Need to make India a truly low cost economy for global competitiveness

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The high cost of finance for domestic manufacturing needs to be rationalised immediately so that made-in-India products can become globally competitive.

guestcolumnWednesday, August 13, 2014: Consider a vertically integrated company that has invested vast resources in the entire value chain of a consumer appliance. This would cover the mining of raw materials like coal, drilling for the crude oil/gas, refining of metals or petrochemicals and power generation, on to the manufacture of sheets, plastics, powders, chemicals, etc. This vertical integration would also include production of parts, components and packing materials; systems/modular assembly, and finally, the assembly of the finished consumer appliance. In this scenario, the costs of producing the consumer product while being involved in the entire value chain are only the salaries paid and the cost of finance.

Now, guess what the viable selling price would be for a typical home appliance whose current price is around Rs 1000 + excise + VAT, in the event finance was free of interest. Would you believe it if I said that the price would be about Rs 550 + excise + VAT?

To make this point more clear, take a look at the tables showing the cost of finance (Table I) and the residual taxes (such as CST); their compounding, cascading and related overhead costs (Table II); and comparative cost structures of India and China (Table III).

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Why Chinese products are cheaper

Tables I and II show the consequential cost increment (total impact of 390 + 68 = 458) due to the high rate of interest @ 12 per cent and the 2 per cent CST on the entire value chain. Investments at each level and value addition may vary, but the tables definitely show the enormity of the incremental cost. As per the computations illustrated in the tables, the Chinese value chain is around 20 per cent more competitive, mainly because the average cost of finance in that country is about half of ours. More than a 5 per cent cost hike in the value chain is because of the 2 per cent CST or similar residual local taxes.

Table III provides clarity in quantified terms as to how the Chinese products (manufactured with finance that costs less than half the rate prevailing in India and having no residual taxes) are 20 to 30 per cent cheaper than our domestically manufactured products, in spite of the fact that the manpower cost in China is more than double the cost in India. China’s high labour costs are offset by the fact that the average productivity or value addition of an Indian worker is only about 40 per cent of that of a Chinese worker. So the low cost of finance and no residual taxes are the two principal factors that enable Chinese products to enjoy a cost advantage vis a vis Indian products!

Depreciating rupee…

In spite of such a huge difference in the costs (nearly 24 per cent, as shown in Table III), the enormity of the situation is not widely felt. One of the main reasons for this seems to be the depreciation in the value of the rupee. Although this provides protection to domestic manufacturing to a certain degree, it also fuels inflation to a large extent. Prices of domestically produced goods are equated with the landed cost of similar imported products. The domestic manufacturers have to adjust their prices based on the landed cost of similar products. If rupee appreciates, prices have to be reduced. In most of the electrical/electronic products, majority of the input materials are imported, hence cost of production also varies with fluctuation in the rupee exchange rate.

So how long can we watch the value of the rupee depreciating (eroding the value of our assets) in order to see our economy grow? Can we take long term investment decisions based on the depreciating rupee, since the exchange rate depends on many other global factors also. The falling value of the rupee is one major reason why investing in manufacturing is perceived as highly risky today.

Burden of the cost of finance

Our learned economists are aware of the enormous burden of the cost of finance in the cost structure for domestic manufacturing. It is therefore imperative that rationalising the cost of finance is given utmost priority to make domestic manufacturing competitive on a global scale. The need of the hour is to consider the manufacturing industry at par with other sensitive sectors like agriculture and textiles (notably in Gujarat) for adopting rational fiscal measures, which would lead to a substantial reduction in the rates of interest and hence the cost of finance.

Indian manufacturing industries were heavily protected from the global economies by way of quantitative restrictions as well as high customs duties in the 1970s and 1980s. Hence, they could sustain themselves and grow until the early 1990s, when the WTO came into existence. Armed with the money power, international organisations like the World Bank and the IMF, pressurised India to remove the import restrictions and lower customs duties drastically. These multilateral agencies, which are guided by the interests of the developed world, did not pressurise the Government of India to simultaneously bring down the cost of finance and eliminate the intermediary taxes/duties in order to remain competitive. Since 2005, there have been moves by these agencies to almost eliminate the customs duties, starting with electronics/IT hardware, and most of the other items of mass consumption by way of the fair trade agreements (FTAs), regional trade agreements (RTAs), non-agticultural manufactured articles (NAMA), extending the list of ITA-I or ITA-2 items, etc.

High rates of interest

The interest rates in India currently range between 10 per cent and 14 per cent, whereas these are below 5 per cent in the USA, Japan, Taiwan, South Korea and even in China. The rate of interest is considered to be the ‘factor cost’ and hence RBI is keeping it high in order to control inflation and maintain the cost of fund for the banks. (RBI uses the rate of interest as a factor cost and manipulates it by increasing/decreasing the SLR, CRR, REPO/reverse REPO rate, etc to maintain certain cost of fund for the banks). It needs to be studied as to how these countries are not only sustaining these low rates but also making their manufacturing industries highly viable/competitive. It is worth noting that the Japanese economy has been facing deflation for the last several years in spite of maintaining near zero rates of interest. This is contrary to the general perception among economists that lowering the rate of interest fuels inflationary pressures.

China has maintained its rate of interest between 2 and 5 per cent for manufacturing industries and has adopted the VAT after eliminating all the intermediary taxes. The Chinese government continues to incentivise manufacturing and exports, which has helped China to become the manufacturing hub of the world.

In India, the RBI allowed the bankers to reduce interest rates to between 7 per cent and 11 per cent from 2005 to 2010. As a result of that, growth in the manufacturing industry reached the double digit mark. The MSME sector grew around 11 per cent during 2006-11 and grew by 19.6 per cent in 2011-12. This shows the direct relationship between the rate of interest and industrial growth.

Contribution of manufacturing to GDP

The contribution of the manufacturing sector to our GDP has ranged between 13 per cent and 15 per cent for the past decade. There is an urgent need to enhance it to around 25 per cent so that employment for a 100 million Indians (as per the National Manufacturing Policy) can be generated and the real demographic dividend is achieved within the next eight to ten years.

India is not merely ‘one country’ but a sub-continental expanse that is home to 1/6th of the world’s population. We should be capable of controlling almost the entire value chain in a majority of the consumer products. Segments like electrical/electronics consumer products alone have the potential to provide direct employment to 28 million people, provided manufacturing is made competitive even in the zero customs duty environment. This is essential because the value chain starts facing negative protection when finished products are allowed zero customs duty.

Since it has been established that lowering the cost of finance deserves the highest priority for the Indian manufacturing industry to become competitive even in the zero duty scenario, let us think out-of-the-box as to how to compensate those sectors that will suffer losses due to the lowering of the rate of interest. Let the CST and all the intermediary taxes and duties get abolished even before the GST is implemented at the highly rationalised rate of around 10 per cent to explore potential market demand. This will also help the entire value chain for automobiles, which is facing a challenge now, to compete globally.

How to make manufacturing competitive

Competitive manufacturing will attract huge investments including FDI, accelerate employment generation which should be the top priority of the government (even higher than the generation of revenue) and create more than enough wealth, part of which can be used to compensate all the losers.

As a geo-political reality, the tariff barriers are gradually disappearing due to globalisation. In such a scenario, how long can a country sustain its manufacturing competitiveness only on the basis of non-tariff barriers such as the cost of logistics, regulatory compliances, safeguard duties, etc? Ultimately, manufacturing has to stand on its own feet and sustain itself even without any barrier (fiscal or non-fiscal).

The mid-term impact of lowering the cost of finance to between 2 per cent and 5 per cent and a comprehensive GST fixed at 10 per cent will facilitate industry to scale up and become globally competitive.

This should attract investments including FDI and strengthen the value of the rupee against other currencies, reduce inflation and ultimately pave the way for manufacturing to contribute more than 25 per cent to our GDP, on a sustainable basis, leading to achieving a real demographic dividend.

SOME RECOMMENDATIONS 
In such a complex situation, industry needs a level playing field (comparable with competing countries like China). The following reforms are urgently needed for this purpose:

Lower the cost of finance to between 3-4 per cent. The net impact of the current 12 per cent interest rate works out to 40 per cent of the cost of the finished products, as it affects the entire value chain. So lowering the cost of finance will make the finished consumer products cheaper by about 25 per cent.

Labour law reforms: This can be coupled with adequate compensation for parting ways with an employee. The lowered risks that result from this will encourage entrepreneurs to invest heavily. The employment in the organised sector will also grow.

Remove the intermediary taxes such as CST, LST, etc, to remain globally competitive. This 2 per cent reduction will make the finished products cheaper by more than 5 per cent.

Rationalise indirect taxes: Reduce the excise duty, VAT and service tax for exploring market potential as this will result in lowering the cost to the consumers. The combined net indirect tax should be rationalised to around 10 per cent. This will make our manufactured products less taxing for the poor people of our country. Tax evasion will be reduced and ultimately, revenue to the government will increase. Remove products like cell phones from the zero duty category.

 

Table I: Impact of Finance Costs on the Manufacturing Value Chain      

Stages/Tiers of

manufacturing

Selling price

(INR/unit)

Value addition

Investment

IMPACT OF FINANCE COSTS @ 12%

       

Direct

Addl ROI @ 3% as offset

Total impact

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(01) Finished product

1000

100

200

24.00

6.00

30.00

(02) Sub-assembly (including PCB assembly)

900

150

300

36.00

9.00

45.00

(03) Components (electronic & others)

750

200

450

54.00

13.50

67.50

(04) Piece parts

550

200

600

72.00

18.00

90.00

(05) M. sheets, plastic powder, wafers, etc.

350

225

650

78.00

19.50

97.50

(06) Ore, chemicals, silicon, etc.

125

125

400

48.00

12.00

60.00

312.00

78.00

390.00

Note: (01) Investments include the fixed capital and the working capital equivalent to one month’s inventory and one month of processing. Debtor/creditor aspects are not considered. Materials are supplied from Tier 6 to Tier 5 and so on up to Tier 1. It is presumed that there is no credit extended to the buyer, i.e, material is supplied against payment.

(02) The additional ROI is a must in order to mitigate higher risks due to high finance costs and many other risk factors.

(03) In the scenario of 6 per cent finance costs, the possibility of reduction in prices is (312 + 78) ÷ 2 = 195

Table II: Indian Manufacturing: Adverse impact of CST      

Computation of the adverse impact of 2 per cent CST on manufacturing: The table shows the adverse impact of 2 per cent CST and its cascading effect (tax-on-tax as well as the overheads) on the total value chain of manufacturing, considering the CST/LST levied at every stage.

Stages of

manufacturing

Selling price (INR/units)

Value addition (INR/units)

Impact of 2% CST

     

Direct

Tax on tax 2% on (4)

Cascading effect due to overhead & profit at each stage (15% of tax on inputs) 15% on (4+5)

Total impact of CST @ 2% (4+5+6)

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(1) Finished product

1000

(977.71 + 22.29)

50

19.00

0.38

2.91

22.29

(2) Sub-assembly

950

(930.06 + 19.94)

100

17.00

0.34

2.60

19.94

(3) Components

850

(835.92 + 14.08)

250

12.00

0.24

1.84

14.08

(4) Piece parts

600

(590.62 + 9.38)

200

8.00

0.16

1.22

9.38

(5) Sheets, powder, wafers, etc

400 (397.07 + 2.93)

275

2.50

0.05

0.38

2.93

(6) Ore, chemicals, silicon, etc

125

(122.5 + 2.5)

Nil

Nil`

Nil

Nil

Nil

TOTAL

58.50

1.17

8.95

68.62

 

Table-III: Indian manufacturing: Global competitiveness    

Computation of cost structures of India and China based on interest rates

Factors

India @ 12%

China at 6%

Remarks

Manpower (salaries)

@ Rs 120,000 /year

33%

37.5%

The Chinese average salary is more than double that of India’s, but productivity of the Chinese worker is 60 per cent higher.

Finance cost of the entire value chain

31%

15.5%

Assuming similar investments (total funds involved) in the value chain.

Profit

10%

5%

Higher transaction, difficult to do business, lower debt:equity ratio; hence higher profit margins are expected to mitigate risks.

Intermediate taxes like CST

6%

0%

 

Average excise & VAT on IT/electronic products

20%

(-) 6% Export Subsidy + 24% (CVD + VAT + SAD)

China refunds17% VAT on exports. Average benefit due to the VAT on the inputs is around 6%.

Indian excise duty has been taken @ 10%, and the VAT @ 10% as an average

TOTAL

100%

76%

 

A brief note on comparative cost structures of India and China based on the cost of finance

Salient points of India-China comparison

  • To reduce the difference of cost advantage being enjoyed by China

  • India has limited capability to match the Chinese cost advantage

  • However, it is perceived that lower rate of interest and removal of the intermediate taxes, along with the investment incentives, will facilitate Indian manufacturing

Objectives of the Electronics Manufacturing Policy 2012

  • Yearly production expected: Rs 25,000,000 million (US$ 400 billion)

  • Employment generation: Direct 28 million; Indirect: 28 million x 2.5 = 70 million

Electronics Bazaar, South Asia’s No.1 Electronics B2B magazine

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