Reshape Indian economy by ‘servicification’ of manufacturing

India’s demographic dividend

India has a rich demographic dividend with 68% of population in the working age (15-64 years) and a median age of 28 years, compared to 39 years for China. This is one of the key factors underpinning the confidence of the government, the technocrats, and the corporates in India to achieve accelerated economic growth vis-à-vis its Asian peers over the next decade. However, to bring the best out of India’s youth and to reap this dividend, it is important to provide skill sets and education to those entering the workforce, making them employable in the industry.

As per India Skills Report 2024, nearly half of India’s graduates are still unemployable. Therefore, while India’s labour force participation rate (LFPR) has continued to increase over the last 5 years, it is important to look at the quality of jobs being created. India Employment Report 2024 alludes to key concerns in the labour market such as: (i) increase in women LFPR is largely driven by self-employment / unpaid family work in rural areas, (ii) more than 90% of the workers continue to remain employed in informal sector with no written contracts and, (iii) wages and earnings for regular salaried segment have either been stagnant or declining. These indicate that employment conditions remain poor with widespread livelihood insecurities as only a small percentage of workers are covered by employment contracts.

Capturing the ‘value’ in manufacturing value chain

With a GDP per capita of only $2,850, India lags most Asian economies today. There is a clear thrust on developing manufacturing capabilities by the government to improve our economic growth. Campaigns like ‘Make in India’ and ‘Skill India’ aim to raise the contribution from manufacturing sector from 16-17% of GDP, which has been fairly stagnant historically, to 25% by 2025. While investing in manufacturing facilities and developing manufacturing capabilities will likely boost India’s GDP, it is also important to look at the gross value added (GVA) metric which measures the nominal value of the amount of goods and services produced in an economy after deleting input costs that have gone into the production of those goods and services. The share of manufacturing in GVA has remained stagnant at ~16% over the last decade and stands slightly higher at ~17% as of FY23. This is despite the Production Linked Incentive (PLI) scheme which was launched in 2020 to boost manufacturing. 

As highlighted in a paper co-authored by Raghuram Rajan and Rohit Lamba, post implementation of the PLI scheme, there was a sudden spurt in rise of mobile phone exports. However, this was complimented by a commensurate rise in imports of mobile phone components (semi-conductors, PCBA, display etc.). Based on the net export data, they implied that the combined net exports fell indicating a plausible increased dependence on imports, albeit on mobile phone components instead of the phones themselves. This directly relates to the famous ‘smile curve’ of value addition in the global value chain which shows that majority of the value is added either at the beginning of the value chain i.e., during R&D, product design & conceptualisation or at the end of the curve i.e., through marketing, financing, transportation & logistics etc. The middle part which involves product assembly is where the least value addition happens (see Figure 1 below).

The PLI scheme intends to address this issue of low domestic value addition in certain sectors by linking the eligibility to avail PLI with percentage of domestic value added in the product. While the requirements of domestic value addition are different across 14 sectors covered under PLI, but as per a recent review done by Ministry of Commerce and Industry, 6 out of 14 sectors did not avail any subsidy under the scheme and only ₹2,900 Cr was disbursed to the remaining sectors out of the ₹1.97 lakh crore allocated by the government as of FY23. This shows that most of these sectors are not able to meet the eligibility criteria to avail PLI scheme and thus the scheme on a standalone basis is insufficient.

Interdependence of manufacturing and services

The objective of capital expenditure and its linked subsidies should be to increase the domestic value addition and improve technological depth in manufacturing. In order to do that, it is important to recognise that with increase in automation, the proportion of value being added in goods from embedded ‘services’ (R&D, product design, business services, logistics, sales, marketing etc.) is increasing. This phenomenon, also known as ‘servicification’ of manufacturing makes services and manufacturing interdependent on each other. Therefore, identifying these linkages and developing capabilities in such embedded services will enable India to add greater value in the global supply chain and accelerate economic growth. The graphs below compare ‘servicification’ of manufacturing exports between India and China during the period 1995-2020 (latest available data on OECD TiVA database).

In the above charts, services exports refer to total export of services and services VAD (value added) in manufacturing exports refers to export of services through value added in manufacturing exports. Services VAD in manufacturing exports has grown faster (14% CAGR) than overall services exports (8% CAGR) in China. This directly contrasts with India where overall services exports growth (14% CAGR) has been higher than services VAD in manufacturing exports (10% CAGR).

On further break-up of services VAD in manufacturing exports, it can be concluded that VAD content from the competitive IT sector in India is minimal while most of the services VAD comes from traditional services like distribution, trade, transportation etc. This is even though IT services account for the largest share in overall services exports. Hence there is a clear mismatch between value of modern services produced in India and the ability of manufacturing firms to absorb them.

While the data shown above is dated, but the key point to highlight is that if India wants to make its manufacturing capabilities competitive in an environment of increasing automation and underpin its economic growth on manufacturing, it needs to improve ‘servicification’ of manufacturing sector by better absorption of high-quality services (IT and business services).

IT and business services can be used by manufacturing to: (i) automate production processes, (ii) 3D printing to develop product prototypes, (iii) improve synchronisation between various production processes to reduce wastage / spillage, (iv) predict demand to streamline inventory levels and transportation, (v) understand consumer behaviour for better product marketing etc.

Making Indian manufacturing more ‘valuable’

For India to increase ‘servicification’ of the manufacturing sector and become a more valuable contributor in the global supply chain, it needs to bring about certain structural changes to the industrial ecosystem. Some of these are:

-Improving the ease of doing business in India: India jumped from a rank of 142 in 2014 to 63 in 2019 in global ease of doing business rankings. While this illustrates that India has come a long way, there is still significant headroom for improvement especially if India is rooting for a 70% growth in GDP / capita by 2030. Some specific areas which will improve the experience of multinational firms opening shops in India are:

-Overhaul of existing labour laws: The multiplicity of rules and procedures that employers need to adhere to, and high costs associated with hiring and firing labourers make it difficult for global multinational firms to operate nimbly in India. While the labour reforms bill passed in 2020 tried to address some of the issues, but a number of structural improvements are still required to encourage firms to set up large manufacturing units handling critical parts of value chain in India.

-Streamlining land acquisition process: Land acquisition is a complex issue. Foreign firms consider land acquisition as a high-risk transaction due to lack of clear titles (land related disputes form 60-70% of total civil litigations), difficulty in acquiring agricultural land for non-agricultural purposes, issues in access due to inadequate infrastructure etc.

-Incentivising MSMEs to automate / digitise production facilities: Given abundantly available cheap labour, there is little incentive for MSMEs to incur capital expenditure and make their manufacturing units more digitised / automated and simultaneously invest in up-skilling / training the labour force. This makes it important for the government to educate MSMEs of the long-term advantages of improvement in productivity and profitability and subsidise the cost of such one-time upgradations, thereby eliminating the myopic view that exists today.

-Realigning SEZ incentives to promote manufacturing units: ~60% of Indian SEZs cater to IT or business services (global capability centres). India has been unable to attract high value manufacturing businesses in SEZs due to lack of fiscal and non-fiscal incentives which MNCs would need to set up manufacturing units. For example, given high logistic costs (as % of GDP) due to under development infrastructure, Indian manufactured exports are uncompetitive. While India will continue to develop infrastructure in the longer term, the government should subsidise a portion of logistic costs for exports in SEZs as a tactical measure. Additionally, while India has increased its focus on Free Trade and Warehousing Zones (FTWZs), which allow duty / tax free import and export of goods, it would be helpful to examine fiscal and non-fiscal policies offered to FTWZs by other countries.

-Improve the ecosystem for promoting deep tech startups: India is home to world’s third largest base of tech startups, with most of them being software related. As per a report by NASSCOM, India added 1,300 active tech startups in 2022 taking the total number of startups to 25,000-27,000. However, less than 5% of these startups are deep tech startups. This is because:

-While India has requisite qualified graduates to build deep-tech startups, there is a need to provide them with adequate safety net to improve the risk appetite. Government’s ‘Atal Innovation Mission’, ‘Startup India’ etc. are a step in that direction. However, India would also need an equivalent of ‘Universal Basic Income’ scheme, which provides a regular and unconditional cash transfer, for entrepreneurs to safeguard them against failure.

-There is a need to develop adequate infrastructure for carrying out R&D, hardware development etc. with a long-term view which will require substantial investment and support from the government. Once infrastructure is in place, Venture Capital (VCs) funds would need to bring in long term capital as deep tech startups typically take longer time than software related startups to break-even, given they are more capital intensive.

The government has been working towards taking India to the forefront of global manufacturing supply chain. The big infrastructure push has been coming through to improve India’s image as a favoured investment destination at the global stage. With demographic dividend on the right side and a favourable investment climate amidst faltering western economies, it is a golden chance for India to race ahead of Asian competitors with whom India has always been playing a catch-up game. At this juncture, it is important for all stakeholders involved in India’s growth story to realise that true economic value addition will happen if India is able to leverage its robust services exports platform and embed that into manufacturing to improve productivity. With the dawn of automation and GenAI, the world is moving towards leaner and more efficient supply chains, especially post COVID, and that is where true value lies for India’s manufacturing sector.