Industrial policy was once so out of fashion that it was jokingly called “the policy that shall not be named.” Now it’s back in a big way. On issues ranging from clean energy to semiconductors to Covid-19, governments are trying to improve the performance of key business sectors. Can they manage to do so without subverting competition and subsidizing special interests?
This article is part of ProMarket‘s series on industrial policy. Stay tuned as we publish an article each week this quarter on the topic.
After pursuing an economic strategy of liberalization and global economic integration that has given primacy to market forces since 1991, India has changed tracks once again. Confronted by the need to create decent jobs for the nearly 12 million people who join the workforce every year, India turned to the potential of manufacturing when Prime Minister Narendra Modi launched the Make-in-India (MII) campaign soon after forming his government in 2014. However, unlike the mixed results of India’s first attempt at industrial policy in its early post-independence period, India’s evolving industrial policy this time around is more likely to succeed in fostering its industrial transformation and help realize its Vision 2047 of becoming a developed nation.
Import-Substituting Industrialization: mid-1960s-1991
India pursued import-substituting industrialization (ISI) from the mid-1960s until the reforms of 1991. The policy included high tariffs (up to 350%), import licensing, industrial licensing (or approvals), a rather strict foreign direct investment (FDI) regime, and a softer intellectual property protection regime that did not recognize product patents in pharmaceuticals. The industrial policy helped build a diversified industrial base by the end of the 1980s, one that produced virtually all items of consumption in India. During this time, manufacturing’s share of GDP nearly doubled from around 9% to 17.5%. India’s overall dependence on imports dropped dramatically even for heavy machinery and capital goods. However, industrial licensing and high tariffs and quantitative restrictions on imports led to the creation of virtual monopolies resulting in high prices, poor quality, and limited variety for Indian consumers. Poor attention paid to innovation led to technological obsolescence, and international competitiveness suffered.
Given their poor competitiveness, many of Indian companies could not stay in business when exposed to foreign competition after 1991. Many of them entered joint ventures with multinational enterprises (MNEs) to update their technology or were acquired by them. This underscored a crucial difference between India’s experience with industrial policy and those of the East Asian countries such as South Korea. Indian policy targeted import-substituting industrialization in a closed economy context and did not particularly seek international competitiveness. The East Asian countries, on the other hand, focused on building internationally competitive industries. They constantly leveraged rivalries between domestic champions and pushed them into international markets through export incentives and performance requirements.
This is not to say, however, that import-substituting industrialization strategy failed completely in India. India’s success in generic pharmaceuticals, information and communication technology (ICT) software, and building a vertically integrated automobile industry with global leadership in two-wheelers and compact cars can be attributed to the strategic interventions of the time. Some of today’s leading Indian enterprises with significant global footprints, including Hindalco Industries, Tata Motors, Tata Global Beverages, Mahindra & Mahindra, Bajaj Auto, Ashok Leyland, TVS Motors, and Hero Motors, also have their origins in the import-substituting industrialization era.
Reforms of 1991: Liberalization and global economic integration
Economic reforms adopted since 1991 have removed the industrial licensing system and liberalized the entry of portfolio foreign investment and FDI policy with automatic approvals for proposals fulfilling certain conditions of the latter. One-hundred percent foreign ownership is now permitted. Tariff rates have been gradually reduced to align broadly with those in the Southeast Asian countries, the rupee’s exchange rate is floated on the market, and quantitative restrictions on imports have been phased out. India also phased out performance requirements on MNEs under the World Trade Organization’s Agreement on Trade Related Investment Measures and adopted a new patent law consistent with the WTO’s Agreement on Trade Related Intellectual Property Rights.
The reforms and liberalization have led to a lot of restructuring of Indian industry. Besides opening the economy to the imports of foreign-made goods, local producers began to outsource production to cheaper sources in other countries, especially China, in a trend sometimes referred to as the “hollowing out” of Indian manufacturing, which lead to premature deindustrialization. Consequently, the share of imports in final consumption rose sharply in many sectors, such as electronics, electrical equipment, and telecommunication equipment, but also labor-intensive, household electric goods, such as toasters, wall clocks, electric irons, refrigerators, and televisions, among others. The current account balance was kept in check by the rising export of services, while rising inflows of FDI and portfolio investments helped to close the remaining deficit. Manufacturing’s share of GDP came down from a peak of 17.8% in 1997 and has stagnated at around 14-16%, compared to around 30% in the East Asian countries.
As the manufacturing sector struggled, India’s economic growth was sustained by the services sector, which now accounts for 56% of the GDP. While the service sector has delivered robust growth rates, it has failed to absorb workers proportionately, leaving agriculture to sustain as much as 46% of India’s workforce with barely a 15% share of GDP. This imbalance translates into low productivity, pervasive informality, and persisting poverty.
Revival of Industrial Policy
The imperative of job creation has pushed the Modi government to implement MII to harness the potential of manufacturing. As part of MII, the government has focused on improving the ease of doing business (EODB) in India through the abolition of obsolete regulations and processes that hindered industrial investments. The government has also increased FDI ownership limits in a number of sectors—such as railways, defence manufacturing, insurance, medical devices—and created an investment promotion and facilitation agency, Invest India. Import tariffs were raised in select sectors to give some infant industry protection, and the government also identified six industrial corridors across the country for development.
As a result of these steps, India’s place in the World Bank’s EODB rankings moved up sharply from 142 in 2014 to 63 in 2019 (the World Bank abandoned the rankings in 2021). India has started to attract greater magnitudes of FDI inflows, which crossed a record figure of $81 billion in 2021-22.
MII was reinforced in a big manner by the production-linked incentives (PLI) scheme introduced in 2020 as a part of the Aatmanirbhar Bharat package announced to revive the economy in the aftermath of the Covid-19 pandemic. The PLI scheme provides a 3-5% incentive to boost local production (or substitute imports) and exports for 14 select sectors. These include sunrise and green manufacturing products, such as solar photovoltaic cells and modules, advanced chemistry batteries, active pharmaceutical ingredients, large-scale electronics, medical devices, specialty steels, and telecom and networking equipment. In an effort to create a full ecosystem of electronics, the government launched in 2022 a $10 billion Semiconductor Mission to foster the manufacture of semiconductor chips and displays. Also in 2022, the government announced a $2.3 billion Green Hydrogen Mission with the objective to make India a leading manufacturer and exporter of green hydrogen. The government has also focused on improving the logistics infrastructure in the country through the $1.2 trillion National Master Plan for Multi-modal Connectivity launched in 2021.
One could argue that India’s recent manufacturing push through various industrial policy instruments is a part of the global trend of governments incentivizing domestic manufacturing to create jobs and re-shore value chains. In the U.S., once the greatest champion of free markets and globalization, the Biden Administration has defined its industrial policy with the CHIPS and Science Act, the Inflation Reduction Act, and the Infrastructure Investment and Jobs Act, seeking to revive domestic manufacturing through billions of dollars in subsidies and incentives.
The Chances of Success
There are key differences between India’s industrial policy of early post-independence period and now that will ensure greater success. Today’s policy is more strategically focused on tapping opportunities of import-substitution or exports in specific sectors, especially sunrise and green industrial sectors. It is being implemented in an open economy context with a clear focus on competitiveness, including through scale economies, unlike the last time.
This time around, India will be helped by its position as a “geopolitical sweet spot,” having friendly relations with key industrial countries in the West and East. This will allow India to benefit from global companies friend-shoring supply chains to diversify them away from China. India is also enjoying a “demographic sweet spot” with a relatively young population, while populations are aging in most industrialized and newly industrialized countries. India is also attracting a lot of investment from global companies seeking to build global capability centers or offshore R&D centers. These centers aim to tap into India’s abundant pool of skills, ICT software and chip design expertise, and national innovation system famed for its frugal engineering capabilities.
The early results have been encouraging. India has turned into a net exporter of mobile handsets after being a net importer. Monthly exports of India-assembled mobile handsets crossed $1 billion in September 2022. There are indications that Apple could be sourcing 25% of its handsets from India by 2025, up from under 5% at present. Leading Indian energy companies have also committed large investments in the manufacture of green hydrogen. There are also some credible proposals for the manufacture of semiconductor chips and display devices, including by Foxconn.
Projections from the Institute for Studies in Industrial Development (ISID) suggest that translating the opportunities for strategic import-substitution and exports, new electronics, and green industries have the potential of doubling India’s manufacturing value added (MVA) to $1 trillion by 2026-7, thus advancing the economy toward the government’s $5 trillion target (India’s GDP is currently $3.2 trillion). India’s evolving industrial policy, and its ultimate boost to manufacturing activity and job creation, will be critical to fostering the inclusive and sustainable transformation of the Indian economy in tune with its Vision 2047, the year when India will celebrate the centenary of its independence.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.