequence of raising the

price of tradable products, which counteracted the price-reducing effect of cutting the

tariff. The unit cost ratio in terms of domestic prices (UCd) declined from an average of

1.001 in 1987/88 to 0.984 in 1997/98. This means that the total unit cost, including the

opportunity cost of own capital, declined from rough equality with the price to a level,

which is two percent below the ex-factory price.

Table 2: Domestic competitiveness, measured as unit cost ratio in domestic prices (UCd), in Indian manufacturing industries UCd UCd

1987/88 Rank 1997/98 Rank Food industry 20,21 0.9899 9 0.9881 8 Beverages & tobacco 22 0.9279 1 0.8770 1 Cotton textiles 23 1.0454 15 1.0482 17 Wool & silk-based textiles 24 1.0128 11 1.0066 13 Jute & hemp textiles 25 1.0877 17 1.0021 10 Clothing industry 26 0.9620 5 0.9799 7 Wood products 27 0.9932 10 1.0367 16 Paper & printing 28 1.0436 14 1.0359 15 Leather products 29 0.9897 8 0.9749 6 Rubber, plastic, petr.& coal 30 0.9448 2 0.9720 5 Chemicals 31 0.9861 7 1.0030 11 Non-metallic minerals 32 1.0292 12 1.0175 14 Basic metals 33 1.0768 16 0.9510 2 Metal products 34 0.9592 4 1.0056 12 Machinery 35,36 0.9745 6 0.9633 3 Transport equipment 37 1.0334 13 0.9973 9 Other manufactures 38 0.9585 3 0.9675 4 Total Total 1.0011 0.9842 Textile industry 23,24,25 1.0357 1.0304

It can be seen in table 2 that the most profitable industry has been, and still is, the

beverage & tobacco industry. This is due to its high protection, as seen in table 1, a

situation, which prevailed in 1997/98. The least profitable industries at the end of the

study period were Cotton textiles, Wood products and Paper & printing.

The table also shows the dramatic reversal of profitability in the Basic metal

industry, which changed its ranking from the second-least profitable to the second-most

profitable industry.

10

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2.3 Changes in export competitiveness

International or export competitiveness is interpreted here as the situation where full unit

costs in terms of domestic prices are inferior to the price on the international market. This

condition is reflected by a unit cost ratio (UCx) inferior to one, as this index divides the

total unit cost in market prices by the border or free trade price. This indicator is shown in

table 3, which also ranks the industries according to cost competitiveness. The fact that

in both years none of the industries comes even close to one, required for

competitiveness, reflects two realities: first, the high cost of protection on tradable inputs,

and second, the use of full opportunity costs of owned capital.

Table 3: Export competitiveness in terms of unit costs and rankings UCx UCx Rank Rank Relative 1987/88 1997/98 1987/88 1997/98 change 20/21 Food products 2.3312 1.3435 4 4

22 Bever.& tobac. 2.3198 1.4018 3 12 D3 23 Cotton textiles 2.3473 1.4794 6 16 24 Wool, silk,etc. 2.5521 1.3472 13 5 R3 25 Jute, hemp etc. 2.6105 1.4530 14 15 26 Garments 2.3177 1.4341 2 13 D2 27 Wood prod. 2.3368 1.5033 5 17 D1 28 Paper, printing 2.7112 1.3949 15 11 29 Leather prod. 2.4248 1.3506 10 7 30 Rubber, plast. 2.2790 1.3422 1 3 31 Chemicals 2.9738 1.3572 17 8 R2 32 Non-met. Min. 2.5279 1.4465 12 14 33 Basic metals 2.9565 1.2600 16 1 R1 34 Metal prod. 2.5146 1.3595 11 9

35/36 Machinery 2.3533 1.2877 7 2 37 Transport equ. 2.3763 1.3890 8 10 38 Other manuf. 2.3870 1.3481 9 6

Total 2.5207 1.3475 Standard dev. 0.215 0.065

11

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The indicators of table 3 suggest that for the manufacturing sector as a whole

export competitiveness has increased dramatically, by nearly 50 percent, but unit costs

still exceed free-trade prices by 35 percent, on average. Industries also have become more

uniform in terms of export competitiveness, since the standard deviation has declined

from 21.5 to 6.5 percent.

The “rising stars”, industries which experienced the strongest decline in unit costs

relative to the free-trade price are Basic metals (33), Chemicals (30) and Wool and silk-

based textiles (24). Industries in relative decline, in terms of their ranking, are Wood

products (27), Clothing (26) and the Beverage & tobacco industry (22).

2.4 Comparative advantage

The reduction of industrial protection under the Indian reforms is expected to have at

least three results: (1) First and in the short run it will lower the prices of tradable outputs

and intermediate inputs. Since this effect is normally stronger on the output side than on

the cost side, profitability is immediately reduced. (2) Firms are then expected to react by

cutting costs beyond the cost of intermediate inputs. Such cost cutting usually takes the

form of shedding redundant labour, using the existing capacities more efficiently (to the

extent that sales allow this to happen), and to cut down on non-traded inputs such as

energy, communications and administrative overhead. The resulting cost reduction has a

short-term component reflected by reduced input prices and a long-term component,

which changes the technical coefficients. In the present computations of unit costs we

observe only the short-run effects, however. (3) Firms that do not survive in the market of

increased competition exit or shrink, whereas those succeeding in drastic cost cutting

expand and, in particular, expand into export markets. This changes the structure of the

industrial sector, which is expected to gain comparative advantage. Resources are

expected to flow into those industries with existing or potential comparative advantage

and out of those industries that have neither existing nor a potential for comparative cost

advantage.

12

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As table 4 suggests, comparative advantage, as measured by the unit cost ratio in

terms of shadow prices, has been increased over the study period. This means that the

manufacturing industries on average have come closer to comparative advantage by

lowering their unit cost ratio from 1.14 to 1.08, a five percent improvement. The variation

of unit cost ratios also has been reduced from 8.8 percent to 4.6 percent, indicating that

the sector has become slightly more homogeneous in terms of comparative advantage.

This does not exclude cases of industries that have seen their comparative costs rise.

Table 4: Comparative advantage and its change UCs UCs Rank Rank Relative 1987/88 1997/98 1987/88 1997/98 change 20/21 Food products 1.0540 1.0362 2 1

22 Bever.& tobac. 1.1075 1.1135 7 11 23 Cotton textiles 1.1472 1.1666 11 16 24 Wool, silk,etc. 1.1497 1.0675 12 6 R3 25 Jute, hemp etc. 1.3205 1.1628 17 15 26 Garments 1.1008 1.1421 5 13 D3 27 Wood prod. 1.1019 1.1686 6 17 D2 28 Paper, printing 1.2353 1.1322 14 12 29 Leather prod. 1.0800 1.0607 3 5 30 Rubber, plast. 1.0027 1.0982 1 9 D1 31 Chemicals 1.2537 1.0524 15 4 R2 32 Non-met. Min. 1.1987 1.1545 13 14 33 Basic metals 1.3060 1.0511 16 3 R1 34 Metal prod. 1.1114 1.0942 9 8

35/36 Machinery 1.0908 1.0477 4 2 37 Transport equ. 1.1214 1.1113 10 10 38 Other manuf. 1.1100 1.0760 8 7

Total 1.1387 1.0796 Stand.dev. 0.0878 0.0460

The industries that achieved greatest gains in terms of comparative cost advantage

are Basic metals (33), Chemicals (31) and the Wool and silk-based textile industry (24).

They are identified in the table as “rising” (R1 to R3). The industries that have lost out in

terms of comparative costs are Rubber, plastic, petroleum and coal products (30), Wood

products (27) and the Clothing industry (26).

13

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The changing structure of the manufacturing sector can be seen in table 5, where

the relative size of each industry is shown in terms of value added and the resource flows

are identified by rising or declining arrows. It can be seen that the expanding industries

have a lower ranking in terms of comparative advantage than the declining industries.

This can be understood as evidence of resources moving towards industries with greater

comparative cost advantage.

Table 5: Value added and its change

VA VA share VA VA share 1987/88 1987/88 1997/98 1997/98 Food products 20,21 25879 0.0903 128105 0.0893 ↓ Bever.& tobac. 22 7360 0.0257 40749 0.0284 ↑ Cotton textiles 23 18741 0.0654 67602 0.0471 ↓ Wool, silk,etc. 24 11121 0.0388 59555 0.0415 ↑ Jute, hemp etc. 25 3051 0.0106 12207 0.0085 ↓ Garments 26 3817 0.0133 32576 0.0227 ↑ Wood prod. 27 1380 0.0048 4241 0.0030 ↓ Paper, printing 28 11306 0.0395 39922 0.0278 ↓ Leather prod. 29 2152 0.0075 12755 0.0089 ↑ Rubber, plast. 30 26206 0.0915 266449 0.1857 ↑↑ Chemicals 31 46472 0.1622 90998 0.0634 ↓↓ Non-met. Min. 32 15148 0.0529 68815 0.0480 ↓ Basic metals 33 33547 0.1171 235113 0.1639 ↑↑ Metal prod. 34 8140 0.0284 35848 0.0250 ↓ Machinery 35,36 46405 0.1620 199728 0.1392 ↓ Transport equ. 37 22059 0.0770 113861 0.0794 ↑ Other manuf. 38 3689 0.0129 25936 0.0181 ↑ Total 286474 1.0000 1434459 1.0000 Textile industry 23,24,25 32912 0.1149 139364 0.0972 ↓

3 Manufacturing exports and their changes

Manufacturing exports have grown substantially during the study period. Annual average

growth amounted to % in nominal terms and % in real terms. This performance is

superior to the growth in the preceding ten-year period. The following table 6 shows the

growth performance of the 15 two-digit-level industries. The number is reduced from the

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earlier used number of seventeen because in the export statistics cotton, wool, silk and

synthetic textiles, as well as jute & hemp-based products, are aggregated into a single

textile industry (separate from the clothing industry).

3.1 The changing structure of exports

The export performance varies substantially between the industries. Annual average

growth rates during the study period are shown in table 6. The table shows that the Non-

metallic minerals and Basic metals industries experienced the strongest export growth in

terms of growth rates. The most important export industries, however remain the group of

Other manufactures (mainly jewellery), Textiles (Spinning, weaving & finishing), Food

products and the Clothing industry. The growth rates in the second column refer to semi-

real export values. They are given in current US$, such that the Indian inflation

differential is excluded.

Table 6: Export growth in manufacturing industries from 1987/88 to 1997/98 Industry Code Average annual

growth rate (in percent)

Export value 1997/98

Leading products (by increase in export value)

Food 20-21 10.7 3,786,580 Grain mill products Bever.& Tobacco 22 0.7 8,8125 Malt liquors Textiles 23-

24-25 11.0 5,748,024 Spinning, weavg. & finishing

Knitting mills Clothing 26 10.4 3,699,960 Garments Wood prod. 27 9.6 36,002 Furniture Paper & printing 28 15.5 119,950 Pulp & paper Leather prod. 29 3.1 1,284,243 Leather products Rubber, plastic, petrol. & coal

30 3.5 728,176 Tires, tubes

Chemicals 31 15.0 3,546,665 Pharmaceuticals Non-met. minerals 32 20.9 413,051 Div. NMMs Basic metals 33 17.1 1,305,982 Iron & steel products Metal prod. 34 12.7 817,889 Fabricated met. products Machinery 35-36 10.5 1,802,006 Radio, TV, Comm. equipmt. Transport equipment 37 12.7 874,087 Motor vehicles Other manuf. 38 8.1 5,859,121 Jewellery Total 30,109,858

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3.2 Determinants of export growth

Export expansion may result from a number of factors, some of which are likely a

consequence of the reforms. First, the trade liberalization as reflected by declining rates

of protection, has increased foreign competition and this competitive pressure has forced

the producers to lower their production costs. The reduction in production costs can be

seen as consisting of two parts: secondary input costs decline directly when the protection

of traded inputs is reduced; but primary inputs, in particular labour inputs may also

decline through increased competitive pressure inducing efficiency gains. Firms may also

change their technology through new investments, which is most likely under foreign

investments. The inflow of foreign direct investment may be an important determinant of

export expansion, but the lack of relevant data limits the analysis at this point.

Another source of export expansion may be the reduction of export restrictions,

especially licensing. Unfortunately we do not possess enough quantitative evidence to

examine this potential explanation of export success. Further changes that may have

encouraged exports were institutional changes such as privatisation and hardened budgets

in the case of state-owned enterprises. Here again we miss the quantitative evidence

necessary to analyse this type of reform-related factor.

Based on our approach involving the observation of unit cost ratios we examine

here to what extent export growth is related to the three kinds of competitiveness,

domestic and international competitiveness, as well as comparative advantage. We expect

all three of these indicators to be positively related to export expansion. Domestic

competitiveness, however, should be the least correlated with export expansion, because

it tends to be high under strong protection, which is a disincentive to efforts in favour of

productivity and efficiency gains. Export competitiveness, on the other hand, is expected

to be closely related to export expansion as it measures the profitability in export

markets. However, it is also possible that firms are aware of the potentially ephemeral

nature of price distortions, some of which are implicit subsidies. It will be remembered

that the difference between export competitiveness and comparative advantage is that the

former includes and the latter excludes all kinds of price distortions. Currency under-

valuation, for instance, provides an implicit subsidy to profits, but it may quickly

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disappear through currency appreciation, and with it the international competitiveness of

whole industries. If firms are aware of these different sources of competitiveness, they

may direct their efforts towards the export market only when they achieve real

competitiveness, which equals comparative advantage.

The following table shows that the most significant determinants of export growth

(dX/X) are productivity growth, measured as the average annual increase in value added

per worker (equation 8) and the change of unit costs at shadow prices (equation 2), which

is our measure of comparative advantage. The coefficient of the latter variable is negative

because unit cost declines imply greater comparative cost advantage.

Table 7: Determinants of export growth Equ. # Dependent var. Independent var. Coefficient t-stats R-square 1 X (1997/98) UCs (1997/98) -1.6 E 07 -1.2 0.11

2 dX/X dUCs/UCs -43.0 -2.6 0.35

3 dX/X UCs (1997/98) 48.7 3.8 0.53

4 dX/X dUCx/UCx -46.5 2.03 0.24

5 dX/X dUCd/UCd -0.18 -0.49 0.018

6 dX/X d(K/L)/(K/L) -0.33 -0.38 0.01

7 dX/X dVA/VA 0.53 1.22 0.10

8 dX/X d(VA/L)/(VA/L) 0.0156 2.89 0.39

While this finding is fully supported by economic theory, it is somewhat

surprising that the export unit cost ratio is a less significant predictor of export growth

than comparative advantage. This may demonstrate that firms are indeed aware of the

potentially volatile nature of export competitiveness as measured by market prices and

including price distortions. Even more surprising is the wrong sign of the regression (#3)

of export expansion on the indicator of comparative advantage itself, rather than its rate

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of change. Equally, the regression of export expansion (dX/X) on the change in capital

intensity in equation 6 yields a negative sign, which may suggest that export expansion is

not necessarily obtained by investments in more capital-intensive products or processes.

Finally, export expansion is also very weakly correlated with the growth of value added.

In other words, during the study period export growth does not seem to have induced

growth of the industry.

4 Employment growth under the reforms

Employment growth is a crucial aspect of this investigation because of its dual function

with respect to income growth and poverty alleviation, which are, or should be, the final

goals of economic policies. The first function of employment is to generate income and it

amounts to a positive relationship between employment growth and income growth. The

second function is to generate costs, which amounts to a negative relationship between

employment growth and productivity, and hence competitiveness, exports and growth.

Under trade liberalization and globalization the short-run impact is usually employment

reduction, but the long-run effect is expected to be employment growth through raised

productivity and competitiveness. Since we are in this study comparing two points in

time over a ten-year period, where the main policy changes fall into the first half of the

period, we expect to observe more of the longer-run effects. The questions of interest are

then (a) whether there is substantive evidence of employment growth, and (b) whether

employment growth is strongly correlated with export growth.

4.1 Employment vs. productivity growth

As table 8 shows, employment in manufacturing has grown at an average annual rate of

2.24 percent over the study period. The growth rate was particularly high in the Rubber,

plastic, petroleum and coal industry (13.2 percent) as well as in the Clothing industry

(10.5 percent). It was particularly low in Chemicals (negative 4.6 percent), as well as in

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Cotton textiles (0.3 percent), Non-metallic minerals (0.46 percent), Wood products (0.69

percent), Basic metals (0.77 percent) and Jute & hemp textiles (0.96 percent).

Table 8: Employment growth over the study period

Industry Code

Industry Employed 1987/88

Employed 1997/98

Annual growth

20-21 Food 997,483 1,333,822 0.0291 22 Bev.& Tob. 436,442 599,345 0.0317 23 Cotton text. 834,922 860,690 0.0030 24 Whool & silk 307,606 354,049 0.0141 25 Other textile 196,008 215,986 0.0097 26 Clothing 128,815 369,639 0.1054 27 Wood prod. 70,490 75,502 0.0069 28 Paper & print 290,419 336,664 0.0148 29 Leather prod. 76,389 122,015 0.0468 30 Rubber etc. 209,483 785,571 0.1322 31 Chemicals 549,697 347,792 (0.0458) 32 NMMs 422,720 442,791 0.0046 33 Basic metals 617,278 666,591 0.0077 34 Metal prod. 201,214 278,780 0.0326

35-6 Machinery 810,488 899,492 0.0104 37 Transp. equ. 481,482 551,705 0.0136 38 Other manuf. 77,357 148,383 0.0651

TOTAL 6,708,293 8,388,817 0.0224 23,24,25 Textile ind. 1,338,536 1430725 0.0224

In some of these “low employment growth” industries, however, value added grew

rapidly, thus raising the labour productivity. The greatest increase in labour productivity

is observed in Basic metal (9.6 percent), Wool & silk textiles (6.3 percent), Transport

equipment (6.0 percent) and Non-metallic minerals (5.6 percent).

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Table 9: Labour productivity and its changes

Industry VA/Empl.

1987/88 VA/Empl. 1997/98

Annual growth*

Annual growth**

20-21 25,944.60 38,772.77 0.0402 0.0251 22 16,863.64 27,447.19 0.0487 0.0217

23 22,446.17 31,708.29 0.0345 n.a.

24 36,152.09 67,906.82 0.0630 n.a.

25 15,564.16 22,816.57 0.0383 n.a.

26 29,630.87 35,577.65 0.0183 0.0182

27 19,578.66 22,678.31 0.0147 (0.0019)

28 38,930.99 47,871.46 0.0207 0.0699

29 28,175.52 42,201.10 0.0404 0.0270

30 125,100.37 136,926.85 0.0090 0.0101

31 84,541.67 105,626.22 0.0223 0.0732

32 35,834.60 62,740.06 0.0560 0.0680

33 54,347.15 142,389.30 0.0963 0.0220

34 40,455.44 51,911.18 0.0249 0.0333

35-6 57,255.51 89,639.73 0.0448 0.0372

37 45,815.00 83,316.08 0.0598 0.0393

38 47,686.70 70,562.47 0.0392 0.0277

TOTAL 42,704.47 69,031.51 0.0480 n.a.

23,24,25 24,588.13 39,323.70 0.0470 0.0314

Notes: Values in Rupees per employee

* based on real values using the GDP deflator

**based on US$ values

The last column in table 9 shows, for comparison, growth rates of labour productivity

based on international statistics using US$ values. They are generally lower because the

Rupee strongly depreciated in real terms during the study period, so that these growth

rates are likely to understate the real growth of labour productivity.

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It follows from the calculations shown above that during the study period total

employment in manufacturing did not shrink, as it could have been expected under the

competitive pressure, which resulted from the substantive decline of protection and

globalization. Instead, it expanded at a rate of 2.2 percent, with some industries

generating more than or close to 10 percent employment growth. This means that in spite

of the painful adjustments required by trade liberalization and globalization, the

manufacturing sector contributed positively to the growth of income and employment.

5 Conclusion

This paper has attempted to analyse the performance of India’s manufacturing sector

under the reforms of the early 1990s. We found that the level and structure of protection

was drastically changed by the reforms and that this change was accompanied by an

increase of the sector’s comparative cost advantage. Resources seem to have moved in

the direction of industries endowed with comparative advantage. In a number of

industries this has led to increased exports. It is particularly interesting to observe that

export expansion was more strongly driven by comparative advantage than by domestic

profitability, which is high under high protection. Even the profitability on export

markets, but including various distortions on the cost side, was found to matter less for

export success than comparative advantage. Finally, it was also seen that the sector

managed to increase its employment base at an average annual rate larger than two

percent. This suggests that the reforms, although painful for those workers losing their

employment in less successful industries, did not lead to drastic employment loss.

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References Ahluwalia, M., 2002a, “Economic reforms in India since 1991: Has Gradualism

Worked?,” Journal of Economic perspectives 16(3), 67–88.

Cockburn, J. et al. (1999), “Measuring competitiveness and its sources: The case of

Mali’s manufacturing sector”, Canadian Journal of Development Studies, Fall.

Haragopal, K. Sai, “Trade Reforms and Export Performance”, in Bishwa Nath Singh,

Mohan Pd. Shrivastava, Narendra Prasad, Economic Reforms in India, APH

Publishing Corp., New Delhi, India.

Joshi, V., I.M.D. Little, “India’s Economic Reform 1991-2001”, Clarendon Press,

Oxford, 1996

Panagariya, A.(1999), “The WTO Trade Policy Review of India, 1998”, NCAER, (mimeo).

Panagariya, A. (2002), “India in the 1980s and 1990s: A Triumph of Reforms”, IMF

Working Paper WP/04/43 (mimeo)

Pandey, M. et al. (1998), “Protection of Indian Industry”, NCAER, Delhi, (mimeo).

Rodrik, Dani, 2002, “Institutions, Integration, and Geography: In Search of the Deep

determinants of Economic Growth,” in Dani Rodrik, ed., Modern Economic

Growth: Analytical Country Studies (forthcoming).

Shrivastava, M. P., “A Decade of Globalization, Liberalization and Economic Reforms in

India: An Assessment”, in Bishwa Nath Singh, Mohan Pd. Shrivastava, Narendra

Prasad, Economic Reforms in India, APH Publishing Corp., New Delhi, India.

Siggel, E. (2001), “India’s Trade Policy Reforms and Industry Competitiveness in the

1980s”, The World Economy, vol. 24, No. 2, February, pp. 159-183.

Siggel, E., G. Ssemogerere, (2004), “Uganda’s policy reforms, industry competitiveness

and regional integration: a comparison with Kenya”, Journal of International

Trade and Economic Development, vol. 13, No. 3, pp.325-357.

Singh, P., S. Kaur, “Second Generation Economic Reforms: Some Emerging Issues”, in

P.P. Arya, B.B. Tandon (ed.), Economic Reforms in India: From First to Second

Generation and Beyond, Deep & Deep Publications Pvt. Ltd., New Dehli, India

Srinivasan, T.N. and Suresh D. Tendulkar, 2003, Reintegrating India with the World

Economy, Washington DC: Institute for International Economics.

World Trade Organization (1998), Trade Policy Review: India, Geneva, WTO

Secretariat.

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Appendix

Indicators of competitiveness and comparative advantage

The indicator of competitiveness used in the present study is a unit cost ratio (UC), defined as total

cost (TC) divided by the value of output (VO), which in turn equals output quantity times the ex-

factory price. For domestic sales, the ex-factory price is the domestic market price (Pd), which is

typically higher than the international price of a similar imported product by a margin equal to the

nominal rate of protection. For export sales, on the other hand, the ex-factory price is equal to the

international (fob) price (Pw).

This particular definition of the unit cost ratio serves a double purpose. First, it helps to

overcome the differences in product mix and quality that make inter-firm comparisons always

problematic. We assume that the output price is usually proportionate to the quality attributes of

products. Therefore, when two firms have the same total cost, but one produces a higher-quality

product with a higher price and total output value, its unit cost ratio would be lower, implying that it

is deemed to be more competitive than the other firm. Second, it makes the unit cost indicator

independent of the data of an international competitor, whose cost we would otherwise need for

comparison. We assume, therefore, that the international price (Pw) corresponds to the unit cost of a

typical international best-practice producer. The fact that Pw is measured as the border price (cif)

means that the benchmark for international comparison includes the transport cost to the border and

therefore a margin of natural (geographic) protection. Our criterion for international competitiveness

or export competitive advantage is then

(1) UCx = TC/(Q Pw) ≤ 1

meaning that a firm is deemed to be competitive if its cost per unit of output is less or equal to the

free-trade price of an equivalent import. This concept of cost competitiveness is multilateral, as

opposed to a bilateral firm-to-firm or country-to-country comparison, but it allows bilateral

comparison as well. For instance, if UCxA > UCxB > 1, then neither country A nor country B, is

export competitive, but B is more competitive than A.

Domestic competitiveness, as defined earlier, means a cost advantage under protection. In

this case the denominator of the unit cost ratio is the output value at domestic prices (VOd = Q Pd),

so that the criterion of domestic competitive advantage becomes

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(2) UCd = TC/(Q Pd) ≤ 1.

For those firms that export part of their output, Pd of the exported output equals Pw.

In both indicators, UCx and UCd, total cost (TC) includes the interest paid on borrowed

capital as well as the opportunity cost of own capital, taken as the capital stock minus outstanding

debt times the market interest rate. UC exceeds unity if the rate of return is lower than the interest

rate, and it is less than one if the rate of return is higher. Clearly, the indicator sets a high standard of

competitiveness, because the criterion implies that the firm is able to replace its total capital stock by

borrowing at the current interest rate. In times of high interest rates, this may be difficult even for

otherwise truly competitive firms. The indicator has, therefore, this long-run characteristic.

The most important distinction, however, and the hallmark of our method of analysis is the

one between competitiveness and comparative advantage. While competitiveness is understood as a

cost advantage based on market prices including various price distortions, subsidies and penalties,

comparative advantage corresponds to a cost advantage at equilibrium prices. In order to measure

comparative advantage we replace all prices, in output as well as all inputs, by shadow prices. A firm

or industry has then comparative advantage if the unit cost ratio in terms of shadow prices does not

exceed unity:

(3) UCs = TCs/(Q Ps) ≤ 1

where TCs is total cost in shadow prices and Ps is the shadow price of output. For tradable goods, the

shadow price is usually equal to the international price (Pw), but adjusted for any distortion of the

exchange rate. TCs is the sum of all cost components adjusted for all price distortions and subsidies.

It is now evident that the concept of competitiveness differs from the one of comparative

advantage only by including the sum of all price distortions. When UCd is smaller than UCs, the

price distortions act as subsidies; when UCd exceeds UCs they act as penalties. Since price

distortions affect both inputs and outputs, they have the opposite effect on the cost and output sides.

A tariff on output lowers the unit cost ratio (i.e. increases domestic competitiveness), whereas a tariff

on tradable inputs raises it and thereby lowers competitiveness. This shows that in the protected

domestic market a producer is more competitive than under free trade, as production tends to be

more profitable under protection. But comparative advantage, which is the real core of

competitiveness, is not affected by the existing price distortions. However, as a consequence of

protection and other distortions, input coefficients at shadow prices may be affected as well. In other

words, price distortions may lead to lower efficiency and loss of international competitiveness in the

longer run.

Finally, total unit costs net of distortions are broken down into four components, tradable

inputs, non-tradable inputs, labour cost and capital cost, and the distortions are calculated and added

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to the unit costs at shadow prices to obtain unit costs at market prices. This leads to the following

schema showing how UCd, UCx and UCs related to each other:

(4) VITs/VOs (Shadow unit cost of tradable inputs) +VINs/VOs (Shadow unit cost of non-tradable inputs) +LCs/VOs (Shadow unit cost of labour inputs) +KCs/VOs (Shadow unit cost of capital inputs) __________ = TCs/VOs = UCs (Total unit cost at shadow prices) +dpe (Exchange rate distortion of output) +dpj (Tradable input price distortion) +dpje (Exchange rate distortion of tradable inputs) +dw (Wage rate distortion) +dpk (Capital goods price distortion) +dr (Interest rate distortion) +ds (Direct subsidy, negative) ___________ = TC/VOw = UCx (Total cost per unit of output at international prices) +dpp (Output price distortion) ___________ = TC/VOd = UCd (Total unit cost at domestic prices)

In other words, total unit cost in shadow prices (indicator of comparative advantage), augmented by

all cost distortions, adds up to unit cost per output value at free-trade prices (indicator of export

competitiveness), and adding the output price distortion leads to unit cost in domestic prices

(indicator of domestic competitiveness). This accounting framework serves us to identify, with some

limitations, the sources of competitiveness. The distortions are all expressed as proportions of unit

costs, so that the highest proportions indicate the strongest influence on unit costs.

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