Technological deflation and structural reform
Aluminium is the third-most abundant element in the earth’s crust, yet it wasn’t until the 19th century that humans were able to mass-produce it. Iron, the fourth most abundant element, has been used by human civilizations the world over since ancient times. Despite its availability, the difficulty of extracting and processing aluminium gave it the status of a precious metal in the 18th and 19th centuries.
It was used for making jewellery, and Napoleon III is known to have served food in aluminium plates. In 1886, everything changed with the Hall-Heroult process which enabled the isolation of high-purity aluminium metal from alumina. The industrial production of aluminium reduced its price by orders of magnitude and allowed innovators to create new products that could not have been made otherwise. The deflationary effect of the mass production of aluminium would have hurt those who stockpiled it as a precious metal. Today, aluminium is treated as a commodity metal, and operational efficiency is the name of the game for aluminium producers.
The tyre industry went through a similar deflationary curve in the 1970s. As investor Andy Kessler recounted in The Wall Street Journal, the radialization of tyres dramatically increased their life. Even though radial tyres were more expensive, their longer life meant that customers would change tyres less frequently, and the industry was saddled with overcapacity. In the case of aluminium, production process innovation reduced prices and created space for new use cases. In the case of radial tyres, as product life increased and replacements took longer, the tyre industry as a whole had excess capacity that put downward pressure on pricing.
The transitional period in both cases was a painful one, as technological innovations overturned received wisdom, changed the existing business models and undermined the power of incumbents. The net effect of such technological change was deflationary, with the balance of power shifting from producers to consumers, the latter able to obtain better products at lower prices in the new paradigm. The counter-intuitive result was that a technological leap induced dramatic supply expansion and improved utilization of installed assets, and this commoditized the aluminium and tyre industries. The proverbial “WhatsApp moment” in Indian banking, as entrepreneur Nandan Nilekani has described the wave of digitization sweeping India’s financial and banking sectors, may yield similar results. An industry dominated by the public sector and notorious for its lack of customer-friendliness will be forced to adapt, and there will be a redistribution of value away from producers (i.e., the financial institutions) to consumers.
The analogy in government is the introduction of productivity-enhancing structural policy reforms that impose upfront costs, but deliver long-term benefits. Such reform has the similar effect of enhancing capacity, which leads to lower utilization in the short-term accompanied by a depression in prices. Notably, the capacity “expansion” takes place without investment because reforms force a rearrangement in which actors capture the most value, creating new winners and losers in ways similar to when technological change occurs.
In a 2005 paper published by Indian Council for Research on International Economic Relations (ICRIER), former chief economic advisor Dr Arvind Virmani christened this phenomenon the “J-curve” of productivity and growth. In the paper, Virmani expounded thus on the features of liberalization’s J-curve: “One, the rebalancing of historically distorted prices, which raise (lower) the relative price (weight) of previously slow (fast) growing sectors. Two, the immediate reduction in capacity utilisation in unprofitable product lines due to capital immobility, till depreciation eliminates the excess capacity. Three, gestation lags in investment in newly profitable product lines and the S-curve of technology diffusion that slows productivity improvements. Four, the resources and effort needed to adopt unfamiliar technology that may reduce the productivity of existing technology/capital.”
In a 2011 International Monetary Fund (IMF) working paper on India’s manufacturing sector after the 1991 liberalization, Virmani and co-author Danish Hashim observed that “decline in productivity and output growth immediately after reforms can mainly be linked to factors such as the deterioration in capacity utilization resulting from obsolescence of product lines and capital used to produce it (which would still be a part of measured capital), the gradual adoption and spread of new technology and the diversion of human resource for learning new technology and markets. Once the firms adjust to the new situation by appropriately developing the capacity, they start experiencing the rise in productivity and output growth.”
There has been much public debate and hand-wringing about the slowdown in private investment. As the well-known song goes, growth follows investment, and without investment future growth will remain muted. This reasoning neglects the impact of structural reforms such as the introduction of the goods and services tax (GST) that would have further reduced the already low capacity utilization of 71.2% recorded by Reserve Bank of India’s survey of inventories and capacity utilization for Q1 FY 2018. The non-performing loans crisis in the banking sector alone isn’t responsible for the slowdown in investment—Indian businesses are holding back from investing because they are going through the J-curve.
The process will not be smooth and all firms will not survive the transition, but the J-curve paradigm suggests that once the period of readjustment passes and businesses adapt, the economy will operate on a higher productivity plane. The reward of structural reform is that India will shift to a higher trend rate of economic growth.
Rajeev Mantri is executive director of venture capital firm Navam Capital and co-founder of the India Enterprise Council.