Despite the rapid expansion of services in the economies of developed and developing countries, it still remains true that a nation's economic strength is in the final analysis based on the strength of its commodity producing sectors. Also, given the more rapid pace of productivity expansion in manufacturing, the creation of a substantial and dynamic manufacturing sector has historically been the centre-piece of development strategies.

Seen from that perspective, there is much that is disconcerting about the development process resulting from the adoption of a neo-liberal reform agenda in the 1990s. To start with, despite claims to the contrary by the government, manufacturing growth performance during the 1990s and more recently has been worse than in the 1980s. Not only has the trend rate of growth tended to be at best similar to that observed in the 1980s, but the pace of manufacturing growth has tended to be extremely volatile with creditable growth rates being concentrated in one or two year periods separated by slow growth and recessionary conditions. Second, there are some signs of the "hollowing of the middle" in Indian industry, with growth occurring in the very large scale sector, while the medium and small scale industry has witnessed slow growth and high rates of mortality because of competition from imports or import intensive "domestic" products, a recessionary environment, waning state support and inadequate credit access at times of distress. The small scale sector that tends to persist is that which caters to the ancillarization needs of large firms, to niche markets and to low margin markets that persist because of low per capita income and high poverty. Third, there are clear signs of consolidation within the large industrial sector, in which foreign firms encouraged by liberalization of rules governing foreign direct investment, play a major part. Since these firms invest and expand in India to cater to domestic and not export markets and since they are characterized by large outflows on account of intermediate imports, royalty payments and profit repatriation, their growing presence not only limits the maneuverability of the government when it comes to industrial policy, but also has adverse balance of payments implications in the form of a rising trade deficit that encourages dependence on purely financial flows to help finance that deficit. Finally, the most disconcerting feature of industrial development during the 1990s is the lack of any contribution of output growth in the organized sector to employment growth. In fact, there appears to be a negative relation between output and employment growth. While it is known that the manufacturing sector tends to be far less labour-absorbing than agriculture or services, this feature of growth in organized industry is extremely disturbing and needs correction.

There is reason to believe that most of these features of manufacturing growth during the neo-liberal era were a direct result of policy, defined as consciously designed acts of commission and omission. These have had implications for both the pace of growth and its volatility, as well as for the pattern of growth with several attendant consequences as noted above. Consider, for example, the fact that a feature of the 1990s was the extreme volatility of growth rates in the manufacturing sector, which in the past had been more characteristic of areas like finance. This instability also suggests that even the moderately positive performance of the industrial sector may not be sustainable.

There are two factors that seem to explain instability. On the one hand, the evidence indicates that public expenditure has been far more unstable in the 1990s. The latter has been partly because of variations in the government's degree of adherence to its irrational fiscal deficit targets initially imposed by the IMF, partly because of a sudden burgeoning of public expenditure towards the end of the 1990s because of the implementation of the Fifth Pay Commission's recommendations, and partly because of the influence of the political business cycle that results in a ramping up of public expenditures of certain kinds in the run up to an election. It needs to be noted that it was not the agricultural cycle that influenced the government's inter-temporal expenditure patterns (as used to be the case when the agrarian constraint was binding in the sixties and seventies); not was it the threat of a balance of payments crisis that constrained government expenditure (despite the experience of 1990-91, India has recently foreign capital flows in excess of that needed to finance its current account deficit). But for the moment what matters is that the instability in government expenditure that contributed in part to the instability in industrial growth has been the result of autonomous actions of the government rather than the result of externally imposed constraints.

The second factor explaining the instability in manufacturing growth is the fact that in the initial post-liberalization years, the sudden increase in access to domestically assembled or produced import-intensive manufactured goods resulted in the release of the pent-up demand for such goods among sections who had had the ability and the desire to consume such goods, but whose consumption of such commodities was limited by import regulation of both final products and intermediates and components. Inasmuch as such pent-up demand is soon satiated, the spur to growth provided by this specific factor evaporated, resulting in a slowing of the growth rate pending an expansion of the market for such manufactures among a larger section of the population.

Finally, instability in the pace of manufacturing growth has been the result of the specific way in which that market for manufactures has been expanded, especially in urban India, during the years of neo-liberal reform: through a boom in housing and consumer credit. One consequence of financial liberalization and the excess liquidity in the system created by the inflow of foreign capital, has been the growing importance of credit provided to individuals for specific purposes such as purchases of property, consumer durables and automobiles of various kinds. This implies a degree of dissaving on the part of individuals and households. It also implies that financial institutions, which are willing to provide such credit without any collateral, are betting on the inter-temporal income profile of these individuals, since they are seen as being in a position to meet their interest payment and amortization commitments based on speculative projections of their earnings profile. These projections are speculative because of the fact that with banks and other financial institutions competing with each other in the housing and consumer finance markets, individuals can easily take on excess debt from multiple sources, without revealing to any individual creditor their possible over-exposure to debt.

There are two implications of the expansion of the market for manufactures through these means. The occurrence and the extent of such an expansion depend crucially on the "confidence" of both lenders and borrowers. Lenders need to be confident of the future ability of their clients to meet interest and repayment commitments. Borrowers (excluding those consciously involved in fraud) need to be confident of their ability to meet in the future the commitments that they are taking on in the present. This crucial role of the "state of confidence" in triggering this form of demand is what is captured in the oft-used phrase: "the feel good factor". Since there is a strong speculative element involved in lenders providing credit and borrowers increasing their indebtedness, the state of confidence of both parties matters. When such confidence is "good", we can experience growth or even a mini-boom. When such confidence is low in the case of either borrowers or lenders, we can experience recessionary conditions. To the extent that financial liberalization provides the basis for an expansion of the world of debt - mediated either through bank accounts or plastic cards - a degree of volatility in manufactures demand is inevitable.

The second implication of debt-financed manufacturing demand is that it is inevitably concentrated in the first instance in a narrow range of commodities that are the targets of personal finance. Commodities vary from construction materials to automobiles and consumer durables. To the extent that these commodities are of a kind that are capital- and import-intensive in nature, the domestic employment and linkage effects of this expansion would be limited. Not only would employment growth be limited, as has been the case, but sustaining the growth process would require generating more of the same kind of demand. Manufacturing growth would become increasingly of a speculative character.

It hardly bears stating that a large share of the commodities for which demand is triggered by credit are both capital- and import-intensive in character. There are a number of other reasons why manufacturing outputs sucked out by a credit boom tend to have these characteristics. First, the liberalization of policy with regard to foreign direct investment has meant that much of the credit-financed "new" market for manufactures is catered to by these transnationals, endowing these products with a greater degree of import- and capital-intensity. This tendency has been helped along by the fact that those favoured with credit fall in the middle classes, which too is characterized by a pent-up demand for "foreign" goods that could not be satiated earlier, not just because of protection but also because they lacked the means (including credit) to acquire these commodities rapidly. A second reason why domestic linkage and employment effects would tend to be low is that a combination of import competition, the induction of larger firms into the small-scale sector through the redefinition of "small" and "dereservation" of areas of production has undermined the ability of smaller firms to service certain markets. Finally, with end of the era of development banking in general and directed credit in particular, the possibility of such firms obtaining the finance to emerge and survive has declined.

The net effect of all these has been the set of disconcerting trends we spoke of earlier. Identifying the proximate causes for those trends also helps us specify certain measures that must be part of any industrial policy agenda. In the long run, a conducive industrial environment requires significant structural change such as the breakdown of land monopoly in rural India, in order to expand the mass market for manufactures. While the realization of that goal must wait, the decision of the new government, as embodied in the CMP, to launch on a pro-poor development path, provides the basis for the correction of the errors in policy during the 1990s that have generated the scenario that we just described. That scenario was one characterized by speculative debt-financed consumption and dissaving, growing import intensity of domestic production and a sharp rise in capital intensity that implied "job-displacing growth".

There are four elements that in our view should enter into any interim industrial policy. First, the role of public expenditure, especially public investment as an important stimulus to industrial expansion, through direct demand expansion and income generation and by relaxing infrastructural bottlenecks, needs to be restored. This requires reversing the decline in the tax-GDP ratio, increasing revenue collection through more appropriate rates and a wider tax net and focusing on generating additional non-tax revenues by reorganizing the public sector rather than resorting to quick privatization of profit-making public enterprises. It also requires encouraging demand based on income growth rather than debt expansion. Second, the role of finance as a stimulus to manufacturing dominantly through debt-financed consumption spending must be replaced by one in which financial institutions dominantly support investment through lending and investment. This requires reversing the tendency to undermine the development finance institutions by converting them into universal banks. Further, the earlier tendency of the financial institutions to lend to a few big firms in a few areas, which led up to the UTI-debacle for example, must be corrected. More widespread lending, including to small and medium sized firms is crucial if the phenomenon of job-displacing growth in manufacturing is to be reversed.

There is one possibility that needs to be considered seriously in this context. The commercialization of development banking has seen the increasing presence of the financial institutions as active traders in domestic stock markets in search of high returns. This speculative presence in the market, which increases the ratio of their assets held for speculative as opposed to productive purposes, needs to be curtailed. However, over the years these institutions have not merely accumulated non-performing assets in the form of credit to some of the leading corporate groups in India, but they have also acquired a large volume of debt and equity in well-performing large firms. Having supported the growth of these firms and business houses, it is perhaps time for the financial institutions to gradually withdraw from these locations by selling out their assets and using the funds so acquired to finance new ventures of a kind characteristic of a dynamic economy.

This implies that new legislation that helps financial institutions pursue firms in which they hold non-performing assets should be implemented. Innovative practices like securitization of debt to withdraw from debt provided to more successful business groups should be adopted. And financial institutions should resort to a careful process of sell out of equity acquired (either directly or through the exercise of the convertibility option) in successful firms in the past. All this would help release resources that could go into financing new and needy projects. This would partially reduce the pressure on the government to increase the investment ratio in the economy by investing its own budgetary resources.

The third area in which the government should make changes is with regard to foreign direct investment. Such investment is indeed required and can play an important role if of an appropriate kind. But foreign investment, which acquires large chunks of equity in firms catering to the domestic market, uses these firms to market import-intensive branded products and then takes out large amounts of foreign exchange in the form of technology payments and dividends, needs to be regulated. The obvious adverse balance of payments implications of the operations of these firms, implies that to earn their profits they are draining the national pool of foreign exchange resources which is then refurbished with capital in the form of hot money that not merely drains out further foreign exchange but increases the vulnerability of the system to financial crises. It is perfectly rational as well as reasonable that foreign firms with equity holding above a certain limit and extracting large technology payments should at the minimum earn the foreign exchange that they propose to take out. Further, in terms of emphasis, the effort should be to encourage foreign investment that uses India as the outsourcing base for world market production, with positive net employment and balance of payments effects. If outsourcing in software and IT-enabled services is seen as such a major source of strength for India, there is no reason why outsourcing in manufacturing should not be seen as positive, and provided more privileges than foreign investment catering primarily to the domestic market and regulated for balance of payments reasons.

Finally, industrial policy should encourage small scale production with both employment and linkage effects in mind. Protecting small scale production with the employment objective in mind in a labour-surplus economy is not a form of charitable intervention but rational economic policy. This was recognized by Mahalanobis in his four-sector model which explicitly provided for small and cottage production as a means of neutralizing the adverse employment implications of investment in capital-intensive sectors. Such protection would involve a rethink of excessive import liberalization in sectors where small-scale production is viable, a restitution of measures of protection like reservation of production and differential tariffs, and a conscious direction of credit from the appropriate financial institutions to meet investment and working capital needs.

These are some of the principal measures that the government can adopt immediately to redress the distortions which indiscriminate liberalization parading as "reform" has resulted in.

July 5, 2004.