RCEP can spell RIP for domestic manufacturing jobs

https://www.financialexpress.com/opinion/opening-up-manufacturing-without-proper-employment-impact-assessment-might-prove-disastrous/1486932/

No one can deny that overall there are net gains from free trade (FT). If the most efficient producers are provided access without artificial restrictions (political or geographical boundaries) obviously it would optimize the costs for a given level of consumption.

But how those gains are distributed is an unsettled question. We can have examples of countries losing out due to FT and others gaining at their expense. It is not even difficult to construct examples of just one country garnering all the gains and all the others losing.

Its also possible that the gainer(s) gain far more than the gains from free trade efficiencies at the expense of others (kind of loss imposition on losers). Unless one is careful about what to negotiate/avoid and does homework properly, one may be a heavy loser. Lets see an illustration.

Illustration

The illustration seeks to break up the supply curve in the standard demand supply analysis of micro economics. The supplying units are arranged from the most efficient to least efficient from left to right. Efficiency is measured by how low the total variable cost is. The thick ridge line running over the top of various bars representing individual units comprises the supply curve. Those to the left of where the Demand curve meets the Supply curve gets to supply the market.  Those to the right will incur a cash loss since the market price is less than their variable cost.

The illustration studies the impact of removal of import duties after FTAs. After removal of import duties, the supply curve accommodates more overseas players to the left and push out some domestic suppliers to the right of equilibrium pricing and hence face closure.

The net impact (difference between before and after scenarios) in the illustration is as follows:

  • The Government has lost whatever Import duties it was getting from the Korean (for example) suppliers who were already competitive suppliers in the market. The entire amount would have accrued to the Korean suppliers,
  • The domestic consumers have benefitted from a price reduction of less than 1%. This is most likely from better efficiencies of the overseas suppliers.
  • There is a net loss in domestic employment (loss of 9% down from 139 to 127 in the illustration).This would have either resulted in better employment overseas or better capacity utilization for them.

This kind of relatively flat demand or supply curves prevail in commodity industries where consumers don’t pay much premiums for brand and supply efficiencies come from factor cost differences, scale economies, cheap labour, patents, etc.

Net loss in employment.

Larger and concentration of capacities enabled by FT does facilitate mechanization and result in net loss of employment as empirically observed. These net losses in employment have also to be distributed and one can end up with a disproportionate share of this unemployment as in the above case where the host country ends up with all the employment loss.

Ineffectiveness of Revealed Comparative Advantage

One of the methods oft-used by trade economists to identify industries with export or import competitiveness is the Revealed Comparative Advantage (RCA) and its variants. Essentially this method calculates the ratio of (i) % of a particular commodity in a country’s exports to (ii) the % of global exports of the commodity in world exports. If the ratio is more than 1, then the country is supposedly export competitive. Instead of global %, one may use specific country %s, regional %s, or host country’s %s, to identify export competitiveness or import vulnerabilities.

But it is terribly reliant on the past like using KL Rahul’s yesteryears averages to play him in todays matches. What is important is the current competitiveness in an ever dynamic world, where the steep price fluctuations in some key inputs like oil, metals, interest rates, etc. can vastly change the fates of several industry players’ competitiveness.

As can be seen from the illustration the units around the equilibrium price – may be 20-30% on either side would largely decide the gains or losses from trade. Units which are highly competitive (leftmost) or least competitive (rightmost ones) will hardly matter. For example, ASEAN units despite a duty reduction do not enter domestic market. There may not be much point in negotiating access in such a commodity if we are in a similar situation.

Likely effects of Regional Comprehensive Economic Partnership (RCEP)     

This kind of analysis should be done for both commodities where we have some basic strengths and where we would like to invite competition. Using elasticities alone may not suffice as so much depends on capacities of individual players around the equilibrium price. ASEAN FTA has not resulted in much gain or loss over the last 5 years it has been in full operation. But China is a different player altogether.

Many Chinese commodity players have huge capacities – in select cases a single unit or player have enough capacities to supply the entire Indian market. If an import facilitating measure or cut in duties make them competitive in domestic industry, then the whole domestic manufacturing can get wiped out resulting in loss of domestic employment.

India’s strength in its low cost labour, but largely untrained and low skilled. In most manufacturing units the wages account for 8-12% and dwindling by the day. Even a 30-40% cheaper labour translates to only a 3-5% overall advantage which is not even sufficient to counter our unreasonably high real interest rates. But where wages constitutes 40-50% like in many services, IT, research, design, etc. a 30-40% cheaper labour can give 10-20% overall advantage. These are also less capital and machine intensive and interest rates are less impactful.

India’s homework so far in negotiating trade agreements has not been stellar. Opening up our manufacturing without proper employment impact assessment might prove disastrous with RCEP. Even if services are negotiated well, it will open up opportunities for higher skilled but the low skilled and labour which are newly transferred from agriculture and rural areas may be left in the lurch.

Illustration:  Before and After FTA – impact of duty reduction

RCEP jpeg

In case the picture is not clear, you may kindly open XL file from the link below

RCEP

A case for CSR and MAT levies on imports.

A case for MAT and CSR levies on imports

V Kumaraswamy

Sec 135 of the Companies Act 2013, enjoins companies meeting some criteria to spend at least 2 % of their average (of preceding 3 years) PAT on social projects. These thresholds are quite low, less than a $ million in PAT or $ 150 million in Sales or less than half that in Networth. As the table shows the PAT of just the listed firms would have had to spend an estimated Rs 4000 cr on CSR using 2016-17 as surrogate for the base PAT. The actual spends reported on CSR by all firms (listed or otherwise) are about Rs 8500 Crores in 2016 as per MCA website.

Sec 115JB of the Income tax act specifies a Minimum Alternate Tax (which now comes to an effective 21.55% of PAT) The objective of introduction of MAT is to bring into the tax net “zero tax companies” which in spite of having earned substantial book profits and having paid handsome dividends, do not pay any tax due to various tax concessions and incentives provided under the Income-tax Law. MAT is in its 3rd avatar: after 2 attempts in 1980s (both American style of deeming certain % as minimum income to be offered for income tax, irrespective of tax shields) it was reintroduced in 1996-97 and has steadily grown in its significance nullifying several other incentives offered.

It should be noted that of the relevant competing countries for our markets – ASEAN, Japan, S Korea and China – very few have an equivalent tax. None of the ASEAN has anything as draconian as ours. Philippines and Cambodia have MATs (titles Minimum Corporate Income Tax MCIT for short) at 2 and 1% of turnover and Malaysia in a facilitative not extractive (purpose is to do away with procedures and elaborate book keeping etc) way has a minimum Tax on Labuan Offshore entities at 3%. Only S Korea has anything that comes close to India’s but the rates are 10-17% depending on size of profits (17% kicks in at an equivalent of about $ 100 million) and SMEs suffer 7%. All very low compared to India. Most of these economies offer various incentives for investment, trade and business promotion, export promotion, employment creation, development of less developed areas, etc. But none of these including incentives including on exports are offset by a levy like MAT.

India’s MAT design and the rate have more or less nullified all the incentives. In fact, Japan had protested strongly against MAT before and in 2014 praying for at least Japanese companies operating in India to be exempt from MAT.  What one policy and goal of government offers the other policy seeks to nullify that too within the same Act – great policy making indeed!

As its stands our investment incentives are neither focused nor competitive. The cash outflows from both CSR and MAT are peculiar to entities and manufacturers operating within India. However, if the same Indian market is accessed from outside India, the entities behind them suffer no such levies or cash outflows. The ASEAN agreement has reached a stage of fruition and in many segments India has seen steep increases in net imports into India due to inherent cost competitiveness. There are other free trade agreements in various stages of reaching peak effectiveness and newer ones are being negotiated.

As our imports grow – as of now there are signs that this will not abate anytime soon- the base on which the Government can collect MAT and CSR (or cause to spend in activities it directs) will shrink in relative terms if not in absolute terms.

Estimates of Loss: The PAT margins on India’s listed enterprises excluding government entities and finance sector is about 6.5%. Our imports excluding oil, gold, semi-precious stones (which are largely for re-exports) and defence, are about $ 200-210 billion. The estimated (at the same rate as ours) PAT margins on this is about $ 3.2 billion and the MAT and CSR that would have accrued to the government /welfare spends is about Rs 21,700 Crore. (Pl see table attached).

Mat and CSR

On deemed profits on imports this would translate to about 1.54% of import values. An equivalent levy should be imposed and recovered on imports. Imagine an addition of this to the existing margins of 6.4% – it can make a huge difference.

 

Sure similar entities suffer income tax levies in their home countries. But it is also important to remember that almost all countries provide exemption or even incentives for boosting exports and hence don’t suffer MAT or normal taxes. In several of these countries profits of units located in SEZs is exempt for long periods. And profits on specified products and units (depending on focus products and areas) are exempt for varying lengths of time some extending to 20 years.

MAT and CSR are a net differential on our imports and hence a source of competitive advantage for them. Domestic producers are to that extent at a disadvantage, since their profits are taxed at least at MAT. The government has to study all additional obligations on Indian companies and either impose similar obligations on imports or recover through compensatory mechanisms and create funds and spend on targeted activities.

Indian infrastructure is a huge drag on domestic firms; at least the additional levies should be neutralized.

The Irrelevance of CCI in an Open Economy

https://www.financialexpress.com/opinion/decoded-relevance-of-competition-commission-of-india-in-an-open-economy/1193644/

Like particles behave unpredictably under zero gravity in Physics, in economics what works well in a closed economy may not work that effectively in an open economy and vice versa.

The current controls over monopolies, anti-competitive practices, abuse of dominant positions and mergers exercised by Competition Commission of India (CCI) seem inappropriate for an open economy.

Somehow, from the days of Joan Robinson whose work on imperfect competition is the basis of such market interventions, lesser prices are taken to mean better consumer welfare in our socialistic mindset. Indian telecom market which has expanded solely based on cheap and cheaper prices is an example of how unremunerative  prices can destroy consumer welfare and lead to shoddy services: you cannot even say ‘I love you’ to your beloved on cellphones these days without 3-4 call drops in between.

As it stands today, India is a considerably more ‘open economy’ and particularly more so since ASEAN-FTA, trade agreements with S Korea and Japan from where virtually most goods are available at zero duty at cheaper import parity prices and from China despite duties.

Most manufactured goods can be freely imported – so how can anyone (or in collusion) control or manipulate prices and fix them beyond import parity prices? Conversely, if the Indian prices are lower despite nil-duty imports, it only signifies domestic industry being competitive – so what’s the grouse anyway. Indian firms would be exporting in such cases.

In an open economy the comparative competitive landscape is not just Indian firms alone but includes other relevant supplying countries say China, ASEAN, Japan, Korea and some others, over which CCI has no control. Controlling only the domestic subset leads to loss of competitiveness. Bangladesh and Vietnam have taken a huge part of our share in Textile trade (the prime reason for bleak domestic employment scenario is textiles, potentially our largest employer) due to scale economies: average firm sizes in BD and Vietnam are 10-20 times that of India’s. In some cases, a single machine or unit in China manufactures what the entire Indian industry manufactures or consumes. Scale is an essential component of efficiency and competitiveness and restrictions on them are self-destructive.

Indian regulators have often gotten into the morals of pricing – the very antithesis of free markets. Indian agri produce markets are the most ‘perfect’ competitive – many tiny producer sellers and many individuals buying: the ideal of any Robinsonian economist. Yet from time to time, Tomato and Onion prices fluctuate like an ECG graph whose needle has come unhinged – much more violently than tractor prices, airline prices, white goods, and electricals. Should the CCI get into controlling Onion and Tomato prices and underlying market practices? These have more impact on the daily lives of more people on the brink than many manufactured goods.

Does collusion work in India. Price is the main driver for most consumer decisions in India. Its not unusual to find a Mercedez buyer  bargain for a free key chain. In markets where demand curves have high elasticity there is very limited scope of manipulating prices by firms: small hikes in prices will drive away lots of customers to alternative products. Competition legislations are relevant more for inelastic demands.

Collusive price hikes would lead to reduction in sales in price sensitive markets. But who would volunteer to take these cuts like Saudi Arabia does for Opec? If demand is weak, most players would want to jostle with others and gain market share. If demand is inelastic and hefty price increases are possible with small cuts in production (very few such examples in India: can washing machine manufacturers cut production by say 5% and achieve 25% price jumps?), will any player cut his volume and watch others make money at his expense? Preposterous.

As economist William Baumal concluded over half a century ago, firms are more guided by sales maximization and other such proxies than profit maximizing in their behavior.

Collusion requires co-operation. Where sly and open evasion of every rule or tax-laws are the norm, gentlemen agreements or voluntary self-controls in India is unthinkable. We are terribly competitive in our behavior: otherwise you won’t see such uncouth queue jumping or impatient driving or ‘one for each day in year’ number of national level political parties. Giving up for greater good is just not in our bloodstream.

The right focus

Why be concerned with B2B transactions when both parties are informed, experienced and likely to behave rationally and not psychologically pressurized? Far more collusive behavior is witnessed in B2C transactions say between a doctor (prescribing tests upon irrelevant tests, refusing an operation unless you pass the ‘show me the money’ tests) drug firms and diagnostic labs or between lawyers, a legal system completely under their thumb and hapless clients. To focus on such B2C transactions would be far more welfare additive. CCI should focus more on beefing up enforcement and delivery of consumer protection laws.

Competition laws should definitely be concerned where the products or services are priced below their variable costs. A society not paying variable costs is wasting resources. Such cases in telecom, power and petroleum pose huge systemic risks to the financial system.  In any case why would an Ola or Uber recover less than variable costs unless it is to drive away competition and start exploiting when others have folded up. Such practices are a matter of larger concern, but don’t seem to merit the attention of our CCI.

Competition laws should not be concerned with products can be imported at zero duties or are being imported in large quantities despite duties or products of discretionary expenditure. Why be concerned with scale or prices of consumer electronics, white goods or cars except to ensure that contractual obligations are adhered to and people are not ‘cheated’. Let the consumer choose to stay away, if they are not satisfied with service – after all it is discretinary.

Competition laws should kick in only when firms reach one-half of ASEAN’s biggest capacity. It can be applicable for life saving drugs or non-discretionary products. Others can be followed up based on surveillance or based on grievance from end users.

There are several areas where there are no market structures or performance of existing ones is poor. The commission should work out structures in those areas (example: market structures for electronic wastes, scrapped automobiles, vehicle parking, rural finance and insurance, Public distribution systems, etc.)

CCI in our open economy context seems more a status symbol pining to belong to economic fashion street.  If Make in India refuses to get up, sub-scale will be one key reason and legislations like CCI will have a lot to answer for. India badly needs to consolidate and scale up for cost competitiveness.

Way to kick start economy – Currency Devaluation or Fiscal Stimulus?

An edited version has appeared in Financial Express on 13 Oct 2017

Currency Correction or Fiscal Stimulus?

V Kumaraswamy

The feeling of sluggishness is palpable everywhere. There are talks of stimulating the economy by fiscal incentives etc. This can be a very innocuous medicine for reasons of (i) dosage, (ii) potency, and (iii) long lead time.

First the dosage. The government may throw Rs 50-60K crores as fiscal stimulus. This is about 0.4% of our GDP. Given the current moribund state of economy with 25-30% underutilised capacities it is too tiny to have any impact. The current closure of capacities or lack of investments have not become so for 1-2% poorer realisations or profitability. While the figures vary for different industries, it is substantial – more in the range of 10-20%. We need a correction of this magnitude. The gaps in our competitiveness with countries exporting to us like China, ASEAN and Korea is 10-15%; not a 1-2% pittance.

Next the potency and wastage. Any incentive will reach both Units operating at full capacity and units with low utilisation and poor profitability. Units which are closed or NPA currently could hardly be revived with a small ‘spread thin’ incentive. The incentives reaching units operating at full capacity will neither create incremental growth nor new employment. There will be a lot of wasted (applying where not needed) efforts.

Finally, the lead time. If stimulus is by way of Income Tax rebates, it will be a year or many quarters before the recipient feels it and reckons it in his decisions. If it is by way of Indirect tax cuts, the recipient knows that it is for a limited period and will not motivate him for taking a long term investment decision. We need some immediate actions and most fiscal measures take a long lead time to get results. It may be well beyond 2019 that one would see perceptible results.

The current problem

The economy is stuck at a low and unresponsive equilibrium.  The current economic impasse is born out of 3 main factors (i) high internal value of currency (low inflation targets resulting in high real interest rates), (ii) may be partially from it, high external value of Rupee and high real interest rates attracting too much forex flows which are beyond the capacity of economy to absorb and (iii) free trade with ASEAN which kicked in from Jan 2014 in full.

ASEAN FTA did increase supplies and kept prices under check. It made import parity as the main basis of price determination for many manufactured goods. But it also eroded domestic industry’s profitability since manufacturing prices have hardly risen to cover inflation of inputs in wages and inputs from agriculture. It delivered customer stable or reduced prices but took away their jobs. India’s growth is creating Jobs but in other countries!

Somehow inflation control has become the focal point of our monetary management in recent years just like fiscal deficit is for our Union Budgets. While the fiscal deficit control is understandable, in an open globalised economy when product of every description could be freely imported, supply shortfall induced inflation is out of question. From Pulses and rice, to apparels, to electronics and Ganesha and Navrathra idols everything can be imported these days. So supply constraint induced inflation is the least that RBI or the Government needs to worry about.

Ways to correct imbalances

The main contributory reason for our lack of competitiveness with other regional players is the high external value of our currency. The sooner it is corrected the better, either by devaluation or dis-incentivising inflows.   But devaluation can cause inflation. As is reasoned out below inflation can be phantom enemy if things are calibrated well.

The first thing is to reduce debt limits available to overseas investors and strictly adhere to such limits. There is nopoint accumulating reserves to earn 1-2% returns by paying 4-5% overseas as interest in $ terms.

Secondly, there could be a temporary tax on overseas investments into India. This can be even for ECBs, investments into government debt and all inflows which are not required for physical imports. Taxing interest on GOI bonds will lower their yields and contain inward flows. There could be a surcharge on inflows till the related imports also take place. These could be used for re-capitalising our banks.

As a corollary, Government can mandate that fresh foreign investments can only be in new government bonds issued, on which the GOI can offer much less interest rate. Such an exercise will help the GOI as well. Such issuances can be allowed for secondary trades may be a separate bond segment with lower interest will develop as a result.

Containing Resultant Inflation 

The Government should bite the bullet like it did with GST and correct the near 22% over valuation in one substantial go. It can reset $=Re at Rs 71-72, which is 11% correction.

Monsoon is good throughout the country and agricultural inflation may not be a risk. If in fact there is excess production, a good forex rate might help evacuate some surplus so that domestic prices don’t crash due to oversupply.

In the long term, a 11% devaluation is about $ 40 billion in added inflation. This on a GDP of approx. $ 2400 is about 1.6% – may not be unbearable. But it’s the short temr effect on imported products and their immediate derivatives and next level products.

Oil is the largest at 25% of import bill.  Government (state and Central) should put a price cap. Their duties (customs, Excise and VAT together) account for a third of final price. There can be a freeze for 12-18 months in Re-terms on these. Oil marketing companies which have expanded their margins in the last few months can be told to absorb a third and the rest can be passed on. An additional 3.7% inflation on oil will amount to about a 1% on final inflation. Gold and Diamonds are next. We should not bother with Gold (the costlier it is, the better) and Diamond is largely for processing and hence related exports will make up for the input inflation.

That will confine inflation largely to manufactured goods. Most prices today in manufacturing sector are determined by import parity prices. A 10-11% correction would most likely translate into a similar uptick in their prices, which could help several factories (most especially textiles) to start chugging again. In any case, buyers of manufactured goods have had it too good for the last 5-6 years without much inflation.

Protecting the pensioners and interest earners needs to be balanced with the interest of freshers in the job market. The total interest paid on all bank deposits and Small savings and MFs is less than 5.5% of GDP. If we remove the government pensioners and those who have not yet retired from this, it would not be more than 1-2%. The number of those entering the job market and finding themselves without jobs will far outnumber those surviving solely on interest.

Currency correction will also solve a lot of NPA issue. A 10-12% increase in industrial realisations will turn many industrial units from potential NPAs to preforming ones.

Superiority over fiscal stimulus

Currency correction will hit the problem where it is. The dosage at 11% on the total value of trade (both imports and exports) is huge. It will alter the domestic profitability substantially and have an immediate impact – from the following day morning.

Sure forex borrowers will suffer. But those who have covered their exposure need not worry. For those who have not covered or partially covered, they have made good gains for the last 12 years on the trot. Why should not they not be made a pay some back now?

An equilibrium cannot be corrected by fiscal stimulus which will be better for rectifying confidence issues.

(The writer is the author of Making Growth Happen in India, Sage Publications).