The production-linked incentive scheme could spell success for India, but uncertainties remain

Industrial policy, the idea that the government can play a significant role in building out parts of the economy for various purposes, is back globally. The United States’s Inflation Reduction Act is the prime example, using state subsidies, tax breaks, loans, and grants to support industries that the US has deemed strategic. India, too, is no stranger to this trend. India introduced Production Linked Incentives in 2020, providing a financial boost to firms that expanded their manufacturing within the country, starting with three industries – pharmaceutical, electronics, and medical devices – and then expanding them to cover many more sectors.

But how do these domestic-focused policies fit into broader efforts to integrate into the “global value chain” and the “diversified, democratic” re-globalisation that India has called for?

To understand, we have to go back to the Covid-19 pandemic and the discourse around global value chains that emerged at the time. The ripple effects of disruptions caused by the pandemic brought home the characteristics of a globalised world that obtains many items of consumption through the global value chains. The important question then turned to the risks associated with these chains and their resilience.

Until recently, countries were trying to integrate into existing global value chains. Global value chain participation generally brings economic benefits in terms of enhanced productivity as well as greater sophistication and diversification of exports. Consequently, understanding what determines participation in global value chains has implications for policymaking. Yet, the gains from value chain participation vary significantly between countries.

Typically, integration in global value chains is captured through backward and forward linkages. Backward linkages measure how an economy imports intermediate goods or services as inputs in the production of its own exports, while forward linkages refer to inputs provided by one country to another, which, in turn, produces consumer goods that are further exported to third countries.

In recent times, many countries have resorted to industrial policy to decouple from over-reliance on certain trading partners. But how do we make sense of these production networks in the context of India?

Global value chain integration

Global value chains are networked through lead firms, usually major multinational companies that play key roles in building these value chains. From a country’s point of view, belonging to these chains leads to networks and exports. Global value chain participation is dependent on a variety of factors including the size and location of a country, its manufacturing share in gross domestic product and trade and investment policies.

A country’s global value chain integration matters due to the nature of trade, which, since the mid-1960s, has increasingly been in intermediate goods – the inputs that are used in the production process that lead to final consumer goods. Certain factors like lowering transport costs, easing tariffs, and technological advancements in transport have led to an increase in trade in intermediates whereby value is added in each subsequent stage in factories located in different countries. This has led to regions or countries producing and specialising in certain goods and the moniker of “Factory Asia” for electronic products. On the other hand, not belonging to these chains means it is difficult for countries to break into export markets.

Lead firms

Along with these, the role of lead firms is important. Lead firms have been defined as small, medium, or large firms that have forward or backward linkages with a large number of micro, small, and medium enterprises. A lead firm governs the whole of a value chain.

The emergence of lead firms and global value chain participation depends on factors that lead to a conducive business environment, attracting foreign investment, and internationalisation of domestic firms. Internationalisation of domestic firms can be done when they start exporting to international buyers and through imports of intermediates by domestic final producers. Global value chains in manufacturing can better contribute to employment creation, skills upgrading, and other benefits associated with manufacturing-led industrialisation. Across this ecosystem, there is a desire to create an environment that supports local manufacturers as they attempt to upgrade their productive capabilities and increase their competitiveness.

However, many domestic firms in developing countries, especially micro, small, and medium enterprises, do not integrate into global value chains easily, and face challenges in participation. The rise in South-South trade has made local and regional value chains more important for developing countries.

The global value chain literature stresses the role lead firms (such as global buyers) play in supporting producers’ learning and innovation activities in less developed countries by transferring knowledge to their suppliers. However, it has been noted that while these firms generally outsource “commodity like” activities that add little value, they retain direct control over intangible, high value-added activities as opposed to low value-added activities. Hence, the transfer of knowledge occurs more through certain activities or tasks and certain industries.

While upgrading to high value-added activities can raise domestic labour productivity and skills, developing countries are often locked in low value-added activities with little or no technology transfer. Upgrading is defined as “strategies that firms, countries, or regions implement to move toward higher value-added activities and increased value capture.” The role of lead firms becomes critical in this context.

From a policy perspective, how global value chains integrate into the economy is critical and the role of the lead firm is vital. Also, the role of industrial and other policies in encouraging global value chain integration and upgrading is significant.

Whither industrial policy?

Industrial policy is at the heart of development policy, and has often taken various names (for example, export facilitation, promotion of foreign investment, or free trade zones). It is not only about incentives given to manufacturing industries but also those given to services or agriculture.

Theoretically, the argument for industrial policy stems from market failure. Economist Dani Rodrik argues that the need for industrial policy is theoretically sound and well-articulated. It can address market failures, but it is difficult to implement in practice. As he explains, the conventional case for industrial policy is due to market failures in markets for credit, labour, products, or knowledge.

There are two main objections to industrial policy in practice, according to Rodrik. One is information asymmetry and the other is corruption and rent-seeking. In the first case, it is impossible for governments to identify winners in firms, sectors, or markets that are impacted by imperfect markets – yet industrial policy, in some ways, forces them to. Secondly, it is argued that industrial policy often leads to corruption or rent-seeking. There are arguments on the empirical evaluation of industrial policy by both the proponents and opponents of industrial policy. Proponents suggest that in many instances, usually backed by case-based evidence, industrial policy works.

India’s global value chain integration and industrial policy

Despite India’s manufacturing prowess, especially in medium tech industries, its participation in global value chains remains limited. Moreover, the participation of India in global value chains is largely concentrated in a few industries (example, automobiles). India has also been losing its share of exports in labour-intensive products, especially garments.

Also, in the case of India, while product upgrading (defined as the movement into higher value-added products within a global value change) and process upgrading (which involves increased productivity in existing activities within a global value) have occurred, functional upgrading (which involves the movement into more technologically sophisticated or more integrated aspects of a production process) and intersectoral upgrading has been limited. This has been the case in garments. Inter-sectoral or chain upgrading involves a move into higher value-added supply chains.

Developing countries can better stimulate their integration into global value chains and increase the development benefits from multi-national company activities in their economies by aligning their policies to attract Foreign Direct Investment. The typology of industrial policies that countries can follow in enhancing global value chain participation includes three sets of policies. These are horizontal policies that affect the entire national economy (for example, the Goods and Services Tax), vertical industrial policies that are targeted at particular sectors or industries (like the Automotive Mission Plan 2016-’26 for the automobile industry), and finally, global value chain-oriented policies.

This last type of policy could include the possibility of upgrading and improving the links across different segments of the value chain. India’s policy approach has been largely addressing logistical and infrastructure bottlenecks and improving the ease of doing business, and can be classified in terms of horizontal or vertical. However, what is needed for greater integration is global value chain-oriented policies.

Industrial Policy 2.0

In recent times, there has been a resurgence of industrial policy, such as the Inflation Reduction Act of the United States and, in the Indian context, the recent production-linked incentive schemes. These policies have been announced for 14 sectors and could be extended to more in the future. They are India’s newest set of industrial policies after the earlier “Make in India” program. Through these schemes, India is trying to attract foreign direct investment, or FDI, and create “champion firms”.

The new Foreign Trade Policy announced earlier this year has the objective of integrating India into global value chains and making India an export hub. It is in this context that we need to see the production-linked incentive schemes aimed at improving the international competitiveness of the firms and increasing the localisation of Indian industries. The production-linked incentive schemes should also be seen in the context of global value chain-oriented policies aimed at increasing India’s global value chain integration. By trying to create champion firms, these policies are trying to pick “winners” which is in line with the objectives of industrial policy. However, it remains to be seen whether these firms will also become lead firms.

In line with the policy announcements, the tariffs on imported inputs have been increased to promote indigenous manufacturing. While these may work in the long run, in sectors where there is no capacity (for example, solar panels, EV batteries), the cost of production increases in the short run. What India is trying – through a combination of production-linked incentive schemes and import tariffs – is to create a larger part of the production chain within the country.

If successful, India will have built a successful indigenous manufacturing base capable of exporting, too. On the other hand, if the manufacturing of the inputs does not become globally competitive despite the tariff protection, India will have lost the chance to integrate even the downstream industry into the value chains of “Factory Asia”.

The distinction between industrial policy and import substitution needs to be understood. Import substitution can lead to greater reliance on domestically produced intermediates – thereby promoting indigenous manufacturing – but need not lead to greater global value chain integration. Hence, the objective of greater integration with global value chains through the production-linked incentive schemes is uncertain. Whether these policies will propel India’s manufacturing sector and help overcome the “jobless growth” remains to be seen.

Saon Ray is an author and economist specialising in industry and international trade.

This article was first published on India in Transition, a publication of the Center for the Advanced Study of India, University of Pennsylvania.