India’s Industrial Sector

Theme of the Session

• With the introduction of economic reforms in 1991
India hoped for a dynamic industrial sector, in particular
manufacturing sector.

• But the sector never took off as it did in other countries

such as China and South Korea.

• According to estimates to achieve a growth rate of GDP

of 8 to 10% consistently over a longer period the
industrial and manufacturing sectors respectively needs
to grow at 11.21% and 12.26%.
• Moreover, in so far as subsectors within manufacturing
have performed well, these have been relatively
capital-or skill-intensive industries, not the unskilled
labour-intensive ones as would be expected for a
labour-abundant country like India.

• This pattern of manufacturing growth has two major

negative fallouts: (i) the relatively slow transformation
of India from a primarily agricultural and rural
economy to a modern one; (ii) jobless growth.
• Therefore, the challenge of transformation facing
India is that of creating an environment that allows
unskilled labor-intensive manufacturing to grow
rapidly.

• In this context, for reaching the goal of a dynamic

manufacturing sector and achieving faster growth of
unskilled labor intensive manufacturing, the
governments have launched several initiatives such as
Make in India, Start up India and Skill India.
• According to analysts, to realise the goal of making
India a manufacturing powerhouse, it is imperative to
promote the growth of Micro, Small and Medium
Enterprises Sector (MSME).

• Against this background, the aim of this session is to

discuss various challenges facing the development of
manufacturing sector in general and MSME sector in
particular in India and identify policy solutions to
overcome the challenges
 Definition of MSMEs

Composite Criteria: Investment in Plant & Machinery/equipment and Annual Turnover

Classification Micro Small Medium

Manufacturing Enterprises Investment in Plant and Investment in Plant and Investment in Plant and
and Enterprises rendering Machinery or Equipment: Machinery or Equipment: Machinery or Equipment:
Services
Not more than Rs.1 crore and Not more than Rs.10 crore and Not more than Rs.50 crore and
Annual Turnover ; not more than Annual Turnover ; not more than Annual Turnover ; not more than
Rs. 5 crore Rs. 50 crore Rs. 250 crore
 Significance of MSME for India
(1) Source of Employment:
• As per 4th Census of MSME Sector, the sector
employs 59.7 million persons spread over 26.1
million enterprises.
• Since the sector is more labour-intensive, it has the
potential to create more employment per unit of
capital employed.
• Also the sector is capable of generating
unskilled/semi-skilled employment
(2) Contribution to manufactured output and
exports:
• In terms of value, MSME sector accounts for about
45% of the manufacturing output.
• Around 40% of the total exports (in value terms) of
India is contributed by MSME sector
(3) Best way for achieving inclusive growth:
• Income benefit of small enterprises is derived by
large population while large enterprises encourage
more concentration of economic power
(4) Taps latent resources:
• MSMEs are a training ground for entrepreneurial
talent.
• A MSME of today will be a big enterprise of
tomorrow, and might well become a MNC
eventually, if given adequate policy support.

(5) Reduces regional disparity:

• To spread benefit of industrialization to smaller
towns and country side MSMEs play major role.
 Reasons for Inadequate Manufacturing Growth
• Infrastructure constraint • Dependence on consumer goods
industry
• Difficulties with tax administration
and tax rates • Inability to attract FDI on a large
scale
• Governance issues, particularly
• High transaction cost of doing
corruption
business
• Shortage of availability of skilled • Low R&D expenditure
labour
• Poor performance by PSEs
• Labour market regulations
• Inadequate efforts on the part of
• Cost and access to finance or states
credit constraint • Absence of export led
manufacturing
• Sub-optimal levels of operations
(absence of economies of scale)
 India’s Policy Towards SSIs/MSMEs
Pre-1991
• Reservation (from 1967): In many
industries only MSMEs were
allowed to operate and produce.
• Preferential purchase of MSME
products by government agencies
• Supply of materials, technology,
and inputs at concessional rate
• Lower/concessional interest rates
on loans. Priority sector lending by
banks
• Many other initiatives to improve
credit availability (SIDBI, SFC,
NSIC)
• Fiscal measures like excise duty
exemptions and tax concessions
Post-1991
• Progressive reduction in reservation
list (from year 2000) – from 47
products in 1967 to 821 in 1999 to
239 in 2007
• Import liberalisation, espl.
consumer goods (from April 2001)
• FDI inflows leading to greater
competition
• Reduction in public sector demand
for SSI products
• Reduction in no of products
reserved for purchase by PSEs
(PSE procurement revived recently)
• Withdrawal of concessional lending
• Expansion of sectors under priority
sector lending
Result: Compete or Perish
 Major issues concerning SSI/MSME sector in India
• Lack of availability of adequate, • Inadequate skilled manpower for
timely credit & high cost of credit manufacturing, services,
marketing
• Lack of collateral to offer to avail
of bank finance • Problems of storage, designing,
packaging and product display
• Declining prospects of supply to
government departments • Lack of proper access to global
markets
• Inadequate infrastructure
facilities, including power, water, • Seasonality of markets (faced by
and roads unorganized sector)
• Low technology levels • Issues relating to taxation and
procedures thereof
• Lack of access to modern
technology and innovation • Delay in settlement of
dues/payment of bills by large
• Weak marketing facility
scale buyers to MSMEs.
• Poor quality of products
 Manufacturing: India Vs China
Factors Explaining Chinese Surge
(1) Role of FDI
(2) Role played by Chinese diaspora
(3) Lack of protection for domestic industry
(4) Critical role of Town and Village Enterprises (similar to our MSME)
(5) Export-led industrialization
(6) Higher labour productivity
(7) Importance given to agriculture
(8) Role of indigenous entrepreneurship
(9) Reform of PSUs
(10) Absence of land market
(11) Availability of Cheap capital
(12) “Trial and error” approach
 Share in world exporters of Manufacturing Goods:
India Vs China
Country 1980 1990 2000 2017

China* 0.8 1.9 4.7 20

India 0.5 0.5 0.7 2.0
Source: International Trade Statistics, WTO
* - Ranked No.1

Key observation: In a globalised environment, China’s share in

world export of merchandise increased significantly over the
years compared to marginal increase witnessed in case of India.
 Case Study: Textiles and Clothing Sector

We lost to China and others after the

removal of import quota by nations under
WTO in four phases between 1995-2005
 Country-wise Share in World Textiles Exports (%)

Country 1980 1990 2000 2005 2008 2016

China* 4.6 6.9 10.3 20.2 26.1 38

India 2.4 2.1 3.6 3.9 4.1 6.5

Key observation: After quota restrictions on world textile trade was removed in
2005 by WTO, China’s share in world textile and clothing exports increased
significantly. Even Bangladesh ‘s share has increased notably.

Country-wise Share in World Clothing Exports (%)

Country 1980 1990 2000 2005 2008 2016
China 4 8.9 18.2 26.9 33.2 40
Bangladesh 0.0 0.6 2.6 2.3 3.0 6.1

India 1.7 2.3 3 3.0 3.0 4.7

 Constraints Facing Indian Textiles & Clothing Sector
(same as constraints facing manufacturing sector growth)
• Dominated by small producers and hence is fragmented
• Delivery times from India are longer than from other comparator countries
• India’s exports in T&C have been characterized as low technology intensive
compared with many other competitors
• While labor costs in India are one of the lowest in the world, this is offset by low
labor productivity
• Poor quality (or perceptions about poor quality)
• Regional Trading Agreements signed by US & EU
• Prices competition
• Absence of labour market flexibility
• Absence of an effective exit policy
• Low economies of scale
• Administrative/ bureaucratic hurdles (such as delays at customs and other red
tape)
 Performance Indicators: India Vs. China
Indicator Name Year India China
Quality of infrastructure
Logistics performance index: Overall (1=low to 5=high) 2018 3.18 3.61
Liner shipping connectivity index (max. value in 2004 = 100) 2019 55.54 151.90
Time required to get electricity (days) 2019 52.85 32
Power outages in firms in a typical month (number)* - 13.8 0.1
Tax policy environment
Ave. number of meetings with tax officials (for affected firms)* - 3.1 2.1
% of firms expected to give gifts in meetings with tax officials* - 15.3 10.9
Time to prepare and pay taxes (hours) 2019 252 138
Regulatory Environment
Time required to start a business (days) 2019 17.5 8.6
Time required to enforce a contract (days) 2019 1445 496
Time to resolve insolvency (years) 2019 1.6 1.7
Time to import, documentary compliance (hours) 2019 19.9 12.8
Time to export, documentary compliance (hours) 2019 11.6 8.6
% of firms experiencing at least one bribe payment request* - 22.7 11.6
Access to credit
Real interest rate (%) 2018 5.13 1.38
Domestic credit to the private sector by banks (% of GDP) 2018 50.05 161.13
Quality of workforce
Human capital index (HCI) (scale 0-1) 2017 0.44 0.67
Labour productivity per hour (in Euros) 2016 7 11.3
Openness to trade
Weighted avg. of applied tariff rate on manufactured products (%) 2018 6 4.29
R&D
High-technology exports (% of manufactured exports) 2017 7.35 30.89
 Video Links
• MSMEs in India (Education Video by MHRD, GoI)
https://www.youtube.com/watch?v=Kcl3DFPTdco

• FabIndia’s Community-owned-Company Model (3 Parts):

http://www.youtube.com/watch?v=03zsWdXlVEg&feature=relat
ed
http://www.youtube.com/watch?v=ZXEfZAr6sTQ&feature=relat
ed
http://www.youtube.com/watch?v=lFO6Pshq4qw
 Video Link

1) Why Chinese Manufacturing Wins (11.03

Minutes)
https://www.youtube.com/watch?v=E7Jfrzkmzyc

2) Town and Village Enterprises in China (18.147

minutes)
https://www.youtube.com/watch?v=0pfK3Npc3mM
https://www.youtube.com/watch?v=XdKMyyqAufM
 Policy Issues for Class Discussion

(A) Can India catch up with China in manufacturing prowess?

Justify your stand with critical reasoning.

(B) Does Parliamentary democracy suite India’s long-term

economic interest?
India’s Industrial Sector - Solutions
Solutions for meeting infrastructure requirements of MSMEs
(1) Cluster development: MSMEs should be permitted to
come up only in designated industrial areas or clusters
or estates. Govt. runs the following scheme in this
regard: Micro & Small Enterprises - Cluster
Development Programme.

(2) Involve the private sector including FDI in the

development and management of infrastructure in
existing and new industrial estates/parks/clusters and
permit provision of infrastructural services on payment.
 Solutions for supply funds/credit for MSMEs
• Suitable incentives should be provided to MSME-
focused angel/venture capital funds

• Set up of dedicated MSME stock exchange (BSE &

NSE have it)

• Provide collateral-free financing (There is a govt.

scheme i.e. Credit Guarantee Fund Trust for Micro
and Small Enterprises to provide such financing. But
needs to increase its reach to include more small-scale
enterprises)
• Pradhan Mantri Mudra Yojana: seeks to offer
refinance products having a loan requirement up to
R10 lakh and support to micro finance institutions
(MFI) by way of refinance.

• Credit rating/scoring Scheme - lenders are wary of

the MSME sector due to its propensity to default and
information asymmetry (the government introduced a
a scheme in this regard)

• Set up separate bank branches for SME financing

• Restructure MSME loans (as done by RBI recently).
(i) Allowed one-time loan restructuring for GST-
registered borrowers with a loan of up to Rs.25 crore.
(ii) Debt restructuring would not lead to a downgrade in
asset classification.
(iii) lenders have to set aside 5% of the outstanding loan as
provision, over and above the current outstanding
amount.
(iv) Each bank/NBFC should formulate a policy for this
scheme with the board approval.
• Though restructuring may undermine credit culture, it
could be defended on following grounds:

(a) Unlike large corporate, MSMEs are not funded by

public money. They are owner-funded.

(b) MSMEs get only 14% of bank credit

(c) MSMEs are victims of usurious interest rates

(d) MSMEs are victims of inordinate payment delays by

clients.

(e) After effects of demonitisation and GST

Solutions for improving quality of MSME products
• Technological innovation in the form of development of new
products/processes or improvement of existing
products/processes. We have following govt. schemes

• Credit Linked Capital Subsidy Scheme (CLCSS): aims at

facilitating technology upgradation by providing capital
subsidy for modernisation of production equipment (plant and
machinery) and techniques

• Technology Upgradation Fund Scheme (TUFS): This scheme

provides interest subsidy, capital subsidy or margin money
subsidy on the basic value of the machineries.
• Major initiative has to come from small industry
itself, particularly through their associations (learn
from IT industry!)

• Promote MSME growth in terms of quality/value

than quantity (Remaining Small and Exclusive
Makes Sense)

• Open up new opportunities through

subcontracting/outsourcing.
• Certify the quality standards on par with global
standards (Govt. scheme: Incentive Scheme for
Certifications - reimbursement of charges of
acquiring ISO 9000/ISO 14001/HACCP certifications
to the extent of 75 per cent of the expenditure)

• Educate and expose MSMEs to best practices

 Solutions for improving marketing of MSME products

• Online business-to-business (B2B) marketplaces

• Open up new opportunities for

subcontracting/outsourcing

• Make use of ICT, e-commerce

• Offer fiscal incentives (Govt. runs a Marketing

Assistance Scheme under which MSMEs can get
subsidies to organise and participate in domestic and
foreign trade exhibitions and also buyer-seller meets).
Solutions to promote entrepreneurship in MSME sector
• Promoting Innovation and Rural Entrepreneurs
(ASPIRE): ASPIRE was launched on March 16,
2015 with the objective of setting up a network of
technology centres and incubation centres to
accelerate entrepreneurship and promote start-ups for
innovation and entrepreneurship in rural and
agriculture based industry

• Scheme of Fund for Regeneration of Traditional

Industries (SFURTI): Launched for making
Traditional Industries more productive and
competitive by organizing the Traditional Industries
and artisans into clusters
 Other Solutions
• Create Awareness about Government Schemes

• Udyog Aadhar Memorandum (UAM): To promote

ease of doing business for MSMEs. MSME
entrepreneurs just need to file an online
entrepreneurs’ memorandum to instantly get a unique
Udyog Aadhaar Number (UAN). The information
sought is on self-certification basis and no supporting
documents are required. This marks a significant
improvement over the earlier complex and
cumbersome procedure.
• Employment Exchange for Industries: To facilitate
match making between prospective job seekers and
employers an employment exchange for industries.

• Scheme for Assistance to Training Institutions:

The Scheme envisages financial assistance for
establishment of new institutions (EDIs),
strengthening the infrastructure of the existing EDIs
and for supporting entrepreneurship and skill
development activities.
 Lecture Note: India’s Industrial Sector

www.ndtv.com The Hindu, July 27, 2014

Theme of the Lecture:

With the introduction of economic reforms in 1991 India hoped for a dynamic industrial sector,
in particular manufacturing sector. But the sector never took off as it did in other countries such
as China and South Korea. According to National Manufacturing Competitive Council to
achieve a growth rate of GDP of 8 to 10% consistently over a longer period the industrial and
manufacturing sectors respectively needs to grow at 11.21% and 12.26%. Moreover, in so far as
subsectors within manufacturing have performed well, these have been the relatively capital-or
skill-intensive industries, not the unskilled labour-intensive ones as would be expected for a
labour-abundant country like India. This pattern of manufacturing growth has two major
negative fallouts: (i) the relatively slow transformation of India from a primarily agricultural
and rural economy to a modern one; (ii) jobless growth. Therefore, the challenge of
transformation facing India is that of creating an environment that allows unskilled labor-
intensive manufacturing to grow rapidly.
Against this background, this lecture note discuss various challenges facing the development of
manufacturing sector in general and MSME sector in particular in India and identify policy
solutions to overcome the challenges

This lecture note was prepared by the Instructor (Sthanu R Nair, Indian Institute of Management
Kozhikode) for the sole purpose of student learning. It is nothing but proper arranging/ordering
of relevant parts from the sources indicated at the end of the note with data/photo additions.
Please do not circulate this note in any public platform or share to others without the Instructor’s
permission.

1 
 
1. The Issue:

Industrial sector in India consists of mining; manufacturing; electricity, gas and water
supply; and construction. Of this manufacturing constitutes about two-thirds of industrial output.
The share of industry in GDP rose from 11% in 1950-1 to 17% in 1980-1 to 20% in 1990-1 and
has stayed there for long. Correspondingly, the share of manufacturing rose from 9% in 1950-1
to 15% in 1990-1 and has stayed there for long. In terms of growth, the performance of the
industry/manufacturing sector has been unimpressive since 1991 reforms. All these despite that
many reforms undertaken since 1990s were aimed mainly at industrial/manufacturing sector.

In fact, with the introduction of economic reforms in 1991 India hoped for a dynamic
industrial sector, in particular manufacturing sector. But the sector never took off as it did in
other countries such as China, South Korea and Taiwan. According to National Manufacturing
Competitive Council to achieve a growth rate of GDP of 8 to 10 per cent consistently over a
longer period the industrial and manufacturing sectors respectively needs to grow at 11.21% and
12.26%. The similar figure for services and agriculture respectively are 10% and 4%.

Moreover, in so far as subsectors within manufacturing have performed well, these have
been the relatively capital-or skill-intensive industries (automobiles, engineering goods,
chemicals, pharmaceuticals, iron and steel, petroleum and petroleum products, textiles, gems and
jewellery), not the unskilled labour-intensive ones (footwear, toys, apparel) as would be expected
for a labour-abundant country like India. Among our leading exports only apparel is unskilled-
labor intensive. This pattern of manufacturing growth has two major negative fallouts: (i) the
relatively slow transformation of India from a primarily agricultural and rural economy to a
modern one (in other words, slow transition of the labor force from agriculture to non
agricultural activities); (ii) the poor employment record of economic reforms, terms popularly as
“Jobless Growth”.

Therefore, the challenge of transformation facing India is that of creating an

environment that allows unskilled labor-intensive manufacturing to grow rapidly and rise as a
proportion of GDP. Such growth would pull workers from agriculture in to gain full employment
more rapidly than is the case currently, and it would reduce the burden of labor on the land. Also
such growth may ensure faster reduction in poverty: rapid growth in unskilled labor-intensive

2 
 
industry is likely to create many more opportunities for the poor than will growth in capital-
intensive and skilled labor-intensive sectors.

2. Factors responsible for the lackluster performance of industrial sector during the post-
reforms period:

(a) Infrastructure constraints: Infrastructure-related bottlenecks are widely believed to

be a part of the explanation. In particular, poor quality of power supply, road networks, and ports
and airports are believed to create significant disadvantages for Indian manufacturers by pushing
up their costs of production, and making them uncompetitive in export markets.

According to World Bank’s Investment Climate Survey infrastructure is the critical

obstacle for operations and growth from the perspective of the firms in India. Almost 40% of
respondents cited it as a major or severe obstacle. However, disaggregating this variable shows
that the concern with infrastructure is overwhelmingly driven by concerns with electricity.
Telecommunications are hardly considered a problem. Tax-related issues, incorporating
difficulties with either the tax administration system or complaints about tax rates, are considered
to be a major or severe constraint by more than 40 per cent of respondents. One fifth or more
respondents cite governance issues (which include concerns with corruption) and the cost and
access to finance as the major obstacles. An almost equal per cent of respondents cite skills and
labour regulations as major obstacles (around 15 per cent).

(b) Credit constraints: Credit constraints due to weaknesses in the financial sector
particularly banking sector may be holding back small and medium sized firms from expanding.
Firm level data show that medium-sized firms -- even those well above the "small scale"
threshold – are subject to credit constraints and appeared to be operating well below their
optimal scale. Since the performance of the bank managers is not linked as tightly with the
profitability of the banks, and is probably influenced more by the incidence of non-performing
loans, they have little incentives to provide credit to the private sector. Hence they play
extremely cautious and rather than lending to the private sector would rather invest in safe
government securities.

(c) Procedural delays: Business regulations might have influenced key decisions of
firms and potential investors. As the World Bank's (WB’s) Doing Business surveys of business
regulations across the world have found, the procedures and costs for starting and, especially,

3 
 
closing a manufacturing business in India are among the most cumbersome in the world.
However, in WB’s Doing Business 2018 report, India climbed 30 positions. The report ranked
India at 100 among 190 countries. The improvement in India’s ranking was driven by ease of
paying taxes, resolving the insolvency problem, access to credit and protection of minority
investors. However, the same report noted that India lagged behind in areas such as starting a
business, getting electricity connection, enforcing contract and dealing with construction permits.

(d) High cost of inputs/production: Due to (i) inefficient indirect tax system; (ii) high
cost of public services like power, railway transport and water; (iii) high cost of finance and (iv)
stringent regulations on land use in India. A comparison of costs of input materials (IM) and
utilities in India, China, Malaysia and Korea across 15 important manufacturing segments
showed that on the average the share of IM and utilities in total output value was as high as
81.3% in India as against 75.5% in China, 68.7% in Malaysia and only 58.5% in Korea. Total
taxes on manufactured goods are 25 to 30% of retail price in India, compared to 15% in China.

(f) Lack of competency and comparative advantage: A CII-McKinsey Report, found that
retail price of Chinese products are lower by 30% in general in comparison to Indian products

(g) Skilled labour shortage: In recent years the availability of skilled labour has also
emerged as a constraint on the growth of manufacturing and services.

(h) Dependence on consumer goods industry: Industrial growth which depends more on
consumer goods industry make growth more volatile since demand for consumer goods is
income-elastic

(i) Export-led growth: Reforms led to export-dependent growth. As export growth is

based on international demand, industrial growth will become more volatile.

(j) Sub-optimal levels of operations: scaling up of operations (like China) would be

difficult to achieve without a strong demand (domestic and foreign)

(k) Poor R&D: The Advanced Technology Products have a sizeable market in the world.
Indian companies continue to display low levels of ambition, as measured by their commitment
to research and development. India's R&D spend as a proportion of GDP, at 0.7%, is one-fourth
than that of the US, less than half of China's and lower than Brazil's. Indian companies are

4 
 
willing to license technology or buy it from willing providers rather than try and develop it on
their own. The technology available in this fashion will never be cutting-edge.

3. Role of Micro, Small and Medium Enterprises1:

According to analysts, in order to improve manufacturing performance and generate more

jobs, India must undertake reforms in two major areas: Micro, Small and Medium Enterprises
(MSME) sector and Labor markets. In fact, the goal of developing a vibrant MSME sector is
an integral part of the government policy programmes such as Make in India and Atmanirbhar
Bharat Abhiyaan. According to the Ministry of MSME, such programmes are highly relevant for
India’s MSMEs. At present, MSMEs in India are defined as follows.

Composite Criteria: Investment in Plant & Machinery/equipment and Annual Turnover

Classification Micro Small Medium

Manufacturing Investment in Plant Investment in Plant and Investment in Plant

Enterprises and and Machinery or Machinery or Equipment: and Machinery or
Enterprises Equipment: Equipment:
rendering Services
Not more than Rs.10 crore and
Not more than Rs.1 Annual Turnover; not more than Not more than Rs.50
crore and Annual Rs. 50 crore crore and Annual
Turnover; not more Turnover; not more
than Rs. 5 crore than Rs. 250 crore

The MSMEs are important for India’s economic development due to the following reasons.

(a) Source of employment: Small industries are recognised as important for employment
generation. This is because small enterprises are labour-intensive and thus create more
employment per unit of capital employed. They are also capable of generating unskilled/semi-
skilled employment. As per 4th Census of MSME Sector, the sector employs 59.7 million persons
spread over 26.1 million enterprises. In India the corporate sector provides just over 14 million
                                                            
1
Before 1991 the nomenclature used to describe small businesses was “small scale industry” (SSI). Hence, in this
note we use the terms SSI and MSME interchangeably.
 

5 
 
(or 10% of India’s employment) jobs. The jobs for the hundreds of millions of other people are
provided by informal sector including MSMEs.

(b) Equitable distribution of income: It is suggested that the income generated in a

large number of small enterprises is dispersed more widely in the community than income
generated in a few large enterprises. In other words, the income benefit of small enterprises is
derived by a large population while large enterprises encourage more concentration of economic
power. Thus, MSMEs are the best vehicles for promoting inclusive growth.

(c) Taps latent resources: Small enterprises are able to tap latent resources like hoarded
wealth, entrepreneurial ability, etc. The growth of an entrepreneurial class requires an
environment. Small enterprises provide that environment which encourages a growing network
of feeder and complementary relations among plants and firms. It is in this environment that
latent talents of individual entrepreneurs find self-expression in localized innovations and cost-
saving measures. In short, SSIs are a training ground for entrepreneurial talent.

(d) Helps reducing regional disparity in industrial development: Large enterprises

are mostly concentrated in metropolitan cities. The smaller towns and the country side in order to
benefit from modern industrialization must encourage small enterprises. Decentralisation of
industrial enterprises also helps to tap local resources and also improves the standard of living in
backward regions. Since, a significant number of MSMEs depend on agricultural, horticultural,
and other forest and non-forest produce they prevent migration from rural to urban areas in
the long-run.

(e) Contribution to manufactured output and exports: A robust MSME sector is the
pillar of broad-based economic growth in any country. In terms of value, MSME sector accounts
for about 45% of the manufacturing output. Around 40% of the total exports (in value terms) of
India is contributed by MSME sector. A significant feature of exports from the small-scale sector
is their share in non-traditional exports.

4. India’s policy towards SSIs/MSMEs sector:

India is one of the very few countries to have consistently supported small-scale
enterprises in order to promote greater employment and perhaps also a more egalitarian
distribution of wealth. Even the Nehruvian model reserved the crucial roles of providing

6 
 
employment and relatively inexpensive consumer goods for the “small-scale sector”. In addition
to the creation of small industrial estates, tax and other financial incentives were provided and
later, many products were “reserved” for this sector.

4.1. Pre-1991 scenario:

(a) Reservation Policy: Under this policy, virtually all unskilled labour intensive products
were reserved for exclusive production by small-scale industry (SSI). The policy of reserving
products for exclusive manufacture in the small-scale sector was started in 1967 with 47 items
(see Table), which was expanded later. The reservation policy ensured protection of SSIs from
large-scale domestic units thereby undermining their competitiveness. Non-SSI units (i e, me-
dium/large units including multinationals) can manufacture reserved items if they have obtained
a carry-on business licence, which capped their capacity, and fixed the location of the plant and
the goods produced, or accept an export obligation of 50% of their production.

Year No of products reserved for SSI

1967 47
1976 180
1978 504
1984 873
1989 836
1999 821
2007 239

This reservation policy alone was sufficient to ensure that India would exclude itself from
exports of labor-intensive manufacturing products. Foreign firms interested in buying labor-
intensive products from cheaper sources demanded a scale and quality standard that the SSI
units were typically incapable of supplying.

(b) Reservation of some of the products produced in the SSI sector for purchase by
government agencies.

(c) Supply of scarce materials, technology and input price concessions like
lower/concessional interest rates on loans from formal financial institutions. Banks were required
to compulsorily ensure that a defined percentage of their overall lending is made to priority
sectors as classified by the government, which includes the small-scale sector. The Small

7 
 
Industries Development Bank of India (SIDBI) was set up as the apex refinance bank for the
sector.

(d) Numerous fiscal measures such as excise duty exemptions and other tax concessions.

(e) Protection to SSIs from imports under the import substitution policy.

4.2. Post-1991 scenario:

Since 1991, the SSI industry in India has been confronted with an increasingly
competitive environment due to:

(a) As part of economic reforms, govt. has progressively trimmed the list of products
reserved for exclusive production by SSI, in particular, from year 2000.

(b) Import liberalization – As part of economic reforms, the government has liberalized
the import regime. In particular restrictions on import of consumer goods were completely
removed from April 2001.

(c) There has been a rapid increase in FDI inflow into diverse sectors of Indian industry.
This has created threats to SSI sector through greater competition, particularly in non-durable
consumer goods industries.

(d) The public sector had been a major customer of small enterprises in India. The growth
of the public sector has declined considerably since 1991 than before in terms of not only
investment and employment but also production and absolute numbers. The curtailed growth of
PSUs has resulted in reduced growth or even absolute reduction in public sector demand for
small industry products in the 1990s and 2000s. In addition, there has been a reduction in the
number of products reserved exclusively for purchase from small industry by the government.
However, in November 2011 the government has revived the public sector procurement policy
by asking the government departments and PSUs to give preferences to MSME while making
purchases.

(e) Withdrawal of concessional element in lending rates for small industry. While the
nominal targets have remained unchanged, the effective burden of priority sector advances has
been reduced by expanding the definition of priority sector lending to include, for example,
information technology companies. As a result, the share of credit going to the SSI sector has de-
clined over time.
8 
 
 All the above changes imply that the SSI sector has no option but to ‘compete’ or ‘perish’
under the new liberal regime.

5. Major issues concerning SSI/MSME sector in India:

MSMEs continue to face innumerable constraints - lack of access to finance, markets,

technology, and infrastructure, among others - all of which act as key impediments to their
continued success.

(a) Lack of availability of adequate and timely credit and High cost of credit: Access to
adequate and timely credit at a reasonable cost is the most critical problems faced by this
sector. The internal resources of SSIs are so small that they have no surplus to live on during the
period of business strain. This leads to instability of their profits. As MSMEs operate in an
extremely cost-competitive environment with limited resources including old technologies, they
are susceptible to failure.

Also the formal lending sector is unable to assess the risk of the applicant due to the
unorganised nature and prevailing asymmetry of information on the MSME sector. MSMEs
pose a challenge for commercial banks desirous of exploring lending opportunities in this sector
or going downstream. This is due to the fact that being associated with MSMEs involves
working on a set of data that could be unreliable vis-a-vis data on the bigger corporate
borrowers.

According to Small and Medium Enterprises Rating Agency (SMERA), the issue gets
compounded in the SME sector as financial statements are often unaudited or incomplete in
nature. Similarly, multiplicity of financial statements, lack of access to authentic information,
internal governance, succession issues, etc., compel the lender to practice safe and cautious
lending in this sector. In developing markets, this problem is further complicated by the absence
of robust information bureaus providing historical credit data. It is now a well acknowledged
fact, based on various studies, that MSME units are most susceptible to cease their operations
in the first two years. Considering these issues, the banking sector's demand of collateral as a
tool to safeguard its interests deters credit flows to this sector. This, in turn, creates a vicious
cycle, resulting in stunted growth of the SME sector.

9 
 
 All these deter banks from giving unsecured loans. Lack of adequate bank finance also
affects the ability of MSMEs to invest or upgrade to better technology. Nor are they able to
expand their market or hire better resources or build business linkages with larger firms in the
domestic or overseas markets.

(b) Limited access to equity capital: At present, there is almost negligible flow of equity
capital into this sector, despite the fact that overall capital inflows have witnessed significant
increase in the recent years. Absence of equity capital may pose a serious challenge to
development of knowledge-based industries, particularly those that are sought to be promoted by
the first-generation entrepreneurs with the requisite expertise and knowledge.

(c) Inadequate infrastructure facilities, including power, water, roads, etc.: MSMEs are
either located in industrial estates set up many decades ago or are functioning within urban areas
or have come up in an unorganised manner in rural areas. The state of infrastructure, including
power, water, roads, etc. in such areas is poor and unreliable.

(d) Low technology levels and lack of access to modern technology: The MSE sector in
India, with some exceptions, is characterised by low technology levels, which acts as a handicap
in the emerging global market. As a result, the sustainability of a large number of MSEs will be
in jeopardy in the face of competition from imports.

(e) Weak marketing facility: This is considered as an important reason for the closure of
small industry units. SMEs do not have the expertise or the strategic tools required to create or
widen their markets, unlike their counterparts in the corporate sector. According to census of
MSME, 44.5 per cent of the units suffering from sickness/incipient sickness cited marketing
problems as the reason for their plight.

(f) Problems in supply to government departments and agencies: While India continues
to be growing market cheap imported goods have a direct impact on the MSEs and their survival.
Given the globalisation, governments across the world are providing supportive measures to the
MSEs through targeted benefits and facilities. In line with the practice internationally, a Public
Procurement Policy for MSEs is vital to ensure a stable market for the MSEs.

(g) Lack of skilled workforce for manufacturing, services, marketing, etc.: Although
India has the advantage of a large pool of human resources, the industry continues to face deficit

10 
 
in manpower with the right skill set for specific areas like, manufacturing, service, marketing,
etc. The HR problem is further exacerbated by the low retention rate.

(h) Absence of a suitable mechanism which enables the quick revival of viable sick
enterprises and allows unviable entities to close down speedily: Worldwide, MSMEs are
credited with high level of innovation and creativity, which also leads to higher level of failures.
Keeping this in view, most of the countries have put in place mechanisms to handle insolvencies
and bankruptcies. The present mechanism available in India for MSMEs is archaic. Business
failure in India is viewed as a stigma, which adversely impacts individual creativity and
development in the country. However, in 2016 the government introduced Insolvency and
Bankruptcy Code (IBC) for resolving insolvencies which at present is a long process and does
not offer an economically viable arrangement. The code is expected to make the process of doing
business in India a cumbersome-less process.

6. CASE STUDY: Concept of Community-owned Companies and upliftment of Rural

Artisans - The Case of Fabindia

In 1993, while holidaying in Australia, William Bissell (MD, FabIndia, a chain retailing ethnic
products) once ran into an experienced surfer who shared an invaluable lesson with the 27-year-
old. Don’t just surf the course, but keep a constant watch on where the next wave is coming
from, he advised him.

William Bissell in a FabIndia Outlet FabIndia connects to her…..

Bissell, 45, hasn’t forgotten that incident. Over the next few months, Bissell’s balancing act will
be tested as he prepares to navigate the next wave that’s about to strike Fabindia, the incredibly

11 
 
successful retail business that his father John started to built way back in 1960. It wasn’t until
William took over the reins in 1999, that Fabindia started to go places.

Today, Fabindia is considered one of the most profitable retailers in the country. Under Bissell’s
leadership, Fabindia has almost singlehandedly built a network of a rapidly vanishing breed of
handloom weavers and artisans, which in turn supply handicrafts to a loyal set of city folk.
Bissell co-opted 22,000 artisans and made them into shareholders through an elaborate
community-owned model

In 1997, Willam Bissell conceptualized a concept called community-owned companies (CoCs)

when Fabindia was faced with the logistical nightmare of sourcing products from thousands of
artisans scattered across the country. Through Artisan Micro Finance Private Limited
(AMFPL), a Fabindia subsidiary, he organised rural artisans into 17 CoCs, based on their
geographic locations. Fabindia now sources all its products only from the CoCs. And each of
these companies in turn sources from rural artisans in their respective regions.

The structure and ownership pattern is common to all CoCs. AMFPL puts in 49% equity and
offers 26% to artisans, non-profit organisations and self-help groups who are their suppliers, and
10% to employees. The remaining 15% is raised from outside sources such as private equity or
venture funds. Thus, by creating CoCs, Bissell was able to attract bank funding against orders
from Fabindia.

Artisans are closely involved in CoCs’ decision-making. Their boards include one artisan
director, key staff members of the CoC who are working directors, three independent directors, a
representative of an outside investor and one AMFPL member.

12 
 
Over a period of time, AMFPL proposes to reduce its exposure to these companies to 26%, with
artisan ownership growing. “The equity thus raised will be used to build common facilities in
regions that artisans hail from,” says Fabindia MD Willam Bissell. The facilities include
warehousing, dyeing houses, technical support and CoC offices to represent artisans in the
region. While for now these CoCs are captive suppliers to Fabindia, they will soon be allowed to
deal with other buyers in the domestic and export markets.

Bissell faced resistance from inside Fabindia. Many felt that splitting the supply chain from a
centrally managed operation into 17 companies would place a huge burden on the system. There
were concerns that artisan shareholders would start driving up prices or not send supplies on time
because they had more power now. It was a radical idea but Bissell knew that if this plan
succeeded the company would achieve two things: Fabindia would get an assured supply chain
and artisans were empowered to control their means of livelihood. Convincing the artisans to
put their money into the company was tough, but William made that happen. He sat with the

13 
 
artisans and explained how inherently valuable their craft was and how it could be capitalised.
He convinced them that they should also have a share in this value by investing in it.

The CoCs have lifted craftsmen and weavers across the country out of their dreary, hand-to-
mouth existence. These small firms lead a silent movement to bring rural artisans and craftsmen
into the mainstream socially and professionally. Apart from providing artisans market linkage for
their products through Fabindia’s retail network, a CoC also brings to them infrastructure and
design inputs, access to technology and systems, quality guidelines and timely payments. Once
far removed from the financial mainstream, artisans now own shares, which give them
ownership rights and rewards, and which they can use as collateral. Where they were once
merely suppliers of wares, they now have a sense of belonging to the company. Their lives have
also improved through the CoCs’ community intervention, such as schools and hospitals in rural
areas.

For instance, one investor was 52-year-old Paru Bai of Dandkala village in Bikaner, who like
most other artisans, crossed over from Sindh province of Pakistan after the 1971 war. Bai today
owns 176 shares of Rangasutra (a CoC). She understands that these shares represent her right to
demand work from the company, apart from being a neat instrument of saving. “We were
nomads, there was no stability in our life, no secure way of earning money. Today, we benefit
from the steady orders,” she says. Today, Bai has a pucca house, with a fully tiled toilet (a
novelty in her village) and a barbed wire securing the house.

The AMFPL model espouses the best of both worlds — capitalism and socialism. “It’s not just
about finding a retail platform for these artisans’ produce, but about building communities,” says
Smita Mankad, MD of AMFPL. “Most of these artisans have never known any income source in
their lives other than a daily wage. It’s a huge feeling for them to own shares in a company,”
says MD, DAH Jaipur, Prakash Tripathi .

For one of the beneficiary, Shambhu Singh, the DAH stake has meant a sea change in his attitude
towards life. “It is our company and we’ll do everything to ensure that it grows rapidly,” he says.
He has understood that his extra income from dividend and his investment will only grow if the
company makes higher profits.

Also shares in CoCs offer artisans a divisible asset class — land is divisible, but it often leads to
disputes. Jewellery is largely indivisible. If an artisan wants to get his daughter married or needs

14 
 
money for his children’s education, he can easily sell his shares. “We can also take a loan by
offering our shares as collateral instead of pledging our land,” says Raj Kishore, an artisan
belonging DHA.

The success of the CoC model has begun to inspire state governments. The Orissa government
recently signed a memorandum of understanding with AMFPL to roll out such CoCs in the state.
AMFPL, on its part, is approaching other state governments with similar proposals. It is in
discussions with them to introduce handicrafts in the National Rural Employment Guarantee
scheme. For the artisans, it can only mean a life closely tied to prosperity.

15 
 
 Sources Used for Preparing this Note
1) Report of Prime Minister’s Task Force on Micro, Small, and Medium Enterprises,
Government of India, January 2010.
2) Bhaduri, Amit (2008): “Predatory Growth,” Economic and Political Weekly, April 19.
3) Business World (2011): “The SME Whitebook 2011-12 – Essential Handbook for Small and
Medium Enterprises”.
4) M H Bala Subrahmanya (2010): “Auto SMEs in Bangalore: Does Innovation Promote
Employment and Labour Productivity?”, Economic and Political Weekly, March 13.
5) M H Bala Subrahmanya (2004): “Small Industry and Globalisation Implications, Performance
and Prospects,” Economic and Political Weekly, May 1.
6) T.A. Bhavani (2002): “Small-Scale Units in the Era of Globalisation Problems and Prospects,”
Economic and Political Weekly, July 20.
7) “Small-Scale Industries”, In The Oxford Companion to Economics in India, edited by
Kaushik Basu, Oxford University Press, 2007
8) Ruddar Datt and K P M Sundharam (2010) “Indian Economy” (Chapter on Small-Scale
Enterprises), S.Chand Publication, New Delhi.
9) “Economic Reforms and Industrial Structure in India” by Sudip Chaudhuri (Economic and
Political Weekly, January 12, 2002)
10) “Growth and Distribution in Indian Industry in the Nineties” by Pulapre Balakrishnan and M.
Suresh Babu (Economic and Political Weekly, September 20, 2003)
11) “Unorganised and Organised Manufacturing in India: Potential for Employment Generating
Growth” by Uma Rani and Jeemol Unni (Economic and Political Weekly, October 9, 2004)
12) “What Constrains Indian Manufacturing?” by Poonam Gupta, Rana Hasan and Utsav Kumar
(ICRIER Working Paper No.211; March 2008)
13) “Overview of the Indian Corporate Sector: 1989-2002” by Petia Topalova (IMF Working
Paper No.WP/04/64; April 2004)
14) “China and India: Idiosyncratic Paths to High Growth” by Kaushik Basu (Economic and
Political Weekly, September 19, 2009).
15) “India’s Recent Economic Growth: A closer look” by R Nagaraj (Economic and Political
Weekly, April 12, 2008).
16) Mousumi Majumdar, Sarbajit Sengupta (2010): “Declining Registration by Small
Manufacturing Units: A Case Study of Durgapur”, Economic and Political Weekly, July 19.
17) Economic Survey, Government of India (Various Years).
18) “Fruits of the Loom”, The Economic Times (Special Feature), October 12, 2010; “Not Easy
to Balance Social, Biz Interests”, The Economic Times (Special Feature), July 25, 2012; and
“Fabindia’s Tightrope Walk”, Forbes India, November 4, 2011.

16 
 
 Recommended Additional Readings

Sebastian Morris, Rakesh Basant, Keshab Das, K Ramachandran and Abraham Koshy (2001):
“The Growth and Transformation of Small Firms in India”, Oxford University Press,
New Delhi.
Konosuke Odaka and Yukihiko Kiyokawa (2008): “Small and Medium Scale Industry in
India and the Model of Japan”, Allied Publishers, New Delhi.
M H Bala Subrahmanya (2003): “Technological Innovations in Small Enterprises:
Comparative Study of Bangalore and North-East England”, Economic and Political
Weekly, May 24.
Hongyi Chen (2000): “The Institutional Transition of China’s Township and Village
Enterprises”, Ashgate Publishing Ltd, England.
Business World (2011): “The SME Whitebook 2011-12 – Essential Handbook for Small and
Medium Enterprises”.
Radhika Singh (2010): “The Fabric of our Lives – The Story of FabIndia”, Penguin Viking.
Also see the readings uploaded in Virtual Classroom.

Recommended Video Links

1) MSMEs in India (Education Video by MHRD, GoI) (28.35 minutes)
https://www.youtube.com/watch?v=Kcl3DFPTdco

2) The Driving Force of Japan: Small and Medium Enterprises (27.56 minutes video)
https://www.youtube.com/watch?v=BBfPeY2ZecA

3) Role of MSME Sectors in India (24.55 minutes)

https://www.youtube.com/watch?v=rexWO0s4C98

4) A short film on MSME (11.25 minutes)

https://www.youtube.com/watch?v=g6-oXlHtgXw

5) FabIndia’s Community-owned-Company Model: This NDTV Profit video (in Three Parts)
provides an excellent account of a business model developed by FabIndia to source fabrics from
rural artisans and empower the artisans to control their means of livelihood.

http://www.youtube.com/watch?v=03zsWdXlVEg&feature=related (Part 1; 10 Minutes)

http://www.youtube.com/watch?v=ZXEfZAr6sTQ&feature=related (Part 2; 7 Minutes)
http://www.youtube.com/watch?v=lFO6Pshq4qw (Part 3; 5 Minutes)

**********

17 
 
 Lecture Note: Can India catch up with China in manufacturing prowess?

Theme of the Note:

China has emerged as the world’s major exporter of manufacturing goods since 1990.
India is not yet a major exporter of manufactured products to the world. Significantly,
China’s industrial growth rate has been consistently higher than India’s by about one and
half times, and the gap seems widening. The world’s economic super power United
States (US) now feels that Chine will inevitably tilt global trade and technology balances
in its favor, ultimately becoming an economic, technological, and military threat to it.
Business and political leaders in the US now fear that China's growing share of world
exports, especially of high technology and industrial goods, signals the rise of yet another
mercantilist economic superpower in northeastern Asia.
In this context, this lecture note traces the factors explaining China’s higher productivity
and competitiveness in world market for manufacturing bases; and discusses the
sustainability of Chinese model of economic growth.

This lecture note was prepared by the Instructor (Sthanu R Nair, Indian Institute of
Management Kozhikode) for the sole purpose of student learning. It is nothing but proper
arranging/ordering of relevant parts from the sources indicated at the end of the note with
data/photo additions. Please do not circulate this note in any public platform or share to
others without the Instructor’s permission.

1
1. India and China in the World Economy:

Today, China and India together account for 40% of the world’s population. Since
1980 Chinese economy has been growing at the average rate of over 9%. India is
following behind China, with an average growth rate of close of 6 per cent a year since
1980, with some evidence that growth is accelerating and can be sustained at 8 per cent a
year in the coming decades. Whereas China has emerged as a predominantly industrial
economy (share of industry in GDP was 46% in China and 27% in India), India became a
service economy (share of services in GDP was 41% in China and 67% in India). The
world’s economic super power United States (US) now feels that Chine will inevitably
tilt global trade and technology balances in its favor, ultimately becoming an economic,
technological, and military threat to it. Business and political leaders in the US now fear
that China's growing share of world exports, especially of high technology and industrial
goods, signals the rise of yet another mercantilist economic superpower in northeastern
Asia.

With huge population base, the two giant economies present a huge and fast
growing domestic market (demand side) for a range of goods and services, and thus
export opportunities for producers in the rest of the world. This is evident from the
growing share of China in world export of manufactures. The share is expected to rise in
the future, assuming of course, China’s rapid growth is not a bubble but will be sustained.
This means that foreign raw material suppliers depend to a greater extent on Chinese
demand. Any disruption in Chinese demand in the short-run can be costly for them. The
market potential of India and China is also evident from the large flows of FDI to these
countries, both for production for the domestic market, but also to use exports to the rest
of the world. The fact that India has attracted far less FDI, is not because of the lack of
potential opportunities in India, but largely because of policy hurdles and other
constraints on investment.

Besides being a major demand market, India and China influence world economy
as major exporters (supply side). Foreign users who depend on China’s exports of
goods/merchandise for a sizeable share of their total use, could be faced with the prospect
of having to search for alternative supply sources if Chinese exports are disrupted for

2
whatever reason. According to Morgan Stanley, low-cost Chinese imports (mainly
textiles, shoes, toys, and household goods) have saved U.S. consumers (mostly middle-
and low-income families) about $100 billion dollars since China's reforms began in 1978.
U.S. industrial firms such as Boeing, Ford, General Motors, IBM, Intel, and Motorola
also save hundreds of millions of dollars each year by buying parts from lower-cost
countries such as China, increasing their global competitiveness and allowing them to
undertake new high-value activities in the United States. Similar argument holds for
India’s exports of services. Therefore, shocks to these two countries’ import demand (and
export supply) are sources of risk for foreigners.

All these simply imply that both India and China have become increasingly
integrated with the world economy. But China has gone much farther in this regard.
China has attracted and continues to attract far more foreign capital (FDI and FII) than
India. A major portion (above 70%) of foreign investment inflows into China consists of
FDI. In case of India, foreign investment inflows are mainly in the form of FII (above
70%).

2. Factors Explaining China’s higher productivity and competitiveness in world

market for manufacturing bases:

(i) China welcomed large-scale FDI:

In contrast to India’s ‘homegrown entrepreneurship dependent’ growth strategy,

China followed FDI-dependent approach. The differences in the strategy are functions of
history. China’s Communist Party came to power in 1949 intent on eradicating private
ownership, which it quickly did. Developments at the microeconomic level in China
reflect this historical factor. China has imposed substantial legal and regulatory
constraints on indigenous, private firms. The restrictions were designed not to keep
Chinese entrepreneurs from competing with foreigners but to prevent private domestic
businesses from challenging China’s state-owned enterprises (SOEs). The government
has ferociously protected SOEs from competition. Foreign investors have been among the
biggest beneficiaries of the constraints placed on local private businesses. Overtime the
government removed a number of sectoral and regional restrictions on FDI. This had
momentous implications for the China’s growth scenario. The creation of SEZs, which

3
exempts foreign investors from regulation applicable elsewhere in China (particularly
relating to hiring and firing and foreign ownership), helped in attracting huge FDI into
China. Moreover, excellent infrastructure facilities, particularly power, road, and
communications also played a crucial role in attracting FDI.

(ii) Dominant role by Chinese Diaspora:

China has a large and wealthy diaspora that has long been eager to help the
motherland. Its money (in the form of FDI) has been warmly received. To overcome
rising wage costs domestically, to overcome limitations of domestic technology to
produce for the world market and to overcome growing competition from the other Asian
economies non-resident Chinese in Hong Kong, Macao and Taiwan invest in China.
Conscious of the absence of a strong domestic entrepreneurship, Chinese authorities have
been very hospitable to non-resident Chinese entrepreneurs.

By contrast, the Indian diaspora was, at least until recently, resented for its
success and much less willing to invest back home. New Delhi took a dim view of
Indians who had gone abroad, and of foreign investment generally, and instead provided
a more nurturing environment for domestic entrepreneurs. With the welcome mat now
laid out, direct investment from nonresident Indians is likely to increase. The Indian
diaspora has famously distinguished itself in knowledge-based industries, nowhere more
so than in Silicon Valley. Now, India’s brightening prospects, as well as the changing
attitude vis-à-vis those who have gone abroad, are luring many nonresident Indian
engineers and scientists home and are enticing many expatriate business people to open
their wallets. With the help of its diaspora, China has won the race to be the world’s
factory. With the help of its diaspora, India could become the world’s technology lab.

(iii) No protection for domestic industry:

China did not give protection to domestic firms, something both Japan and South
Korea did during their periods of rapid growth. Instead, it has allowed foreign firms to
develop new markets for their goods and services, especially high-value-added products
such as aircraft, software, industrial design, advanced machinery, and components such
as semiconductors and integrated circuits. Chinese domestic consumers act as a powerful
domestic coalition against protectionism. They, especially urban consumers, pride

4
themselves on driving foreign-brand cars and using mobile phones and computers with
circuits that were designed and manufactured abroad. The result: in the Chinese market
domestic manufacturers of appliances, motorcycles and TVs, to name a few goods, have
been able to successfully compete with those from Japan, Korea, etc.

(iv) Critical role played by ‘Township and Village Enterprises’:

Most of the industrial units producing lower-end manufactures are not state
owned. Nor are they all owned by individual capitalists. A large proportion of China’s
explosive industrial growth took place in what are known as ‘Township and Village
Enterprises’ (TVEs). TVEs are collectively owned industrial enterprises, owned by the
respective township or village. Their surpluses accrue not to individual capitalists but to
the township or village authority. These TVEs, have a number of advantages. They are
located on land owned by the local authority itself, and thus do not have to pay any rent
for land on which factories are situated, resulting in a substantial price advantage. Also, a
part of China’s savings is held by TVEs, thereby lessening the dependence of the TVEs
on costlier bank credit for working capital. However, the TVEs cannot subsidise losses
through recourse to the public exchequer. They have to stand on their own financially and
cannot exist for a long while making losses.

What contributed to the success of TVEs? First, the dramatic and demonstrative
impact on the growth of the small and medium industries in rural areas was facilitated
through extensive decentralisation of power to regional authorities for improving
efficiency in the planning and utilisation of local resources and development of local
industries. Second, the local governments had a strong incentive to promote TVEs as
these contributed substantially to revenues which the local governments could retain for
themselves under the revenue sharing arrangements. Third, FDI came to be favoured in
the development of TVEs. The impressive development of TVEs was primarily due to
their connections to the international market. The presence of FDI became pervasive in
labour-intensive and export-processing TVEs such as electronics and
telecommunications, garments and footwear, leather products, printing and record
processing, cultural products and plastics. In the TVEs the areas of highest growth were
also the areas of deepest foreign penetration. The connection with FDI brought TVEs in

5
competition with SOEs and stimulated the latter to increase productivity and unit scale.
Fourth, major agricultural boom coming in the wake of economic reform in agriculture,
with better prices and better land tenure, with the farmers acquiring fixed term land use
rights in the late 1970s and moving towards full property rights in recent years. For more
details see the Case Study on TVEs (at the end of this note).

(v) Export-led industrialization or Production for exports:

China followed a export-led growth model. Export units, in addition to catering to

the international market, produce for and compete in the national market as well.
Managers and workers from the export units also move on to set up other producing
units, taking their skills and production knowledge with them. Most of the lower range of
manufactures available in many parts of the world today carry the ‘Made in China’ label
– hall mark of China’s export-led industrialisation.

The policy of dualism in product quality played a significant role in promoting

Chinese products abroad. In China there are two sets of firms – one producing high
quality products and the other producing low quality products. A lot of shoddy goods are
produced in China, often with no attention to safety Standards. Firms producing poor
quality goods cater to the needs of the lower end of the market such as Nepal, Bangladesh
and India. Chinese experience shows that lower quality is not always a liability,
particularly when the trade-off is between quality and price. For example, in case of toys
they are anyway not going to remain useful for very long (whether it is because they
break or because children want something new) you do not need very high durability.

(vi) Higher labour productivity:

One of the factors contributing to China’s competitiveness is the dynamic

advantage of higher labour productivity. This is made possible by the following factors.

(a) The high level of education of Chinese workers. The virtually universal
literacy of Chinese workers enables higher productivity.

(b) The TVEs model does not lead to the same accumulation of profits in the
hands of a few individuals. Also the workers are not made to suffer the consequences of
adjustment, as in the usual privately-owned enterprises. As a result, workers would

6
develop closer attachment with such enterprises which, in turn, stimulates higher
productivity.

(vii) Importance to agriculture:

China and India have taken different reform paths. China started off with reforms
in the agriculture sector and in rural areas, while India started by liberalizing and
reforming the manufacturing and services sector. These differences have led to different
growth rates.

By making agriculture the starting point of market-oriented reforms, a sector

which gave majority of the people their livelihood, China could ensure a widespread
distribution of gains and build consensus and political support for the continuation of
reforms. Besides, through favoured demand conditions, prosperity in agriculture
favoured the development of a dynamic rural non-farm sector (TVEs), which provided
additional sources of income outside farming. As rural incomes rose, the demand for non-
agricultural output increased proportionately. The rapid development of the rural non-
farm sector also encouraged the government to expand the scope of policy changes and
put pressure on the urban economy to reform as well, since non-farm enterprises in rural
areas had become more competitive than the state-owned enterprises (SOEs). The major
elements of farm sector reforms in China are:

(1) Individual farmers secured an incentive to produce more than their obligation to
plan, which they could sell in open market

(2) Land reforms (land distribution & tenure system, limiting the number of landless)

(3) Health and education provided free

(4) Heavy govt. investment in power

(5) Rural electrification

(6) State procurement system dismantled everywhere except for main grain-
producing regions

(7) Food rationing system was abolished in early 1990s

(8) Private agriculture trade promoted

7
 Of these the measures 2, 3, 4 and 5 were initiated by China before the
introduction of economic reforms starting from 1978.

(viii) Absence of a land market:

Land is a collectively owned resource in China. There did not exist a formal or
officially approved land market up to the early 1990s. Any units in society, public or
individual, who needs land must obtain permission to the right of land usage from the
government. For instance, only the rights to the use of land are entitled to rural
communities, the rights to transfer and dispose of land are not, any allocation of farmland
lies in the hands of local community governments.

Thus, in China as a whole, land is not yet a commodity, not yet real estate. This
was a major advantage the country had in its march towards industrialisation (this is
especially the case of TVEs). Of course, a lease market is growing in China and this is
likely to put an end to the advantage it has in land not being a commodity.

(ix) Cheap capital:

Capital in China is substantially cheaper than in India. China’s savings rate is

more than 40 per cent compared to around 29 per cent for India. The savings are
deposited with the state-owned commercial banks in the closed financial system, which
has little autonomy but to follow political guidelines in its investment decisions. A part of
this savings is held in the TVEs, lessening their dependence on costlier bank credit for
working capital.

(x) “Trial and error” approach:

China follows trial and error approach in implementing reforms. The adoption of
new measures through experimentation rather than a predetermined blueprint increased
the likelihood of the success of reforms since it implied a “learning by doing” approach
or, in the words of Deng Xiaoping, one of “crossing the river while feeling the rocks”.
This was peculiar to the Chinese reform process in which the government made sure that
each new policy was field-tested at length and determined to be successful in selected
experimental districts before it could be applied nationwide and the next measure
introduced.

8
 (xi) Centralisation of decision making:

In both Indian and China there was political will to carry out reforms, but in
practice outcomes were shaped by the different patterns of governance. India is a
“debating society” where political differences are expressed freely. Policymaking is
exposed to the pressure of various interest groups and there are long debates before
decisions are taken. The lengthy bureaucratic procedures, intended to ensure checks and
balances in the system, often delays decision-making and implementation. This exercise
is compatible with the needs of a free and dynamic polity but in practice is a key reason
for India’s slow pace of economic reforms.

China, on the other hand, is a “mobilising society” where decisions are taken
faster and state power is backed by mass mobilisation. As a result, implementation of
decisions is more effective although there is lack of more elaborate debate in China on
major reforms. Another key factor in the effective implementation of reforms in China
was the ability of the leadership to set both clear objectives and time frame for transition
to the reformed regime. This is made possible due to centralization of decision making.
On the other hand, in the context of a highly pluralist society like India, consent is more
difficult to achieve, and so neither clear objectives nor time frames for transition can be
set.

3. Future challenges facing China’s Growth Story:

The infirmities in China’s microeconomic, institutional and entrepreneurial bases

seem to raise many doubts on the sustainability of its superior performance. The
infirmities are as follows:

(a) Growth of labour and savings is expected to slowdown in future:

In China, the share in population of persons in prime working age (15-59) is

projected to fall to 53.3% by 2050 from the present level of 67.7%. Also the dependency
ratio is projected to rise, from 57% to 88% by 2050. Analysts say this is the outcome of
(a) draconian and coercive one-child policy instituted in 1979 and (b) decline in fertility
in the decade before. China’s high savings and investment rates are also unlikely to be

9
sustained indefinitely into the future due to the expected fall in the working age
population.

But, India’s position on this front is more favourable than China’s. The share of
population in the age group 15-59 in India’s total population is projected to rise to 61% in
2050. Also dependency will fall slightly from 67% to 64% during the same period.
India’s saving and investment rates are likely to increase further for life cycle as well as
other reasons.

(b) Lack of efficient financial sector:

China doesn’t have a well-functioning and efficient financial sector consisting of

commercial banks, markets for debt, equity and insurance and a strong regulatory agency.
High domestic savings are deposited with the state-owned commercial banks, which has
little autonomy but to follow political guidelines in its investment decisions. Massive
investments in the public sector has not only promoted many commercially unviable
projects, but also created excess capacity, leaving the banking sector with a huge number
of nonperforming loans. Banking system managed to survive high NPA problem as (a)
the financial sector is still closed and (b) government repeatedly writes down bad loans
with fresh infusion of capital. As regards the other arms of the financial sector,
bureaucrats remain the gatekeepers, tightly controlling capital allocation and severely
restricting the ability of private companies to obtain stock market listings and access the
money they need to grow. These policies have produced enormous distortions while
preventing China’s markets from gaining depth and maturity

By contrast, India’s domestic financial system has far greater depth and wider
international linkages. This is despite the low gross domestic saving rate in India.
Though, like China, India’s commercial banking system is still dominated by public
ownership of nearly three quarters of its assets, nevertheless it has become more efficient
with increasing competition from dynamic new domestic private banks and also foreign
banks. India’s capital markets operate with greater efficiency and transparency than do
China’s. Indian stock and bond markets generally allow firms with solid prospects and
reputations to obtain the capital they need to grow.

10
 (c) Neglect of indigenous domestic industry:

China’s export-led manufacturing boom is largely a creation of FDI, which

effectively serves as a substitute for domestic entrepreneurship. Few of the Chinese these
products are made by indigenous Chinese companies. During the last 20 years, the
Chinese economy has taken off, but few local firms have followed, leaving the country’s
private sector with no world-class companies to rival the big multinationals. China's
private firms are not yet significant global players. Despite more than two decades of
economic reform, China's leading domestic industrial and technology companies are still
primarily SOEs, which remain inefficient and dependent on government-subsidized
loans, and foreign firms.

India, on the other hand, developed a softer brand of socialism, which aimed not
to destroy capitalism but merely to mitigate the social ills it caused. For democratic,
postcolonial India, allowing foreign investors huge profits at the expense of indigenous
firms is simply unfeasible. It was considered essential that the public sector occupy the
economy’s “commanding heights” However, that did not prevent entrepreneurship from
flourishing where the long arm of the state could not reach. While China has created
obstacles for its entrepreneurs in the post-reforms period, India has been making life
easier for local businesses during the post-1991 reform period. As a consequence,
entrepreneurship and free enterprise are flourishing in India.

(d) Incredible legal system/rule of law:

China’s developing capitalism is not solidly based on law, respect for property
rights and free markets. The business climate in China remains capricious and often
corrupt. Local governments protect their own counterfeiting operations as a source of
local revenue. The Chinese government continues to be the policy maker as well as the
judiciary. As long as this continues there is no way the legal system will be credible.
China’s intellectual property right protections, although strong in theory, are in fact
impossible to enforce in much of the country.

On the other hand the property rights regime is firmly entrenched in India. The
protection of private ownership is certainly far stronger in India than in China. The rule
of law, a legacy of British rule, generally prevails. Moreover, India developed much

11
stronger legal infrastructure to support private enterprise. India’s legal system, while not
without substantial flaws, is considerably more advanced. Corporate governance has
improved dramatically in India.

(e) Slow down in economic growth:

The first decade of the last century, with its relentless double-digit growth, may
well have seen the peak of China’s economic exuberance. Growth will inevitably slow
over the next decade, as China settles into its status as a middle-income country, and the
burden of caring for an ever larger number of elderly people in a slower economy may
make middle-class life far more uncomfortable. As a result of the impending slowing in
economic growth, the love affair between a communist party that calls itself the vanguard
of the proletariat and its actual, middle-class supporters is now under threat. The
government is struggling to shift China away from the current unsustainable model,
where growth is propelled by vast investment and export-led manufacturing.

(f) Sustaining urbanization:

China will have to work harder to sustain the urbanisation that has fuelled the
economy. China has succeeded in attracting underemployed young rural residents to
urban jobs. But the supply is beginning to slow. It would help if farmers could sell or
mortgage their rural land and use the money to help gain a stronger foothold in the cities.
But the government remains overly fearful of privatising farmland, partly for atavistic
fears of a destitute peasantry, and partly for ideological reasons.

Worse still, the system of household registration, or hukou, defines even long-
staying urban migrants as rural residents, cutting them out of housing, education and
other benefits (i.e. treating them as second-class citizens). No wonder that the migrants
are increasingly restive. Urban unrest has not become more common in China. If the
party is to keep the peace in cities and if it is to continue to attract migrants in sufficient
numbers, it needs to find ways to turn them into full-fledged city-dwellers, with the
consumer power to match.

Here it runs up against the middle class most directly. To give migrants the same
housing and other benefits as urban hukou holders, and to build a proper social safety-net

12
will be expensive. And if more tax is the solution, then the middle class could well begin
demanding a greater political say.

CASE STUDY: Town and Village Enterprises in China

1. Concept and components of TVE sector:

The TVE sector comprises four types of enterprises: township enterprises,

village enterprises (called collective TVEs), enterprises owned by joint rural
households, and enterprises owned by single rural households or individuals or
private enterprises.

Township enterprises and village enterprises are collective enterprises owned by

all residents of the township or of the village. The joint household enterprises are owned
by a group of rural residents, which can be viewed as semi-collective enterprises. Only
the private enterprises are owned by private owners.

Among the four types of enterprises, TVE sector was actually predominated by
collectively owned enterprises [i.e. township enterprises and village enterprises] rather
than private enterprises in terms of contribution to the TVE sector’s output and
employment generation (but not in terms of number of units).

2. Property rights structure of collective TVEs:

The property rights and the governance of collective TVEs can be described as
two-tier principal-agent proxy relations (see Figure).

13
 The Two-tier Principal-agent Relations in Collective TVEs

The community residents, as the nominal, or de jure (by right/according to law),

owners of a collective TVE (whose assets legally belong to the residents of the township
or the village), delegate the control rights (including the residual distribution rights)
in the firm to the community government1, who serves as the de facto owner of the
firm. In return, the community government assumes responsibility in the provision of
public goods and services, agricultural production support, local welfare, and capital re-
investment for the community residents. This completes the first-tier of principal-agent
relations.

The community government, as the principal, re-delegates at least part of the

control rights in the firm to the firm manager. In return, the firm manager receives
certain economic compensation through an operation contractual arrangement. The firm
manager thus has the obligation to remit profit, pay rents and fees to the community
government. The community government through the fiscal system will share the taxes
paid by the firm to the state as well. This illustrates the second-tier of principal-agent
relations in collective TVEs' organization.

The community residents enjoy the employment opportunities and income

increase provided by the firm.

1
Township government in a township enterprise case, or the village leaders in a village enterprise case.

14
3. Contributions made by TVEs to China:

Township and Village Enterprises (TVE) sector has made incredible contribution
to China in terms of improvements in economic growth, output, employment, tax
revenue, and rural income.

TVEs have efficiently utilized local (rural) resources to provide employment

opportunities to rural surplus labourers. For instance, in 1978, the TVE sector hired
only 9.2 percent of rural labor and provided 7.0 percent of nationwide employment.
However, in 1995, these figures rose to 28.6 percent and 18.9 percent respectively.

TVEs helped to improve rural income through the spread of non-agricultural

rural economic activities. In 1993, 94 percent of rural per capita net income increase
was contributed by TVEs. In 1978, an average rural resident earned only 3 yuan of labor
income from enterprises, which accounted for 3.4 percent of his total labor reward and
2.3 percent of his net income. By contrast, in 1996, an average rural resident earned
311.51 yuan of labor income from enterprises, which was 69.1 percent of his total labor
reward and 16.2 percent of his net income.

The increase of rural income stimulated consumption demand thereby enlarged

domestic markets and stimulated economic growth. TVEs gross output value of industry
in 1978 accounted for less than 10 percent of the national gross output value of industry.
After only 17 years, it produced 56 percent of national industry output in 1995.

The TVE sector contributed only 4.2 percent of the total tax revenues in 1978,
but this contribution reached 21.6 percent in 1995.

4. Factors contributing to the success of TVEs:

(i) China’s market liberalization (especially product markets) has exposed

collective TVEs to market competition, and the competition gave firms incentives to
improve their efficiency.

(ii) With the award of more and more economic autonomies to local authorities as
part of economic reforms, many local leaders became actively involved in the initiation
and the development of TVEs.

15
 (iii) Local community governments/leaders acted as a 'public entrepreneur',
which has clearly defined property rights, hard budget constraints, and strong incentives
to enforce improvement in efficiency in collective TVEs. Compared with other
transitional economies, the community governments/leaders functioning as the
catalyst rather than barriers is one of the most distinctive features in China's reform
practice. Their active and powerful role in rural enterprise development and
modernization is probably a unique experience among many developing countries. In
other transitional counties, local leaders tend more to be barriers to growth.

(iv) Local government leaders had strong incentives to launch and promote the
development of TVEs. The incentive structure for local leaders consisted of the following
elements:

(a) Government assigns growth targets to lower government authorities.

Assigned targets range from overall production value to per capita rural income,
sometimes even including growth rate in firm profit or exports.

(b) Local leaders have the obligation to fulfill the assigned targets to build up
their political image and ensure promotion. Under the cadre evaluation system in
China, local leaders' repute and likelihood for political promotion are determined by their
career achievements. Underperformers would be removed from their current positions
and relegated to lower ones. They could also be transferred to a remote and/or less
developed area if they were unable to achieve those targets. In short, they would 'lose
face and lose future' if such situation applied to them.

(c) Revenue incentive: The imperative of self-financing combined with the

overwhelming township government reliance on rural industry as a revenue source
created an incentive for township local leaders’ vigorously to promote the development
of rural firms. The township government must negotiate a multi-year fiscal contract with
the county government (the next higher level in the administrative hierarchy). According
to such fiscal contract, the township government as an agent of the central government
collected taxes from the enterprises and other entities under its jurisdiction and received a
share of the tax revenues it collected.

16
 Performance Criteria for Township Leaders
(Qingyunpu Township, Jiangxi Province), 1993

(d) Personal Benefits: Local leaders receive a base salary from the state payroll.
In addition, there are various side-payments and personal benefits for local leaders that
became possible as a result of local TVEs development. The number one category of
such benefit is the privileged welfare program for local leaders funded by local
governments' revenue. For example, a township in Jiangsu had built a number of
townhouses at the cost of 140 thousand yuan each, exclusive of land costs. These
townhouses were sold to the major township leaders at the price of 20 thousand yuan
each in 1994. Another perk was travels. Many of the local leaders traveled all over the
country, even abroad, at the expense of the township governments or villages. Those
travels were in name of business trips, training trips, or research visits. Another category
is the possession of consumer goods produced by local TVEs. Two furniture producing
factories in the Hubei investigation site reported that about 10 percent of their output was
taken by local leaders, either from their own township and neighbor townships, or from
the City which is the direct higher authority of the township, at be1ow cost price. Yet
another category that incurs the most criticism is the side payment in the form of free
dinners and valuable personal presents, usage of luxury goods 'borrowed' from TVEs or
TVE managers, or even direct cash payments to the local leaders in exchange for favored
tax treatment, land or credit allocation privileges, raw-materials or energy provisions to

17
the enterprises. Thus, more TVEs, particularly profitable TVEs, in a locality mean more
personal benefits through legitimate methods.

(v) The awareness of local leaders of their responsibility to stimulate

community/local income increase and improve local living conditions has led to their
active involvement in, and commitment to, the development of TVEs. Many local leaders
viewed the township enterprises or the village enterprises as their 'own enterprises' or
‘children'.

(vi) Competition among the local leaders: whenever leaders of a township or

village observed that their neighboring townships or villages had increased income
brought about by newly established enterprises, they simply launched enterprises of their
own to catch up with such income increase. A local leader expressed such a feeling in the
following words: 'when I saw many residents in our neighboring village had built new
houses, I was really ashamed. My fellow villagers elected me as the director, hence, it is
incumbent upon me to improve their life. I then made my mind and promised to set up
more and better enterprises in our village than our neighbor's.' Local leaders are desirous
of more funds to perform their functions.

(vii) Monitoring by local residents: As township and village are small

communities, the performance of both the firm and the local leaders are relatively easy to
be observed by local residents. This provides to some extent effective means to the local
residents in disciplining local leaders' behavior when deviating from the profit-
maximizing objective. Note that, in the absence of formal voting or election, local
residents may not directly exercise their control and regulate the behavior of the
community government leaders. Nor can they change the decisions made by local
leaders. However, local residents may 'voice out' when they are unsatisfied with the
performance of the community TVEs or local leaders. Such repeated 'voice' could
severely damage the reputation of local leaders, project a bad impression of local leaders
to higher authorities. Furthermore, it could cost the local leaders future promotion or even
current positions.

(viii) Easier access to land: Village leaders have the easiest access to land
because land is under their direct control. When a Villagers' Committee decides to launch

18
a new village enterprise, it simply assigns a piece of land within the boundary of the
village farmland to this proposed enterprise. The peasant household that was previously
cultivating the land would be moved to other piece(s) of land, generally without much
ado. The village may provide the household employment opportunities in the firm as
compensation. Very few financial exchanges would be involved in such land acquisition.
When the higher levels of governments have their eye on land that is out of their direct
control to set up collective enterprises, they must negotiate with the community that has
the rights over the land. In most cases, the community leaders cannot refuse such
requisition, but would bargain for more favorable compensation.

Source: Hongyi Chen (2000): “The Institutional Transition of China’s Township and
Village Enterprises”, Ashgate Publishing Ltd, England.

Recommended Video Links

1) Why Chinese Manufacturing Wins (11.03 Minutes)
https://www.youtube.com/watch?v=E7Jfrzkmzyc

2) The Biggest Factory in the World (47.20 minutes)

https://www.youtube.com/watch?v=lKseBx1YPgo

3) Exploring China's technological revolution (24.30 minutes)

https://www.youtube.com/watch?v=kwD3MUtZxeE

4) Town and Village Enterprises in China (18.147 minutes)

https://www.youtube.com/watch?v=0pfK3Npc3mM
https://www.youtube.com/watch?v=XdKMyyqAufM

19
 Sources used for preparing this Note
1) George J. Gilboy (2004): “The Myth Behind China’s Miracle,” Foreign Affairs,
Jul/Aug. Vol. 83, Iss. 4; pg. 33
2) D.N. Ghosh (2001): “Basis of China’s Competitiveness,” Economic and Political
Weekly, February 17.
3) D.N. Ghosh (2005): “FDI and Reform: Significance and Relevance of Chinese
Experience,” Economic and Political Weekly, December 17.
4) T.N. Srinivasan (2006): “China, India and the World Economy,” Economic and
Political Weekly, August 26.
5) R. Nagaraj (2005): “Industrial Growth in China and India: A Preliminary
Comparison,” May 21.
6) Yasheng Huang and Tarun Khanna (2003): “Can India Overtake China?,” Foreign
Policy, July/August.
7) Shenggen Fan and Ashok Gulati (2008): “The Dragon and the Elephant: Learning
from Agricultural and Rural Reforms in China and India,” Economic and Political
Weekly, June 28.
8) Bishwanath Goldar (2005): “Impact on India of Tariff and Quantitative
Restrictions under WTO,” ICRIER Working Paper No.172, November.
9) Prasad Ananthakrishnan and Sonali Jain-Chandra (2005): “The Impact on India of
Trade Liberalization in the Textiles and Clothing Sector,” IMF Working Paper
No.214, November.
10) World Trade Organisation: International Trade Statistics (Various Issues)
11) Samar Verma (2007): “Indian Textile and Clothing Industry: Economic Policy
Reform Experience During ‘ATC’ Period”, in India’s Liberalisation Experience:
Hostage to the WTO?, Edited by Suparna Karmakar, Rajiv Kumar and Bibek Debroy.
Sage India.
12) The Economist (2012): “China and the Paradox of Prosperity”, January 28-
February 3.
13) The Economist (2011): “Rising Power, Anxious State”, June 25.
14) Hongyi Chen (2000): “The Institutional Transition of China’s Township and
Village Enterprises”, Ashgate Publishing Ltd, England.
15) Howard E. French (2017): Everything under the Heavens: How the past helps
shape China’s push for Global Power, Alfred A. Knopf

20
 Recommended Additional Readings
Jonothan Story (2010): China Uncovered: What you need to know to do business in
China, Pearson.
Chun Liao (2009): “The Governance Structures of Chinese Firms – Innovation,
Competitiveness, and Growth in a Dual Economy”, Springer.
Ashok Gulati and Shenggen Fan (2007): “The Dragon and The Elephant –
Agricultural and Rural Reforms in China and India”, New Delhi: Oxford University
Press.
“China After 1978: Craters of the Moon”, Essays from Economic and Political
Weekly, Hyderabad: Orient Blackswan Private Limited.
Tarun Khanna (2009): “Billions of Entrepreneurs – How China and India Are
Reshaping their Futures – and Yours”, Penguin Books.
Pallavi Aiyar (2008): “Smoke and Mirrors – An Experience of China”, New Delhi:
Fourth Estate.
Also see the readings uploaded in Virtual Classroom.

21
Reforming the Labour Laws for better Industrial
Performance: Is there a way out?
 Theme of the Session
With introduction of economic reforms in 1991 India hoped for a
dynamic industrial sector, in particular manufacturing sector. But
the sector never took off as it did in other comparable countries
(e.g. China). Lack of flexibility in the labour market has been
considered as one of the prime reasons for the lackluster
performance of Indian manufacturing sector. In particular, certain
provisions in the Industrial Disputes Act 1947 (IDA) are said to
be market-distorting. On its part, the government is facing an acute
dilemma over this issue and labour and managements are at
loggerheads with each other, forcing the government to be
circumspect in reforming the labour market. Faced with fierce
resistance from trade unions, the government is facing difficulty in
introducing drastic labour reforms, especially that of providing
employers the flexibility to hire and fire workers.
In this context, this session focuses on the implications of the
existing labour laws on manufacturing performance, the views for
and against deregulation of labour market, and the possible way
out of the policy logjam.
 The Issue
• Lack of flexibility in the labour market has been
considered as the prime reason for the lackluster
performance of Indian manufacturing sector.

• In particular, the following provisions in the Industrial

Disputes Act 1947 (IDA) are said to be market-
distorting.
(1) Government intervention:

• IDA confers on government the power to regulate labor-

management relations.

• Also, the labour judiciary has predominantly ruled in

favor of workers.

• In most other countries, government move to intervene

only after bilateral negotiations between workers and
management break down.
(2) Difficulty in changing working conditions:

• Under Section 9A of the IDA an employer must give three

weeks' written notice to a worker of any change in his or
her working conditions.

• These changes include (a) changes in shift work, (b)

changes in grade classification, (c) technological change,
and (d) changes in employment, occupation, process, or
department.

• Worker has right to object to these changes, which may

culminate in an industrial dispute.
(3) Difficulty in layoff, retrenchment and closure:
• Under Chapter V-B of IDA, it is mandatory for firms with
hundred or more workers to seek the permission of the
Labour Department for layoff and retrenchment of
workers, and closures of industrial units.
• The permission is seldom forthcoming.
• In addition, notice and compensation has to be issued
to workers.
• Even when the firm is bankrupt, it must pay its workers
out of profits from other operations
• Claims of unfair dismissal can be made until 3 years
later
 What about firms of other sizes?

• Firms with 50 to 100 workers does not require official

permission, imposes shorter notice periods, and
provides a cap on compensation in cases “where the
undertaking is closed down on account of unavoidable
circumstances beyond the control of the employer”.

• Firms employing less than 50 workers are not required

to give notice of closures to the government, or to pay
compensation for layoffs.
• If a firm chooses to employ less than ten workers (twenty if it
does not use power) [Note: such firms fall under unorganized
sector].

Workers are not covered by most of national labor legislation

It does not have to offer formal employment contracts or the

usual benefits such as paid annual leave, sick leave, or
medical and pension benefits.

It can also fire workers without notice and does not owe any
severance pay.

Minimum wage regulations may apply, but these are not

vigorously enforced.
 Labour Reforms
Arguments of Industry
• Government/judiciary mostly favors
workers
• Difficult to respond quickly to
technological changes or changes in
demand conditions (Section 9A)
• Encourages firms to stay small (due to
Chapter V-B)
• Encouraged to adopt capital intensive
technologies
• More jobs in informal sector (3 out of 4
working in non-agri. sector are in
informal jobs)
• Replacement of regular with contract
labour.
• Encouraged to outsource activities
• Lack of any relationship between
productivity and wages
• Detrimental effect on the entry of large-
scale firms
Arguments of Trade unions
• Labour cannot be treated like any
other commodity
• Already, Indian industry has been
adjusting its workforce.
• Increased use of contract labour &
outsourcing is a proof of flexibility.
• Closures through informal routes
(non-payment of electricity bills,
etc)
• Noncompliance with the labour
regulations
• General decline in TU strength
• Increase in incidence of lockouts
and a decline in the incidence of
strikes.
• Unemployment could be the result
of many other factors
• Labour mkt. reforms, even in most
of the advanced capitalist countries,
has not been able to contain high
unemployment.
 Video Links

1) Truth vs Hype: Maruti - Trouble at the plant

(20.15 Minutes)
http://www.ndtv.com/video/player/truth-vs-hype/truth-vs-
hype-maruti-trouble-at-the-plant/214402

2) Why Honda Workers Are on an Indefinite

Hunger Strike at Jantar Mantar (8.05 Minutes)
https://www.youtube.com/watch?v=LXskgOBEhWg
 Questions for Discussion
(A) Who is at fault here? Is it industry or workers or
government or all together?

(B) Does India need a flexible labour law?

(C) What are the ways to ensure cordial industrial

relations in India?
 Lecture Note
Reforming the Labour Laws for better Industrial Performance: Is there a way out?

Theme of the Lecture:

With introduction of economic reforms in 1991 India hoped for a dynamic industrial sector, in
particular manufacturing sector. But the sector never took off as it did in other comparable
countries (e.g. China). Lack of flexibility in the labour market has been considered as one of the
prime reasons for the lackluster performance of Indian manufacturing sector. In particular,
certain provisions in the Industrial Disputes Act 1947 (IDA) are said to be market-distorting.
In this context, this lecture note focuses on the implications of the existing labour laws on
manufacturing performance, the views against deregulation of labour market, and possible
remedial measures.

This lecture note was prepared by Sthanu R Nair for the sole purpose of student learning. It is nothing but proper
arranging/ordering of relevant parts from the sources indicated at the end of the note with data/photo additions. Do
not circulate this note in any public platform or share to others without the Instructor’s permission.

1
 “A lot of things can be simplified. All the old antiquated laws like labour laws have to be
modified. Today, it may sound a cliche, our labour laws are presently pro-employee. It should
be pro-employment. The law should encourage the industry to employ more people. You cannot
say you shouldn’t lay off people whether you have business or not. This is not right in a
competitive environment because today customers are ruthless. The way they cut down
schedules from Germany or US is ruthless. If we want to take more risk there, we should also
have some flexibility. Most importantly, government should bring a simple law with respect to
engaging non-permanent workers. It has to define wages, hygiene conditions, preferences and
norms during recession period, among others. Globally, every factory uses 40-50 per cent
temporary workers to keep the costs down”

L. Ganesh, Chairman of the Rane Group

1. The Issue:

The term “labour market flexibility” comes nowadays in the discourse on “market
reforms” and economic growth. The basic idea is that free play of market forces results in
employment of resources at the market-clearing prices; this leads to both efficiency (as almost all
resources are employed) and equity (all are rewarded according to their marginal contribution).
Regulation of the market by the state leads to deviations from full employment of all resources.
Hence, attempts should be made to remove as many of these imperfections in the market as
possible so as to achieve full employment of all resources and optimal social welfare.

In the case of labour market, trade unions and protective labour legislations are said to be
market-distorting agents, which curtail the free operation of market forces to ensure full
employment of labour. Interference by collective institutions (law and trade unions) in the
market process increase transaction costs, which mar investment, thereby resulting in
unemployment and welfare loss. These institutional interventions in the name of equity and
social justice superimpose terms set above the market-clearing prices. As a result, markets do not
clear, wages become “sticky” and the cost calculations of firms go haywire. These institutions
not only tamper with the “price” and the essential market signals that enable efficient functioning
of the market, but also affect the freedom of employers to adjust the “quantities” of resources,
which, in turn, leads to unemployment. They also result in “inequity” because by protecting the
interests of “insiders”, they hurt the chances of “outsiders” entering the labour market, who thus
remain unemployed. A social divide is created, which perpetuates, inequality. While the
“outsiders” remain scattered and their political power becomes diffused, the “insiders”, on the
other hand, are well-organised and vocal, and influence policy decisions more than their

2
unfortunate counterparts. Hence, it is strongly argued that the labour market should be
deregulated for stimulating investment and employment, as well as equality in order to provide
flexibility in entry and exit.

The essential ingredient of policy concerning labour and employment in India,

particularly during the first three decades of planning, has been to treat labour not as a mere
resource for development, but as a partner in and beneficiary of social and economic
development. This philosophy of labour had its roots in the national movement and many
legislative provisions for protecting labour were enacted before independence, which were
strengthened later. Accordingly, provisions of social security were made more comprehensive
and expanded to include various kinds of risks. Further, detailed laws governing industrial
relations were enacted, and a mechanism for fixing and implementing minimum wages was
developed. The basic idea behind all these protective measures adopted for labour was that the
workforce was a relatively weaker partner vis-à-vis capital in the production process and that in a
poor country like India, it was desirable to safeguard workers to promote both social justice and
an appropriate industrial and productive climate.

However, after the introduction of economic reforms in 1991, it has been increasingly
realized that the rigidity of the Indian labour market is one of the prime reasons for the lackluster
performance of Indian manufacturing sector. In particular, certain provisions in the Industrial
Disputes Act 1947 (IDA) are said to be market-distorting. On its part, the government is facing
an acute dilemma over this issue and labour and managements are at loggerheads with each
other, forcing the government to be circumspect in reforming the labour market. Faced with
fierce resistance from trade unions, the government is hesitant to introduce drastic labour
reforms, especially that of providing employers the flexibility to hire and fire workers.

2. The Debate on Labour Market Reforms in India:

2.1. The main contentions with existing labour law in India:

(i) The Industrial Disputes Act 1947 (IDA) confers on the state (i.e. government) the
power to regulate labor-management relations. This is unlike the laws of most other countries,
where the state can move to intervene only after bilateral negotiations between workers and
management break down. Once the Labor Departments of the central and state governments with
jurisdiction over a firm, decides that a certain dispute merits its intervention, it initiates a process

3
aimed at reconciling the two sides. If this process fails, the matter is sent to the labor judiciary.
The latter has predominantly ruled in favor of workers. Labor unions prefer this system to
alternatives because it greatly increases their bargaining power vis-a-vis management.

(ii) Under Section 9A of the IDA an employer must give three weeks' written notice to a
worker of any change in his or her working conditions. These changes include (a) changes in
shift work, (h) changes in grade classification, (c) changes in rules of discipline, (d) a
technological change that may affect the demand for labor, and (e) changes in employment,
occupation, process, or department. The worker has the right to object to these changes, which
may culminate in an industrial dispute with the associated costs in terms of time and financial
resources. This provision makes it very difficult for the firm to respond quickly to technological
changes or changes in demand/market conditions.

(iii) Under Chapter V-B of the IDA, it is mandatory for firms with hundred or more
workers to seek the permission of the Labour Department (government) for layoff and
retrenchment of workers, and closures of industrial units.1 In addition, notice and compensation
has to be issues to workers. The permission is seldom forthcoming. Therefore, under current
provisions, a firm with one hundred or more workers has effectively no right to retrench or layoff
workers. Even when it is bankrupt, it must pay its workers out of profits from other operations.
In this context, it is to be noted that, when this provision was originally inserted into the IDA by
an amendment passed by Parliament in 1976, chapter V-B applied to industrial establishments
employing an average of 300 or more workers. An amendment in 1982 (brought into effect in
1984) reduced this employment threshold to 100.

The introduction of Chapter V-B was prompted by rampant use of layoffs, retrenchments
and many closures – “about half a million workers were laid off after the declaration of
Emergency during the period of June 1975 to December 1975. Besides, more than thirteen
thousand workers were retrenched and 76 establishments were closed down rendering about ten
thousand workers jobless”. The government tried to persuade employers to stop these unilateral

1
According to IDA a layoff “means the failure, refusal or inability of an employer on account of shortage
of coal, power, or raw materials or the accumulation of stocks or the breakdown of machinery or natural
calamity or any other connected reason to give employment to a workman whose name is borne on the
muster rolls of his establishment” (IDA Section 2 (kkk)). Layoffs are limited to 45 days on half pay.
Retrenchment means the permanent termination of a worker’s service, other than on account of
punishment, retirement, ending of a contractual period, or continued ill-health [IDA, section 2 (oo)].
4
acts; when these efforts failed, the government brought about the amendment to the ID Act to
introduce the (in) famous restrictive provisions. Emergency was bad, but this law was good at
least then. Now, this restrictive provision is seen to hurt the process of employment generation.

(iv) Factories with 50 to 100 workers are covered by Chapter V-A of IDA, which does
not require official permission, imposes shorter notice periods, and provides a cap on
compensation in cases “where the undertaking is closed down on account of unavoidable
circumstances beyond the control of the employer”.

The aforementioned stipulations are not applicable to undertakings employing less than
50 workers. They are not required to give notice of closures to the government, or to pay
compensation for layoffs. If a firm chooses to employ less than ten workers (twenty if it does not
use power) its workers are not covered by most of the national labor legislation [Note: Such
firms fall under unorganized sector]. It does not have to offer formal employment contracts or
the usual benefits such as paid annual leave, sick leave, or medical and pension benefits. It can
also fire workers without notice and does not owe any severance pay. Minimum wage
regulations may apply, depending on the state and the sector, but these are not vigorously
enforced. 88.3 percent of non agricultural workers were employed in the unorganized sector
under precisely this set of conditions in 1999-2000. If a firm chooses to employ ten or more
workers (twenty or more if not using power) the firm must establish a pension fund for the
workers.

2.2. Possible consequences of the provisions under IDA:

(i) Pro-worker regulation encourages firms to stay small so as to avoid registration (or)
drop below the radar of Chapter V-B of the IDA.

(ii) Encourages firms to adopt capital intensive technologies. For instance, in the
aftermath of 2012 labour unrest at Maruti’s Manesar plant, Maruti disclosed its plan to automate
certain critical production functions in its Manesar plant that would bring its Manesar operations
on par with its hi-tech plants in Hamamatsu, Japan. Chief operating officer (production) at
Maruti Suzuki, MM Singh at that time said "We gradually plan to automate our plants in India to
bring consistency in the quality of our cars. We have already started the process at Manesar's
first plant to take automation to the maximum possible 99% level, where the press and weld

5
operations would be on par with the second (manufacturing) facility," 2 For a detailed account of
the labour unrest at Maruti’s Manesar plant, see the case study in Appendix.

(iii) Replacing regular with contract labour.

(iv) Outsourcing (or subcontracting) some inputs previously produced in-house. The
advantage of the subcontracting option is that by doing so a greater part of the firm’s activity
goes outside the purview of labour legislation. The disadvantages of subcontracting are: (a)
further expansion of unorganized sector and (b) huge sacrifice in terms of feasible
technologies and scale economies due to fragmentation into such small units.

(v) Detrimental effect on the entry of large-scale firms in the unskilled labor-intensive
sectors in at least two mutually reinforcing ways. First, firms are afraid that should they go bust
for some reason, they will be stuck having to pay full wages to a large workforce despite
bankruptcy. Second, various labor laws have disproportionately strengthened the hand of the
unions in wage negotiations. Consequently, the wages in the organized sector are now several
times those in the unorganized sector. These high wages are less of an issue for the firms in the
capital-intensive industries since labor costs are only a tiny proportion of their total costs. But for
unskilled labor-intensive firms, such high wages result in a very large increase in their unit costs
and render them uncompetitive.

3. Arguments of Pro-labour Reform Section in India:

(i) In India, several economists, industry associations and mainstream media have
attributed the deceleration in employment growth in India, particularly in the organised
industrial/manufacturing sector, to inflexibility/rigidity in the labour market – identified in
terms of job security provisions, and lack of any relation between productivity and wages.
Absence of such provisions (or labour market flexibility) is believed to have increased the labour
costs for enterprises, thereby promoting capital-intensive methods in the organised sector,
encouraging the use of non-regular workers and hindering investment (including foreign
investment) in manufacturing sector and economic growth.

(ii) Employment protection laws are also believed to be inequitable, dividing workers
into protected and unprotected categories. Over-protection of a small section of workers is not

2
‘Maruti Suzuki to use more robots at manesar plants’, The Economic Times, September 3, 2012.

6
only ostensibly inimical to the growth of employment, but also goes against social justice as
more and more workers are faced with deplorable working conditions.

(iii) Employment law (Employment (Standing Orders) Act] and the judicial process
(emphasising the principles of natural justice) have made difficult removal of even ‘bad’
workers; it is a case of justice hurting efficiency as the difficulties involved in the process
introduce rigidities.

In this context, very often the example of China is given, which has drastically changed
its system of labour market from a rigid security of employment to one in which labour is
extremely mobile. It is said that it has greatly helped China in generating employment as well as
successfully redeploying workers who were laid off in the process of restructuring of enterprises.

However, in China, the underpaid and overworked workers have started protesting, forcing
employers to raise wages. This can have a two-fold effect in India: one, Indian employees may
also start negotiating for higher wages. Two, wage inflation may force some companies to lose
their competitiveness in China and shift to India. This process may raise the pace of wage
increase in India, particularly when it comes to the educated and skilled workforce. The unskilled
workforce would, of course, continue to remain at the lower echelons. It is argued that more than
100 developing countries have reformed their labour laws in response to competitiveness in the
era of globalisation, but India remains among a select few countries with a rigid system of labour
protection.

4. Arguments of Anti-labour Reform Section in India:

(a) Labour cannot be treated like any other commodity, and measures like minimum
wages, job security, separation benefits, social security, trade union rights, etc, are socially and
politically necessary even for sustaining the process of globalisation, as they increase labour
productivity. In India there is no ‘right to work’ and no general unemployment assistance; in
such a situation it is not practicable to “give a blank cheque to the employers – government or
private, to operate exit policy.” Hence, for trade unions provisions such as Chapter V B
“encompass the right to livelihood, natural justice and transparency.”

(b) Despite all the hue and cry about inflexibility in the labour market and stringent
labour laws, the Indian industry has been adjusting its workforce, more so after liberalisation.

7
 (c) The fact that employers have resorted to the increasing use of contract labour in the
post-reforms period suggests that employers have been able to find ways to reduce the workforce
even with the “restrictive” provisions in place. Studies have found that the percentage of contract
workers to total workers in manufacturing has increased significantly over the years.

(d) Firms have increasingly dispensed with permanent workers in the non-core activities
through outsourcing to other firms. This has resulted in increasing informalisation of the
workforce. The proportion of unorganised sector employment has considerably increased in
construction, transport, storage and communications, and financial services. Apart from new jobs
largely being created in the unorganised sector, a large number of retrenched workers have found
refuge in the unorganised sector.

(e) Although VRS has been the main instrument to reduce workforce, large-scale
closures through adopting informal routes (non-payment of electricity bills, etc) have also been
used.

(f) In practice, noncompliance with the labour regulations is widespread. Several

states have relaxed the provision of enforcement of labour laws leading to flexible practices at
the ground level. Some of the states have issued directives to prevent or hinder inspection of
firms. For example, in Uttar Pradesh, the labour inspectors can carry out inspection only after
prior consent of an officer of the rank of labour commissioner or district magistrate. The states of
Rajasthan and Andhra Pradesh have also reduced the scope of labour inspection, and have
exempted several establishments from the purview of labour inspection. All these took place
without much resistance from trade unions.

(g) Flexible labour practices at the ground level have adversely affected the trade
unions and there has been a general decline in their strength. Trade unions have been further
weakened by the ascendancy of managerial rights and new strategies like outsourcing and
parallel production. The weakening of workers’ bargaining capacity and rise in the militancy of
employers are also manifested in the significant increase in the incidence of lockouts and a
decline in the incidence of strikes. All these have enabled employers to resort to flexible
practices on a wide scale, bypassing the formal rigidities of the labour market. In a significant
number of cases where informal routes have been adopted (e g, unofficial closures), the workers
have suffered a lot, as they have been deprived of their dues.

8
 (h) Almost all over the world, higher wages are associated with higher employment,
implying that unemployment could be the result of many other factors (e.g. increasing pressure
on manufacturing units to adopt capital intensive production technique).

(i) A ILO study, based on data collected from 162 countries, concludes that stronger trade
union rights do not generally hinder trade competitiveness, including trade of labour intensive
goods, and indeed countries with stronger trade union rights tend to do comparatively well.

(j) Deregulation of the labour market, even in most of the advanced capitalist countries,
has not been able to contain high unemployment even after decades of implementation.

(k) Flexibilisation is a strategy to weaken labour rights and to increase the profitability of
firms and their bargaining power, without any positive impact on the level of employment.

(l) Insecurity (in all forms) has risen in the wake of liberalisation, privatisation and
globalisation processes. Hence, more protection should be given to the labour force.

(m) There should not be ordinarily any retrenchment due to introduction of automation,
computerisation and modernisation. However, if surplus exists on account of these the factors
surplus workers should be redeployed by the same firm without affecting the existing service
conditions.

(n) Employers ask for exit policy to close down the unionised firms and take them to
backward areas to enjoy income tax and sales tax exemptions granted by the government – a
kind of subsidy. Employers employ nonunionized flexible categories of employment in the
backward areas and pay them low wages. Many Indian and multinational companies follow this
practice. Hence, trade unions argue that companies that receive subsidies from the taxpayers for
creating employment should come under social scrutiny for maintaining employment.

To conclude, the logic of attributing the slow growth of employment to labour market
inflexibility is not correct in all cases. Labour market institutions play a minor role, if any at all,
in determining investment and employment. This weakens the case for the total removal of the
provisions relating to closure and retrenchment.

9
5. Policy recommendations for achieving cordial worker-employer relationship:
The following initiatives/measures will go a long way to ensuring cordial worker-
employer relationship.
(a) An income security system consisting of unemployment or social security benefits
for a specified period, provisions for re-training and active assistance for job search should
precede the grant of reasonable and limited freedom to employers to retrench workers with
sufficient notice and adequate as well as timely compensation. The policy of “free hire and fire”
can be tackled if the state intervenes to ensure the security of income to all workers. India is
among those countries that spend least on social services and social security. China, whose
example is often cited in the context of labour flexibility, adopted a wide range of security of
workers before introducing reforms in the labour market.
(b) Rationalisation of work practices in consultation with trade unions should be
allowed in order to adjust to the rapid changes taking place in technology and markets. Since
labour productivity is a function of skill and technology, employers should agree to invest in
both the development of workers’ skill and upgradation of technology. An active labour market
policy of skill development and redeployment, as has been successfully implemented in the
Scandinavian countries, should be pursued in which the trade unions, employers and government
should closely collaborate.
(c) The burgeoning employment in the informal sector, along with its low productivity,
low wages, fragile employment and income insecurity, necessitates the regulation of this sector
in such a way as to create organised sector-like conditions of higher productivity, better
employment and wages. In the absence of unionisation of workers and the enforcement of even
minimum labour standards, this sector is inevitably caught in the conundrum of low productivity
and low wage equilibrium. This equilibrium needs to be disrupted by ensuring a floor of labour
standards in this sector.
(d) Indian labour laws are too voluminous and ambiguous to be effective from the
point of view of either labour or capital. This only promotes costly litigation and corruption in
the labour departments of state governments. Accordingly, a rational businessman would prefer
to violate labour laws at the lesser cost of bribing the inspector or paying the measly fine
imposed by the courts. Hence it is alleged by many that the hue and cry about getting rid of
the inspector raj and the non-existent inflexibility of the labour market is intended to get
rid of both the cost of compliance and that of violation altogether. Hence, there is an urgent
need to simplify, rationalise and consolidate different labour laws into a maximum of three
simple pieces of labour legislation after wide consultation among employers, trade unions and
labour law experts.
(e) Workers should be willing to undergo training or retraining at employers’ costs and
accept redeployment without loss of current earnings or status.
(f) Severance pay an allowance paid by the employer for terminating an employee
irrespective of the reason for termination. It is provided where social security is not existent or
inadequate. It is paid by the employer or by a fund set up specifically for this purpose with
employer’s contributions. Severance pay may be a fixed amount; but in most cases it is
calculated taking into account level of wages and length of service.

10
 Severance pay prescribed should be treated as ‘minimum’ and the rates can be modified
upwards by collective agreements; differential severance pay should exist as in other countries; it
should vary according to the economic health of the firm. Constitution of a ‘severance fund’
could be thought of with contributions from both employers (higher rates) and workers. This
fund could be used for various purposes such as retraining, job-placement services, early
retirement programmes, relocation subsidies, etc. As in the Latin American countries they could
be used for paying the severance package payments.
(g) Layoffs should be taken out of the government purview; instead the rates of
compensation for layoffs should be progressively higher: it should be 50 per cent of wages and
allowances for the first month, 75 per cent for the second month and full salary subsequently.
The high cost of layoff itself would discourage the employer from using it frequently and
without merit.
(h) Avenue for Redressal and Reinstatement: Protection of workers in cases of unfair
dismissals covers avenues for rederessal also. The principle here is that the affected worker
should have the right to appeal against what he/she thinks to be unfair dismissals. The bodies that
enquire into these appeals may be employment or labour courts, administrative bodies, private
arbitration agencies, or special bodies created by the collective agreements. Remedies in cases of
proven unfair dismissals include reinstatement of the dismissed worker. If reinstatement is
impractical, then financial compensation is provided.
(i) Role of Government: A number of countries (31 countries including US, UK, France
and Germany)), require the firms to notify the government authorities of all job losses. It was
found that some 33 countries in 1980 had laws requiring employers to notify a government
agency in advance of collective dismissal of workers. An ILO Survey (1980) found that some 15
countries, mostly developing countries, required explicit requirements for government
authorisation of workforce reductions – Algeria, Chile, Colombia, France, India, Iraq, The
Netherlands, Panama, Portugal, Peru, Senegal, Sri Lanka, Spain, the Sudan and Zaire. Thus, a
few countries require the employers to obtain prior permission before effecting dismissals. In
sum, it can be said that prior authorisation for effecting labour separation and closure is the most
significant difference between India and most other countries; to be sure, it exists in a few
countries, but only in a few.
(j) Fixed-term Contracts: Most OECD countries and several developing countries
recognise the use of fixed-term contracts in ‘objective’ situations, a term which typically refers
to specific projects, seasonal work, replacement of temporarily absent permanent workers (on
sickness or maternity leave) and exceptional workload. These workers do not require notice of
dismissal and severance pay; it is a flexible arrangement. Its use is generally unrestricted.

6. Recent Policy Initiatives by the Central and State governments in the Labour Market
(a) Shram Suvidha Portal: A unified labour portal scheme called ShramSuvidha Portal
has been launched for timely redressal of grievances and for creating a conducive environment
for industrial development. Its main features are: (i) Unique Labour Identification Number
(LIN) allotted to around 0.7 million units facilitating online registration; (ii) filing of self
certified, simplified single online return instead of 16 separate returns by industry; (iii)

11
transparent labour inspection scheme via computerized system as per risk-based criteria and
uploading of inspection reports within 72 hours by labour inspectors.
(b) Amendment of Apprentices Act: The Apprentices Act, 1961 was amended on
18.12.2014 to make it flexible and attractive to youth and industry and an Apprentice Protsahan
Yojana to support micro small and medium enterprises (MSME) in the manufacturing sector in
engaging apprentices has been launched. Government is also working affirmatively to bring a
single uniform law for the MSME sector to ensure operational efficiency and improve
productivity while ensuring job creation on a large scale.
(c) Under Employees’ State Insurance Corporation (ESIC) Project Panchdeep:
Digitization of internal and external processes to ensure efficiency in operations, especially
services to employers and insured persons. The portal enables employers to file monthly
contributions, generate temporary identity cards and create monthly contribution challans online,
issue of pehchan card for insured persons for fast and convenient delivery of services. Through
the IP Portal, insured persons can check contributions paid/payable by employers, family details,
entitlement to various benefits, and status of claims. Integration of its services will promote ease
of business and curb transaction costs.
(d) Under Employees Provident Fund (EPF): Digitization of complete database of 42.3
million EPF subscribers and allotment of universal account number (UAN) to each member,
which facilitates portability of member accounts. UAN is being seeded with bank account,
Aadhar Card and other KYC details to promote financial inclusion. Direct access to EPF
accounts will enable members to access and consolidate previous accounts. Online pensioners
can view their account and disbursement details online. The statutory wage ceiling under the
Employees Provident Fund and Miscellaneous Provisions (EPF&MP) Act was enhanced to Rs.
15000 per month from 01.09.2014. A minimum pension of Rs.1000 has been introduced for
pensioners under the Employees’ Pension Scheme 1995 w.e.f 01.09.2014.
(e) Registration made easy: Registration with the Employees Provident Fund
Organization (EPFO) and Employees State Insurance Corporation (ESIC) has been automated
and ESIC registration number is being provided on a real-time basis. A unified portal for
registration of units for Labour Identification Number (LIN), reporting of inspection, submission
of returns and grievance redressal has been launched by the Ministry of Labour and
Employment.
(f) For Unorganized Workers: The Rashtriya Swasthya Bima Yojana (RSBY) is a
scheme under the Unorganized Workers’ Social Security Act 2008. It is a smart card-based
cashless health insurance scheme, including maternity benefit, which provides a cover of Rs
30,000 per family per annum on a family floater basis to below poverty line (BPL) families in
the unorganized sector. It is proposed to extend the RSBY to all unorganized workers in a phased
manner.
(g) A National Council for Vocational Training-Management Information System
(NCVT-MIS) portal has been developed for streamlining the functioning of Industrial Training
Institutes (ITI), Apprenticeship Scheme, and assessment/certification of all NCVT training
courses.
(h) National Career Services Portal: The Government is mandated to maintain a free
employment service for its citizens. This is now being transformed with the launch of the

12
National Career Service (NCS) Portal on 20 July 2015. The NCS is envisaged as a digital portal
that will provide a nationwide online platform for job seekers and employers for job matching in
a dynamic, efficient and responsive manner. As of 31 December 2015, approximately 3.58 crore
job seekers, 9 lakh employers and 27,000 skill providers are registered on the portal. The
Government has also approved the establishment of 60 model career centers and these are likely
to become functional during 2016-17.
(i) The Payment of Bonus (Amendment) Act 2015: The Payment of Bonus
(Amendment) Act 2015 received the assent of the President on 31 December 2015. The
eligibility for bonus payment as defined under section 2 (13) of the Payment of Bonus Act 1965
has been increased from R10,000 to R21,000 per month. Section 12 of the principal Act states
that the calculation of bonus with respect to certain employees where the salary or wage of an
employee exceeds R7000 (or the minimum wage for the scheduled employment as fixed by the
appropriate government, whichever is higher) shall be paid per month, the bonus payable to such
employee under section 10 or, as the case may be, under section 11, shall be calculated as if
his/her salary or wage were R7000 per month (or the minimum wage for the scheduled
employment as fixed by the appropriate government, whichever is higher).
(j) The Parliament has recently passed three labour code Bills named The Industrial
Relations Code, 2020 (hereafter IR code), The Code on Social Security, 2020, and The
Occupational Safety, Health, and Working Conditions Code, 2020. In 2019 another piece of
labour legislation named The Code on Wages, 2019 was enacted by the Parliament. These codes
were based on the Second National Commission on Labour (2002) recommendations that the
plethora of central and state labour laws need to be simplified, rationalised and grouped into
functional codes that can be easily understood and complied with by the industry and workers.
Currently, there are around 40 central and 100 state laws related to labour. Among these, The
Industrial Relations Code (IR Code) is touted as one that would energise industry and spur
economic activity, as it aims to free employers from the constraints of earlier labour laws. The
following are the key features of IR code.
 The provisions that require the prior permission of the government for lay-off,
retrenchment and closure are made applicable to only establishments that had
employed 300 or more workers. The Code also allows the government to raise this
threshold by notification. However, the requirements for issuing notice and paying
compensation to the laid-off and retrenched workers have been retained at the
present level of firms employing 100 or more workers. This reform measure implies that
industrial establishments using less than 300 workers need not have to obtain prior
government permission for layoff and retrenchment of workers and closure of their
establishment.
 Worker re-skilling fund: The Government shall set up a fund to be called the worker re-
skilling fund. The fund shall consist of (a) the contribution of the employer of an
industrial establishment an amount equal to fifteen days wages last drawn by the
worker immediately before the retrenchment, or such other number of days as may be
notified by the Central Government, for every retrenched worker in case of retrenchment
only; (b) the contribution from such other sources as may be prescribed by the
appropriate Government. The fund shall be utilised by crediting fifteen days wages
last drawn by the worker to his account who is retrenched, within forty-five days of
such retrenchment, in such manner as may be prescribed.

13
  Works Committee: In the case of any industrial establishment in which one hundred or
more workers are employed or have been employed on any day in the preceding twelve
months, the appropriate Government may by general or special order require the
employer to constitute a Works Committee, in such manner as may be prescribed,
consisting of representatives of employer and workers engaged in the establishment. It
shall be the duty of the Works Committee to promote measures for securing and
preserving amity and good relations between the employer and workers and, to that
end, to comment upon matters of their common interest or concern and endeavour to
compose any material difference of opinion in respect of such matters.
 Grievance Redressal Committee: Every industrial establishment employing twenty or
more workers shall have one or more Grievance Redressal Committees for resolution of
disputes arising out of individual grievances.
 Establishment that employ 300 or more workers must prepare standing orders
relating to classification of workers, manner of intimating to them periods and hours of
work, holidays, pay days etc, shifts, attendance, conditions for leave, termination of
employment, or suspension, besides the means available for redress of grievances.
 The IR code introduced ‘fixed term employment’, giving employers the flexibility to
hire workers based on requirement through a written contract. Fixed term employees
should be treated on a par with permanent workers in terms of hours of work, wages,
allowances and other benefits, including statutory benefits such as gratuity.
 There shall be a negotiating union or a negotiating council in an industrial
establishment having registered Trade Union for negotiating with the employer of the
industrial establishment. Where there is more than one trade union in an establishment,
the sole negotiating union status will be given to the one that has 51% of the
employees as its members. Where no union qualifies under this criterion, the employer
must constitute a ‘negotiating council’ consisting of representatives drawn from the
various unions, with only those with at least 20% of employees as its members.
 The Code prohibits strikes and lock-outs in all industrial establishments without
notice. No unit shall go on strike in breach of contract without giving notice 60 days
before the strike, or within 14 days of giving such a notice, or before the expiry of any
date given in the notice for the strike.

(k) State-level reforms: Of late, the central government has been encouraging states to
change their labour laws according to their needs and conditions. Making use of this opportunity,
states like Haryana, Rajasthan, Madhya Pradesh and Gujarat have introduced labour
reforms in their respective states. Haryana reformed its labour law to allow enterprises with up
to 300 employees to lay off workers without the government’s permission.

Key highlights of labour reforms initiated in Rajasthan is as follows:

 Industrial establishments employing up to 300 workers are now allowed to retrench

employees without seeking prior permission of the Government

14
  The threshold of the number of employees required for the purpose of applicability of the
Factories Act has been increased from 10 to 20 (in electricity-powered factories) and
from 20 to 40 (in factories without power) thereby putting small factories in Rajasthan
outside the purview of the Factories Act

 Membership of 30 per cent of the total workforce needs to be recorded for a union to
obtain recognition, up to 15 per cent, a move that will halt productivity losses due to
industrial dispute

 As against the existing threshold of 20 contract labour/workmen, the Contract Labour Act
will be applicable only to those establishments and contractors in Rajasthan who employ
50 or more contract labour/workman in the preceding 12 months

Key highlights of labour reforms introduced in Madhya Pradesh is as follows:

 Companies employing up to 300 workers will be allowed to retrench workers or shut

shop without government approval against the provision for up to 100 workers earlier.
However, employers will have to pay higher compensation, three months’ notice and at
least three months’ salary, in the event of retrenchment. Earlier, either of the two was
allowed and employees were paid 15 days’ wages for every year worked.

 Workers in Madhya Pradesh will get the benefit of earned leave after six months of
service, in the same calendar year. This will apply to factories with at least 10 workers if
they are without power connection, or factories with at least 20 workers if they have
power connection. At present, employees are entitled to annual leave after they have
worked for at least eight months, but they are able to avail of these in the next calendar
year.

 Overtime hours for workers in a quarter will be increased from 75 hours to 125 hours.
The factories will have to maintain a record of overtime of workers and pay double the
wages if the work hours are extended.

 Women will be allowed to work in night shifts at factories — they could work from 8 pm
to 6 am in morning. The state government will make necessary provisions for their safety
and security.

Key highlights of labour reforms introduced in Gujarat is as follows:

 Gujarat has eased “hire and fire” provisions in special investment regions like the Delhi
Mumbai Industrial Corridor (DMIC), National Investment and Manufacturing Zone
(NIMZ), export-oriented industrial establishments and some other economic zones. In
these areas, companies are allowed to lay off workers without the government’s
permission, but wages equivalent to 60 days of work every year have to be paid to the
retrenched workers.

 For settling disputes between workers and management, a 'compromise' formula

with payment of 'penalty' to the government was introduced. Under this, industrial
employee(s) can arrive at a compromise with the employer without moving court, in case

15
 of an industrial dispute. The amended labour law has a provision where both the parties
(workers and industry) can end their dispute through compromise called as 'compounding
of offenses'. Under this new system of compounding of offenses, workers can arrive at
compromise with the employer without approaching court. For this, government will
charge upto Rs 21,000 as penalty from the employer and give 75 per cent of that penalty
money to the affected employee or employees. However, this compounding of offenses
will be only implemented if both the parties agree to it,

 The state government is allowed to prohibit labour strikes in public utility service from
the minimum period of six months to one year.

 A workman gets only a year to make an application against his dismissal, discharge, etc,
for raising an “industrial dispute” to the labour court or tribunal, which was hitherto three
years.

 Where any Shops and Commercial Establishment or factory employs 20 or more

employees, it shall make the payment of minimum wages through bank account. This
amendment will bring transparency in paying minimum wages.

The Government of Maharashtra is also in the process of making changes in the existing
legislations. The government has proposed an overtime of 115 hours from the present 75 hours
for workers in small-scale industrial units. Among the notable changes, factories employing up
to 300 workers can be closed without government permission, compared with the earlier floor of
100 employees.

(k) Legalising fixed-term employment: In certain sectors namely footwear, leather and
accessories and apparel the central government has allowed businesses to offer fixed-term
contracts to workers. In other words, an establishment could sing on employees for a
specified duration under the assumption that their employment will be ended once the
project that they are hired for is finished. It is expected that this reform may address some of
the problems faced by companied in India, especially those that wish to expand or invest in
new plants. Currently, any investment or expansion decision is complicated by the fact that
new employees are technically for life. In the recent Union Budget the government had
announced that the system of fixed term employment will be expanded to all sectors in the
years to come.

16
 APPENDIX I

CASE STUDY: How Maruti Suzuki lost connect with its Workers

A day after workers at Maruti Suzuki's Manesar facility went on strike in June, 55-year-old MM
Singh, the company's head of manufacturing, was scheduled to address a meeting of the
company's functional heads of departments. "Hum apna connect kahaan kho gaya? Kya gadbad
hua? (how did we lose the connect with our workers? what went wrong?)," Singh said in his
opening remarks, in part question, part introspection.

Maruti Suzuki has enjoyed relatively good relations with its labour force. The last labour strike
was in 2000, at its other facility in Gurgaon. The image of the company in the minds of many
management personnel seems to have been that of one where the workers were happy. This
could have contributed to negative feedback from workers not trickling all the way up as
frequently or forcefully as it should have.

Part of the answers to Singh's introspective question might lie in measures he spearheaded at the
company a little over a year ago. In early-2010, coming out of the slowdown in car sales in 2008
and 2009, Maruti experienced a spurt in demand. While the company expected demand to rise, it
was not prepared for the sudden jump -- a 30% rise year-on-year -- in bookings.

Scenes in Maruti Suzuki factory, Manesar after workers unrest

17
What made the situation worse was that the company had not invested in manufacturing capacity
during the slowdown. The longer wait period for Maruti's models meant rivals started
cannibalising market share. "Losing market share due to lack of capacity can prove to be the
death knell for an auto company," Singh told Forbes India in an interview published in April this
year.

Singh and his team put in place a series of measures to produce more. This included more
frequent maintenance of machines, reprogramming robots that control the assembly line to
squeeze out efficiency, and implementation of a "flexi-line" that could produce multiple models.
Production zoomed.

Singh's measures saved Maruti the cost of a new assembly line -- Rs 1,700 crore. Its Manesar
plant, with an installed capacity of 250,000 cars a year then, started making 350,000 cars. To
ensure worker buy-in, their incentives were aligned to production.
In essence, Maruti stepped on the gas hard, responding to market realities. But life on the shop
floor took a turn for the worse. While production at its Gurgaon facility rose by 17%, Manesar
was pushed harder, with a 40% jump.

Young and Local Workforce

The highly automated plant at Manesar was inaugurated in February 2007. Later that year, in
December, Shinzo Nakanishi became the managing director of the firm, taking over from
Jagdish Khattar, a former bureaucrat who helmed the company for more than eight years.
Nakanishi, a nephew of Suzuki Motors chairman Osamu Suzuki, had been non-executive
chairman since 2002. But for the first time since 1983, the highest-ranking executive officer at
Maruti Suzuki was now Japanese.

According to a company spokesman, the Manesar plant draws its employees mostly from
Haryana, in particular from regions such as Jheend and Jhajjar. The plant has about 950 regular
workers, 400 trainees, 700 contract workers, and 400 apprentices.

A regular worker at Maruti could make up to Rs 25,000 per month in CTC (cost to company) in
his first year of employment (after three years of traineeship). About 50% of this is in the form of
performance incentives, including an attendance reward that amounts to 18% of CTC and has
become a contentious issue in the ongoing strike. Trainees make Rs 13,000-14,000. And a

18
contract worker, depending on his skills, anywhere from the minimum wage (Rs 4,644 in
Haryana) to Rs 12,000.

About 60% of Maruti workers are regular employees and the remaining are contract workers.
The minimum qualification to be a regular worker at Maruti is class ten and an Industrial
Training Institute diploma. The average age of workers at Manesar is under 25, while that at
Gurgaon is above 30. Very few workers at Manesar are married or have children, allowing them
greater staying power in a strike.

Most workers at Manesar worked their way through three years of traineeship at Maruti and
became regularised in 2010, entitling them to privileges trainees and contract workers don't
enjoy. It was a little after that the Singh-helmed acceleration of production seems to have
resulted in increased friction in labour relations.

The 7.5-Minute Tea Break

The strategic decision to squeeze out maximum possible efficiency from existing plants didn't
trickle down smoothly to the shop floor. Striking workers complain about abusive behaviour and
even instances of slapping by supervisors, charges the company denies. Workers say the
conditions at the Manesar plant were too stringent, while the management can't seem to
comprehend the difficulty as the Gurgaon plant has operated under identical conditions for more
than 25 years now.

In an eight-hour work shift, workers get a 30-minute lunch break and two 7.5-minute tea breaks,
according to the company spokesman. "You have to remove your safety equipment, run 150
metres to grab your tea and snack, and then run to the toilet that is about 400 metres away, and
be back in seven minutes," says Shiv Kumar, general secretary of the proposed Maruti Suzuki
Employees Union. "If you are a bit late, abuses from the supervisor. In the morning, the place
resembles a busy train station, with everyone grabbing tea and running to the toilet."

Kumar is a brooding, well-built 27-year old, with an intense air about him. He strikes a contrast
to the affable and lanky Sonu Gujjar, the president of the proposed union, who has become the
charismatic and savvy face of the agitation. Kumar says workers can't leave their workstation
even for a minute, supervisors sometimes deny permission for an additional toilet break, and
steep salary cuts are effected for even a day of absence from work.

19
The Maruti spokesman says the 7.5-minute break has been designed in a way that allows workers
just enough time to have tea, snack and use the restroom. Tea and snacks are laid out at 80 rest
areas adjacent to each work station, across the plant. "I'm not saying you will see anyone
strolling about during the tea break, but it is designed to be just sufficient," he says.

In the Gurgaon plant, the rushed break never seems to have been a problem. For more than 20
years, workers from Gurgaon used to be sent to Japan in batches of 60 each month to work in
Suzuki's plants for six months. More than 2,000 workers from the Gurgaon plant have worked in
Japanese factories fabled for the rigors of operations and processes. This practice was
discontinued before the Manesar plant went live, as India had managed to build world-class
industrial operations by then.

Another sticky point is the steep cuts in compensation effected for absenteeism. Workers quote
different figures -- Rs 1,200-1,500 -- as cuts for a day of leave, authorised or unauthorised. The
company spokesman says this impression is due to a misunderstood HR policy designed to
encourage 100% attendance. "For an employee whose attendance reward was Rs 2,000 per
month, each day of leave in a month reduced attendance reward by Rs 500 (25% of the
attendance reward) progressively. At three days of leave in a month, the attendance reward came
down to zero," he wrote in an emailed response.

Such cuts were subject to a cap of three leaves in a quarter. This meant if an employee took two
days of leave in a month, and didn't take any in the next two, the deducted salary would be
refunded at the end of the quarter. The company spokesman admits that the policy and it being
part of the performance-linked portion of the compensation was perhaps not adequately
explained to shop floor workers.

'Maruti is Our Company'

Many of these policies are dictated by the demands of the assembly line, where production halts
if even a single worker doesn't do his part in the specified time. There is little manoeuvring
room, and for this reason, all manufacturing firms place a premium on attendance. But such
policies tread a thin line between acceptability and outrage.

"Please understand sir, Maruti is our company. It is our family, it is our organisation," says Shiv
Kumar. "We want it to be the number one company always and we have given it our everything.

20
When they have asked for 100,000 cars, we have given them 120,000. But, the management
must also understand this: they cannot treat us badly and be vindictive."

It was issues such as these, and the alleged mistreatment, that led the Manesar workers to
demand a union to negotiate with the management. According to some accounts, the workers
first approached the office bearers of the Maruti Udyog Kamgar Union (MUKU), the Gurgaon-
based union recognised by the company as the union for all Maruti workers. The union took a
paternalistic view towards their younger colleagues from Manesar. They were told they were
young, they were new, and all this was par for the course.

This is where the divergence in accounts begin. Demands for a separate union seem to have
started towards end-2010 or early-2011. The company says it has "persuaded" the Manesar
workers to be part of the existing union and not form a new one. The workers say the company
first promised elections to the existing union in April and officials began warning workers
against forming a new union, a charge the company denies. Maruti chairman RC Bhargava was
unavailable for an interview last week.

In May, the company announced that elections to MUKU, with a proposed new chapter for
Manesar workers, would be held on July 18. (When this election eventually happened, Manesar
workers boycotted it, and a panel in the Gurgaon union that was seen as backed by the
management was thoroughly beaten by a rival panel.)

Manesar workers first struck work at 4 pm on June 4. Workers say the provocation was that
company officials were forcing workers to sign an affidavit stating they were happy to be with
the Gurgaon union and don't want a new one. The company spokesman denies this, and says the
provocation was that some workers were taking the signatures of others for the purpose of
forming a union and supervisors objected to it being done during work hours.

A day before, the workers had filed an application with the Haryana government labour
department to form a new union -- titled Maruti Suzuki Employees Union. On June 6, the
company summarily dismissed 11 workers for indiscipline and striking work. This included the
four office bearers of the proposed union. The strike went on till June 16, when the company
agreed to take back the 11 dismissed workers.

21
At this stage, the workers were being helped by the Gurudas Dasgupta-headed All India Trade
Union Congress (AITUC), a leftist trade union. "It is a positive development for the united trade
union movement," he told a newspaper reporter the day the first strike ended.

Enter the Trade Unions

The cautious statement masked what the strike represented for AITUC and the trade union
movement in general. Nearly 400,000 workers are employed by about 1,000 companies that form
the Gurgaon-Manesar-Dharuhera-Rewari auto hub. Trade unions have had a mixed track record
here. AITUC and the Hind Mazdoor Sabha (HMS) are the two most prominent trade unions in
this belt. The general perception is that AITUC, like other Left-aligned trade unions, has a
propensity for violence, while the HMS is more conciliatory.

AITUC leaders claim that HMS colludes with managements, while HMS leaders say violent
trade unionism ultimately hurts workers and claim their functioning is more progressive and
suited to the needs of the modern worker. It is no secret that most company managements view
HMS as the lesser evil.

In the months prior to applying to form a union, Maruti Suzuki's Manesar workers had grown
close to AITUC. They frequently sought advice from Suresh Gaur, the union leader at the
adjoining Honda Motorcycles plant, who rose to prominence during the violent strikes at that
facility in 2005.

That union is affiliated to AITUC, of which, Gaur is a district committee member. AITUC
helped the Manesar workers file the application with the Haryana labour department, its leaders
met with department officials along with the Maruti workers, and at one point during the strike,
Haryana chief minister Bhupinder Singh Hooda met with AITUC's Dasgupta.

But after the first strike ended on June 16, the Manesar workers, according to a AITUC leader,
"no longer remained in our grip". A number of trade unions were now "advising" the striking
workers. Sonu, Shiv Kumar et al, listened to everyone, but confided in none. This was an astute
move.

The union at Suzuki Powertrain India, which is based in the same Manesar campus and shares
the assembly line, is affiliated to HMS, as is the union of Suzuki Motorcycles a few kilometres

22
away. Too much proximity towards AITUC would have made it difficult to secure the support of
these workers.

Apart from HMS and AITUC, leaders of Central Industrial Trade Union (CITU), New Trade
Union Initiative (NTUI), and numerous other trade unions started advising the Manesar group.
This included Mazdoor Kranti Parishad general secretary Amitava Bhattacharya, a key figure in
the 2007 strike at Kolkata's Hindustan Motors as well as Mamata Banerjee's agitation against the
land acquisition for the Tata Nano factory at Singur.

Who had how much influence is hard to ascertain, but everyone agrees that different people
enjoyed the confidence of the Maruti workers at different points. Sonu and Shiv Kumar both
maintain they have remained independent and plan to do so in the foreseeable future.

After the first strike ended on June 16, Maruti went into damage control mode. It brought in
external trainers and the spiritual organisation Brahmakumaris to organise sessions with the
workers, where they were encouraged to speak about their problems. "A process of healing had
to begin, and it was clear from the amount of feedback we received from that exercise that we
had been somewhat cut off from how they were feeling," says a company official.

Tenuous Peace

But the peace didn't last long, and the reasons are contested. Company officials claim that the 11
reinstated workers started flouting all shop floor norms and interfered in the plant's functioning
by appointing their own representatives at each bay and asking workers to obey their orders
instead of company supervisors and managers. Sonu Gujjar denies this, asking this reporter
instead: "Do you think we could do that?"

Shiv Kumar says company officials started victimising workers and threatened false cases
against leaders. "Show-cause notices, pay cuts, what have you," he says. According to company
sources, through August, workers started adopting a go-slow policy. Production fell from 1,200
cars a day to 700; on two days at the end of August, to 400. On those days, only 95 cars passed
the quality check, and the company says workers were sabotaging the cars.

On August 29, the company locked the factory and demanded workers sign a 'good-conduct
bond'. The company terminated the services of 18 trainees; and 44 regular workers were either
suspended or fired for "sabotaging production and deliberately causing quality problems". The

23
problems included "improper clamping of vehicle doors leading to them falling apart during
production, cutting of wiring harness in manufactured cars and dents on the body", the company
said in a statement then.

When asked if company had CCTV footage or other evidence of workers indulging in sabotage,
the company spokesperson said such evidence has been handed over to the Haryana government.
A senior Haryana government official familiar with the negotiations at Maruti said the company
has indeed handed over photographs of company officials being manhandled by workers, but had
only handed over details of sabotage and not evidence. He wasn't aware if such evidence has
been given to other departments or the police.

Workers say the allegations of sabotage are fabricated to force the good-conduct bond upon
them. The bond is essentially a four-sentence statement that reiterates to the worker that the
company has the power to dismiss those found indulging in such activities as "go-slow,
intermittent stoppage of work, stay-in-strike, work-to-rule, sabotage..." as per the existing
provisions governing the factory.

The workers refused to sign. They sat outside the factory and started the second round of protests
that would last 33 days. During this period, the company hired contract workers, got its
supervisors to work on the shop floor, ushered in the 170 workers who signed the bond, and
started production.

The company made about 600 cars a day, about half of regular capacity. By the end of the
second strike, it managed to have about 1,000 workers staying in the factory full-time and churn
out about 800 cars a day. This gave the management the upper hand, and the striking workers
started to tire. Doubts started emerging from their midst if such a long strike was warranted.

Negotiations at this stage were made complex by the varied political influences on workers. "We
would make some headway, they would agree, one of them would go to the restroom, make a
call, come back and say, 'sorry we didn't agree to anything'. It was going nowhere," a person
familiar with negotiations said. Another person who was present at the negotiations representing
another side, corroborated this version of events.

By this time, deep resentment had set in, and workers were truly agitated. This meant that the
leaders advocating a moderate view came to be favoured less, and those with a more radical

24
approach began to be favoured. But representatives of different trade unions ET spoke with all
agreed that ultimately, the Manesar boys took their own decisions and nobody could claim to
have had their ears for an extended period.

The two sides reached an agreement on October 1, 2011. Workers would sign the good-conduct
bond, the 18 trainees would be reinstated, and among the 44 regular workers, those who were
dismissed would now only be suspended, and internal investigations would proceed against
them.

Plight of Contract Workers

The Haryana government official says they were sometimes frustrated by the management's
sudden moves and harsh approach. During the strike in June, while the labour department was
negotiating with the workers, the management went ahead and dismissed 11 people. "Sometimes
we felt they could be more lenient," he says..

But the company had been thrown into disarray by the strike. It was losing millions of dollars
each day and possibly critical market share at a time when rivals were launching small cars, such
as Honda's Brio and Hyundai's Eon. Besides, like Osamu Suzuki reminded everyone in Delhi, it
was not in the company's culture to tolerate indiscipline. "Not in Japan, not in India," he said.

When workers came back on October 3, 2011 the company took in 170 contract workers and
said the remaining would be taken back in phases as the plant scaled up gradually to capacity,
according to the spokesman. Workers viewed this as a move to victimise contract workers who
had participated in their strike.

They also term this as a violation of the October 1, 2011 agreement, even though all agreements
have been between the company and regular employees. The workers started demanding that all
contract workers and the 44 suspended workers be taken back. If the company can go back on its
word, we can renege on our terms as well, they say, even though the company hasn't technically
gone back on the agreement.

The plight of the contract workers have been a big factor in the ongoing agitation and the general
resurgence of trade union activity in the region. Maruti contracts workers through various labour
contractors and pay them as per the skills of the hired workers.

25
Workers are paid by contractors, not the company; other benefits, such as medical coverage, are
also incumbent upon the contractor. This could mean a contract worker doing the same work as a
regular employee on a Maruti assembly plant could make a third in compensation and be entitled
to no benefits.

The Maruti spokesman says the company ensures contract labourers hired by it are paid at least
the minimum wages. But this is done by asking the contractor to furnish proof and that makes it
easy for contractors to fudge. They often bill the company more than what they pay the labourer,
and pocket the difference, workers say.

This is not a Maruti-specific problem. Many auto companies and component makers function
with sometimes as much as 80% of their workforce as contract workers. This means less pay, no
benefits, no hassles brought on by the antiquated labour laws, and greater flexibility to adjust
production as per demand. This practice has spread in the auto hub and is causing a build-up of
resentment, union leaders say.

The workers of Maruti Suzuki's Manesar plant went on strike again on 7 October, 2011. This
time, they were joined by workers at the adjoining Suzuki Powertrain and Suzuki Motorcycles.
The strike at Suzuki Powertrain dealt a bodyblow to Suzuki's operations in India. It makes the
company's popular diesel engines and critical components of the petrol engine.

Within days, the disruption in the supply chain started choking production at the Gurgaon plant.
Maruti Suzuki had to completely stop production of popular models such as Swift and DZire,
just ahead of the Diwali festive season, when car sales soar each year. The gloom has spread to
the company's dealer network across the country, where festive shoppers are turning back due to
the long and now uncertain wait list.

The management worried for the safety of the factories as workers laid siege to them. Over the
weekend, the state administration pressed 4,000 cops into service and kept another 12,000 on
backup, as it moved in to shift the workers out of the plant following an order of the Punjab and
Haryana High Court.

Although the strike has now been declared illegal by the Haryana government, it has already
gone far beyond what anybody expected when workers first laid down tools at Manesar on June

26
4. For better or for worse, the company that ushered mass car ownership to India will never be
the same again.

Different treatment for ordinary workers and union bosses

On July 8th 2012, a fresh violence broke out in Maruti Suzuki’s manesar factory, which resulted
in the death of the plant’s HR General Manager, Mr. Awanish Kumar Dev. An investigation
carried out by Economic Times daily describes the reasons leading to this incident as follows:

In May 2012, the company suspended the workers' union president Ram Mehar Singh, accusing
him of manhandling a supervisor. While the union president and another union executive
committee member, Ram Bilas, who was also suspended in the same incident, were let off after
an oral apology, the company decided to launch disciplinary proceedings against an ordinary
worker, who faced similar charges. According to factory insiders, the tough stance of the
management against Jia Lal, an ordinary worker, in contrast to letting off leniently the union
heavyweights, had emboldened the workers. "It was clearly double standards of the company,"
says a Maruti worker, who was present at the scene of both incidents, involving the union office
bearers and the ordinary worker. "All the three employees were accused of manhandling their
supervisors, but the union office bearers were treated differently," says the worker, who
requested anonymity for fear of backlash from both the union and the management. The different
treatment for the same kind of offense has affected the morale of the Maruti worker.

Violence soon began, leaving a senior company executive dead and 96 more seriously injured.
As per Maruti's standing orders, which are applicable in all its labour disputes, the first step in a
labour indiscipline, is warning to the erring worker, followed by a chargesheet. Then the
employee is given a chance to prove innocence and if found guilty he/she could be suspended by
the company. And after due inquiry depending on the outcome he can be taken back into the
services or dismissed by the company. In Ram Mehar Singh's case, the workers allege that the
norms were overlooked, resulting in his re-induction into the company with an oral apology.
"Ordinary workers were treated differently from the union bosses. This created mistrust within
the workforce," says another Maruti worker, who asked not to be named.

According to Maruti Suzuki, the withdrawal of suspensions against the union president and
executive committee member was a "goodwill response". In a written statement, the company
told ET, "Two workers were suspended in May 2012. Subsequently, after discussions with the

27
Union and based on their verbal assurance, the suspensions were revoked. This was to give them
an opportunity towards building a positive and participative work environment, as a goodwill
response from the management." Maruti executives say that the suspension issue involving the
worker (Jia Lal) was also handled with a positive and supportive alternative of keeping the
‘suspension in abeyance’, till the next day. The workers however, chose to resort to barbaric
violence.

It is found that the company failed to maintain agreements signed with workers on the creation of
the Works Committee and the Grievance Committee, which was part of the October 19, 2011,
agreement. Both committees have not been formed yet. While the company may be right as the
workers' union did not want to allow alternative unions develop within Maruti, the formation of
these committees would have increased the trust of common workers who form the backbone of
its manufacturing operations.

The firm defended its role in implementing the agreements. "Except for these two pending
committees, all others that are part of the tripartite settlement have been sorted out," says a
Maruti spokesman. "MSIL management made its best efforts to convince the workers' union to
nominate their representatives, even requesting support from the District Labour Commissioner
Office, Gurgaon. But the workers representatives vehemently opposed the formation of the two
committees. We have even finalised and nominated management representatives on both the
committees," the spokesman says.

Sources: The Economic Times (Special Report), October 17, 2011; and “Maruti’s Leniency to
Union Bosses Reason for Rift Among Workers”, The Economic Times (Investigation), August 6,
2012.
**********

28
 Sources used for Preparing this Note
Aditya Bhattacharjea (2009): “The Effects of Employment Protection Legislation on Indian
Manufacturing,” Economic and Political Weekly, May 30.
Alakh N Sharma (2006): “Flexibility, Employment and Labour Market Reforms in India,”
Economic and Political Weekly, May 27.
Anwarul Hoda and Durgesh K. Rai (2015): Labour Regulations and Growth of
Manufacturing and Employment in India: Balancing Protection and Flexibility;
ICRIER Working Paper 298.
Anwarul Hoda and Durgesh K. Rai (2017): Labour Regulations in India: Improving the
Social Security Framework; ICRIER Working Paper 331.
Arup Mitra (2010): ‘India's competitive edge from low wages’, The Economic Times,
September16.
Badri Narayanan G (2005): “A Note on Labour Flexibility Debate in India”, Economic and
Political Weekly, September 24.
CNBC-TV18 (2009): “What's Causing the Labour Unrest in India?” October 21.
Haryana pushes for labour reforms, Assembly passes 4 Bills, The Times of India, March 30,
2016.
K.R. Shyam Sundar (2005): “Labour Flexibility Debate in India: A Comprehensive Review
and Some Suggestions”, Economic and Political Weekly, May 28-June 4.
Labour Reforms in Rajasthan, http://resurgent.rajasthan.gov.in/investing-in-rajasthan/labour-
reforms
Poonam Gupta, Rana Hasan and Utsav Kumar (2008): “What Constrains Indian
Manufacturing?” ICRIER Working Paper No.211, March.
President clears Madhya Pradesh labour reforms, Business Standard, November 25, 2015
Shyam Sundar (2015): Industrial Conflict in India in the Post-Reform Period Who Said All
Is Quiet on the Industrial Front?; Economic & Political Weekly, January 17.
Sunanda Sen, Byasdeb Dasgupta (2008): “Labour under Stress: Findings from a Survey,”
Economic and Political Weekly, January 19.
Sunil Kumar (2015): Rising tide of Labour Reforms in India;
http://www.manupatrafast.in/NewsletterArchives/listing/ILU%20RSP/2015/Oct/Rising%20t
ide%20of%20Labour%20Reforms%20in%20India.pdf
Supriya Roy Chowdhury (2004): “Globalisation and Labour”, Economic and Political Weekly,
January 3.
Recommended Readings
Maya John (2012): “Workers’ Discontent and Form of Trade Union Politics”, Economic and
Political Weekly, January 7.
Atulan Guha (2009): “Labour Market Flexibility: An Empirical Inquiry into Neoliberal
Propositions”, Economic and Political Weekly, May 9.

29
Kaushik Basu, Henrik Horn, Lisa Roman and Judith Shapiro (2003): “International Labor
Standards”, Blackwell Publishing Limited.

Video Link
1) India: 150 million workers on strike! (7.47 Minutes)
https://www.youtube.com/watch?v=2gcHZEohm4g
2) Truth vs Hype: Maruti - Trouble at the plant (20.15 Minutes)
http://www.ndtv.com/video/player/truth-vs-hype/truth-vs-hype-maruti-trouble-at-the-
plant/214402
3) Maruti's Manesar plant: The problems behind labour unrest (5.51 Minutes)
https://www.youtube.com/watch?v=vmSIYrkk2dE
4) Why Honda Workers Are on an Indefinite Hunger Strike at Jantar Mantar (8.05
Minutes)
https://www.youtube.com/watch?v=LXskgOBEhWg

30
India’s Services Economy – What lies ahead?
 Theme of the Session
Over the last two decades services sector has emerged as largest and
fastest growing sector of Indian economy. A growing ‘tertiarisation’
of structure of production and employment has been taking place in
India. While other sectors experienced phases of deceleration,
stagnation and growth, services sector has shown a uniform growth
trends overtime. A major part of decline in share of primary sector in
GDP was picked up by service sector. This is a unique feature
witnessed by India and has given rise to a debate whether a growth
model heavily based on service sector growth is sustainable. Many
observers have argued that in a low income economy like India a
larger share of services in GDP is unnatural. In this context this
session, after tracking the growth, causes and contribution of the
services growth for India’s economic progress, addresses deeply the
question of sustainability of the services-led growth. It also
explores the possibility of positioning India as ‘world’s services
provider’ like China has positioned it as ‘world’s factory’.
 Significance of Services Sector in World Economy

• Services sector has emerged as largest and fastest

growing sector in global economy

• The sector provides more than 60% of global output

and employment

• Share of services in world transactions has been

increasing

• Worldwide, FDI is shifting away from manufacturing

sector towards service sector – the sector accounted for
two thirds of global FDI stock in 2015

• In line with global trend, this sector has grown rapidly

in India, especially since 1990s
What Constitutes Services sector?

Trade, hotels & restaurant, real estate, business

& legal services, banking and insurance, public
administration, defence, transport, storage,
communication, community, social & personal
services (According to India’s National
Income Accounts)

Note: Services sector includes many segments,

not just IT-ITES.
Components of Some Individual services
• Trade: wholesale trade and retail trade in
commodities both produced at home and
imported, purchase and selling agents, brokers
and auctioneers

• Personal services: Domestic, laundry, beauty

shops, tailoring etc

• Communication: Postal, money orders,

telephones, overseas communication services
• Community services: Education, research,
scientific, medical, health, religious etc

• Dwelling & real estate: Services associated

with construction (building real estate on
contract basis, building design, interior design
etc)
 Classification of Services
Low Earning High Earning
• Repair & maintenance • Legal services
• Transport • IT/ITES
• Cobblers • Telecommunication services
• Shoe-shine • Financial & accountancy services
• Hair dressing • Customer relations management
• Dry cleaning • Health & educational services
• Construction, housing &
engineering
• Tourism, Retail, entertainment
and media
 Comments on High-earning services
• Development of such services create demand for low-
earning services

• Example: IT boom generated demand for transport

services, education, hair dressers, air-condition
mechanics, financial services, health services, courier
services etc

• For 1 job created in IT-ITES, 4 jobs are created in rest

of the economy in sectors such as commercial real
estate, physical security, transport, catering, hospitality
and mortgage banking industries
• The IT sector provides employment to low
skilled/educated workers as well.

• Nearly 75% of the workforce employed by the

major service providers to IT is SSC/HSC or
less educated (NASSCOM).
 Significance of Services Sector in India

• Currently the fastest growing sector of the

economy

• A growing ‘tertiarisation’ of structure of

production and employment has been taking
place in India.

• Since 1990s, services sector emerged as major

sector of economy both in terms of growth
rates and share in GDP
• While other sectors experienced phases of
deceleration, stagnation and growth, services sector
has shown a uniform growth trends overtime

• Among top 15 economies, in 2016, services Gross

Value Added (GVA) growth rate (at constant prices),
was highest in India at 7.8% followed by China at
7.4%.

• A major part of decline in share of primary sector in

GDP was picked up by service sector. This is a
unique feature witnessed by India (See Table below)
 Sectoral Growth of GDP/GVA (%)
Period Agriculture Industry Manufacturing Service sector
and allied
activities
1950-51 to 1979-80 2.16 5.36 5.21 4.55

1980-81 to 1991-92 2.97 6.10 5.58 6.20

1992-93 to 20012-13 2.88 6.71 7.25 8.63

2011-12 to 2017-18 2.34 7.00 7.40 8.00

GVA at Basic Price
(Base Year : 2011-12)
Source: Instructor's calculation based on Handbook of Statistics on Indian Economy
(HSIE), RBI
 Sectoral Composition of GDP (%)

Agriculture and Industry and

Year Allied Activities* Manufacturing** Services
1950-51 55 (48) 11 (9) 34
1960-61 51 (45) 13 (11) 36
1970-71 44 (39) 15 (13) 40
1980-81 38 (34) 17 (14) 45
1990-91 31 (29) 20 (15) 49
2000-01 24 (22) 20 (15) 56
2012-13 14 (12) 19 (15) 67

* Figures in brackets indicate the share of agriculture in GDP

** Figures in brackets indicate the share of manufacturing sector in GDP
Source: Handbook of Statistics on Indian Economy, RBI.
 Sectoral Composition of GVA (%)

Agriculture and Industry and

Year Allied Activities Manufacturing* Services

2011-12 19 23 (17) 59

2012-13 18 23 (17) 59

2013-14 18 23 (17) 60

2014-15 17 23 (17) 61

2015-16 15 23 (18) 62

2016-17 15 23 (18) 62

* Figures in brackets indicate the share of manufacturing sector in GDP

Source: Handbook of Statistics on Indian Economy, RBI.
 Sectors contributed to Services Boom in India
• IT-ITES
• Telecommunications
• Banking
• Civil aviation
• Real estate
• Health
• Education
• Trade, hotels and restaurants
• Transport
• Personal services
• Public administration
Significance of Services Sector for India

Some Data Presentation

 Sectoral shares in India's total employment: 1951 to 2009-10

1951 1961 1972-73 1983 1993-94 2004-05 2009-10

Agriculture 74.7 76.2 73.9 68.6 64.7 56.4 53.1

Manufacturing 10.1 10.7 11.3 13.8 14.8 18.8 21.5
Services 15.2 13.1 14.8 17.6 20.5 24.8 25.4
Output per worker(rupees per person at 1993-94 constant prices): 1983 to 09-10
Average annual rate of growth
1983 93-94 04-05 09-10 of output per worker between
1983 and 2009-10 (%)

Agriculture 12,488 14,962 14,994 15,198 0.9

Industry 36,048 51,951 60,665 63,981 2.3

Services 39,065 55,653 87,254 109,441 3.9

 India's Exports of services: 1990, 2008 & 2017
India’s share in world Exports of services as a %
services export of total exports

1990 0.6 21.6

2008 2.7 36.4
2017 3.47 37.9
Private final consumption expenditure on services in India
As a percentage of total private final consumption
Year expenditure
1950-51 12.5
1960-61 12.5
1970-71 14.6
1980-81 16.8
1990-91 20.9
1999-00 27.2
2008-09 41.1
2014-15 47.2
 Figure A.T. Kearney Global Services Location Index 2014
8

0
Indonesia
Mexico

USA
Brazil

Sri Lanka

Germany
China
India

Malaysia

Thailand
Financial Attractiveness People skills and availability Business environment Overall Index
ICT service exports (% of service exports)
Performance of India’s Services Sector: Some Indicators
 The Great ‘Manufacturing Vs Services’ Debate

“The view that everybody has to go through the same historical

sequence is wrong. The world today is different from what it was 50
years ago, there was no IT then, and there is no particular reason you
have to go through the same sequence. It may be that for India it is
appropriate to skip the manufacturing stage, that China may have a
comparative advantage in manufacturing. I'm not saying that's true, but
there is no a priori reason to stress manufacturing. We should ask what
the comparative advantages are, and, from a global perspective, whether
one can have sustained growth based on a service sector economy. The
answer is clearly yes. Can you have heavy exports related to services?
Again, the answer is yes.”

Winner of the 2001 Nobel prize for economics, Joseph Stiglitz, when asked
“Can a country of India's size develop without manufacturing being a
major contributor?”
 India’s position close to China in Services…..but far away in
manufacturing
Share in World Export of Manufacturing Products (%)

Country 1980 1990 2000 2007 2010 2016

China 0.8 1.9 4.7 11.9 14.8 20
India 0.5 0.5 0.7 1 1.4 2.0

Share in World Export of Commercial Services (%)

Country 1997 2000 2005 2007 2010 2016

China 1.87 2.04 2.99 3.70 4.6 4.3
India 0.68 1.08 2.24 2.73 3.3 3.4
Performance of Services Sector: International Comparison
 India Vs China
Factors contributing India’s success in Factors contributing to China’s
Services (IT-ITES sector as case)) success in Manufacturing
1. Well-trained, English-speaking & 1. Role of FDI
inexpensive specialists
2. Role by Chinese diaspora
2. Inexpensive overall package
3. Lack of protection for domestic industry
3. High quality standards
4. Critical role of TVEs
4. Population at working age is high
5. Export-led industrialization
5. Liberal economic policy environment
6. Higher labour productivity
6. Strong demand from industrial nations
7. Importance given to agriculture
7. Global network of Indian emigrants
8. Role of indigenous entrepreneurship
8. High income elasticity of demand for
services 9. Reform of PSUs
9. Spread of outsourcing model 10. Absence of land market
10. Protection to intellectual property 11. Cheap capital
11. Scalability – ability to handle large 12. “Trial and error” approach
projects
12. Easy option for new entreprenuers
Of these, China lacks
(1), (3), (4), (10) & (11)
 Policy Issues for Resolution
(A) In the light of what we have learned so far on industrial
sector, labour market, India Vs China comparison and services
sector, what should be the approach of India towards economic
growth?

Should India aspire for and build a robust manufacturing sector

like China, South Korea etc’
[OR]
Should India choose services-led growth path, i.e. positioning us
as ‘world’s services provider/back-office’ like China known as
‘world’s goods provider/factory’ (stand in support of Stiglitz view
above)

(B) Is India’s services sector-led growth sustainable ? Justify your

stand.
 TOPIC: Services Sector
India’s Services Economy

Theme of the Lecture:

During the last two decades services sector has emerged as largest and fastest growing sector of
Indian economy. A growing ‘tertiarisation’ of structure of production and employment has been
taking place in India. While other sectors experienced phases of deceleration, stagnation and
growth, services sector has shown a uniform growth trends overtime. A major part of decline in
share of primary sector in GDP was picked up by service sector. This is a unique feature
witnessed by India and has given rise to a debate whether a growth model heavily based on
service sector growth is sustainable. Many observers have argued that in a low income economy
like India a larger share of services in GDP is unnatural. In this context this lecture note, after
tracking the growth, causes and contribution of the services growth for India’s economic
progress, addresses deeply the question of sustainability of the services-led growth.

This lecture note was prepared by the Instructor (Sthanu R Nair, Indian Institute of Management
Kozhikode) for the sole purpose of student learning. It is nothing but proper arranging/ordering
of relevant parts from the sources indicated at the end of the note with data/photo additions.
Please do not circulate this note in any public platform or share to others without the Instructor’s
permission.

1 
 
1. Significance of Services Sector for India

Services sector has emerged as largest and fastest growing sector in global economy. The
sector provides more than 60% of global output and employment. Share of services in world
transactions has been increasing. Worldwide, FDI is shifting away from manufacturing sector
towards service sector. In line with global trend, this sector has grown rapidly in India, especially
since 1990s.

In the Indian context, according to National Income Accounts classification, services

sector consists of the following activities: Trade, hotels & restaurant, real estate, business & legal
services, banking and insurance, public administration, defence, transport, storage,
communication, community, social & personal services. In terms of income generation, services
activities can be broadly classified as low-earning and high earning activities. Some of the
examples of low-earning services activities are repair and maintenance services, local transport
services, cobblers, shoe-shine, catering, hair dressing and dry cleaning. Examples of high earning
services activities are legal services, IT/ITES, telecommunication services, financial &
accountancy services, customer relations management, health and educational services,
construction, housing and engineering and tourism, Retail, entertainment and media. The
significant point to be noted here is development of high-earning services sector can
automatically create demand for low-earning services. For example, IT boom in India has
generated demand for transport services, dry cleaning, hair dressers, air-condition mechanics,
courier services, physical security, catering etc

Currently services sector is the fastest growing sector of the Indian economy. A growing
‘tertiarisation’ of structure of production and employment has been taking place in India. Since
1990s, services sector emerged as major sector of economy both in terms of growth rates and
share in GDP. While other sectors experienced phases of deceleration, stagnation and growth,
services sector has shown a uniform growth trends overtime. A major part of decline in share of
primary sector in GDP was picked up by service sector. This is considered to be a unique feature
witnessed by India.

Growth pattern in services sector has not been uniform across all services. In post-1990s
business services (which includes IT), communications & banking sectors experienced
maximum growth. Growth of trade and communications increased consistently over the decades.

2 
 
In the first half of the current decade, majority of the service segments witnessed high growth.
This trend clearly indicates that apart from ITES (which comes under business services), many
other sectors have made credible contributions to the new found dynamism of the service sector
(See following Table).

Performance of India’s Services Sector: Some Indicators

In addition, services sector makes greater contribution to employment generation and

exports (See Tables 1 to 3 and following Figures). The most visible and well-known
dimension of the services boom in India has been in IT/ITES sector. Indian IT vendors focus
on (i) Software development, (ii) Software products and (iii) BPO. Currently India commands
55% of the global market for IT and BPO offshoring. IT software and services industry is now
India’s top exporter among all services. Net foreign exchange earnings of software services
industry have been highest among all services. For an excellent data presentation on various
aspects of computer software & ITES exports from India see
https://rbi.org.in/Scripts/BS_ViewBulletin.aspx?Id=16565

3 
 
 Table 1: Distribution of the workforce across economic sectors in India 2017 (%)
Agriculture Industry Services
2007 53.68 20.62 25.7
2008 53.16 20.72 26.13
2009 52.38 21.33 26.3
2010 51.52 21.81 26.68
2011 48.8 23.45 27.75
2012 47 24.36 28.64
2013 46.66 23.79 29.55
2014 45.52 23.94 30.54
2015 44.36 23.8 31.74
2016 43.44 23.72 32.84
2017 42.74 23.79 33.48
Source: World Bank (https://www.statista.com/statistics/271320/distribution-of-the-
workforce-across-economic-sectors-in-india/)

Table 2: India's Exports of services: 1990 & 2016

India’s share in Exports of services as a
world services export % of total exports
1990 0.6 21.6
2008 2.7 36.4
2016 3.4 37.9

Table 3: Export of Commercial Services (% share in world exports)

Country 1997 2000 2005 2007 2010 2014
India 0.68 1.08 2.24 2.73 3.3 4.1
China 1.87 2.04 2.99 3.7 4.6 6.2
Brazil 0.42 0.61 0.58 0.69 0.8 1
Europe* - - 34.33 33.77 30.6 26.2
USA 17.82 18.81 14.62 13.86 14 18.3
Japan 5.32 4.7 4.13 3.86 3.8 4.2
Canada 2.35 2.66 2.18 1.87 1.8 2.3
* Excluding intra-EU exports/trade
Source: International Trade Statistics, WTO (Various Issues)

4 
 
 Figure: Leading Exporters of Commercial Services
(annual % change)

Hong Kong, China
Netherlands
Spain
India
Japan
2013
China
France 2012
Germany
UK
USA
‐10 ‐5 0 5 10 15

Source: International Trade Statistics, 2008 (WTO)

Figure: ICT service exports (% of service exports)

5 
 
3. Explanations for the Boom in the Services Sector in India:

The factors contributing to the enormous success of the services sector in India can be
explained by referring to the case of India’s success in IT-ITES sector.

(a) Well-trained, English-speaking and inexpensive specialists – English has a key

role in IT-ITES as most customers come from Anglo-Saxon countries. Naturally, German,
Japanese and Spanish clients also appreciate service providers with respective language skills.
But these providers are not always available and often have only regional scope (Eastern Europe,
China, Latin America). According to A.T. Kearney Global Services Location Index India
occupies top position in financial attractiveness, and second position (after China) in people
skills and availability. Most importantly, Indian specialists work for much lower pay than their
US or European counterparts.

(b) Inexpensive overall package – Foreign clients do not, however, base their decisions
on pay alone. Their calculations are based on the total costs arising from a foreign venture.
Additional costs are incurred for telecommunications infrastructure, management and the
establishment of a workplace. Even factoring in all such additional costs, India offers most
inexpensive package compared to other offshore locations.

(c) High quality standards – High numbers of IT companies that are certified according
to internationally recognised quality standards (Six Sigma, CMM Level 5 and ISO 9000) are
from India. Of the software companies worldwide with a Capability Maturity Model (CMM)
Level 5 rating - highest rating that a software company can attain – majority are from India

(d) Population at working age is high - The current demographic status indicates that a
large percentage (almost 45%) of Indians are under 25 years of age. This pool of manpower, if
tapped correctly can sustain the cost advantage.

(e) Liberal economic policy environment

(f) Strong demand from industrial nations

(g) Global network of Indian emigrants - Indian expatriates in the US made a major
contribution. They established first contacts in order to seal international contracts and they
continue to cultivate these contacts. In India itself the managers are also often returnees with

6 
 
professional experience gained in the US. Example: 95% of international companies in STPs in
Bangalore are run by Indians who have lived and worked abroad, mostly in US

(h) High income elasticity of demand for services: That is as our income increases we
tend to spend a greater part of our income for the consumption of services than for food and
other manufactured goods (see following table).

Private final consumption expenditure on services in India

As a percentage of total private
Year final consumption expenditure

1950-51 12.5

1960-61 12.5

1970-71 14.6

1980-81 16.8

1990-91 20.9

1999-00 27.2

2008-09 41.1

2014-15 48.9

(i) Splintering (means Outsourcing) – Means contracting out business operations that
were done internally by individual firms. Splintering results in an increase in net input demand
for services from industrial sector. In their drive to becoming more competitive, manufacturing
units increasingly outsourced non-core functions such as accounting or payroll management,
security guards, drivers, canteen staff to other firms thus giving rise to a flourishing services
industry.

(j) Protection to intellectual property - Protection of intellectual property is of

particular importance in off-shoring. Offshore supplier gains detailed insight into the business
processes of his clients. In some cases the supplier has access to sensitive data or develops
software which is not meant to be available to unauthorised third parties/wrong hands. In this

7 
 
context, software piracy is a serious problem. According to estimates software piracy is low in
India.

(k) Scalability – ability to handle large projects – For example, Largest Chinese
companies in the IT-ITES sector namely Neusoft and VanceInfo has 20,000 and 14,111
employees respectively. In contrast, the employee strength of top three Indian players namely
TCS, Infosys and Wipro respectively are 385,809 (as on June 2017), 200,364 (as on March
2017) and 160,000.

The three largest Indian IT players have a share of over 46% in IT based Indian export
revenues. They grow faster and are more profitable than the smaller suppliers. In China, 3 largest
offshore software developers have a share of less than 15% in offshore market. Remaining share
is accounted for by a large number of smaller suppliers. This highly fragmented supplier
structure is a disadvantage as customers wish to have reliable, high-quality service providers –
these usually being large suppliers.

(l) Global IT revolution, which provided great opportunity for IT/ITES.

(m) Easy option – For many entrepreneurs, services are an easier segment to enter
because they usually require less physical infrastructure than industry and are subject to fewer
controls (e.g. restrictive labour policies not applicable). The profitability of sunrise sectors like
IT/ITES and telecommunications was vastly greater than that of older manufacturing industries,
like textiles or steel. The cost arbitrage between India and the markets that offered offshoring
contracts has been massive, and it has been routine for IT firms to enjoy a 30 per cent profit
margin on sales-a level unthinkable for manufacturing companies. In telecommunications, also,
even though the policy challenges have been substantive and repetitive, the arrival of mobile
telephony, vast untapped demand, and a sharp reduction in costs as the economies of scale have
kicked in, have allowed a profitability that has made access to capital easy.

One study compared the growth of industries that are more dependent upon
infrastructure, have greater financial needs, and are more labour intensive. They find that, in the
post-1991 period, companies that were above the median in terms of infrastructure intensiveness
grew 10 per cent less than those which were below the median; those which were above the
median in terms of labour intensiveness grew 19 per cent less than those which were below the
median. That is, the costs of poor infrastructure and rigid labour laws were significant

8 
 
differentiators. To the extent that services firms have lower infrastructure dependence, and
restrictive labour laws do not apply to them, they have been in a better position to grow than
their counterparts in the industrial sector.

(n) Demand-repression - Services sector is simply playing catch-up-decades of

repressed demand have created a huge market for services, ranging from telecoms to financial
services, from education to health services, and even transport. For instance, in the pre-
liberalisation period, telecom services were scarce; the transport network was rudimentary; and
financial services, for the most part, were confined to narrow urban elite.

4. Is the present growth pattern of services in India sustainable?

The answer seems to be yes, as will be argued below. As new service sectors get onto the
growth turnpike, more services will be added to the list of rapidly growing sectors in the
economy.

(a) Changing Consumption patterns: Till the liberalization of the early 1990s, the trend
in private final consumption expenditure was a straightforward one - the share of services in the
total consumption basket rose by around 3 percentage points each decade. However, the share of
services in private consumption has increased at a faster rate (up to 10 percentage points) after
1990-91 reforms. A shift in the consumption pattern of this nature indicates that the demand-
side impetus to growth in services will continue. Indeed, it will only get stronger (See Box 1).

Box 1: Rising Consumption of Services – A Story from Beauty Industry 

 
No jazzy music. No flashy lights. No waiting lounges stacked with magazines. Only single‐room ‘beauty 
parlours' where clients sat huddled awaiting their turn, while the ones getting the works done sat with 
their faces slathered in gooey pastes or hair pulled back into embarrassing knots with the others looking 
on. So much for discreet beauty treatments. The alternative was probably to walk into a five‐star hotel 

9 
 
and  get  services  done  at  their  posh  fragrant  salons  and  of  course  shell  out  a  lot  extra.  There  weren't 
enough mid‐level salons to bridge the gap between the two and that's when Veena thought of starting 
Naturals. The first salon came up on Khader Nawaz Khan Road in Chennai in 2000. “It was a way to keep 
myself occupied. At that point Chennai mostly had small parlours and many people weren't comfortable 
walking  into  a  big  hotel,  so  we  thought  a  salon  such  as  this  would  be  a  good  idea,”  says  Veena 
Kumaravel. 
“Initially funding was difficult. Even  banks wouldn't fund salons. It was a hassle those days to procure 
salon  equipment.  The  furniture  for  the  salon  was  imported  from  Italy.  It's  easier  now,”  says  Veena 
adding,  “We  broke  even  after  three  years  and  then  opened  our  second  salon  in  Anna  Nagar.”  More 
outlets  were  opened  across  the  city,  the  business  grew  bigger  and  required  more  help.  So,  Veena's 
husband C.K. Kumaravel, who already had his own business, joined her. And the fairytale continues as 
the salon has just launched its 128th outlet in the country. It is probably the only salon from Chennai to 
have such a wide presence. So far Naturals has branches in several cities in India. “We are also catering 
to smaller towns..... These are good markets for us as there is not much competition there. It is amazing 
how  beauty  conscious  people  are  these  days.  Television  has  penetrated  their  living  rooms  and  they 
aspire to be what they see on TV,” adds Kumaravel. 
The  couple  recalls  that  till  about  a  few  decades  ago  going  to  a  parlour  was  considered  taboo.  When 
Naturals  came  up  with  unisex  salons,  the  conservative  Chennaiite  wasn't  too  comfortable  with  it.  But 
gradually things began to change. And most men stopped going to ‘barber shops' and got introduced to 
the world of salons. Veena believes that this industry suffers from misnomers. “Earlier people thought 
that  those  who  were  not  academically  inclined  would  take  up  this  profession.  But  today  we  get 
graduates approaching us for training,” smiles Veena. 
Naturals  have  their  own  training  academies  in  T.  Nagar,  Coimbatore  and  Siliguri  and  shortly  plan  to 
open  in  Bengaluru  and  Hyderabad  as  well.  “By  opting  for  the  franchise  model  we  ensured  the  proper 
functioning of the salons because it was getting difficult for us to handle everything on our own,” she 
adds.  Most  of  the  franchisees  are  women  and  Veena  and  Kumaravel  are  happy  that  they  have 
empowered more than 600 women and provided about 15,000 jobs. 
Following the success of Naturals, the duo wanted to establish a high‐ end salon and in 2010 Page 3 was 
launched. “We tied up with Kerastase and Keraskin for treatments. This salon focuses on a different line 
of treatments and products altogether,” says Veena.  
What's next? “We're aiming at a pan‐Indian presence.”, they say. 

(b) Exports: Since liberalization began, India's services exports have increased 15-fold.
Exports of business services, mostly IT/ITES, have increased at over 25 per cent per year in the
past decade, a record unmatched anywhere in the world. As a result, while India's share in global
services export has reached 3.3% in 2015 against 1.6% in the case of manufacturing goods.
Services exports account for 38 per cent of India's total exports of goods and services.

Since the size of global software and BPO market was around US$ 385.3 and 24.6 billion
respectively, NASSCOM estimates that the addressable market is large enough to leave enough
headroom for growth for several years. Over time, a host of new service areas are also likely to

10 
 
grow. For instance, the USA stands to save over US$ 1.5 billion annually if only 10 per cent of
US patients choose to undergo medical treatment overseas for just 15 low-risk procedures. It has
been calculated that the scope for providing medical services in India for nationals of other
countries can be compared to what has been achieved in software services.

(c) The retail sector: As India's middle class has grown in both size and proportion,
retailing has grown from its tiny beginnings. India’s retail market is expected to increase on the
back of factors like rising incomes and lifestyle changes by middle class and increased digital
connectivity. India is expected to become the world’s fastest growing e-commerce market,
driven by robust investment in the sector and rapid increase in the number of internet users.

(d) Entertainment: Over the past few, the entertainment and media sector has grown
significantly and will continue to grow. Within this, animation and gaming are new phenomena,
emerging as a serious business just a few years ago. The Bollywood film industry is likely to
grow including tie-ups with Hollywood involving the co-production of films.

(e) International Financial Services: With India integrating into the global economy, the
two-way flow of money has involved from being not just payment for trade but also money
being invested in physical capital as well as in stocks and bonds. Moreover, with Indian firms
buying firms in other countries, there has also been an outflow of capital as well as substantial
fees paid for a variety of financial services. According to the Report of the High Powered Expert
Committee on Making Mumbai an International Financial Centre (MIFC), the best way to look
at this transition and its impact, is to look at the trade-to-GDP ratio to begin with. It has now
risen to around 40 per cent.

Based on the projected size of exports/Imports, FII and FDI inflows, the fees paid by
Indian firms to investment bankers overseas, etc., the MIFC projects the total external flows over
the next decade. It then works out what this means in terms of brokerage fees, currently paid to
financial firms located outside the country. Based on a weighted average paid to merchant
bankers for different services, MIFC calculates the total fees that India stands to gain if Mumbai
is to become an international financial centre. The estimate for 2015 was US$ 48 billion, based
on the medium-low projections of overall flows.

11 
 
 (f) Banking Sector:

The impact of the spread of banking on GDP growth is well established. It should be
remembered that this contribution took place when the vast majority of Indians remained
unbanked, For instance, National Sample Survey data reveal that over half the 45 million
farmers in the country have no access to credit, either informal or formal. And of these, just
around half have access to formal credit. All told, around three-quarters of farmers have no
access to formal credit.

Even in the case of the top-most income quartile, less than half of those who take loans
take them from the banking sector. This suggests that bank formalities may be too cumbersome,
or credit risk assessments too stringent for most people. Given that around half the loans taken
by those in the lowest income quartile are at interest rates of over 36 per cent per year, the scope
for growth in the banking sector is clearly large. Not surprisingly then, even the largest Indian
banks are quite small when compared on a global scale: only one bank, the State Bank of
India, figures in the top 100 global banks in terms of assets. Therefore, it can be safely asserted
that if greater financial inclusion is to be achieved, the growth of the banking sector, and its
contribution to GDP, will have to increase manifold.

Finally, as the exposure of Indians to other financial instruments (life insurance, mutual
funds, equity investments, microfinance) is limited, vast potential lies in these areas. Perhaps the
present situation will change due to the entry of aggressive players from the private sector.

(g) Education:

The education industry in India has been growing strongly with major contribution from
K-12 (pronounced "k twelve"/"k to twelve" is a designation for the sum of primary and
secondary education) and higher education segments. The Indian education industry is in its
development stage. The numbers of junior basic schools are highest in the country and there is a
strong need to set up higher secondary schools as well as colleges with a focus on IT education.
The Government has set up many ICT schools but still more than fifty percent of the market is
untapped which shows an opportunity for private players. In respect to the country's population
and number of students, trained teacher's ratio is low which emphasizes the need of training
institutes. The growing IT industry in India is driving IT education and has enhanced the need
for training market as well as enhanced teaching techniques. With over 50% of the population

12 
 
falling in the age group of 15-64 years, with a median age between 20-30 years, India presents an
attractive market for the higher education sector.

(h) Transport sector:

The rapidly expanding road network, with a proper system of national highways, has
speeded up truck movement by 50 per cent and more. The improved traffic and operating ratios
achieved by the railways, and the large investments planned for expanding the system (like the
dedicated freight corridors from the north to ports in the west and east) mean that there will be
active competition between road and rail. The new policies of the government like building of
new air ports in many parts of the country and expansion of air connectivity through UDAN
scheme could sustain the growth of civil aviation industry in the medium to long-term.

(i) Application of ICT in agriculture:

Thanks to telecommunication revolution, telecom and internet density has grown by leaps
and bounds because prices have been cut to the bone, with local and long distance calls costing a
tiny fraction of what they used to. A supporting role has been played by the steady drop in
handset prices. The result is that the scope for application of ICT has expanded in many areas
including agriculture sector. For instance, due to a a unique mobile agri-information service
provided by start-up company IFFCO Kisan Sanchar (IKSL) the yield of the famers has
improved significantly (see Box 1). The service allows farmers to connect in real time with
agriculture and veterinary experts, who provide ready solutions for most farm-based
problems. More than 8.5 million Indian farmers are now part of this agri-telephony network.
This example suggests that farmers in India need information, indeed on daily basis. Models
such as the one built by IKSL has just scratched the surface and there is a long way to go. Such
kind of technology platform can help in bringing awareness among farmers. When compared to
technology in agriculture in the advanced countries, we are still far behind. There, farmers pitch
their problems to companies and entrepreneurs and pay for the solutions. In the Indian context, it
is a huge opportunity waiting for entrepreneurs and companies. They can create a sustainable
business by taking ICT to millions of farmers in India.

13 
 
 Box 1: Dialling in for Better Farms, Crop and Profit 
B L Linge Gowda, a 58‐year‐old farmer in rural Karnataka, is a happy man. The quantity of crops grown 
on  his  fields  have  doubled,  his  cows  produce  more  milk  and  he  has  more  free  time  to  spend  with  his 
grandchildren.  This  turnaround  in  fortunes  came  in  after  Gowda  signed  on  to  a  unique  mobile  agri‐
information service provided by start‐up company IFFCO Kisan Sanchar (IKSL).  
The  service  allows  him  to  connect  in  real  time  with  agriculture  and  veterinary  experts,  who  provide 
ready solutions for most farm‐based problems. More than 8.5 million Indian farmers are now part of this 
agri‐telephony  network  launched  by  startup  company  IKSL,  a  joint  venture  between  Star  Global 
Resources, founded by entrepreneur Ranjan Sharma, mobile phone operator Airtel and Indian Farmers 
Fertiliser Co‐operative (IFFCO).  

 
Ranjan Sharma with a Farmer  
 
Sharma, who has over three decades of experience in the fertiliser industry, launched his own venture 
Star Global Resources in 2005. His idea was to use insights in farming gained during his career, to build a 
dedicated information service using mobile telephony as a medium. 
In a pilot project conducted at Barabanki in Uttar Pradesh in 2006, he assessed the information needs of 
farmers  and  began  sending  them  daily  messages  on  their  mobile  phones  on  subjects  ranging  from 
availability of power and seeds to tips on handling crop diseases, veterinary problems and solutions to 
increase the productivity.  
The  pilot  was  a  tremendous  success  and  he  found  that  the  farmers  were  indeed  interested  in  daily 
information. Buoyed by the success, he decided to team up with fertiliser giant IFFCO, which has nearly 
5.5 crore Indian farmers as its members through a network of 45,000 co‐operative societies, to spread 
this idea all over the country.  
This strong support from the farmer community has helped IKSL post profits from year one. “There is no 
dearth of agriculture‐related information in our various universities, Krishi Vigyan Kendras, Central and 
state research institutes,” says Sharma.  According to him, there is a wide gap between the knowledge 
farmers need and what they actually know.  
Quick  to  see  the  value  in  this  platform,  Bharti  Airtel  joined  the  JV  in  2008,  agreeing  to  buy  24% 
shareholding in IKSL at an enterprise value of 250 crore. As a result , Airtel has gained around 8.5 million 
new  customers  in  rural  areas  till  now,  said  Sharma.   “This  kind  of  strategy  is  significant  in  the  larger 
global context for the company” said an Airtel executive.  

14 
 
IKSL offers five voice messages every day in 12 languages across 19 telecom circles. Gowda has learnt 
rainwater harvesting techniques through this platform. “The messages are completely customised as per 
the region the farmer belongs to. In case the farmers do not understand the message, or have queries of 
any  kind,  they  can  call  the  toll  free  helpline  number  and  discuss  it  with  the  local  representative,” 
explained a senior manager for  content development at  IKSL. The company also conducts  weekly quiz 
programmes with questions focused on the subjects covered in the messages and gives farmers prizes, 
thereby assessing the receptiveness of the farmers. 
(j) Cultural goods:

Cultural goods and services are special goods which carry symbolic, aesthetic, artistic or
cultural value. The main components of trade in cultural goods are: Cultural and natural
heritage (e.g. pieces of historical, archaeological interest, antiques); performance and
celebration (e.g. music); visual arts and crafts (e.g. original sculptures, articles of jewellery in
gold or silver, articles in woven fabrics); books and press; audiovisual and interactive media
(e.g. cinematographic films and video games); design and creative services (e.g. architecture
plans and drawings).

In 2010, the UN General Assembly recognised the importance of culture for

sustainable development. Besides creating jobs and increasing turnover, exports of cultural
goods and services contribute to the dynamism of local economies. The movement of trade
liberalisation that started several decades ago has resulted in the extensive growth of
international trade. This was accompanied by a multiplication of trade agreements to enhance
national growth and development. In several cases, cultural goods and services were subject to
exemptions due to their specific nature.

In 2013, the global trade of cultural goods amounted to US$190.5 billion, representing

US$212.8 billion for exports and US$168.3 billion for imports. The value of world exports of
cultural goods almost double in 2013 compared to 2004, which was US$108.4 billion.
Interestingly, exports of cultural goods were less impacted by the economic and financial
crisis of 2008. From 2008 to 2009, exports of cultural goods decreased by 13.5% compared to a
decrease of 22.4% for the exports of total goods. Opening a country’s economy to international
trade in cultural goods and services could be a factor of economic growth. For example, over the
last 20 years China has enjoyed double-digit economic growth, and its role in exporting
cultural goods has become preponderant. Importantly, in this digital era, products can travel
physically but also virtually via the Internet.

15 
 
 According to UNESCO study titled The Globalisation of Cultural Trade: A shift in
consumption during the last ten years, India together with Turkey and Malaysia has emerged as
leading exporters of cultural goods and services. Currently, India is within the top 10
exporters (5th position. In 2004, India was in 8th position) of cultural goods and services. And
along with China, India is a net exporter of cultural goods. Interestingly, with the exception of
Mexico, all countries with a significantly high level of exports of cultural goods are in Asia, led
by China, then India, Malaysia and Thailand. Moreover, Asian countries have emerged as strong
exporters of cultural goods overtime. In 2004, South and East Asian countries (China, India and
Singapore) accounted for only 23% of exports of cultural goods within the top 10, which at the
time was dominated by Europe and North America, accounting for a share of 77% of total
exports. By 2013, the top 10 exporting countries were equally distributed among Asia and
Europe and North America, holding 49% and 51% of shares of cultural goods exports
respectively.
Top 20 exporters of cultural goods
Category India's China's
Rank (2013) Rank (2013)
Cultural and natural heritage 20 10
Performance and celebration - 3
Visual arts and crafts 3 1
Books and Press 15 4
Audiovisual and interactive media - 1
Design and creative services 10 6

India is third largest exporters of visual arts and crafts domain. Visual arts and crafts
made up most of the world trade in cultural goods from 2004 to 2013, growing by 185% over
this period. India also witnessed high exports of jewellery. Embroidery made of cotton or
manmade fibres belongs to one of the strongest cultural export sectors of India: handloom or
crafts in textiles. The United Arab Emirates, USA, China and a small number of other countries
such as Nigeria and Malaysia are the most important importer of Indian cultural goods. These
facts suggests with right set of policies India can develop additional sources of services sector
growth in the various cultural goods and services domain listed above, thereby create more jobs,
income and exports opportunities.

16 
 
5. Factors determining the sustainability of IT-ITES growth:

5.1. Moving up the value chain:

Traditional IT services – software and application development – represent lion’s share of

offshoring in India. Of the total IT export revenues only 20% come from high-value added
services such as engineering & R&D; off-shore product development and made-in-India
software products. This is due to various barriers such as high R&D and marketing costs, risk,
entry barriers (MNC dominance), and software piracy in domestic mkt. Hence, to maintain
leadership position, Indian IT industry will have to invest in innovation and in evolving newer
business models that can deliver greater value to the customers. Presently only 2-4% of total
spending of software companies in India is on R&D. Against this, internationally reputed
software firms spend 14-19%. However, in the near future, we seem to be in the ‘safety zone’
due to following facts:

 India attained competitive strength in offshore IT services with 65% share of the global
offshore market and 46% share of global BPO industry

 The scope for future expansion continues to be large as only 10% of potentially
addressable global IT/ITES market has been realized

However, the critical question that emerges in this context is: What would make India a
global leader in IT products segment as in the case of IT services? A combination of risk
capital, knowledge/entrepreneurship, ecosystem and government policy can pitch Indian
companies into leadership position in IT products (see Boxes 2 & 3).

(a) Government policy:

(i) Local start-ups should be provided the opportunity to compete on government

projects. For example, the US and Israel’s defence and high-tech industries offer some fresh
insights. The US has for long pursued programmes such as 8(A) and HUB Zone to harness the
innovative potential of the SMEs for military and economic strength. Federal agencies including
the department of defence and NIH set aside 2.8% of their annual research budgets for SMEs and
commercialisation of academic research. India’s ministry of defence’s new procurement policy
says that “prime contractors” should set aside a portion of their business for SMEs. If the policy
is strictly implemented, software product firms in the aerospace, machine system automation and

17 
 
controls can reap benefits. The ministry should not only protect public sector navratna
companies, but also ensure that private SMEs can benefit from set-offs of global tenders.

(ii) Government should apply more technology. Directly or indirectly, government will
be much bigger than the private sector. E-governance projects often explicitly rule out
involvement of local niche software players, even if the company has credible deployments.
Qualification criterion like independent revenue (not the company’s total revenue) is a difficult
hurdle to cross for many SMEs. Setting aside certain percentage of projects for Indian SME
product companies in e-governance projects is a must to encourage local innovation.

(b) Entrepreneurship: The approach of the entrepreneurs and investors to building

technology companies in India has been timid/nervous. Indian companies need to be alert about
grabbing opportunities as in the way start-ups like Tejas Networks have done. Once the collapse
of the World Trade Centre upset their business plan of targeting global markets, the start-up did a
quick turnaround and picked up business in India just the point when domestic demand started to
boom. Today 80-90% of India’s ethernet traffic for local area network goes to Tejas equipment
(See also Box 2).

Box 2: From Lobbying to Guiding – The Role of NASSCOM 
Industry body NASSCOM, best known for its role as lobbyist for the country's offshoring industry, is now 
seeking to recreate that success in nurturing emerging companies. It has launched a series of initiatives 
from  mentoring  services,  technology  events,  annual  listing  of  the  top‐50  software  product  firms  and 
launch  of  the  Rs.  60‐crore  Innovation  Fund  for  very  early  stage  investments  in  technology  firms  all 
aimed at catalysing the start‐up ecosystem in the country. 
For young start‐up companies, networking with other entrepreneurs, finding the right talent to hire, and 
closing deals with investors are crucial components in building a new company. Mentor groups are seen 
as enablers, who can lead the way in meeting these targets. One business account that we got from a 
NASSCOM recommendation is growing to thousands of dollars each year. Entrepreneurs expect to see 
more of an evangelizing role from NASSCOM as they grow start‐ups from revenue levels of $5 million to 
$100 million or more. 
Emerge 50, an annual ranking of software product firms by NASSCOM works as a funnel to showcase 
emerging technologies. By channelling its efforts on building software product capability, NASSCOM is 
aiming to ride the wave of innovation arising out of multiple triggers such as expansion of the mobile 
market,  launch  of  the  UID  project,  which  is  creating  a  market  for  new  tech‐enabled  services  and 
products, as well as new technological trends like cloud computing.  
Industry  watchers  say  entrepreneurship,  across  developed  markets,  has  benefited  from  sustained 
advocacy and policy support. This ranges from abolition of sales tax on e‐commerce transactions in the 
US to sustained policy support, which has created big telecom firms such as Huawei in China. If you go to 
the Silicon Valley, bigger firms such as Cisco have always taken interest in product firms.  

18 
 
Other  start‐ups  are  looking  to  apex  bodies  to  help  them  solve  problems  such  as  access  to  the  right 
talent. In India, most people are not willing to work for start‐ups (and instead choose to work in large 
MNCs). As a result, of that innovation created by Indians is happening in (such) large MNCs. IT bodies 
such as NASSCOM and other networks need to encourage the Indian talent to work in start‐ups. 
Accessing global markets is another area that start‐ups are seeking ecosystem support for. Start‐ups 
don't  have  marketing  budgets,  so  introduction  to  customers  by  networks  such  as  NASSCOM  provides 
visibility. Affordability is another issue that entrepreneurs face while engaging with networking groups. 
For instance, at elite networking events, bootstrapping entrepreneurs can find it difficult to pony up fees 
of  Rs.5,000  and  more  for  an  evening's  session.  It  is  exactly  such  issues  that  NASSCOM  attempts  to 
address. 
As the apex body now aims to be the wind in the sails of grass‐root entrepreneurs industry watchers say 
NASSCOM  must  enhance  its  inherent  advantages.  It  has  its  strength  in  terms  of  having  influence  on 
policies. They can help in building an affordable and intelligent ecosystem in which start‐ups can work 
smoothly with easier regulations. 

(c) Capital: Access to institutional finance is yet another area that needs to be addressed.
The number of VC and PE investments has grown substantially but the value of these funds are
small and their portfolio strategies limits their interest, investment and hence the development of
key technologies. Software product entrepreneurs should have easy access to collateral-free
funding. IP valuation for collateral is an accepted practice in all developed world and Indian
banks must be educated and encouraged to adopt the practice. Credible external benchmarking
can also help Indian software product companies to fortify their true claims and challenge the
competitors. Finally, angel investors should be free to open up their wallets even more. 13-14
deals in a year is low. We need every angel to do at least 5 deals.

(d) Ecosystem: A mature ecosystem, Sillicon Valley for instance, should be able to
generate start-ups in new areas every 10 to 15 years. We went through a cycle where failure was
not accepted and risk taking was an issue. We as a society were always focused on self reliance
and import substitution. If you look like product companies that are world leaders now,
Microsoft or Oracle, nobody paid attention to them in their first few years. And that was
important as you need time to privately evolve. In India, all that is getting developed now. There
is angel funding. Money is not a major issue now. We are starting to see a lot of experienced
people coming out and starting up ventures, especially from large MNCs.

Also, assembling talent from other sources takes time. We have to get that foundation
ready. Once we get going in the Sillicon Valley, we draw from a pool of talent from even giants
like Google, Yahoo and Microsoft. Don Valentine, the founder of Sequoia drew talent from
19 
 
Sillicon Velley (IBM and Xerox PARC). He was the original investor in Apple and then Cisco
and Google. Their foundational companies were IBM and Xerox.

Box 3: Higher Productivity will be a Dream Unless Mindset Changes 

 
Sridhar Vembu 
Indian IT industry is at a crossroads. The professional services model is no longer fuelling the growth it 
once did. Productivity, as measured by revenue per employee, has long been stagnant among Indian IT 
majors. 
The  leading  Indian  IT  powerhouses  bring  in  $45,000  per  employee  per  year  while  for  the  second‐and 
third‐tier  firms,  it  sinks  to  $30,000  per  year.  Compare  that  to  Google  and  Facebook,  which  make 
upwards  of  $1  million  per  employee  per  year  in  revenue,  and  enterprise  software  companies  like 
Oracle bring in $350,000 per employee per year. In Indian IT, these numbers are a distant dream. They 
don't have to be. 
Yet, higher productivity will remain a distant dream unless there is a wholesale cultural and mindset 
change. Google and Facebook are rewarded with high productivity because of their flexible cultures that 
empower  employees  and  their  intrinsic  risk  taking  attitude.  Indian  companies,  by  contrast,  have  very 
conservative top‐down corporate cultures. The services business model also encourages bloat, and the 
bloat becomes a core part of a culture. 
In  a  product  company,  all  our  incentives  are  aligned  to  use  people  as  efficiently  as  possible.  In  a 
services  business  model,  the  more  headcount  a  project  can  justify,  the  more  money  it  makes,  which 
makes it difficult for a project manager to use resources efficiently. 
At  Zoho,  we  resisted  the  easy  allure  of  the  services  business  in  our  early  days  (in  the  late  1990s), 
instead choosing to forge a path based on creating compelling products. It was a difficult path at first, 
because there just wasn't any expertise in building products in India and penetrating a market with new 
products is never easy. 
After a slow start, we have emerged as one of the leading software product companies coming out of 
India. Our productivity is not yet on par with our global peers, but it is still substantially ahead of Indian 
services companies. We have set ourselves the goal of reaching global productivity levels in the next 5 
years. 
How do we do it? It all comes down to culture. We turn every piece of received wisdom in Indian IT on 
its head. We do not care about certifications like CMM. Our recruitment model focuses on real ability 

20 
 
and  passion  than  on  degrees  and  paper  credentials.  We  are  proud  to  say  that  most  of  our  people 
actually were originally rejected by the major IT companies in India ‐‐ their loss was our gain. 
We  do  not  have  the  rigid  hierarchy,  endless  meetings,  and  a  slavish  devotion  to  process  that 
characterise the life of most IT professionals. Instead, we emphasise flexibility, adaptation and cultivate 
a  certain  disregard  for  authority  in  our  people  ‐  we  absolutely  prohibit  ancestor  worship  in  our 
company! Our promotions are based on demonstrated performance, not on the number of years spent 
doing it. It is not uncommon for relatively "junior" people in positions of authority in our firm. 
We do not force anyone to stay with us; we follow the same "at will" employment rule that is common 
in the US, meaning that anyone can leave us anytime, with absolutely no notice to us if they choose. Yet 
our attrition rate is among the lowest. That is not for lack of opportunity: our employees all know that 
their experience at Zoho is very valuable, but they voluntarily choose to stay because of the culture and 
opportunity. 
We  believe  the  path  ahead  for  Indian  IT  is  in  embracing  more  flexibility  and  innovation,  discarding 
ideas that may have worked in the past but no longer work in today's age. The path to productivity lies 
in empowering employees to reach their full human potential. 
Source: Authored by Sridhar Vembu. He is founder and CEO of Zoho Corporation.  Zoho is a software‐as‐
a‐service  (Saas)  provider  that  has  been  profitable  from  the  get‐go  and,  with  its  roughly  $400  million 
annual  revenues.  They  are  the  makers  of  the  online  Zoho  Office  Suite  as  well  as  several  business 
applications.  Sridhar  Vembu  has  been  in  the  news  not  only  for  creating  one  of  the  first  online  (Cloud 
Computing)  office  suites  as  a  company,  but  also  for  the  unique  staffing  practices  of  ZOHO  which  hires 
economically disadvantaged high school graduates and puts them through two years of education with a 
strong focus on engineering / software.  

According to Infosys Co-founder Kris Gopalakrishnan “It is not that we are nowhere in
the product sweepstakes. Look at two Kerala companies, IBS and SunTec, the former a global
IT product brand in the transportation and logistics domain, and the latter a reputed name in the
billing and payments area.” He is also bullish about Infosys' own banking product, Finacle. “It is
one of the top three core banking solution products in Europe, and across developing countries
and Asia-Pacific, and we have crossed $200 million in billings for Finacle in 2009-10. That is
3% of our business turnover and the products prospects are very good”. There are also product
solutions that are licensed to clients. “There are ‘point solutions', for instance, that are a boon to
many retailers. Often, there are operators who have multiple products and multiple vendors and
they seldom have a comprehensive supply chain visibility. We see some of these clients
becoming big over time, benefiting both of us”. Gopalakrishnan knows only too well the difficult
path for IT products to turn successful in the global arena. “Finacle is 23 years old”, he says,
making it almost as old as Infosys itself.

21 
 
 5.2. HR related challenges:

No economy, and more so one looking at rapid growth in its services sector, can grow
beyond a point if its population is largely illiterate, or semi-literate. Yet, this seems precisely
what India is managing to do. Despite very high primary school enrollment ratios, the level of
functional literacy achieved is low because of very high drop-out rates, and. the poor standards
achieved in most primary schools. India's track record when it comes to higher education -
especially in science and technology - is even worse. So far, the way out has been to privatize the
already largely privatized education system. Thus, India's largest IT/ITES firms virtually run
their own universities - that is, places where graduates of Indian schools and universities
are once again trained to meet the requirements of their current jobs. However, such firm-
level-and even industry-level solutions are at best stop-gap measures. If a more permanent
solution is not found, it could well slow India's progress on the services front.

The government has now set its mind to increasing public spending on education. There
is also a greater willingness to allow the private sector an expanded role, especially when it
comes to technical education and for public-private partnerships. All of this will improve supply,
as also (one hopes) quality.

5.3. Lack of focus on domestic IT market:

Indian IT industry is predominantly export oriented. But, domestic IT demand is

witnessing gradual change in India: from predominantly hardware driven towards a services
oriented. Liberalisation is the key driver of increased IT adoption in India. Significant IT
adoption was witnessed in telecom and banking sectors. Pressure of competition in sectors like
airlines, insurance, and manufacturing; and e-governance initiatives are expected to enhance
domestic demand for IT services in near future.

The following are the major reasons for the narrow base of the domestic IT-ITES market
in India as highlighted in a NASSCOM-IDC Study on the Domestic Services (IT-ITES) Market
Opportunity.

(i) Significant portion of domestic corporate IT spends lies in-house. In-house spending
on IT services accounts for more than half of corporate IT spend in India, while outsourced

22 
 
spends account for 45%. In-housing IT spending includes training costs, salaries of in-house IT
staff and associated overheads

(ii) Majority of CIOs felt that domestic customers were not a focus area for IT service
providers. Also, CIOs felt that IT service providers hardly offer Indian customers the kind of
commitment and expertise that they offer their global customers. CIOs believe that potential of
domestic IT market is still not appreciated by many of domestic IT services providers

(iii) The level of awareness about the potential of using IT as an enabler of competitive
advantage has been poor. The cost arbitrage continues to be less attractive justification for
outsourcing in India. Hence, IT companies need to clearly articulate value proposition of their
services and relate it to business benefits

(iv) CIOs are under pressure to justify IT investment by demonstrating value (competitive
advantage) delivered from IT investments. Higher expectations from IT require CIOs to move
from routine IT operations to strategic IT management. This means that they need to spend most
of their time and effort in day-to-day operations of IT solution. Here, IT services providers are
expected to play a key role in helping CIOs in streamlining their IT operations

(v) Apart from banking, financial services and telecom new verticals (manufacturing,
tourism, healthcare) need to be developed to expand IT services market in India.

(vi) Larger and mature IT users increasingly prefer end-to-end IT services. This will be a
major growth engine for domestic IT market.

5.4. Country-specific concentration of exports (USA & Europe):

Currently, India’s software services are concentrated majorly in the USA & Canada
market (61.7%). The remaining is shared between Europe (23.5%), Asia (8.4%), Australia and
New Zealand (3.4%) and the rest (3%). Efforts at expanding UK and European markets have
intensified in the past few years to avoid risk. But this market is still dominated by the U.S and
East Europe. Continental Europe is reluctant to engage with India due to language hurdle. IT
majors are also targeting Southeast and East Asia for more business (see Box 4).

23 
 
 BOX 4: Japan ramping up its interest in India’s IT talent pool 

Increasing protectionism in the U.S., combined with the trend of Western firms choosing to retain Indian 
talent locally, means that global opportunities for Indian IT professionals are getting squeezed. But even 
as the technology sun may be setting in the West, it could be rising in the East, with Japan ramping up its 
interest in India’s talent pool. 

Japan’s  shrinking  demographics  are  causing  a  rethink  of  the  country’s  notoriously  immigrant‐averse 
outlook. In 2016, only 9,80,000 babies  were born in Japan,  down from 2 million in 1975.  The working 
age population is predicted to decline from 77 million in 2015 to 67 million in 2030. Unsurprisingly, more 
than half the companies surveyed recently by Japan’s Ministry of Economy, Trade and Industry, say they 
have  an  interest  in  recruiting  from  overseas.  To  boost  skilled  immigration,  Tokyo  now  allows  foreign 
professionals to get permanent residency in Japan after living in the country for one to three years. 

Japan’s shortfall in talent in the IT sector is acute. The country already suffers a lacuna of 2,00,000 IT 
engineers,  which  is  expected  to  grow  to  8,00,000  by  2030.  India  is  a  fertile  hunting  ground  for  new 
talent. Yohei Shibasaki, CEO of Fourth Valley Concierge Corp, a headhunting firm based in Tokyo, says he 
has begun recruiting from 30 Indian universities, including the IITs. “Japan realises that the best talent 
is in India, but we cannot manage with English speakers,” he adds. As a result, only 20 of Japan’s top 
firms recruit from India. 

The  numbers  of  Indians  working  in  Japan  are  gradually  increasing.  About  8,000  of  the  23,000‐strong 
Indian diaspora here are IT professionals. But he admits that living as a foreigner in Japan continues to 
be onerous from having to file tax returns in Japanese, to an inheritance tax that applies on global assets 
even  for  people  who  have  only  worked  in  the  country  for  a  few  years.  Securing  housing  without  a 
guarantor, who is legally required to pay the rent if a tenant falls behind, is another obstacle. 

Some of these challenges have eased. In particular, a few Indian schools have opened in Tokyo. Housing 
with simpler rules for renting is also increasingly available, and areas with a preponderance of Indians, 
like  Nishikasai  in  eastern  Tokyo,  have  emerged.  But  V.  Sriram,  a  long‐term  Japan  resident  who 
established  Infosys’s  first  Japan  office  in  1997,  believes  the  crucial  issue  that  constrains  more 
immigration  from  India  is  the  difference  in  sensibility  and  work  culture.  In  Japan,  every  task  is 
considered equally important, big or small, he says, whereas Indians prioritize certain outcomes over 
others. There is little room in Japan for India’s famous improvisation. “The Japanese spend much more 
time testing for unlikely, random exceptions than Indians are used to.” 

Mr. Sriram thinks it works better for both Japanese firms and Indian professionals to collaborate in third 
markets like the U.S. rather than in Japan itself. “The expectation remains that others have to change 
to  fit  Japan  rather  than  Japan  changing  to  accommodate  them.”  Mr.  Shibasaki  however,  remains 
optimistic  and  points  out  that  Japan’s  foreign  labour  force  is  growing  by  about  20%  every  year.  His 
company has proposed the setting up of Japan Centres in select IITs to teach students Japanese and 
familiarise them with cultural niceties connected to food and dress. For Indian IT job seekers, learning 
to wield chopsticks and the correct way to bow could yield rich dividends. 

24 
 
 5.5. Metro-centered IT development:

In India, the growth of IT-ITES sector has been centered majorly around urban areas. The
spread of IT development beyond urban areas has been slow. As a result, in the metros IT
industry has been spending substantial amounts on transportation, power, communication and
security. All these add up to the total industry cost. Money saved on these fronts can be deployed
for more constructive projects and infrastructure creation in Tier II and Tier III cities.

But, off late things are slowly changing: India’s BPO delivery footprint had grown
beyond a few metros. Even well established players have opened their business centres in small
towns (see Box 5 for the case of Zoho Corporation). The implication of this is the need to
increase delivery centres which means creation of both social and physical infrastructure in the
Tier II and III cities.

Box 5: India’s Small‐town Coders – The Case of Zoho Corporation 
Mathalamparai  in  south  Tamil  Nadu  is  an  unusual  choice  for  a  global  software  development 
centre. Yet, it is not by chance that Sridhar Vembu (founder & CEO) chose the village near the temple 
town  of  Tenkasi  in  Tamil  Nadu  to  set  up  Zoho  Corp’s  eight  acre  campus.  It  was  from  here  that  the 
company’s  200  member  team  developed  and  launched  the  lucrative  and  popular  helpdesk  software 
Zoho Desk in 2016. 
In  the  process,  Zoho  has  provided  a  means  of  livelihood  to  rural  youth,  sparing  them  the 
ordeal  of  migrating  to  large  cities,  leaving  their  families  behind.  “If  you  look  at  the  smaller  towns  in 
India,  smart  people  just  have  to  leave  if  they  want  to  land  good  jobs,”  says  Vembu.  Part  of  Vembu’s 
critique of urbanisation is that it comes at crippling costs. He says “When you build gigantic cities, the 
cost of infrastructure shoots up. And I don’t mean just absolute costs, but also per capita costs. And it’s 
not just the cost of the building but also the cost of all the surrounding infrastructure.” “Never pay your 
landlord  exorbitantly,  instead  channel  that  [the  money  saved]  into  three  meals  a  day  for  your 
employees,” says Head of Engineering of the company. 
 

25 
 
  
Inside Zoho Corporation’s development centre at Tenkasi 
This conviction is Zoho’s premise and its Tenkasi facility is an affirmation of the same. Many of 
the employees there are from small towns in Tamil Nadu. Some even shifted base from Chennai so that 
they could be closer to their families in nearby towns. This comes with perks for the employer too. At 
Tenkasi  centre, Zoho has zero attrition. The fact  that employees  can  be  close  to their families is a  big 
draw that helps the company to retain local recruits. In Tenkasi town, two‐ and three‐bedroom flats are 
available  for  a  monthly  rent  of  a  few  thousand  rupees.  Some  employees  even  team  up  and  share  an 
apartment, making it all the more cost effective. And the pleasant commute to work, with paddy fields, 
hills and even waterfalls along the way, is an added perk. 
The cost benefits are passed on to customers. The company does not  nickel‐and‐dime them for 
its software. The idea is to always pass on the benefits of cloud software to the end users. The company 
also has Zoho University in the Tenkasi campus to train the young workforce. 

5.6. Growing global competition:

Competition from Pakistan, Bangladesh, Israel, Latin America, Ireland, Singapore,

China, Malaysia, Philippines, Eastern Europe, South America, South Africa, and Sri Lanka has
been increasing. The last 5 are aggressively competing for BPO space by offering a variety of
fiscal and other incentives. However, dominant Indian players are adopting a proactive approach.
They recruit experts from competitors (Pakistan, Bangladesh and China) and thereby expanding
their capacity.

According to Infosys co-founder Kris Gopalakrishnan it's no more a case of Indian IT

companies being seen as local companies with big turnovers, but global players in the true sense
of the word. According to him one can see a distinct trend of companies extending their
26 
 
footprints across the globe. And these are primarily because of two reasons: Firstly, there is the
need to support clients and their businesses in languages other than English, for which a single-
location operation will not suffice. And secondly, there is the need to take advantage of time-
zone differences. We are, after all, talking about 24X7 services and no company can afford to
offer any less in a globally competitive arena.

5.7. Persistent threat from anti-outsourcing lobby in USA:

Results in difficulty of securing right type and number of American visas. Hence,
handling political process in US will be important. However, Cognizant CEO Francisco D’Souza
says the recent protectionist measures by USA cannot be treated as rhetoric. He thinks there
are some real pressures in the US right now because of high unemployment rate (10%). To him,
the discussion needs to go back to what is the alternative question. Because the challenge we
have in the US is that while unemployment is at 10%, the IT unemployment is very low. The
reality is that US is not producing scientists and engineers at the rate that the industry
needs. So, it’s a real problem for US companies. To compete in the US companies in the world
is becoming more technology intensive. He thinks the recent restricting on granting H-IB visa to
Indian IT professionals was unfortunate because sufficient debate didn’t happen around the
broad implications of such a move when it comes to competitiveness of companies inside the
US. It’s in everyone’s interest for the economies of the world to recover, and the fastest way to
achieve this is by making the companies healthy. He thinks it’s very dangerous when you try to
hold back a key pool that companies need in order to be competitive: which is talent. Many
companies are responding to the backlash by announcing more local hiring in the US.

Sources used for Preparing this Note

1. World Development Report (2004): Making services work for Poor People, World Bank.

2. “Zoho’s small-town coders”, Forbes India, November 24, 2017.

3. Pallavi Aiyar (2017): Rise of the technology sun in the East, The Hindu, December 3

4. UNESCO (2016): The Globalisation of Cultural Trade: A Shift in Cultural

Consumption–International flows of cultural goods and services 2004-2013.

5. Sunil Mani (2014): Emergence of India as the World Leader in Computer and
Information Services, Economic and Political Weekly, December 6.

27 
 
 6. Sunil Jain and T.N. Ninan (2010): “Servicing India’s GDP Growth” in India’s Economy:
Performance and Challenges – Essays in Honour of Montek Singh Ahluwalia. Edited by
Shankar Acharya and Rakesh Mohan, Oxford University Press.

7. Deutsche Bank Research (2005): “Outsourcing to India: Crouching tiger set to pounce.”
October 25.

8. Deutsche Bank Research (2009): “Offshoring to China: From Workbench to

Backoffice?” January 13.

9. Rashmi Banga and Bishwanath Goldar (2007): “Contribution of Services to Output

Growth and Productivity in Indian Manufacturing Pre- and Post-Reforms”, Economic
and Political Weekly, June 30.

10. Rashmi Banga (2005): “Critical Issues in India’s Service-led Growth”, Working Paper
No.171, Indian Council for Research on International Economic Relations.

11. Seema Joshi (2004): “Tertiary Sector-Driven Growth in India: Impact on Employment
and Poverty”, Economic and Political Weekly, September 11.

12. The Economic Times, 12 November 2010

13. The Economic Times dated 14 February 2012.

14. The Economic Times, October 12, 2012.

15. The Economic Times, 7 January 2011

16. James Gordon and Poonam Gupta (2004): “Understanding India’s Services Revolution”,
IMF Working Paper (No. WP/04/171).

17. Dipak Mazumdar, Sandip Sarkar (2007): “Growth of Employment and Earnings in
Tertiary Sector, 1983-2000,” Economic and Political Weekly, March 17.

18. Government of India (2008): “Report of the High Level Group on Services Sector”,
Planning Commission, New Delhi

19. “Key Highlights of the NASSCOM-IDC Study on the Domestic Services (IT-ITES)
Market Opportunity” (http://www.nasscom.in/upload/5216/Domestic%20Services.doc)

20. “The Marketing Whitebook 2010-11”, Business Standard.

21. Rupa Chanda and Sasidaran G. (2007): “GATS and Developments in India’s Services
Sector”, in India’s Liberalisation Experience: Hostage to the WTO? Edited by Suparna
Karmakar, Rajiv Kumar and Bibek Debroy. New Delhi: Sage Publications India Pvt. Ltd.

28 
 
 Recommended Readings
Ejaz Ghani (2010): The Service Revolution in South Asia; Oxford University Press
S. Ramadorai (2011): “Towards Tomorrows India: The Future of Healthcare”, in The TCS
Story … and beyond; Penguin Books India.
Government of India (2008): “Report of the High Level Group on Services Sector”, Planning
Commission, New Delhi.
‘Now, salon owners are not just hairdressers, but entrepreneurs’, Interview with Groom India
MD, The Hindu, 6 Dec 2017.
Also see the readings uploaded in Virtual Classroom.

29 
 
Scanned with CamScanner
Macro policy instrument:
Fiscal Policy
 What is Fiscal Policy?
• Govt. decisions about the level of taxation and
public spending are called Fiscal Policy (FP).

• FP is more than just simple budgeting

• Choices about how much to spend, how to spend it,

and how to raise the necessary funds can have dramatic
impacts on the economy
 Objectives of Fiscal Policy

1. Maintaining macroeconomic balance (i.e. containing

inflation, preserving healthy external
position/balances, maintaining debt sustainability)

2. Providing room for counter cyclical policy measures

3. Supporting private investment and promoting savings

4. Striving for inter-generational equity

 How Fiscal policy affects the economy?
• Fiscal policy affects the economy by influencing (i.e.
increasing or decreasing) aggregate demand (AD).

• From earlier discussion we know that

AD = C + I + G + NX

• Shifts in AD curve translate into higher or lower output

and price levels throughout the economy.

• FP affects AD through two channels: government

spending and tax policy.
 Fiscal policy channel: Government spending

• Government spending affects “G” in the AD equation.

• An increase in govt. spending will generally shift AD

curve out (to the right) and vice versa. Why?

• Govt. spending can have indirect effects on the “C”

and “I” components of AD

• The effect of G on C and I come through mechanisms

called the multiplier effect (discussed earlier) and
crowding out (discussed below).
 Fiscal policy channel: Tax policy
• Govt. takes some money in taxes, before we get a paycheck

• Our consumption therefore depends on disposable income

(i.e. what’s left after taxes) rather than on total income.

• If the tax rate increases, workers will take home less

disposable income, and we can expect them to reduce their
consumption. As a result, the AD curve will shift in (to the
left).

• The opposite effect will occur if the tax rate decreases.

• Thus, tax policy channel of fiscal policy affects AD directly

through consumption (C) part of AD equation.
 Expansionary Vs Contractionary Fiscal Policy
• Expansionary FP describes the overall effect of
decisions about govt. spending and taxation
intended to increase AD

• Increased govt. spending & lower taxes have

expansionary effects

• They shift AD curve to the right

• Contractionary FP describes the opposite and

will have the opposite effect.
 How govt. spending/fiscal policy counteract effects of
negative demand shocks?

• Suppose there is an economic slowdown

• This would shift the AD curve to the left (see figure in

next slide)

• The decrease in AD causes the economy to produce

below its level of potential output

• The result was lower GDP (output), prices and higher

unemployment
 Housing-market crash
Price level
LRAS

SRAS

P1
E1
P2 E2

AD 1

AD 2

Y2 Y1 Output
• If nothing else happened, the economy would have
automatically corrected itself-eventually

• Wages would have fallen in response to

unemployment, and lower production costs would
bring other prices down

• This response would cause short-run aggregate supply

curve to shift to the right until the economy returned
to its original level of potential output level at Y1

• In the long run, output would have recovered to its

previous level, with lower overall prices in the
economy
• Why didn’t govt. & policy makers simply wait for this to
happen?

• Because it could have been a painful and very slow

process.

• The wage rate would have had to fall along with other
prices.

• However, this might not happen quickly (due to sticky

nature of the wages)

• When businesses fail and people lose their jobs, they

want their government to do something about it.
• They don't want just to hear that the economy will work
the problems out if they wait long enough.

• As economist John Maynard Keynes once said, "In the

long run, we are all dead.”

• The govt. can try to boost demand, either by spending

more or taxing less, called expansionary policy response

• This kind of expansionary policy is often called

"Keynesian," in recognition of John Maynard Keynes,
who championed the strategy after the Great
Depression of the 1930s.
• The challenge is finding the dosage of fiscal policy that
restores aggregate demand to its prerecession level

• A completely successful stimulus plan would shift the AD

curve all the way back from AD2 to its original position,
AD1 (see figure in next slide)

• If the stimulus is only partly successful, then it would

move the curve only part of the way back, from AD2 to
AD3

• Even a partially successful stimulus may be better than

nothing since it pushes the economy toward a better
outcome (and economy can continue adjusting toward
the long-run equilibrium over time)
 Government stimulus
Price level
LRAS

SRAS

P3 E3
P2
E2
AD 1
AD 3
AD 2

Y2 Y3 Output
• What should govt. do when economy is growing too quickly?

• People are often happy when economy is booming, but govt.

policy-makers worry that big booms can get out of hand

• Implementing contractionary fiscal policy to slow down

economy is a lot like shutting down a raging party because
you are worried that the guests might regret their choices in
the morning!

• It can be the smart thing to do, even though there will be

plenty of grumbling.

• Contractionary fiscal policy slows down economy by cutting

govt. spending or increasing taxes, shifting AD curve back in
to the left.
 Economy overheats from too much AD Contractionary fiscal policy lowers prices and output
Price level Price level
LRAS LRAS

SRAS SRAS
P2 P2
P3
P1 AD 2 AD 2

AD 3
AD 1
AD 1
Y1 Y2 Output
Y3 Y2 Output

• The government can spend less or tax more.

• The contractionary policy decreases aggregate demand.
• Output and price levels decrease.
 Limitations of Fiscal Policy
• Though increasing direct government spending
has a larger multiplier effect on output than a
similarly costly reduction in taxes (discussed
below), it doesn’t work that simple.

• In the real world, things are more complicated.

• The following are some of the major limitations

of fiscal policy as a policy tool.
1. Crowding out effect:
• Govt. spending can crowd out (i.e., reduce) private-
sector spending
• Crowding out happens when the govt. has to
borrow in order to finance the extra spending.
• The govt.'s borrowing tends to push interest rates
upward, which then can decrease borrowing &
investment by the private sector.
• The decrease in private investment undermines the
positive impact of govt. spending.
2. Ricardian equivalence:
• Govt.’s often cut taxes in response to recessions
• The idea is that people will spend more money when
they have more cash in their hands
• That spending, in turn, will raise business profits, create
jobs, and help the economy recover
• But tax cuts don't come for free. Govt. will eventually
have to find a way to make up for lost tax revenue
• That means either cutting an equivalent amount of govt
spending or, more frequently, raising taxes in the future
to pay for debt incurred today
• What happens if people see that today's tax cuts just
mean higher taxes tomorrow?
• In that case, people won't want to spend as much
from their tax cuts (i.e. MPC will be less), and stimulus
strategy will be less effective.
• This theory is known as Ricardian equivalence
(developed by David Ricardo).
• This theory predicts that if govs cut taxes but not
increase spending, people will not change their
behavior.
• Because people realize that govt will have to borrow
money to cover financial shortfall created by cutting
taxes
• They realize that at some point in the future, they-or
their children or grandchildren-will eventually have to
repay the extra govt. debt through future tax increases

• Because taxpayers realize that debt will eventually have

to be repaid through future taxes, today's tax cut will
feel more like a loan than a real windfall

• According to Ricardian equivalence theory, rational

people would save what they receive rather than spend
to meet financial obligation of future taxes

• But if people save rather than spend, consumption does

not increase, and tax cut will be unsuccessful in
increasing aggregate demand
3. Time lags:

• There are time lags between when policies are chosen

and when they are implemented

• This means that sometimes it is too late to do any

good.

• Lags in the policy-making process come from three

main sources. They are

(a) Information lag

(b) Formulation lag

(c) Implementation lag

• These three lags in the policy process make
conducting good fiscal policy a tough endeavor

• In fact, the lags may be so large that by the time the

policy takes effect, the economy might have corrected
itself, making the policy unnecessary
(a) Information lag

• Describes time lag involved in understanding what the

current economic situation is (e.g. COVID-19 induced
slowdown).

• It might seem pretty clear that the economy is in a

recession or boom

• But it can take a long time to collect data that tell

policy-makers about GDP, unemployment, and inflation

• GDP figures, for example, are released every three

months, and they report on economic activity that was
happening three or four weeks before.
• These early numbers aren't always accurate, so it may
be six months or more before the true figures are
known

• Three to six months is a short time to register a trend

in the overall economy.

• For instance, it took an entire year's worth of data to

trigger the announcement by the National Bureau of
Economic Research that the U.S. economy was in a
recession in 2008.

• By then, the economy had lost over 1 million jobs

• Just as it takes time to find out how bad things
are, it also takes time to find out if the economy
has reached the end of a recession

• There will be news reports of companies hiring

more workers, but it can take months to
discover if this has translated into real gains for
the economy

• In both cases, policy-makers have to make

important decisions for future, but they only
know where economy was a few months ago
(b) Formulation lag

• Describes the time it takes to decide on and pass legislation

• A policy needs to be drafted and proposed in legislature,

where it becomes a bill

• The bill needs to be debated in the legislature before getting

approved

• Note: This lag occurs only if the govt. attempts to introduce

a stimulus package through a legislation (e.g. American
Recovery and Reinvestment Act of 2009 – a stimulus plan
implemented in US to fight 2006-2007 economic slowdown)
(c) Implementation lag

• Refers to the time it takes for a policy to get

implemented.

• Even after a policy has been proposed and passed, it

may take time for it to take effect.

• It takes time for funds to be disbursed, employees

hired, and materials purchased.

• Even tax cuts can take some time to kick in (because it

takes time for people to spend money)
Fiscal Policy & Public Debt
Expenditure Classifications of Govt.
 Salaries, purchase
Consumption “Current/Revenue”
of goods & services
Expen. expenditure
for current use
(or)
Interest payments; “Current” account
Current Transfer Grants to states, local
Payments govts, & non-profit
institutions; Subsidies;
Pensions

DIRECT: Fixed CF (buildings,

public work etc.) & Increase “Capital” expenditure
Capital formation in work stores (or)
/Investment “Capital” account
INDIRECT: Grants for CF; In
vestments in shares of govt. con-
cerns; & Loans for CF (to states
etc.)
• Revenue Expenditure – Refers to expenditure incurred
on day-to-day functioning of govt. Includes salaries,
purchase of goods & services for current use, interest
payments; grants to states, local govts., & non-profit
institutions; subsidies; and pensions. In general
revenue expenditure do not entail creation of assets.

• Capital Expenditure - Expenditure incurred on any

asset creation. Includes fixed capital formation
(buildings, public work etc.), grants for capital
formation, investments in shares of govt. concerns; &
loans for capital formation (to states etc.)
Receipts of Government
 Tax Direct: Mainly corporate tax;
Revenue Income Tax
Revenue
Receipts
(Current earnings) Indirect: Mainly customs duty;
GST; stamp duty
Non-tax
Revenue
User charges on public services
interest receipts; dividends &
profits from PSUs; grants

Capital Public debt or loans;

Receipts recovery of loans; selling shares in a PSU
(Long-term earnings) (divestment)
 Budgetary Imbalances
• When govts. revenue expenditure exceeds
revenue receipts it results in a deficit in revenue
account of govt. budget. This is called revenue
deficit (RD)

RD = Revenue Expenditure – Revenue Receipts

• When there is a revenue deficit, naturally, the

govt. has to resort to borrowing
• The borrowed money need to be repaid with
interest. For this to happen, following are the
requirements:
(a) Additional revenue should be generated (or)
(b) Reduce current expenditure (or)
(c) Use borrowed money for productive purpose so
that it can yield a return to repay debts
• Use of borrowed funds towards creation of
capital assets can help generating revenues in
two ways.

➢First, productive assets lead to greater growth,

which in turn generates the buoyancy in tax
revenues.
➢Second, user charges (if collected
appropriately) on the newly created assets
generate non-tax revenues.
• If none of the above occurs either fully or partially,
there will be a revenue shortfall to fully meet debt
repayment obligation

• In this case further debt has to be incurred to meet debt

repayment obligation

• If again govt. fails to meet one of the aforementioned

three conditions, it lands up in debt trap (a situation
wherein govt. needs to borrow to repay old debts)

• The gravity of this situation can be understood with the

measure Fiscal Deficit (FD)
• FD = Total expenditure – (Revenue Receipts + Non-debt
capital receipts)

In short, FD represents excess of government expenditure

over ‘non-borrowed receipts’ or total borrowing of
government
• When govt. attempts to influence the economy by
increasing its expenditure, it may lead to a situation
wherein the amount of money a govt. spends goes beyond
the govt’s revenue.
• This scenario is known as budget deficit or high FD.
• Recessions tend to increase FD as during a recession, govt.
spending often increases as part of an expansionary fiscal
policy, while revenue tend to decrease because people are
earning and spending less.
 What is the problem with high FD?
• Crowding out effect: Crowds out private
investment by increasing cost of debt funds (i.e.
interest rates)

• May lead to inflation if FD is financed by way of

deficit financing (i.e. printing currencies). This
happens when output cannot not easily be
increased to meet increased demand arising out
of increased money supply

• Increases interest burden of the govt.

 How does govt. borrow money?
• Govt. borrows money from people by selling
Treasury/Govt. securities (Treasuries/G-Sec).
• Basic idea is that govt. accepts money from people with
an obligation to pay them back by a certain date
• There are two types of Treasuries: Short and Long-term
• Short-term treasuries are short-term promises that the
govt. will pay back money after three months to one
year (Called Treasury Bill – T-Bill).
• Long-term treasuries operate on much longer time
frames (more than a year) (called Govt. bond or dated
securities)
 Short-term Treasuries
• The shortest-term Treasury securities are Treasury bills, also
known as T-bills.

• When an investor (in financial assets) buys a T-bill, they are

buying a promise that the govt. will pay them a set amount of
money on a fixed date - for example, Rs. 1,000 (face or
nominal value), three months or an year from the date of
investment.

• Investors bid for T-bills when they are issued, so depending on

the state of market for T-bills, they might pay, say, only Rs. 990
(at a discount) for this particular promise.

• The Rs. 10 difference is equivalent of interest earned on a

savings account.
• The return on these loans is usually quite low,
but they are liquid (investors money is tied up
in the bond for less than a year)

• Most important, investors consider them to be

very safe, and they thus appeal as a place to
securely park money.

• Based on maturity of T-Bills, in India they can

be classified into 3 types: 91-day TBs, 182-day
TBs and 364-day TBs
 Long-term Treasuries
• For longer-term investments, the govt. issues Treasury notes
(T-notes) or Govt. bonds in 2-, 3-, 5-, 7-, and 10-year
increments.

• For those who are even more patient, the govt. offers its
longest-term option: Treasury bonds mature in 30 years and
pay a specified amount of interest every 6 months.

• In India, tenor of Govt. bonds ranges from 5 years to 40 years

• When you purchase a Treasury note, every six months you

receive an interest payment at a set rate.

• These notes pay more in interest than do T-bills since liquidity

and interest paid are inversely related.
 Who buys Treasury Securities?
• Treasury securities are purchased as financial investments by individuals and
by other governments and banks, both in home and abroad. (e.g. China,
Japan, Brazil etc. in the case of United States T-securities)

• Why would people want to hold government debt? The main reason lies in the
relative safety of investment (risk free), especially when compared with other
investments.

• When you invest in real estate, the housing market can crash. When you invest
in a company's stock, the company can lose market value or go bankrupt.

• Govts. rarely can declare themselves bankrupt, too, and refuse to pay back
money that people have loaned them.

• Investors generally believe that the odds of govt. defaulting payment are quite
low, essentially zero.

• In India, Banks prefer to buy T-Bill since it is eligible for inclusion in SLR.
 Who issues T-Bills & Govt. Bonds in India?
• RBI by acting upon as the banker and issuing agent to
the GoI issues TBs & Govt. bonds

• They are issued through bidding/auction – competitive

& non competitive - process by RBI

• TBs can be bought from the money market: a wholesale

debt market to low-risk, highly-liquid, short-term
instruments/loans

• Govt. bonds can be bought from the capital market - a

market for long term funds – both equity and debt.
For a detailed information on Govt.
securities market in India, refer the
following link
https://m.rbi.org.in/Scripts/FAQView.
aspx?Id=79#3
 Who invests in T-Bills in India?
• Commercial banks
• Financial institutions
• Corporates
• NBFCs
• FIIs
• State governments
• NRIs
 Is govt. debt good or bad?
Benefits of govt. debt
• Allows govt. to be flexible when
something unexpected happens
(e.g. Covid-19 pandemic, global
economic slowdown)
• Borrowed money can be used for
investments (e.g. education,
infrastructure) that will lead to
economic growth and prosperity
and the resultant higher tax
revenues in the long run.
• The revenue can be used to pay
back the debt.
Costs of govt. debt
• The govt. has to pay interest rate on
the borrowed money. Interest
payments on debt are substantial in
many countries.
• Govt. debt can distort the credit
market thereby slow down
economic growth due to crowding
out effect. (see next slide)
• Burden of govt. debt is on future
generation: people today benefit
when govt. spends borrowed
money, but people tomorrow (i.e.
future generation) will have to
repay loans
 What is crowding out effect?
• When the government borrows money, it increases
the demand for credit, and so increases the price of
credit - the interest rate - in the wider economy.

• A higher interest rate increases the cost of borrowing

for businesses that want to invest and for consumers
who want to buy new homes or cars thereby slowing
aggregate demand.

• However, crowding out of private investments will not

occur if investments are highly insensitive to interest
rates. This happens especially during liquidity trap (?).
 Discussion

1.Which policy is more effective during recession? –

Tax cuts or Govt. expenditure?
 Effect of stimulus spending

• As discussed earlier, a multiplier effect occurs whenever there is

an increase in spending that would not have occurred
otherwise.
• The expenditure multiplier is the amount that GDP increases
when government spending increases by one rupee.

1
Expenditure spending multiplier =
(1 − b )
• A smaller b (MPC) results in smaller multiplier effect.
• A larger b results in larger multiplier effect.
 Effect of tax cut
• The taxation multiplier is the amount that GDP
increases when taxes decrease by one rupee.

−b
Taxation multiplier =
(1 − b )
• The multiplier effect of tax cuts is smaller than the
effect of government spending.

• Tax cuts boost GDP indirectly through an effect on

consumption.
 Taxation multiplier

C = MPC (Y –T), where T stands for tax

Y = C + I + G I and G exogenous
= C
= MPC  ( Y − T )
Solving for Y : (1 − MPC) Y = − MPC  T

 − MPC 
Final result: Y =    T
 1 − MPC 
 Taxation multiplier effect
…is negatively related to GDP:
An increase in taxes reduces consumer spending, which
reduces equilibrium income.

…is greater than one (in absolute value):

A change in taxes has a multiplier effect on income.

…is smaller than the govt spending multiplier:

Consumers save the fraction (1-MPC) of a tax cut, so the
initial boost in spending from a tax cut is smaller than from
an equal increase in G.
 Stimulus spending or tax cut
Consider a situation where b = 0.6.

• Use this to determine how much GDP will increase

if the government spends an additional Rs. 100
million on highway construction.

• Use this to determine how much GDP will increase

if there are Rs. 100 million in tax cuts.
 Solution

1
Expenditure multiplier = = 2.5
(1 − 0.6 )
Rs. 100 million × 2.5 = Rs. 250 million added to GDP

−0.6
Taxation multiplier = = −1.5
(1 − 0.6)
–Rs. 100 million × –1.5 = Rs. 150 million added to GDP
Macroeconomic Policy Instrument:
Monetary Policy
 Meaning of Monetary Policy (MP)
• MP/credit policy concerns with supply/controlling of
money (or) MP consists of actions by central bank to
manage money supply in pursuit of some
macroeconomic goals.

• To run the economy we need money/credit. But, both the

excess and shortage of it is bad for the economy &
polity.

• So we need a balance, which MP intends to achieve.

• MP influences economic growth, MS, interest rates,

borrowing, and price level.
 Objectives of MP
(1) Maintaining price stability:
• Chief objective of MP
• Inflation has strong negative impact on social
welfare.
• Especially, the poor are hit hard in a situation of
rising prices.
• After all, inflation is a most sensitive issue in
India and is very much disliked by public. (Next
one is unemployment; Look at poll surveys).
Consequences of Inflation (Discussed Earlier)

• Loss in the purchasing power of money

• Affects investment and saving

• Uncertainty

• Adverse impacts in the external sector

• Adverse impacts on consumption

• Increase in inequalities
(2) High and stable employment:

• Unemployment is a serious problem in any

country.

• Hence, reducing unemployment and maintaining

it at a tolerably low level is an important policy
goal of MP.

• To increase employment opportunities, we need

to grow fast which, in turn, requires availability
of credit at reasonable rate of interest for
investment activity.
(3) Economic growth:

• Productive activities cannot be sustained without

the availability of adequate credit.

• Hence, sound management of MP is vital for

supporting the process of growth in an economy.
(4) Preserving stability in financial markets:

• Strong & stable financial system contributes to

growth by smoothly channeling funds from
savers to investors.

• The lifeline of financial markets is credit flow,

which is regulated through MP
(5) Stability of exchange rate:

• Exchange rate is a crucial factor determining a

country’s position in international trade.

• Wide fluctuations in exchange rate makes

planning difficult for traders.

• Hence, preventing sharp fluctuations in value of

the rupee so as to maintain orderly conditions in
the forex. market is a major goal of MP
 An Important Comment on Objectives
• Some of the goals of MP are contradictory
[e.g. price stability Vs credit
availability/economic growth/employment
growth; price stability Vs exchange rate
stability]

• Conflicting goals confront the monetary

authorities (RBI) with hard choices which have
to be skillfully handled with a proper
balancing of the various trade-offs involved.
 Causes of Inflation (Discussed earlier)
(I) Demand side/Demand pull factors:
(i) Population growth
(ii) Rising incomes
(iii) Rising non-developmental govt. expenditure
(iv) Deficit financing
(v) Increase in money supply
(II) Supply side/Cost push factors:
(i) Inadequate agricultural output
(ii) Speculation
(iii) High cost of imports
 Increase in money supply & Inflation
• Rapid increase in money supply/money incomes with the
public, which exceeds supply of goods and services
causes inflation

• Logic: when people have more money on their hands,

they tend to spend it on purchasing goods. When supply
fixed, ‘too much money chases too few goods’ and
prices are driven up.

• Example: Skyrocketing real estate prices in cities due to

IT boom

• A theory called “Quantity Theory of Money” is the base

for this kind of reasoning
• The theory states that the general price level is
determined by the demand for and supply of
money balances in the economy.

• Proposes that a change in money supply will

cause an equal proportionate change in the
general level of prices.

• Inflation, even if caused by demand-related or

cost-related factors, cannot be sustained over a
long period, if not backed by continuous
monetary expansion.
• Hence, inflation is a purely monetary
phenomenon and blame for it can be squarely
laid on central bank for its inability to control
growth of money supply

• Empirical evidence: Almost every country that

has experienced high inflation over long
periods has also experienced sustained, high
growth of money stock.

• Hence, central banks mainly target money

supply to control inflation.
 Evidence for Q-theory in India
• In simplest form the theory says rate of
inflation equals the rate of growth of money
supply.

• So, we plot time-series data on annual growth

rate of broad (M2) and narrow money (M1)
supply and annual growth rate of wholesale
price inflation (all commodities) [M1and M2
discussed later on]
 -15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
1953-54
1955-56
1957-58
1959-60
1961-62
1963-64
1965-66
1967-68
1969-70
1971-72
1973-74

Growth of M1
1975-76
1977-78
1979-80
1981-82
1983-84
1985-86
1987-88
1989-90
Growth of M1 Vs. Growth of WP Inflation

Growth of WP Inflation
1991-92
1993-94
1995-96
1997-98
1999-00
2001-02
0.0
5.0

-5.0
10.0
15.0
20.0
25.0
30.0

-10.0
 10.0
15.0
20.0
25.0

0.0
5.0
1953-54
1955-56
1957-58
1959-60
1961-62
1963-64
1965-66
1967-68
1969-70
1971-72
1973-74
1975-76
1977-78

Growth rate of Broad money

1979-80
1981-82
1983-84
1985-86
1987-88
1989-90
Growth of M3 Vs Growth of WP Inflation

1991-92
1993-94
1995-96
Growth of WP Inflation

1997-98
1999-00
2001-02
0.0
5.0

-5.0
10.0
15.0
20.0
25.0
30.0

-10.0
 How MS Controlled Via MP?
• Responsibility is with the central bank (RBI).

• It employs certain MP tools to control MS with

the main aim of maintaining price stability.

• Before discussing the tools, it is important to

understand the process which determines total
money stock in economy.

• For this, we need to understand some basics

 1. Components of money stock
• To make the exercise of controlling MS easy we
need to classify total money stock in the
economy according to their impact

• In other words, we need to decide which part of

financial assets present in the economy can be
considered as MONEY

• The RBI follows the following measures of

money supply (MS) called monetary aggregates
• M1 = Coins & currency notes held by public +
Demand deposits of public in banks + ‘Other’
deposits with the RBI* (Narrow money)
• M2 = M1 + saving deposits of post office savings
banks.
• M3 = M1 + time deposits with the banking system
(Broad money)
• M4 = M3 + all deposits with post-office savings
banks (excluding National Savings Certificates)
(see http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/69065.pdf)
* Net RBI credit to the Government including state govts. + RBI credit to the commercial
sector + RBI’s claims on banks (i.e. loans to banks including NABARD) + RBI’s net
foreign assets + Government’s currency liabilities to the public – RBI’s net non-monetary
liabilities
 Explanatory Notes
• RBI’s foreign currency assets are typically divided
into investment in AAA-rated sovereign securities,
deposits with other central banks and BIS, and
deposits with overseas commercial banks.

• ‘Government’s currency liabilities to the public’

comprise rupee coins and small coins.

• Net non-monetary liabilities of RBI are all those

liabilities which do not create any monetary impact.
It includes RBI capital, various reserves, provisions
etc. minus the other assets of RBI.
Source: RBI Bulletin, September 2017
 Some comments on Money Stock
• M1 is most liquid and is called narrow
money. [As asset is liquid if it can
immediately, conveniently, and cheaply, be
used for making payments].

• M2 is less liquid as compared to M1.

• M3 is called broad money or aggregate
monetary resources. It is less liquid as
compared to M2 and M1.

• Thus the main characteristic which separates

one measure from the other is the varying
degree of liquidity.

• As we move from M1 to M4, the liquidity of

assets decreases, while their interest yield
increases (Why?)
 2. Velocity of Circulation of Money
• It is the number of times per year that a given
money stock turns over to finance annual flow of
income.
[OR]
• It tells us the number of times a rupee changes
hands in a given period of time.
[OR]
• Simply, indicates the no of times per year that an
average rupee is spent on goods and services
Illustration

• Suppose that our economy consists of a farmer

and a tractor manufacturer.

• Assume that the farmer needs tractor and

tractor manufacturer needs rice

• Assume that the total money stock in the

economy is Rs.50
• The farmer could buy tractor from
manufacturer and pays him/her Rs. 50

• The manufacturer spends his/her income of Rs.

50 on rice.

• In this case, together both the farmer and

manufacturer spend Rs. 100 [i.e. demand] even
though the money stock in the economy is only
Rs. 50 (or)
• With Rs. 50 money stock, Rs. 100 worth of
transaction is effected in the economy in two
transactions.

• This is possible because each rupee was spent an

average of twice.

• Now, velocity of money can be computed as using

following formula
V=PY/M
Where V – Velocity of money
PY – Money value of total transaction
[i.e. Price level (P)  Output (Y)] [Nominal GDP is
used as proxy]
M – Money stock/supply
• In our case V is Rs.100/Rs.50 = 2 times

• That is, for Rs. 100 worth of transaction to

take place in a given year with Rs. 50 money
stock, each rupee must change hands 2 times
in that year.

• Hence, the concept of velocity is useful to

understand the power of a given money stock
in effecting transactions (or creating demand)
 Active Learning: Velocity of money
• Use the quantity equation to fill in the blanks in the
following table.
Velocity of
Price level (P) Real output (Y) Money supply (M)
money (V)

$1 $10,000 $5,000

$1 $15,000 3

$2 $25,000 5

$8,000 $32,000 1
 Active Learning - Solution

• Use the quantity equation to fill in the blanks in the

following table
Velocity of
Price level (P) Real output (Y) Money supply (M)
money (V)

$1 $10,000 $5,000 2

$1 $45,000 $15,000 3

$2 $25,000 $10,000 5

$4 $8,000 $32,000 1
 3. High-powered money (H) or Monetary base
• Also known as central bank money, base money
or reserve money

• Nothing but currency (notes & coins) held by

public + Banks’ deposits/cash in hand with
banks + reserves (Cash Reserve Ratio) held by
banks at the RBI

• Banks keep reserves with RBI as a precaution

(i.e. to face the situation of a bank-run)
 4. Bank Reserves/Reserve Ratio (RR)
• Currency in bank vaults to meet customer needs
and face bank run (remaining is used for
lending)+ Banks’ deposits at RBI (i.e. CRR).

• In other words, it is the proportion of deposit

which banks held as reserves (both in RBI and
with them).

• Symbolically,
RE
RR = D
 Where RE – Reserves held by banks
D - Deposits with banks
More the RR less will be MS

• Banks hold currency with them to meet demands

of their customers for cash (other than loans).

• Since this earn no interest, banks try to minimize

them.
• To satisfy central bank (RBI) stipulation,
banks need to keep a part of their deposits as
reserves in RBI, called cash reserve ratio
[Discussed later]

• Banks have no control over reserves kept in

RBI. Whatever RBI decides they follow.
 5. Currency-Deposit Ratio (CD)
• Proportion of their deposit which public held as
cash. Symbolically,

CU
CD =
D

Where CU – Currency held by public

D - Deposits held by public
➢More the CU, lesser will be the money supply

➢In this set up, RBI determines total MS (M)

mainly through its direct control over H.

➢H multiply to M through the effect of money

multiplier (mm), i.e. M = H  mm

➢ mm is the ratio of money created by lending

activities of the banking system to the money
created by a country’s central bank (i.e. H). It is
larger than 1.
• We can calculate mm as follows:
1
Money multiplier =
Reserve ratio

RE
• mm is larger, the smaller the RR (= D )

• mm is larger, the smaller the CD (= CU

D
) because
any cash that people hold onto will not enter the
banking system
• A reserve ratio of 10% (or equivalently, 0.10)
means the money multiplier is 10
 Illustration for mm
• Suppose RBI purchases govt. securities in open
market.

• Suppose you sell securities to RBI.

• RBI pays you by writing a cheque on itself,

which you deposit in your bank.

• Now, your bank’s deposits increases by the

amount deposited by you.
• The bank uses a major portion of your deposit for
lending, after keeping a part of it to meet reserve
requirement (cash requirements of customers +
CRR requirement of RBI).

• Suppose the bank lends to Swetha, a business

person, by opening an account in her favour.

• Now, Swetha can draw cheques on her loan to

pay for the transactions (or) deposit the loan
amount in her bank account.
• Those who receive payments (cheque) from
Swetha deposit the money in their Banks.

• Those banks after keeping a part of the deposit

for meeting reserve requirement, lends out the
remaining by opening accounts in favour of
borrowers.

• Now, these borrowers can draw cheques on their

loans to pay for the transactions

• The process goes on like this: the bank will

continue lending and taking deposits
• Thus, MS expands or money is created in the
economy in this way due to lending activities
of banking system as a whole.

• In other words, lending funds enables banks to

“create” money
How banks create money? An Example
 Example of Money Creation
Resulting from the RBI’s Purchase of
Rs 100 Government Bond

Bank Increase Increase Increase

in in in
Deposits Advances Reserves
A 100.00 90.00 10.00
B 90.00 81.00 9.00
C 81.00 72.90 8.10
D 72.90 65.61 7.29
E 65.61 59.05 6.56
F 59.05 53.14 5.91
… … …. …
All Banks 1,000.00 1,000.00 100.00
 Finding the total amount of
money:
Original deposit = 100
+ Firstbank lending = 90
+ Secondbank lending = 81
+ Thirdbank lending = 72.9
+ other lending…

Total money supply = (1/r )  100

where r = ratio of reserves to deposits

In our example, r = 0.1, so M = 1000

• However, the above conclusion is conditional upon
two assumptions

– All the banks are able to find ready borrowers so

that they can utilize the entire amount of additional
deposits above the reserve amount

– Borrowers are keeping the entire advances in the

form of deposits in bank and do not convert a part
of it into currency
 Active Learning: The money multiplier

• Use the money multiplier equation to fill in the

blanks in the following table.

Situation Reserve ratio Money Multiplier

A 10%

B 5%

C 5
 Money Multiplier: Solution

• Use the money multiplier equation to fill in the

blanks in the following table.

Situation Reserve ratio Money Multiplier

A 10% 1 .10 = 10

B 5% 1 .05 = 20

C 1 5 = 20% 5
 The role of the central bank
• A central bank is the institution ultimately
responsible for managing the nation's money
supply and coordinating the banking system to
ensure a sound economy.

• In India, the central bank is Reserve Bank of India

• The central bank has two essential functions:

Managing the money supply and Acting as a lender
of last resort.

• The CB is not the financial arm of the govt.

• In India the financial operations of the govt. i.e., collecting
taxes, issuing debt, and generally managing the nation's
finances are conducted by the Ministry of Finance (MoF)
(Treasury Department in the USA).

• The RBI is responsible for deciding how much physical

Currency should be printed, but the printing itself is done by
both Government of India (GoI) and RBI.

• Two of the currency note printing presses are owned by GoI

and two by RBI, through its wholly owned subsidiary.

• In short, GoI/MoF executes fiscal policy, while RBI conducts

monetary policy.
• What does lender of last resort role of central bank
mean?

• When nobody else is willing to lend to banks

facing a bank run, central bank steps in as lenders
of last resort
Monetary Policy Tools
 Monetary Policy Tools
(i) Open market operations (OMO):

• RBI sells govt. securities/bonds to banks &

individuals in open market if it wants to reduce
MS (H) in the economy and buys securities from
banks if it wants to increase MS

• When RBI sells securities banks subscribe them

which, in turn, reduces fund availability with the
banks and hence their capacity to lend weakens
• The opposite will happen when RBI buys bonds from
banks

• One major advantage of OMO is that the transactions -

the buying and selling of bonds - take place on a daily
basis. This would help to make small but steady
adjustments in money supply rather than sweeping
changes in the economy.

• One major disadvantage of OMO is that the sale of

bonds imposes a cost on govt. as interest will have to
be paid to the purchaser of the bonds (i.e. banks).
(ii) Cash Reserve Ratio (CRR)/Reserve requirements:

• CRR is the ratio of a bank’s cash holdings with

RBI to its total deposit liabilities.

• Banks hold CRR at the RBI and no regular

interest is earned on the balance held at the RBI.

• If the RBI wants to reduce money supply, it

increases the CRR and vice versa.

• CRR is used as a MP too to effect big changes in

money supply
• When CRR is increased, banks would not have
adequate funds to lend (Why?)

• Hence they are forced to lend at higher interest

rate

• Higher lending rate discourages people from

borrowing

• Also banks attract deposits with higher interest

rate
• Higher interests on deposits will induce people to
deposit money in bank, rather than using it for
consumption purpose.

• Hence, CRR is a powerful tool

• Main defect of CRR mechanism is that an

increase in CRR has undesirable side effects on
bank profits.

• For instance, for SBI, a 4% CRR works out to Rs

50,000 crore which won’t attract any regular
interest.
• CRR has been gradually reduced from 15% in
1992. Currently pegged at 3%

• Since changing the CRR involves no interest cost

to the govt., it remains a favourate option in
India.
(iii) Statutory Liquidity Ratio (SLR):

• SLR refers to the rate at which banks are required

to maintain their reserves in govt. securities.

• The govt. imposes an obligation on the banks to

use a proportion of cash to buy govt. securities
[This is to meet govt. borrowing requirement]

• When the RBI wants to reduce money supply, it

increases SLR limits and vice versa.

• Currently, SLR is at 18%

(iv) Bank Rate/Discount Rate/Discount window:
• Bank rate (BR) is the interest rate at which RBI
lends to the banks.
• Banks may approach RBI (or other banks) for
loans to tide over fund shortage.
• If bank rate is high, then banks are discouraged to
borrow funds from RBI against which they can
advance loans.
• Moreover, a rise in BR is usually followed by a
rise in interest rates banks charge on their loans.
• This is because banks take increase in BR as a signal that
the RBI intends to reduce Ms and increase market interest
rates.

• This helps to reduce the demand for credit by firms and

households from banks.

• This instrument is not used much. Why?

• The BR is one of the central bank's primary tools for

providing long-term liquidity window to the banks and
acting as a lender of last resort.

• When a bank is in trouble (e.g. due to bank run), BR can

be a guaranteed source of emergency funds.
• Because of that, any bank that makes use of discount
window opens itself up to significant speculation about
its financial health

• Such stigma makes banks reluctant to use the discount

window.

• Also, the interest rate on the emergency funds (i.e. bank

rate) has generally been higher than interest rates
available in the market.

• As a result, banks tend to look elsewhere for loans.

(v) Repos [Repurchase agreements] and Reverse Repos
(also called Liquidity Adjustment Facility – LAF):

• In a repo, RBI buys govt. bonds from banks with

the contract that it will sell them back to banks
on a predetermined/future date (i.e. within 1 to
15 days) at an agreed price.
• This mechanism is resorted to inject liquidity
(i.e. increase MS) in to the banking system
• Banks borrow money (on daily basis) from RBI
when they face liquidity shortage
• In a repo, RBI is the lender and banks are the
borrowers. The bond acts like a collateral

• After the expiry of the repo period, the RBI

would return back the bonds to banks and gets
back the money from banks.

• The terms of contract are in terms of a 'repo

rate' or simply interest rate.
• The difference between the price at which the
bonds are bought and sold is the lender’s
(RBI’s) profit or interest earnings from
lending the money

• Both buying and reselling prices are

determined prior to entering into the deal

• Repo mechanism is a versatile and most

popular instrument for injecting or absorbing
short-term liquidity
• In a reverse repo, RBI sells govt. bonds to banks with
the contract that it will buy them back on a
predetermined/future date (i.e. within 1 to 15 days) at
an agreed price.

• This mechanism is resorted to absorb liquidity (i.e.

reduce MS) from the banking system

• A hike in repo rate discourages banks from borrowing

from RBI

• A hike in reverse repo rate (which is always below

repo rate) encourages banks to lend to RBI (or park
money with RBI when they are not able to lend)
(vi) Marginal Standing Facility
• If there is a shortage of govt. bonds to keep as
collateral, the banks can avail of MSF.
• In case of LAF/Repos banks cannot sell govt. security
to RBI that is part of bank's SLR quota but it can
borrow any amount of money as long as it has the
govt. securities to sell.
• But with MSF banks can sell govt. security from its
SLR quota to RBI but it can maximum borrow up to
2% (now 1%) of its Net Demand and Time Liabilities
(NDTL) outstanding at the end of second preceding
fortnight.
• The interest rate on MSF will above repo rate
(vi) Selective control method:

• This is used to allocate credit to certain lines, and deny

it to certain other uses, as also fixing the amounts of
credit.

• For example, 40% of total net bank credit has been

earmarked to the priority sectors.
(https://www.rbi.org.in/Scripts/BS_ViewMasDirections.
aspx?id=11959)

• Similarly structure of interest rates has been so used as

to provide low-interest loans to certain sectors like
agriculture and export and restrict credit to others, if
necessary.
(v) Moral Suation:
• RBI persuades banks through letters, meetings
etc. about the need for following the course
desired by the RBI.

• For example, to control inflation RBI may ask

banks to increase rate of interest on bank loans
to real estate sector.
 Rates Now
Policy Repo Rate : 4%

Reverse Repo Rate : 3.35%

Marginal Standing Facility

: 4.25%
Rate

Bank Rate : 4.25%

CRR : 3%
SLR : 18%

Source: https://www.rbi.org.in/
 Economic Effects of MP

• In the short run MP helps to combat recessions and cool

an overheating economy

• But in long run, MP is irrelevant because prices will

adjust to a high or low supply of money, without any
change in overall economic output (monetarists say that
"money is neutral.")

• MP primarily influences economy through changes in

money supply and interest rate.

• Changes in interest rate affect borrowing and lending,

which can have significant impacts on economy
 Mechanism by which MP affects the economy
• Can be explained thru Liquidity-preference model
proposed by John Maynard Keynes in 1936
• To understand mechanics, we need to first understand the
determinants of money demand and supply
(a) Determinants of demand for money:
• Our daily spending needs (we need cash to meet this)
• Preference for liquidity (the ease at which one can turn
an asset into cash)
• Interest rates: interest rates (IR) and savings are
positively related – when IR on savings are high most
people will try to save more and hold less cash and vice
versa.
• Thus, quantity of money people want to hold is a
function of the interest rate

• Therefore, the money-demand curve slopes downward,

showing a negative relationship between interest rate
and how much money is demanded

• When the interest rate rises, we demand a lower

quantity of money, moving leftward along the curve
(see figure in next slide)

• When the interest rate falls, we demand a higher

quantity of money, moving rightward along the curve.
 The Liquidity Preference Model

Interest rate, r

Money supply

r*

Money
demand

Q*
Quantity of money

Note: Here we assume that money supply is completely fixed by the central bank.
(b) Determinant of supply of money

• Supply of money is considered to be set only by central

bank (CB).

• Regardless of interest rate, CB will ensure that there is a

constant quantity of money supplied in the economy.

• This means that money supply curve takes shape of a

vertical line (see figure in previous slide)

• It also means that the only way the supply of money can
change is when CB does so for policy reasons

• The point where the supply of money meets the demand

for money (r*) will determine the nominal interest rate.
• Depending upon the monetary policy stand of the
central bank, the money supply curve shifts.

• Any actions that increase money supply will shift the

money supply curve to the right (e.g. decrease in
reserve requirement, or buying government bonds on
the open market)

• In contrast, any actions that decrease money supply

will shift money supply curve left.

• The changes in money supply curve will increase or

decrease interest rates (see figure in next slide)
Interest rate, r

MSc MS* MS e

rc

r*

re
MD

Qc Q* Qe
Quantity of money
• The slope of the money demand curve determines how
a change in the money supply will change the interest
rate.

• If the quantity of money demanded is really/highly

responsive to changes to the interest rate (a flat, elastic
money demand curve), changes to the money supply
will have a smaller effect on interest rates than if
demand is less responsive (steeper, more inelastic) (see
figure below)

• In other words, if the response of people towards a

change in interest rate is high/very sensitive then the
extent to which interest rate changes will be less.
• This is the case of developed economies (where
speculative motive of savings is higher than
transaction and precautionary motives)

• Transaction motive of saving: desire to

maintain sufficient funds in a bank account for
future needs and wants.

• Precautionary motive of saving: saving occurs

in response to uncertainty regarding future
income.
Interest rate, r
Interest rate, r

MSc MS * MSe
MSc MS * MS e

r
c rc
r*
r MD
e

r*

re
Qc Q* Qe MD
Qc Q* Qe
Quantity of money Quantity of money

The more elastic money demand… The more inelastic money demand…
….smaller the effect on interest rates …greater effect on interest rates.
 Impact of expansionary monetary policy
• Let's say that the economy is in a recession (or)
economy is in a short-run equilibrium marked by
sluggish output and lower prices

• This will reduce aggregate demand (AD): a downward

shift in AD curve.

• To tackle this situation, suppose that the central bank

increases supply of money in the economy by
conducting open-market operations (called expansionary
monetary policy).

• This will cause a decline in interest rates (& savings)

which, in turn, causes increased borrowing and
spending.
• Why lower interest rates causes higher spending?

• Many of the large purchases we make - buying a house,

a car, or an expensive appliance - are made using money
we've borrowed.

• Likewise, businesses borrow to make investments

• Higher spending causes a shift in AD curve to the right

(see figure in next slide).

• Ultimately the effect is the same as that of the

expansionary fiscal policy discussed earlier.
 Expansionary monetary policy Expansionary monetary policy and the AD/AS model
Interest rate, r Price level
LRAS
MS 1 MS 2 SRAS

P2
r1 P1

r2 AD2
Money
demand
AD1
Q1 Q2 Y1 Y 2
Quantity of money Real GDP
• What would central bank (CB) do when the economy is
booming or overheating

• When the economy is booming the system would be

flush with cash & face higher output and price levels
(shifting of aggregate demand curve to right)

• Increases in price level are contrary to CB's mandate to

maintain stable price levels

• In such a situation, the CB often move to increase

interest rate by reducing money supply.

• The increase in interest rate shifts AD curve leftward,

leading to lower prices and equilibrium output (see
figure in next slide).
 Contractionary monetary policy Contractionary monetary policy and the AD/AS model
Interest rate, r Price level
LRAS
MS 2 MS SRAS
1

P1
r2 P2

r1 AD 1

AD 2
MD

Q2 Q1 Y2 Y1
Quantity of money Real GDP
 Monetary Policy Transmission Mechanism

The Monetary Transmission refers to the process by

which a central banks monetary policy decisions are
passed on through financial markets to businesses and
households
 1. Traditional Interest Rate Channel
Business Investment
decisions

Monetary Policy Real Interest rates Investment decisions

Consumer Investment
decisions

The interest rate channel is a mechanism of monetary policy, whereby

a policy-induced change in the short-term nominal interest rates by
the central bank affects the price level, and
subsequently output and employment.
• Advanced economies (AEs):- the interest rate channel
works by impacting the cost of capital.

• Emerging market economies (EMEs):- transmission is

weak due to ill-functioning and underdeveloped
financial market. (people’s participation in formal
financial system is less)

• Lending Rates for certain sectors such as housing and

automobiles respond faster to policy rates compared to
other sectors.
 2. Exchange rate channel

• Monetary policy expansion => Interest rates

fall => Can lead to a fall in value of domestic
currency: boosting factor for exports =>
overall aggregate demand for the economy
 3. Asset price channel
• The asset price channel is the monetary transmission
channel that affect the price of assets. These effects on
the prices of assets will in turn affect the economy

• Decrease in interest rates (offered by banks) affect

(increase) the prices of various assets such as stocks,
and other assets such as gold, houses, land etc.

• An increase in asset prices increases the household and

business communities wealth

• This in turn may encourage investment through

borrowing and consumption spending
 4. Credit Channels
The credit channel of monetary policy describes that a central bank's policy
changes affect the amount of credit that banks issue to firms and consumers,
which in turn affects the real economy.
A. Bank lending channel (relates to reserve ratio not interest rate)
• Reduction in reserve requirements increases the supply of bank loans.
• Small firms which does not have access to stock market excessively depends on
this channel.
• Research suggests that transmission through the credit channel is strong in the
case of micro-finance institutions (MFIs).
B. Balance sheet channel
• Balance sheet channel:- Information asymmetry about borrowers leads to
adverse selection and moral hazard problem which in turn reduces the bank
lending (e.g. NPAs issue in India).
• Also reduction in interest rate increases the cash flow/loan repayment to banks
(due to reduction in debt burden) and reduces the adverse selection and moral
hazard problem.
 MP Transmission Mechanism – Indian perspective
• RBI concentrates heavily on interest rate channel (Policy rates)
which effects lending rates and it is the most effective channel in
India.
• Exchange rate channel is found to be weak in India. Level of
exchange rates is not a policy goal of RBI because tinkering with
exchange rates has political and financial ramifications.
• Asset prices channel is weak in India due to a tendency for
household to invest in gold and real estate which is majorly funded
by informal sources which respond less to the monetary policy.
• Banks credit channel is weak due to the dominance of informal
financial sector. But due to the greater financial inclusion in recent
times the credit channel is getting stronger. Greater number of
MFIs and new banking licenses would increase the effectiveness
of credit channel.
 Limitations of Monetary Policy
(i) Restricted capacity to control inflation:
• Role of MP in combating inflation is somewhat
limited because price situation in a country is not
solely or largely due to monetary forces (i.e. MS)
(Recent experience with inflation control).

• Other factors (like supply-side bottlenecks) can

have significant influence on inflation
• MP can be effective only as a part of an overall
framework of policy which includes fiscal (e.g.
customs duty cut), foreign exchange (e.g.
sterilisation) policy and so on.

(ii) Role of unorganized financial institutions:

• It is difficult to control credit creation by them

as they less amenable to the operations of the
RBI.
(iii) Existence of black money:
• Due to circulation of large amount of money,
supply and demand of money do not remain as
desired by the RBI.

(iv) Independence of RBI:

• Scope of MP would be further restricted if the
RBI is not fully allowed to pursue independent
line in monetary affairs.
• Prior to financial sector reforms, MP played
accomodative role to fiscal policy: Central
govt. could borrow without limit from RBI
(Deficit financing).

• But after reforms, RBI has become more

independent.
(v) Time lags:

• Although monetary policy usually does not take as long

to implement as fiscal policy (becoz. the CB does not
have to wait for politicians to come to a consensus
about the best policy to help the economy), a few
months can pass before the CB's actions start to have
their desired impact.

• By that time, the state of the economy might have

changed.
 Macroeconomic Policy for an Open-Economy:
Balance of Payments & International Capital Flows
Types of International Transactions between countries

• Trade in Goods (tangibles)

• Trade in Services/intangibles (royalty

payments, software services exports, export of
music & entertainment)

• Trade in Capital (e.g. bank deposit, buying

bonds or stocks or financial securities)
 Balance of Trade
• It is the value of a country’s exports (of goods
and services) minus the value of imports (of
goods and services)

• BoT can be either negative or positive

• If a country imports more than it exports, the BoT

is negative (called trade deficit) (e.g. USA, India)

• If a country exports more than it imports, the BoT

is positive (called trade surplus) (e.g. China,
Japan, Germany)
 Balance of Payments (BoP)

• BoP is the record of all transactions – goods, services, &

capital - of the residents of a country with rest of the
world.

• It consists of two parts: current account and capital

account.

• Current account records trade in goods and services, as

well as transfer payments (e.g. remittances, gifts, aids
and grants).

• Capital account records purchases and sales of assets

such as stocks, bank deposits, bonds and land.
• Symbolically,
Current Account = Value of Exports – Value of
imports + net transfers payments from abroad
[OR]
Current Account = Net Exports (trade balance)
+ net transfers payments from abroad

• Note that exports and imports include both goods

and services (invisibles)
 Surplus/Deficit Concepts

• Current account is in surplus if receipts from

trade in goods and services (exports) exceed
payments on this account (imports) PLUS
positive net transfers payments from abroad

• The opposite is the case of deficit.

• Capital account is in surplus if our receipts from
sale of domestic assets (borrowing abroad, e.g.
foreign borrowing) exceed our payments for our
own purchases of foreign assets (lending to
foreigners, e.g. purchase of US govt. securities).

• Assets include stocks, bonds, land, bank deposits

etc

• In India capital account consists of:

 (a) Foreign Direct Investment

(b) Foreign Institutional Investment (also called

portfolio investment)

(c) Loans (external assistance + Commercial borrowing)

(d) Banking capital (incl. NRI deposits) - difference

between a bank’s foreign assets and its liabilities

• A surplus (deficit) on capital account is called a net

capital inflow (outflow)
• If both current account and capital account are in surplus
(deficit), then overall BoP is in surplus (deficit).

• A deficit in current account by itself doesn’t create a BoP

deficit. It may be outweighed by a sufficiently large
surplus in capital account [present case of India] and vice
versa.

• Also, a deficit in current account (i.e. trade deficit) can

be financed by surplus earned in the capital account. This
way a country can sustain trade deficit (e.g. India, USA)

• When one account is in surplus and the other is in deficit

to precisely the same extent, the overall BoP is zero.
 India's BoP (Rs crore)

Item 1990-91 1995-96 2000-01 2004-05 2019-20

A. Trade
balance/Merchandise -16933 -38061 -56737 -151765 -1114902

B. Invisibles* -433 18415 45139 139591 942474

C. Current Account
Balance (A+B) -17366 -19646 -11598 -12174 -172429
D. Total Capital
Account 12661 14312 40610 125367 588584

Overall BoP (C+D)** -4705 -5334 29012 137541 423206

‘-' deficit and '+' surplus

* Includes Services (incl. software); Transfers; Investment income and
compensation of employees
** C+D don’t tally due to inclusion of “Errors & omissions”
• If overall BoP is in deficit it means that the
country is loosing forex. reserves.

• When overall BoP is in surplus, economy (Govt.

& Private sector) may use forex. to pay off debt
or buy assets abroad (like China does
extensively) or import goods & services/to pay
for transactions made abroad

• Alternatively, central bank buys the forex earned

and add that to its forex. reserves.
 How Current Account Deficit is Financed?

(a) Selling assets/Borrowing abroad:

• Borrowing from foreign govts. and

commercial banks by way of selling bonds

• Borrowing from international lending

agencies like IMF or World Bank

• Example: India did this extensively during

1991 economic crisis period.
(b) Foreign Direct Investment (FDI) inflows:
• FDI occurs when a firm runs part of its operations
abroad or owns all or part of another company abroad
• FDI earns foreign exchange and many other benefits
(economic growth, jobs, exports etc.) for the host
country.
• Two types of FDI: Green field and Brown field
• Green field means creation of new physical assets (e.g.
Amazon investing in a new warehouse in India)
• Brown field means acquisition of existing physical
assets (e.g. Amazon buying existing Big Bazaar retail
shops and supply chain infrastructure owned by it)
(c) Foreign Institutional Investment (FII):
• Also called foreign portfolio investment
• Refers to investment in financial assets such as
stocks or govt. securities by foreign sources in an
economy
• Example 1: foreign institutional investors like
mutual funds, banks and insurance companies
purchasing bonds or shares or other financial
assets in India.
• These constitute an important source of financing
current account deficit in India.
• Example 2: Chinese purchases of U.S. government debt (Treasury
securities). Chinese investors have a large reserve of dollars (due to
large exports), using which they buy assets that are U.S. dollar-
denominated.

• FII allows investors to hold financial assets that deliver greater

profit and reduce overall risk relative to financial investments
available at home

• Portfolio investment can generally flow across borders quickly

because it mainly involves transfers between bank accounts.

• Inflow and outflow of FDI doesn’t happen as fast as FII: (a) Firms
cannot just pick up a factory and move it across the border; (b)
Once made, FDI is difficult to take out.
(d) Central Bank Intervention:
• Selling of foreign currency in the forex. market
by central bank from its forex. reserves.

Comments:
(i) It is better for a country to control current
account deficit if it has (a) less assets to sell; (b)
low foreign currency reserves to use up; (c) less
number of lenders; and (d) low FDI & FII
inflows.
(ii) FDI (called cool money) is governed by long-term
considerations. Hence, is the most stable and reliable
source of finance. It is also non-debt creating.

(iii) Short-term (maturity of less than a year) &

speculative borrowing sources (FII) are volatile – called
hot money.

(iv) Excessive reliance of this source was a major

contributory factor behind BoP crisis in many countries
in Latin America and East Asia.

(v) Hence, it is better to encourage non-debt creating

flows (FDI), rather than short-term loans (FII).
 Understanding International Capital Flows
• Why does capital flow into some economies (USA) and
out of others (China)?

• Equilibrium interest rate is determined by the

intersection of the demand for loanable funds and supply
of loanable funds.

• Supply of loanable funds in an open economy (USA) is

nothing but domestic savings

• Domestic savings has a positive relationship with interest

rate.
• Demand for loanable funds (investment) comes from
domestic investment in physical assets & capital outflow
(i.e. investments in financial assets) (when domestic
savings is invested in foreign assets)

• However, since there is also a capital inflow (when

money from abroad is invested domestically), the net
capital flow (NCF) in the open economy is

NCF = Capital inflow – Capital outflow

• Therefore, demand for loanable funds in an open

economy (USA) is: Domestic investment (I) + NCF
• Domestic investment (I) (in USA) has a
negative relationship with domestic interest rate

• Capital inflow (into USA) has a positive

relationship with domestic interest rate: high the
interest rate larger will be the capital inflow

• Capital outflow (from USA) has a negative

relationship with domestic interest rate: it will
increase if domestic interest rate is lower
 • Demand is equal to domestic
investment and net capital
flows.

• Savings consists of public

Interest rate
and private savings.

Savings • The equilibrium occurs at the

intersection of S = I + NCF.
r*

I + NCF

Q*
Quantity of US $
• Suppose the domestic interest rate declines (in USA)

• People in USA will start to look overseas for

opportunities to earn more interest on their money. The
result will be higher capital outflows.

• People overseas will be less keen to invest in the USA

because of the lower returns, so there will be lower
capital inflows.

• Higher outflows and lower inflows would lower net

capital flow (into USA).
• Suppose the domestic interest rate increases (in USA)

• People in USA will be more willing to keep savings in

the economy; capital outflows will go down.

• People overseas will send their financial investments to

the USA in pursuit of better returns: inflows will go up.

• Lower outflows and higher inflows would lead to an

increase in net capital flow (in USA).
 Why China has so much invested in United States
financial assets?
• China funds much of USA’s savings deficit [caused due
to govt. deficit & low household savings] by buying
Treasury securities of US govt. [PS: High govt. budget
deficit causes a decrease in public savings]

• The US saves only 18 percent of its GDP. The rate of

household savings is low (usually less than 5 percent).
The rate of government saving is negative since it runs a
budget deficit.

• When there is a savings shortfall, interest rates (in USA)

will be higher.
• With a higher interest rate, there is more incentive to
invest in the USA (i.e. on financial assets).
• Chinese investors make use of this opportunity well.
• However, higher interest rates in USA “crowds out”
domestic investment (in physical assets) in USA
• From where does Chinese get money to buy/invest in
US govt. securities?
• USA has a huge trade deficit with China.
• In 2019, American consumers bought $471.8 billion
worth of goods and services from China, while
American firms sold only $163 billion worth of goods to
consumers in China.
• The result is an astronomical $308.8 billion trade gap
between what America is buying from China and what it
is selling there.

• Presumably the Chinese don't just keep this money

($308.8 billion) under their mattresses. Where does it end
up?

• They can use the dollar earnings for spending, investing

and savings.

• Interestingly, the Chinese save too much (50% of GDP) -

an extreme case! – and consume less
 Why Chinese save more?

https://www.forbes.com/2010/02/02/china-
saving-marriage-markets-economy-
trade.html?sh=377e20047a83

https://www.facebook.com/TheEconomist/vi
deos/chinas-unbalanced-sex-
ratio/1081020442234958/
• A growing propensity to save decreases interest rate in
China relative to other markets thereby encouraging
encourage capital to flow abroad (USA) searching for
the best return.

• Lot of Chinese end up being invested in U.S.

government debt, which means the Chinese use the
money to make loans to the U.S. government.

• The massive capital outflow from China requires that

large quantities of Chinese currency are exchanged into
US dollar thereby depreciating value of Chinese
currency (Yuan).
• This keeps export competitiveness of China vis-à-vis
USA intact.

• How the trade imbalance between USA and China

could it be corrected?

• There are two ways

• One solution could be for China to reduce its savings

levels and increase consumption. Imports should rise
and exports should fall.

• Another solution could be for the US to increase its own

savings levels and spend a little less.
• However, others, suggest that the trade deficit
between the USA and China stems from China’s
fixed exchange rate, an idea we explore next.
Macroeconomic Policy for an Open-Economy:
Exchange Rates
 Exchange Rate-Meaning
• It is the price/value of one currency (home currency)
expressed in terms of another currency (foreign
currency). [OR] Rate at which one currency is exchanged
for other.

• Usually quoted as number of units of domestic currency

(Indian Rs.) required to purchase a unit of foreign
currency (US $).

• If exchange rate is 1$ = Rs. 45, it means that to buy one $

in forex. market you need to shell out Rs. 45.
 Fixed Exchange Rate System
• Also called Pegged exchange rate system

• A system in which exchange rates are set at officially determined

levels rather than by free market forces, and maintained through
frequent forex. market intervention.

• The purpose of this system is to (a) maintain a country's currency

value within a very narrow band; (b) to allow for more
predictability and stability of the currency value.

• More predictability and stability helps attract foreign investment

and gives businesses that depend on overseas trade more
confidence to invest.
 Flexible Exchange Rate System
• Also called floating exchange rate system

• A system in which the central bank allows the

exchange rate to adjust to equate the supply and
demand for foreign currency.

• Hallmark is determination of exchange rate with

no or less govt./central bank (CB) intervention
• If CB does nothing to influence exchange rate and
if change in rate is caused due to changing
demand-supply situation of foreign currency then
it is called clean floating rate system.

• Under clean floating, CB stays out of forex. mkt.

whatever happens to exchange rate.

• However, such a system is almost unheard of, as

CBs intervene if the situation demands, but not to
extent under fixed system
• If CB intervenes to buy and sell foreign currency to
influence exchange rate it is called managed or dirty
floating rate system

• In practice, this is what happens under flexible system.

But the extent of intervention varies substantially from
fixed system

• Intervention may be required to offset short-term

fluctuations or exchange rate overshoot (i.e. large
changes in exchange rates).
 Devaluation & Revaluation
• These concepts are used under fixed exchange rate
system

• When value of a currency decreases relative to value of

another currency (say 1$=Rs.45 to 1$ = Rs.50) due to
official action, we say that a currency experiences
exchange-rate devaluation.

• This is tantamount to raising the price/value of foreign

currency, i.e. $.
• Devaluation will encourage exports and
discourage imports (Why?)

• It encourages exports because US firms can buy

more of Indian goods

• It discourages import because Indian firms can

buy less of US goods (since we will have to pay
more for US goods)

• The opposite is the case of revaluation [say

from 1$=Rs.45 to 1$ = Rs.40].
 Exchange Rate Depreciation & Appreciation
• These concepts are used under flexible exchange rate
system

• When value of a currency decreases relative to value of

another currency (say 1$=Rs.45 to 1$ = Rs.50) due to
changes in market conditions, we say that a currency
experiences exchange-rate depreciation.

• When a currency depreciates it is worth less; it costs

more rupees to buy one $ (or) rupee can buy less of $.

• The opposite is the case of appreciation

Thus, the concepts of devaluation &
revaluation and depreciation &
appreciation have same economic
meaning. The only thing that differentiates
them is that they belong to different
exchange rate regimes
 Exchange Rate Terminology Comments

Under Fixed Exchange Rate System

Equilibrium Rate: 1$ = Rs.45

Changed Rate 1: 1$ = Rs. 40 Revaluation (i) Exchange rate falls

(of Rs.) (ii) Boost for imports & Disincentive
for exports
(iii) Price of $ falls and hence Rupee
worth more; it costs fewer rupees to
buy a $.
(iv) Americans pay more for Rs. and
Indians pay less for $.

Changed Rate 1: 1$ = Rs. 50 Devaluation (i) Exchange rate increases

(of Rs.) (ii) Boost for exports & Disincentive
for imports
(iii) Price of $ increases and hence
Rupee worth less; it costs more rupees
to buy a $.
(iv) Americans pay less for Rs. and
Indians pay more for $.

Under Flexible Exchange Rate System

Equilibrium Rate: 1$ = Rs.45

Changed Rate 1: 1$ = Rs. 40 Appreciation (of Rs.) Same comments as above

Changed Rate 1: 1$ = Rs. 50 Depreciation (of Rs.) Same comments as above
 Determinants of Exchange Rate
• The foreign-exchange market is a market like any other.

• There is demand for a currency and a supply of that

currency

• An equilibrium price and quantity (i.e. exchange rate) are

determined by the intersection of supply and demand in
respect of currency in the forex. market
 Scenario Impact
(From India’s point of view)

If demand for $ is higher than Rupee depreciates; you will

supply of $ be ready to pay more rupee
to get a $

If demand for Rupee is higher than Rupee appreciates; those who

supply of Rupee need rupee will be willing
to part more $
Forex. Market in Equilibrium
 What determines demand for foreign currency? (or)
Why would Indians demand $?
(a) Consumer preferences: Indians want to use the $ to buy
goods or services or financial assets from USA

(b) Interest rate: High interest rates in the USA relative to India
or overseas will increase the demand for US financial assets
thereby increasing the demand for $

(c) Perceived risk of investing in $ against the perceived risk of

investing in other countries.
• Generally, USA is seen as a safe place to invest.
• However, Indians feel confident about putting money into
emerging economies such as Russia, Brazil, or South Africa,
they will invest more there which reduces $ demand.
 What determines supply of foreign currency?

(a) Export earnings & foreign direct investment

(b) Interest rate: If US interest rate is low relative to

foreign interest rates, financial investors holding US
assets will want to sell them and purchase foreign
(including Indian) assets which would increase the
supply of $ in the Indian forex. market

(c) Perceived risk: If foreign investors’ confidence in

foreign economies (read Indian economy) increases,
the supply of $ will increase as investors sell of U.S.
assets
 How Fixed Exchange Rate System Works?

➢Assume that India is running a deficit in the BoP

vis-à-vis USA [How deficit emerges?]

➢Hence demand for $ increases because people

need more $ to pay for imports

➢With a given $ supply, Rs. faces danger of

loosing value (why?) – Possible destabilisation
effect on exchange rate.
➢ Hence central bank (RBI) has to intervene to prevent
destabilisation of the exchange rate (Why?)

➢ How RBI intervenes?

RBI meets extra demand by selling $ from its reserves
in exchange for Rs.

➢ If country persistently runs deficits in BoPs, and if

demand for $ keep on increasing, RBI eventually will
run out of $ reserves and will be unable to continue its
intervention (India’s situation in early 1990s).
➢If situation goes out of control (see below under
speculative attack), RBI will have to devalue Rs
[with the approval of IMF].

➢Devaluation makes Indian goods relatively

cheaper for foreigners to buy, hence enhancing
export or $ earnings (India resorted to this tactic
in early 1990s)

➢Pressure on $ comes down; value of Rs. restored

 Speculative Attack Under Fixed System
• This could be the worst scenario for a Central Bank (RBI)

• Many countries abandoned fixed system due to this fear

• Suppose RBI’s holding of $ reserves dips low

• Foreign lenders lose confidence in govt. and either

reduce loans or begin demanding higher interest rates.

• Investors begin to doubt the overall health of the Indian

economy. They will start to sell their investments,
increasing the supply of rupees.
• This aggravates the deficit in the BoP

• This triggers expectation of devaluation of rupee in

near future

• So there will be a rush to sell off rupees and buy dollars

– Speculative attack

• Some investors, called speculators look for these kind of

situations

• This is because, after devaluation, speculators can make

profits. How?
• Before devaluation 1$ = 45

• After devaluation 1$ = 50 (A $ gets Rs. 50 now,

i.e. Rs. 5 more!)

• If the speculators dump a lot of the rupee in the

forex. market quickly, they may cause govt. to
run out of its stock of $

• This situation makes life miserable for RBI –

mounting demand for $, which is already in
short-supply.
• This will cause a drop in value of Rupee

• At that point, the speculators come back in and buy the

cheapened Rupee and pocket a profit from having sold
the current at a high price and then buy it back at a low
price

• RBI has to either release $ from forex. reserves or

increase interest rate (to attract more FII flow)

• If these efforts are not successful, it has to resort to

devaluation.

• But, devaluation can cause inflation becoz. imports

become costlier
 Speculative Attack: An Example

• In 1997, Thai baht (Thailand currency) came under

intense speculative attack from investors.

• The Thai government had a fixed-exchange-rate

policy; when the attack began, it needed to use foreign
reserves to buy baht.

• The government spent more than $33 billion (about 90

percent of the country's foreign reserves) trying to
protect the currency.

• It also increased domestic interest rates to encourage

investors to keep money in the country.
• However, the attack continued, and the government
eventually could not continue to defend the baht.

• The only choice was to untether the currency from the

fixed exchange-rate system and let the baht float. Or,
rather, sink:

• When the rate was allowed to float, the baht lost half
its value.
 How China is able to undervalue its currency
without fear of speculative attack?
• As seen already, Chinese government keeps the yuan's
value low by selling piles of yuan in the foreign
exchange market, and it uses a portion of those dollars
to buy U.S. Treasury debt.

• This makes China's exports more attractive to U.S.

consumers and make it harder for U.S. companies to
export to China.

• Why other countries are not able to follow this trick?

• For this policy to work, the following conditions need to

be present.
(a) To maintain a long-term devaluation, a country has
to buy up huge amounts of $, to put more local currency
on the market.

(b) Currency devaluation means that savers tend to send

their money to be invested overseas rather than
domestically. Loss of savings may not be the best way
to develop the domestic economy

(c) Undervalued currency makes imported foreign

goods more expensive.
 How Flexible Exchange Rate System Works?
(When supply of $ increases)

➢ Assume the initial level of exchange rate as 1$ = Rs. 45

➢ Assume that US investors want to buy more shares in

Indian companies or to set up more production plants in
India.

➢ Now, Americans require more Rs to meet their

investment requirements. That is demand for Rs
increases (why?).
➢Since it is a flexible system, RBI simply prefers
to stand aside and let exchange rate freely
determined in forex. market.

➢When demand for Rs. increases, given the

available Rs. stock, the $ price an US investor is
willing to pay to get a rupee increases (or) US
investors will be ready to pay more $ to obtain Rs
➢Hence, Rs. appreciates (e.g. 1$=Rs.40); i.e. a fall
in exchange rate

➢At the same time, Rs. supply increases to the

amount $ is substituted with Rs

➢Rs. appreciation makes US goods cheaper in

terms of rupees (rupee cost of imports will be
lower) and hence demand for US goods in India
increase – i.e. imports will increase.
• On the other hand, exports will be adversely affected
(Why?).

• Thus, appreciation means a loss in India’s

competitiveness.

• Hence there may be pressure on the RBI to intervene

(How?) in the forex. market.

• Since this is flexible exchange rate system RBI

maintains utmost restraint

• But, it may intervene if the situation really demands

• RBI intervention can take two forms:

(a) Reduce interest rate by relaxing monetary

policy. This will lead to capital outflow and
rupee depreciation

(b) Resort to non-sterilised intervention

(explained below) – buy $ to inject more Rs.

• The loss in India’s external competitiveness,

thus vanishes.
• But, what happens if this situation is allowed
to reach its own logical conclusion; i.e. no
active intervention from RBI?

• The following would be the main

repercussions in India and USA
 India USA
US goods become cheaper in India Indian goods become costly in USA
Demand for US goods in India (i.e. Demand for Indian goods in USA (i.e.
imports from USA) increases exports from India) falls - loss in
India’s external competitiveness
Output and employment tend to Output and employment tend to
decline due to falling exports to USA expand due to increased exports to
(Negative Effect) India
(Positive Effect)
Pressure for protection in India to -
keep out cheap imports/Demand for
more incentive for exports
India’s ‘imported inflation’ tends to Imported inflation rises because
decline since rupee cost of imports has Indian goods are now costly in USA
fallen
(Positive Effect) Other possible reason for inflation:
Rise in supply of $ due to increased
exports
(Negative Effect)
• US might welcome an increase in employment as a side
effect of rupee appreciation, but they certainly could do
without the inflation.

• Policy makers in US therefore must decide whether to

accept the higher-employment-higher-inflation effects of
Rs. appreciation or whether they should change their
own policies.

• If inflation is already a big problem in US, the policy

response from US would be to tighten money.
• Monetary tightening in US leads to rising interest
rates in US.

• By and large, financial capital (i.e. FIIs) searches

for countries with higher interest rates -
speculative flow.

• Since US interest rates become high, it results in

outflow/flight of capital [mainly portfolio
investment] from India to US, leading to falling
supply of $ and hence falling pressure on Rs.
demand.
• This ultimately lead to depreciation of Rs. (due
to more demand for $ & less demand for Rs.) to
reach equilibrium/original level.

• Thus, without Central Bank/RBI intervention

India’s competitive position restored!
• What happens if inflation is not an issue in US?
[OR] If US loosens its monetary policy (i.e., fall
in US interest rate which aggravates capital
inflow into India), what India should do?

• India will have two options [Intervention by

RBI]:
(a) Reduce interest rate by relaxing monetary
policy. This will lead to capital outflow and rupee
depreciation
(b) Resort to non-sterilised intervention
(explained below) – buy $ to inject more Rs.

• The loss in India’s external competitiveness,

thus vanishes.
 How Flexible Exchange Rate System Works?
(When demand for $ increases)
• Assume the initial level of exchange rate as 1$ =
Rs. 45

• Assume that US exports to Indian rises (or)

investment made by Indians in US increases.

• Now, Indians require more $ to pay for US

exporters. That is demand for $ increases.
• Since it is a flexible system, RBI keeps mum.

• When demand for $ increases, given the available

$ stock, the Rs price an Indian investor is willing
to pay to get a $ increases (or) Indian investors
will be ready to pay more and more Rs to obtain
a$

• Hence, Rs. depreciates (e.g. 1$=Rs.50); i.e. a rise

in exchange rate
• At the same time, Rs. supply falls to the amount
Rs is substituted with $ – So both $ and Rs stock
falls

• Depreciation makes US goods expensive in

terms of rupees (rupee cost of imports will be
higher) and hence demand for US goods in India
comes down – i.e. imports comes down

• But, exports from India to US increases

• Thus, depreciation means gain in India’s
competitiveness

What happens if this situation is allowed to

reach its own logical conclusion; i.e. no
active intervention from RBI in the near
future?

• The following would be the main

repercussions
 India USA
US goods become costlier in India Indian goods become cheap in USA

Demand for US goods in India (i.e. Demand for Indian goods in USA (i.e.
imports from USA) declines exports from India) increases – gain
in India’s external competitiveness

Output and employment tend to Output and employment tend to fall

expand due to rising exports to US due to falling exports to India
(Positive Effect) (Negative Effect)

- Pressure for protection in USA to

keep out cheap imports
Inflation rises – imported inflation US’s inflation tends to decline since $
(Negative Effect) cost of imports has fallen
Other possible reason for inflation: (Positive Effect)
Rise in supply of Rs due to increased
$ flows due to increased exports
• US might welcome a fall in inflation, a side effect of
rupee depreciation, but they certainly could do without
falling employment.

• Policy makers in US therefore must decide whether to

accept the higher-unemployment-lower-inflation effects
of Rs depreciation or whether they should change their
own policies.

• If unemployment is already a big problem in US, the

policy response from US would be to go for an
expansionary monetary policy.
• Expansionary monetary policy in US leads to
falling interest rates in US.

• This results in inflow of capital from US to

India, leading to appreciation of Rs. (due to
more demand for Rs.) to reach
equilibrium/original level.
• If unemployment is not an issue in US what will
happen? [OR] If US tightens its monetary policy (i.e.
increase in interest rate), what India should do?

• India will have two options:

(a) Keep interest rate higher than US rate by tightening
monetary policy. This will lead to capital inflow and
rupee appreciation

(b) Resort to non-sterilised intervention (see below) –

buy Rs. to inject more $.

• The gain in India’s external competitiveness, thus

vanishes
 Intervention in Forex. Market
➢By now we know that central banks (CBs)
intervene in the forex. market both under fixed
and flexible system (But, what is the difference?)

➢Intervention is buying/selling of forex. by CB in

the forex. market.

➢For this purpose, CB’s hold reserves of foreign

currencies
 Why CB intervention under fixed system?

(i) Belief that induced movements in exchange

rates cause unnecessary changes in domestic
output and employment – e.g. adverse impact of
appreciation on exports.

(ii) To smooth out fluctuations in exchange rates.

(iii) To control inflation

• CBs intervene to fight inflation caused by large
capital inflows. [Due to currency appreciation]

• CBs intervene to prevent exchange rate from

depreciating with the aim of preventing imports
becoming costly and thereby helping to slow
inflation.

(v) Intervenes to make it clear to the world that

there has been a change in policy
 How the CBs intervene under flexible system?

• In two ways: Sterilised intervention and Non-

sterilised intervention.

• Sterilised intervention involved two steps:

➢First, the central bank buys (or sells) foreign

exchange and issues (or buys) domestic currency
in its place.
➢Second, increase (or fall) in home currency is
reversed by an open market sale (or purchase) of
securities – Monetary policy intervention!

➢In this case, therefore, the home money supply is

kept unchanged.

• In case of non-sterilisation, there is a change in

money stock equal to the amount of intervention.
That is, extra domestic currency that is supplied
is not taken back.
• It is widely agreed that non-sterilised
intervention will affect exchange rates.
Because it changes the money supply.

• However, there is widespread scepticism about

the effectiveness of sterilised intervention.

• Another alternative, apart from these two, is

interest rate.
• In situation where domestic currency appreciates,
the central bank can stop it by reducing interest
rates, which reduces capital inflows.

• In case the domestic currency depreciates (more

demand for $), the central bank can increase
interest rates, which increases capital ($) inflows.
 The learnings ………….
Module 1
Assessing & understanding the functioning of an economy - Principles
National Income Accounting
Cost of Living
Unemployment
Aggregate Expenditure and its Determinants
AE Equilibrium and Keynesian Cross & Multiplier Effect
Aggregate Demand and Aggregate Supply - Concept & Dynamics
Module 2
Assessing and Understanding an Economy’s Functioning – Practice
India's Economic Environment since Independence
Agriculture Sector
Industrial Sector (MSME, India-China, Labour Reforms, Land acquisition, S&T policy)
Services Economy (Overall, Education, Health)
Module 3
Macroeconomic Policy Tools
Fiscal Policy (Concepts, Covid-19, GST)
Monetary Policy (Concepts, NPA and MFI)
Open-economy Policy (Concepts, FTA & FDI)