How to make in India–and protect economy from supply shocks

But in the last few months, supply constraints have eased. Last September, the average cost of shipping a 40-foot container was close to $11,000, according to Freightos, an online freight marketplace. Even as recently as March, that cost was still around $9,757. But, by the third week of August, the cost of shipping had fallen to around $5,820. As ports around the world have come out of a lockdown, wait times for loading or unloading cargo have declined. Commodity prices, too, have fallen in the last few months.

It remains to be seen if this softening will continue. But this inflationary episode has drawn attention, like few other recent economic events have, to the underlying structure of the global economy and how vulnerable it can be to sudden disruptions like the covid-19 lockdown.

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Countries, including India, are beginning to seriously think about how they can make themselves less vulnerable to such ‘supply shocks’. Domestic industries that are reliant on inputs from overseas, such as semiconductor chips, can simply stop functioning if the supply of such chips dries up due to shutdowns at a distant port. The idea of ‘reshoring’ such key inputs by having them produced domestically is the idea behind the Production Linked Incentive (PLI) scheme, announced last year. It is aimed at developing a domestic manufacturing base in a range of key sectors.

Incidentally, even as inflation has begun to ease, it’s worth noting that supply shortages in the global semiconductor industry are still acute, according to IHS Markit. The company says that shortages of electronic and electrical items are still running at ‘significant’ levels, with the shortage in semiconductors still at six times the long run average. This shortage has caused knock-on effects which, for example, include car companies deciding to issue buyers of new cars with just one new key instead of the usual two.

As the authors of a recent Reserve Bank of India paper note: “The covid-19 pandemic has delivered the biggest and broadest shock to global value chains (GVCs) in living memory, putting at risk trade in intermediate goods that account for two-thirds of global exports."

The key questions are: which sectors are both important to the overall health of the economy, and also the most vulnerable to supply chain disruptions occurring elsewhere in the global economy?

Backward, forward linkages

In more traditional and older models of trade, based on so-called comparative advantage, the idea of a ‘value chain’, whereby country A sold a good to country B, which processed it and sold it to country C and so on, was virtually unknown. All that mattered, from country A’s perspective was what goods it sold to country B, and what it bought.

However, in the 1990s and 2000s, according to the World Development Report, global production of goods began to ‘fragment’. Falling transport costs, an improved ability to coordinate a range of complex activities at different locations (due to information technology improvements) and falling barriers to trade globally helped production chains, even for individual items, to spread across the globe.

As the report points out, the trade in bicycle parts, has been greater than the trade in bicycles by over 15-25% in recent years. Different parts of a bicycle, from the saddle to the frame, are manufactured in a number of countries, and then brought together to be assembled.

The ‘off-shoring’ of production from the developed West (with its high labour costs) to countries such as China, Vietnam and India (with much lower labour costs) was also a key part of the puzzle of how this fragmentation happened. This changed the dynamics of how trade worked. A shutdown in country A meant that country B’s use of its imports from country A was disrupted. If country B processed those goods and further sold them to country C, then it became very important for country C to worry about supply disruptions upstream and how that would affect its economy.

Quantifying connections

Measuring the extent to which a country like India participates in the global value chain is complex. The ideal way would be to gather data at the level of individual firms, how they source their inputs, from where, and the customers to whom they sell their products. This data is extremely difficult to gather and is basically unavailable for most countries.

Alessandro Borin, Michele Mancini, and Dario Taglioni, in a World Bank paper last September, came up with another method. They looked at trade between countries, and netted out goods that crossed a country border just once. The idea was that if country A sold a good to country B and the trail stopped there, it meant that the good was consumed in country B. If the good was processed further and sold to country C, it was part of a global value chain.

Thus, any good that crossed a country border more than once was seen as part of a global value chain. By this metric, the share of Indian manufacturing trade, whether exports or imports, that is part of a global value chain, has risen from around 30% in the early-1990s by a few percentage points. Further, it has fluctuated in a narrow band in the mid-30% range since.

A country could be processing a product at different parts of the value chain. Country A could be producing components right at the start of a value chain, for instance. If so, it has so-called ‘forward linkages’, which mean its goods form an input into production processes further up the chain. Supply disruptions in country A can then have knock-on effects on countries B and C, to whom it exports. Conversely, countries B and C have ‘backward linkages’ to country A. Often a country will have both—it will import a good, process it, and further pass it up the value chain.

India’s trading pattern since the 1990s shows a pattern common to emerging markets since then. In its export basket, the share of finished consumer goods has risen by about five percentage points, while the share of intermediate goods and raw materials has fallen. In its import basket, the share of intermediate goods has risen and share of finished consumer goods has fallen (see Chart 1).

To summarize, on the exports side, India is processing more finished goods rather than importing them from elsewhere, or simply exporting low-value raw materials to other countries. That’s unambiguously a good thing, though it’s hard to ascertain whether this shift has happened because of the expansion in global supply chains since the 1990s or whether there are India-specific factors (better policies, for instance) that have helped.

On the imports side, India is importing more intermediate goods than before. This shows that the bulk of its processing happens somewhere along the middle of the value chain, rather than at the beginning, or towards the tail end where assembly happens. This means India is affected by shocks to the global value chain for a product, and this can, in turn, affect production in countries further up the value chain.

Stuck in the middle

Which sectors might be most amenable to ‘reshoring’—the process by which critical inputs that are currently imported are produced domestically instead to insulate them from global supply shocks such as the world saw during the covid-19 pandemic?

A Reserve Bank of India working paper by Saurabh Sharma, Ipsita Padhi and Deba Prasad Rath, released last month, explores this subject. As the authors point out, given that the amount of support the government can give a sector to incentivize reshoring is not unlimited, it becomes important to prioritize sectors. That would mean identifying sectors that are the most affected by the non-availability of critical imports, but also whose impact on the rest of the economy is significant.

The paper’s authors argue that sectors such as the manufacture of basic metals, fabricated metals, chemicals and non-metallic minerals are not only supply critical inputs to domestic industries, they are also highly import-intensive.

“It may be advisable to bolster domestic capability in the inputs used in these sectors and diversify existing imports of inputs among a number of countries to reduce vulnerability to external shocks," the authors conclude.

The paper uses data from 2014. Updating some of their analysis to 2020, using data from a World Bank trade database, doesn’t change the analysis much. Chart 2 shows the extent to which a sector in India is reliant on imported inputs—and thus its sensitivity to a sudden stoppage or disruption in imports—against its importance for the manufacturing sector, measured in terms of its share in the overall Indian manufacturing output.

Tracking the RBI analysis, sectors like basic and fabricated metals, and chemicals, are both important to the overall manufacturing sector and are highly sensitive to import disruptions. A sector like electrical and optical equipment is also highly sensitive to import shocks.

Ultimately, the criteria of the share of a sector’s output in total manufacturing output is an imperfect one. A sector like semiconductors, for instance, may not be very large in value terms, as compared to the rest of the manufacturing sector, because semiconductors and chips are so cheap. But almost no economist or engineer or policymaker would disagree that this is an absolutely critical sector in terms of its ability to affect the rest of manufacturing and even services output.

Thirty years ago, anyone suggesting anything like an ‘industrial policy’ to replace imports in certain industries with domestic production would have been laughed out of the room, even if the most successful economies across Asia—Japan, Taiwan and South Korea—did pursue exactly such policies. Today, with semiconductor shortages at historically high levels, that notion is being re-examined—and re-imagined.

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