Weekend reading links

1. High and rising attrition rates among India IT majors.

2. Two very interesting stories about economic clusters in Rajasthan. One is about the already established cluster of coaching institutes at Kota. The article explains the cut-throat competition among the institutes to poach star teachers with exorbitant salaries (and students with attractive offers). The competition has become more intense and dirty with the entry of VC-backed firms like Unacademy and Physicswallah, who have no compunction to poach teachers with annual salaries which often touch several crores.

The article also highlights the risks faced by the original entrepreneurs (in this case Bansal Classes and Allen Career Institute) as the industry matures and competition intensifies. 

Another article is about the emerging industrial cluster of Japanese companies at Neemrana, which straddles the national highway between Jaipur and Delhi. It's reported than over 50 Japanese companies have invested over Rs 6000 Cr in the zone. The cluster has been catalysed by the Rajasthan State Industrial Development and Investment Corporation (RIICO), which apart from developing industrial parks with infrastructure also acts as a financial institution providing loans to large, medium, and small industries. 

3. More on the reality of the small and undeveloped nature of the Indian markets, from the market for business software. The Ken has an article on Tally, the accounting software used by most small and medium businesses in India, to inform why business software companies will struggle to survive on Indian demand. 

Depending on how you measure it, Tally has a market share of 80%. Some reports suggest that that number may be as high as 90%. I can’t think of another product that dominates a category like Tally does, apart from maybe Google in search. And this is an enterprise product which is essential for every single small, medium, and large enterprise across the breadth of India... By all rights, Tally should be an outrageously successful company, making money hand over fist by selling software that every business needs to users who love it in a market that it has a stranglehold on at an obscene profit margin. As a company, it should be worth billions of dollars. In March 2020, Tally reported an annual revenue of around Rs 500 crore. That’s a little less than US$60 million, which is what Netflix paid Dave Chappelle for two of his stand-up specials... 

It took the long, hard road to get to where it is today. It was started in the late 80s, and it’s taken them thirty five years to get here. We keep hearing a lot of stories about the emergence of Indian software-as-a-service (SaaS) companies. Freshworks. Zoho. Chargebee. They are all admirable examples, but what all those stories neglect to mention is that Indian SaaS companies make almost nothing from India. Take Zoho, for example. Last year, it recorded a revenue of close to Rs 4,500 crore (US$570 million). Less than 5% of that was booked from India. There’s a general theory in software and the internet that once you lock-in the users, the money will follow. Acquire now. Engage well. Monetise later... Tally shows us that you can do all of the above, and you still can’t make money.

This should be a cautionary tale for the startups who are pursuing SME business services market. 

4. JP Morgan's Karen Ward sees silver lining in the inflation gloom,

“Good inflation” is a reflection of healthy demand, enough for companies to have a degree of pricing power and confidence to invest for expansion. Then there is “bad inflation” — a cost shock which serves as a tax on growth. While we are experiencing “bad inflation” now, I believe this cost shock should pass within a year. Moreover, inflation will probably settle at a modestly higher rate of good inflation since the cost shock will serve as a catalyst for more robust demand and healthier nominal growth in the future as it encourages households, governments and businesses to invest in labour and energy-saving technologies. Contrary to popular opinion, the new inflation regime should eventually prove to be a good thing for investors. Stronger nominal demand will mean stronger earnings and sustainably higher interest rates.

5. NYT article on the ring-side view (and associated influence) of Washington politics enjoyed by young interns and staff officials to Congressmen and senior government officials, including the White House. 

This is a universal trend. There are at least two pathways to influence. One, the physical presence beside busy and important officials makes these people gatekeepers to them, besides being observers to important events. Two, given that their bosses are too over-burdened and generally grappling with multiple problems, logically appealing (irrespective of their merits) suggestions offered by these non-threatening smart young interns generate natural interest.  

6. Peloton, which makes exercise bikes and treadmills and offers an App to manage your exercise routines, had become a big hit during the pandemic as it helped bring the gyms to people's homes. However, its fortunes have crashed after the pandemic eased - sales have fallen, share prices crashed nearly 75%, and it has laid off 20% of its employees. 

Now comes news that it'll stop making bikes and treadmills at its factories and outsource all its manufacturing. Rexon Industrial, a Taiwanese company that already produces some of its bikes and treadmills will become the primary manufacturer. Peloton is an illustration of the problem with restoring and bringing back manufacturing to the United States. 

7. Good long read about the Conservas Pinhais et Cia in Matosinhos, a fish-canning factory just a few miles from the center of Porto, which has been making the Nuri brand of canned sardines since 1920.

8. The era of quantitative tightening (QT) is on us. The US Fed began reversal of its bond buying program from early June and the balance sheet of major central banks are expected to shrink by $4 trillion by end of next year. 

The era of central bank asset-buying began in 2001, when the Bank of Japan instituted the policy in a bid to stimulate the country’s languishing economy while benchmark rates were already close to zero. From the fringes of the monetary policy toolkit, the practice moved to the mainstream in 2008, when the Fed, BoE and later the ECB established their own bond-buying programmes in response to the crisis that engulfed the global financial system. Through large-scale purchases of government securities, the central banks helped to push up the amount of reserves sloshing around the financial system. The aim was to encourage banks to increase their lending to households and businesses to a degree that would encourage spending, investments and other activities to help ignite growth...

Over the course of last two years, the Fed snapped up some $3.3tn in US government bonds and $1.3tn in agency mortgage-backed securities. As of March, that left the US central bank owning a quarter of all outstanding Treasury debt and a third of agency MBS. The ECB and BoE each own just shy of 40 per cent of their government bonds, while the Bank of Japan, which is unique in having no intention of stopping its purchases, already owns nearly half of Tokyo’s outstanding government debt. As well as expanding the monetary base, official asset purchases also crowd commercial investors out of the world’s safest assets, and force them to support riskier parts of the economy that might otherwise struggle.

For a generation of investors and market participants who have been used to only cheap and plentiful capital, this is a new era. And nobody can predict the consequences of such a massive liquidity drain out. The hope is that the markets are able to adjust to the QT and there is a soft landing with the reversal. 

The scale of reversal is large - by September, Fed is seeking to reach $95 bn per month in scaling down its portfolio ($60 bn Treasuries and $35 bn agency MBS). Different models predict widely varying levels of impact in terms of effective hike in interest rates. 

9. The Economist effective describes Xi Jinping as China's latest Bad Emperor.

Achieving industrial transformation

How do regions attract manufacturing firms and industrialise? How do manufacturing clusters develop? What are the requirements to achieve industrialisation? 

Even with examples of success, explaining the HOW of industrialisation has remained a mystery. I blogged here in the context of the success of Silicon Fen in Cambridge. All that can be said is that industrialisation just happens.

Much of the mainstream debates and literature is focused on the role of infrastructure provision, industrial policy and industrial promotion activities. But, for areas and regions seeking to find a foothold in the industrial landscape, is this sufficient? 

I want to point to two aspects of this issue which are less discussed - the importance of personalised engagement with investors, and the multi-layered nature of industrialisation. 

While the mainstream issues like enabling policies and infrastructure are important, a less discussed but equally important area is the need for personalised and continuous engagement. In fact, this may perhaps be the difference between success and failure in industrial transformations. 

Conditional on an enabling policy environment, what's required is continuous and high-level engagement all through down to commissioning of the project and its initial years. This is a deeply personalized play involving the political leadership and the top bureaucrats. In simple terms, it's about intense schmoozing to court the investor and then continuous handholding support to help them establish and operate the enterprise. It's about the unsexy and diffused art of long-drawn and persistent backroom implementation.

Given its personalised nature, this approach is clearly something only a few politicians and bureaucrats can pull off. And given the political economy of India, where such schmoozing is scorned upon, it's also an immensely challenging task. For example, a bureaucrat found to be dining and wining investors and businesses, even with the best of intentions, is most likely to attract the negative attention of media and commentariat and become the target of allegations and insinuations. I blogged here highlighting the contrast between India and China. 

This requirement for personalised engagement should be seen as a means to overcome the unpredictability and difficulties of doing business in India, especially for foreigners. The personal connections give confidence to the investors that they'll have a helpful ear when they face problems in the ground. 

However, these are only necessary conditions. Even with these, success is by no means certain. It's a long haul, require persistent effort, and lucky breaks. Once some big investors come in, the repeat game dynamics help reinforce investor confidence and bring more. At some point, it tips over. 

It's not for nothing that there are just a handful of examples of regions/countries having made this manufacturing breakout. Successful structural transformation is very rare. 

Now let's come to the second issue of multi-layered nature of industrialisation. 

There are perhaps three levels of industrialisation. The first, and most salient one, involves investments by large global companies - contractor manufacturers like Foxconn with their large plants or factories by large companies themselves. Their arrival most often is accompanied by the emergence of an eco-system of suppliers and ancillaries. The second level involves the medium scale enterprises, mostly domestic ones, which employ a few tens or hundreds of workers and have a smaller footprint than the large global companies. The final level constitutes the numerous small enterprises who provide the major share of job creation in a country as a whole. 

These three levels form an eco-system and are connected by a complex web of endogeniety in their respective growths. The first level provides the trigger for productivity growth through technology transfers and learning by doing spillovers, which cascade across levels. The third level provides the soil for growth of a business culture within the area and the basis for further expansion and growth of attendant infrastructure and support mechanisms. It can be argued that the strength of the middle level is one of the most important contributors to the aggregate productivity and competitiveness of the region or country. 

Successful industrialisations are likely to combine a mix of all three levels. How it emerges can, in theory, be top-down or bottom-up in terms of the levels. But both will take time. 

Constraints to scale manufacturing in India - lack of a cluster approach?

As India looks at the rare opportunity to attract global value chains (GVCs) in manufacturing, it faces formidable challenges. While the constraints like labour issues, cost of capital, difficulty of doing business, and infrastructure bottle-necks are well know, there are a few other equally important factors. I blogged earlier about the entrepreneurship deficit.

This post will cover the deficiency of a distinguishing feature of large scale manufacturing - the need for an eco-system to support such manufacturing facilities. This demands a cluster-focused approach in certain sectors. 

A feature of modern manufacturing is the disaggregation of production stages into a multiplicity of activities and tasks and their outsourcing. This puts the large factory which churns out the finished product at the apex of a massive chain of suppliers, some of which cluster around the factory and others are dispersed globally. For example, Volkswagen has around 5,000 first-tier suppliers, each with an average of 250 second-tier suppliers, so it could end up with as many as 1.25 million suppliers. 

In other words, an essential requirement for scale manufacturing is the presence of a large component manufacturing industry. Take the example of footwear industry. Unfortunately, like with other sectors, components are imported from China. This is not just the case with soles and uppers. Even islets, insoles, and laces are imported from China. It is stunning that even buckles in belts are largely imported from China. 

I blogged here about the strength of China. Over the years, the country has built up an unmatched manufacturing eco-system. Sample this,

Its industrial base has unparalleled depth and has only grown more competitive. In 2005, 26% of the value of China’s exports was added abroad; by 2016 that was down to 17%, according to the OECD. In other words, more of the bits and bobs that end up in Chinese gadgets are themselves made in China.

In contrast, India's manufacturing ecosystem in any product line is limited. Even the large non-leather contract manufacturers like Apache and Lotus import uppers and soles from China, Indonesia and Vietnam and only stitch them together in India. In the case of iPhone manufacturing in India, while  Wistron and Foxconn assemble phones using imported components, the local suppliers merely make packaging materials, chargers, and batteries. 

Large manufacturers are therefore unlikely to relocate to India without being able to replicate an eco-system of suppliers near their locations. This, in turn, calls for a cluster-based approach to manufacturing. It requires public policy to focus not just on the big manufacturing firm but also  to support the emergence of an eco-system of ancillaries and suppliers. Such suppliers may be co-located or located elsewhere in the country, in which case it is necessary to facilitate integration of the supply-chains by removing bottlenecks on inter-state logistics and taxation issues.

Catalysing and nurturing component manufacturing is not easy. They aggregate, grow and become more productive under the umbrella of the large manufacturers. This means that some of the larger branded manufacturers will have to be encouraged to take the lead in this regard. While they could provide the market assurance, the government may have to offer some fiscal incentives and/or interest subvention subsidy also for the suppliers. In simple terms, the government efforts have to go beyond the current policy of focusing only on courting the large manufacturers like Foxconn or Feng Tay or Pou Chen or Toray and ignoring their suppliers.

The fundamental point is that if India has to succeed in attracting GVCs, it has to adopt a policy that is centred on creating manufacturing eco-systems (or clusters) than just assembly-line factories. This demands primarily the government playing an important and very active co-ordination role. Large manufacturers will need the support of the government in co-ordinating both set-up and operations to attract suppliers and ancillaries.

Once the enabling policies and regulations are in place, this would involve actively supporting and facilitating both the big manufacturers and their suppliers with activities like acquiring land, different starting permissions and clearances, and hassle-free transactions with government during their operations. In short, it requires a different culture of operations, especially one which needs to pay as much attention to the eco-system of suppliers as much as the large companies themselves.

Apart from the ecosystem constraints, there are the limitations of the Indian market which prevents leveraging economies of scale. For example, in 2010, while Apple sold 30 million iPhones in China, its Indian market was just 2 million. Apple therefore pays 60% more per unit for Wistron to assemble iPhones in India. A takeaway is perhaps that instead of chasing big names like Apple, it may be prudent to court the likes of Oppo and Xiaomi, who are more likely to find a large enough local demand and also therefore have the incentives to invest in volumes and create eco-systems. They are also likely to support their smaller component manufacturers compared to the likes of Foxconn.

Re-aligning global value chains

An intriguing area at the intersection of geo-politics and world economy, with far-reaching implications, is the impact of Covid 19 on the global value chains (GVCs). In fact, it can be argued that the Covid 19 is only hastening a set of forces which have already been set afoot by the US-China trade war.

Japan has been leading the charge in making realignment of the GVCs an explicit goal in the name of diversifying away and reducing the excessive reliance on China,

In its emergency economic package adopted on April 7, the Japanese government called for the re-establishment of supply chains that have been hit by the virus's proliferation. It earmarked more than 240 billion yen (about $2.2 billion) in its supplementary budget plan for fiscal 2020 to assist domestic companies to move production back home or to diversify their production bases into Southeast Asia. It is a tidy sum of money.

It was later passed by the Cabinet,  

Japan's cabinet in April earmarked 248.6 billion yen ($2.33 billion) for subsidies to businesses that move production back to Japan, covering up to two-thirds of relocation costs.

Japan has struggled with supplies as it tries to ramp up production of medical equipment and other Covid gear,

Japan had struggled to ramp up domestic production. The country's reliance on China for most of its supply of face masks left it unable to keep up with a spike in demand, spurring electronics maker Sharp to begin production. Securing medical supplies to tackle the pandemic has become a primary concern for world leaders. Such shortages have brought back to the fore a long-running debate in Tokyo over pulling manufacturing out of China. With the COVID-19 crisis making the economic security stakes clearer than ever, the government has begun to act... Chief Cabinet Secretary Yoshihide Suga, in an interview with Nikkei, stressed the need for greater self-reliance. "Looking at masks, for example, 70% to 80% are produced in China," he said. "We must avoid depending excessively on particular countries for products or materials and bring home production facilities for goods needed for daily life."

Besides Japan, the US too has been promoting partnerships among like-minded nations like Australia, Japan and India to relocate factories out of China.

Two things. One, the idea of shifting away from China, is embodied in the China plus one strategy adopted by several multinational corporations in recent times. This shift, motivated by the need for diversification and rising labour costs, has been underway for sometime now,

Pou Chen, the world's largest contract footwear maker, has also scaled back its Chinese manufacturing over the years, from 29% in 2014 to 13% in the first quarter of 2019 in terms of total shipments.

Two, shifting out of China is not easy.

Sample Tim Cook himself on why Apple is so focused on manufacturing in China,

The number one reason why we like to be in China is the people. China has extraordinary skills. And the part that's the most unknown is there's almost two million application developers in China that write apps for the iOS App Store. These are some of the most innovative mobile apps in the world, and the entrepreneurs that run them are some of the most inspiring and entrepreneurial in the world. Those are sold not only here but exported around the world... China has moved into very advanced manufacturing, so you find in China the intersection of craftsman kind of skill, and sophisticated robotics and the computer science world. That intersection, which is very rare to find anywhere, that kind of skill, is very important to our business because of the precision and quality level that we like... The products we do require really advanced tooling, and the precision that you have to have, the tooling and working with the materials that we do are state of the art. And the tooling skill is very deep here. In the U.S., you could have a meeting of tooling engineers and I'm not sure we could fill the room. In China, you could fill multiple football fields... China stopped being the low-labor-cost country many years ago. And that is not the reason to come to China from a supply point of view. The reason is because of the skill, and the quantity of skill in one location and the type of skill it is.

A feature of China's manufacturing prowess is the localisation of specific export sectors in a single city or county. There are more than 500 such specialised towns, with some being responsible for 63% of world's shoes, 70% of its spectacles, and 90% of its energy saving lamps.

Sample this about coffin-making,

The coffin-makers of Zhuangzhai, a leafy township of 100,000 people in the eastern province of Shandong, are a case in point. Between them, Zhuangzhai’s three main manufacturers export 740,000 coffins annually, almost all of them to Japan. With just under 1.4m deaths in Japan last year, that gives one Chinese township something around half the Japanese coffin market. 

This is a source of immense strength. It creates an unmatchable manufacturing eco-system. So production is not easily replaced, even if Japan wants to diversify away from China, 

The largest local firm is Yunlong Woodcarving, which ships 20,000 coffins to Japan each month. Its 56-year-old founder, Li Ruqi, has coffin-making in the blood... In 1995 his firm began supplying a Japanese coffin-maker with panels decorated with phoenixes and lotus flowers. Most were carved from the wood of the paotong, which grows all around Zhuangzhai... Some Japanese clients did try sourcing coffins in Vietnam and Indonesia, he concedes. But they found that workers in South-East Asia lacked “discipline”, so returned to Shandong. His corner of China has paotong trees, skilled labour and trusted suppliers. “Price-wise, talent-wise, this place is pretty far ahead,” he says.

However, it is also a source of risk, as seen by the plight of the bra-making town of Gurao.

So there is the challenge of availability of the required conditions to shift large value chains. Vietnam has been the standout beneficiary. But given the scale of realignments and its own smaller size, Vietnam too may be reaching its limits in absorbing businesses relocating out of China. Labour costs are rising and shortages are being felt, and land prices have become prohibitive. And with technology companies coming in large numbers, the lower value manufacturing may be getting displaced from the country. Vietnam appears to be moving up the manufacturing value-add escalator.

"Companies in traditional industries will be squeezed as tech companies are also heading to Vietnam," said Karen Ma, an analyst specializing in emerging markets at Hsinchu-based Industrial Technology Research Institute. "Meanwhile, the cost of expansion there will definitely become much more expansive. ... Most of these existing players in the textile and footwear industry will face a dilemma: Where should they go if they are leaving Vietnam? Currently, there are not many choices for them left in the region as Laos and Indonesia have not yet reached Vietnam's level in terms of infrastructure and quality of the workforce."

But India has to get several things in order before it can become a serious contender. It faces several headwinds as it grapples with efforts to attract companies. For a start, it is currently not anywhere near being a serious proposition for those looking to move out of China,

Nomura Group Study found that in 2019, out of the fifty-six companies which shifted their production out of China, only three of these invested in India; while 26 went to Vietnam, 11 to Taiwan, and 08 to Thailand. In April 2020, Nikkei noted that out of the 1,000 firms which were planning to leave China and invest in Asian countries, only 300 of them were seriously thinking of investing in India.

Further, as Irene Yuan Sun wrote in Bloomberg, India needs to shake off its false confidence,

The fantasy, most common in India, that a country might somehow “leapfrog” from a rural, agriculture-heavy economy straight to a services-based economy is just that: a fantasy. South Asia can’t afford to lose this chance to grow its manufacturing sector. Attracting manufacturing investments will require, first and foremost, that governments in the region acknowledge the competition is passing them by. India, for example, must abandon its overconfidence that investors will come simply for its large population.

Or this,

India has been overplaying its demographic advantage for too long. Even its market is not large or rich enough to allow economies of scale for manufacturers -- unlike China's. Indian wages are low compared to China -- but so is its labor productivity.

Then there is the rise of protectionism,

Donald Trump said he could levy new taxes on American companies that move their manufacturing bases from China to any country other than the United States. Donald Trump has termed taxation as an incentive for companies to return the manufacturing to the United States... Donald Trump said instead of giving incentives to American companies to bring their manufacturing back to the country he would instead tax them for moving anywhere other than the United States. The President of the United States that they will not be doing much for the companies to get them back to the US. He instead said that the companies will have to shift back for the country.

Then there are the numerous questions about India's readiness. Sample these statistics,

The World Bank estimates that between 2014 and 2018 manufacturing declined marginally, from 15.1% to 14.8% of GDP... A recent study by Nomura found that of 56 companies that relocated production from China between April 2018 and August 2019, only three chose India. Nearly half went to Vietnam.

Rahul Jacob who has written extensively on the issue of problems faced by textile exporters is not very optimistic,

The Modi government has instead been arguing that the covid-19 crisis will allow India to position itself as a manufacturing alternative to China... V. Elangovan, who heads a regional buying agents group in Tiruppur... has heard such predictions before. For the past couple of decades, companies in the West have been looking to diversify their outsourcing requirements and pursuing a China+1 strategy.

“India has never been a candidate; the ecosystem is not there. We cannot replace China for 50 years to come," he told a roundtable organized by Apparel Resources, an online trade publication. Impressed by how well the finance ministry in Dhaka works with garment manufacturers and exporters in Bangladesh, Elangovan had a more realistic goal for India: “Let’s compete with Bangladesh."

More from him here, pointing to the fact that talks of shifting production out of China has been on since 2010 but is unlikely to materialise given what China has to offer,

Despite some labour-intensive production moving to Vietnam and Bangladesh, a decade on, China still bestrides apparel and clothing accessories exports like a giant fending off Lilliputians... China + 1 as a sourcing strategy again goes back a decade or so but multinationals have had limited success diversifying away from China... Kathrin Hille, Greater China correspondent for the Financial Times in Taipei, who has for several years covered Foxconn, the largest contract manufacturer in the world for Apple, predicts that smartphone assembly is unlikely to move substantially from China. “Foxconn has more than a million workers in China. If you ask manufacturers about moving to Vietnam or elsewhere in South-East Asia, they say they can’t build factories of more than 20,000 workers there," Hille said, pointing to Foxconn townships in Zhengzhou and Shenzhen in excess of 200,000 workers each. “It’s not just a question of population size. The model doesn’t work elsewhere."

What complicates matters is that any serious attempt at attracting manufacturing will also involve deft use of industrial policy, which in turn is complicated by weak state capacity and the problem of going against the grain of orthodoxy and conventional wisdom. While the former is well known, the latter is equally important.

Given its deficient industrial base and manufacturing capacity and also given the cheap competition from China, fostering local manufacturing (Make in India) demands some kind of infant industry protection. However, this will be seen as a throwback to the earlier regime of autarky and Nehruvian socialism. It will also be a blow on the country's investor perceptions.

The track record of the country's businesses in this regard does not inspire any confidence that this time will be different. Instead of using the protections to grow productive businesses and capture export markets, India's entrepreneurs and corporates became comfortably ensconced and feasted on the domestic market. Once the economy liberalised, the floodgates opened to foreign competition, the local businesses fell away quickly. Businesses are not alone to blame, since governments did little to foster export competition and enhance productivity. This is a story that Joe Studwell describes in great detail contrasting the differing fortunes of North and South East Asian economies, with India and its companies closely resembling the latter.

The plethora of Free Trade Associations (FTAs) have ravaged all sectors. Sample this from Sunil Suresh, chairman of Stanley Lifestyles, a maker of leather furniture who also contract manufactures for Ikea,

“Currently, the furniture industry has zero duty on imports from FTA nations. Many Chinese companies are routing furniture through companies they have bought in countries such as Vietnam, Malaysia, Thailand, but import duty from Western nations such as the USA, Germany and Italy is only at 10 per cent. If there was a structure similar to that for imported cars, manufacturers would be more inclined to set up shop in India and work alongside local players. Imports will stop and the ecosystem will grow”.

And this,

Dhiren Gopal, director at furniture maker Featherlite Group, says more state support is needed. “What’s needed is a level-playing, field which is absent, since mainstream companies in special economic zones can import furniture duty-free,” he said.

It is the same everywhere, footwear to textiles, mobile phones to electronics manufacturing.

The Government of India have initiated measures in this direction. The latest being the new Electronic manufacturing policy, EMC2.0, which targets attracting the largest electronics manufacturers with production linked incentives (PLIs) and ready factory sheds and plug-and-play infrastructure. And the establishment of Empowered Group of Secretaries to co-ordinate attracting investments into the country.

In this context, some of the standard arguments in foreign media about India are pure trope,

Many sectoral regulations are problematic for investors. For instance, price controls on medical devices cap manufacturers' profits. India's raw material protectionism, especially related to synthetic fibers and steel, raises the cost of production in downstream industries. And its e-commerce policies discriminate against foreign companies like Amazon and Flipkart-Walmart.

One could write this on just about every emerging economy, especially so China. And such regulations have been the industrial policy foundations of economic growth of all countries. 

Update 1 (01.12.2020)

NAR on the growing Chinese global trade dominance despite headwinds.

Nikkei analyzed data on 3,800 products compiled by the International Trade Center and found that there were 320 products in 2019 in which China held a share of more than 50% in export markets. By comparison, in 2001, when China joined the World Trade Organization, the number was 61 products. The number of products of which China had a high share stopped increasing from 2016 onwards, when U.S. President Donald Trump took office and then the trade war began, but the number increased again last year.

Stockholm's music cluster

MR points to this fascinating article highlighting Sweden's remarkable success in the field of pop music. Since the seventies, starting with ABBA, Swedes have dominated pop music scene with music bands, singers, song-writers, and producers. Song writers and producers from Stockholm have been behind the success of a long line of singers that include Katy Perry, Lady Gaga, Madonna, Usher, Avril Lavigne, Britney Spears, The Backstreet Boys, Pitbull, Taylor Swift, One Direction, Maroon 5, Kelly Clarkson, and many others. It writes,

Sweden, and in particular Stockholm, is home to what business scholars and economic geographers call an “industry cluster”—an agglomeration of talent, business infrastructure, and competing firms all swirling around one industry, in one place. What Hollywood is to movies, what Nashville is to country music, and what Silicon Valley is to computing, Stockholm is to the production of pop. In fact, Sweden is the largest exporter of pop music, per capita, in the world, and the third largest exporter of pop overall. And in recent years, the country has seized not just the message, but the medium as well: As the industry moves toward a distribution model that relies on streaming music services, the Stockholm-born Spotify is a dominant player, with 24 million users per month.

The article highlights that this success was the unintended result of a concerted arts-education campaign by Swedish authorities, supported by Church and Conservatives, initiated in 1940s to stamp out the growing influence of degenerate music from America and encourage more uplifting classical music. It writes,

Municipal schools of music spread across the country... Many of the schools, which were often free to attend, allowed students to borrow instruments, as if from a public library, for a nominal fee... municipal music schools increased the odds that Swedes would discover their talents, while also giving the country an unusually music-literate domestic audience. Other knock-on effects were less obvious. The municipal schools provided an indirect subsidy to the music industry itself, for instance, by offering a steady supply of flexible teaching jobs to musicians... Outside the classroom, the government also encouraged young musicians with subsidies for practice space and even practice itself... 

And perhaps most importantly, Sweden’s municipal schools gave rise to social networks of musically inclined youth—networks that ultimately formed the basis for the Swedish capital’s music industry cluster. So much information is transferred in bars, informal institutional settings, in social networks, and in the movement of people between firms... Sweden’s capital city was especially conducive to this kind of transfer. The size of Stockholm is probably perfect... Everyone knows everyone. If you go into a music store to buy strings, you know the clerk because you played with him when you were little. If you go to a record label, you know the people there.

This is yet another addition to the literature on the emergence of talent cluster and regional comparative advantage. The larger message I carry from this are two-fold.

1. Such outcomes are largely serendipitous. Post-facto one can point to the series of government interventions as elements of a consciously designed plan. However, as is evident from this story (and from all others), the emergent dynamics of such processes are unpredictable. Even when they produce the intended result, its takes a long period of incubation, with several ebbs and flows.

2. Agglomeration advantages are as important to knowledge-based industries as to traditional brick and mortar ones. The bits and bytes of pop music industry reside in the brains of human beings and is therefore, theoretically atleast, amenable to diffused and dis-aggregated growth. But, as the example of Stockholm highlights, direct human interaction plays a central role in the process of creation and transfer of ideas that drive even this industry. 

Explaining entrepreneurship and development

I had posted esarlier here and here about the debate surrounding the utility of growth clusters and mega-regions.

Alfred Marshall had emphasised three different types of transport costs – the costs of moving goods, people, and ideas – that could be reduced by industrial agglomeration. First, he argued that firms would locate near suppliers or customers to save shipping costs. Second, he developed a theory of labour market pooling to explain clustering that takes advantage of scale economies associated with a larger pool of workers and firms. Finally, he began the theory of intellectual spillovers, which has been re-christened as "network effects" in recent times.

Edward Glaeser and William Kerr find support for all the three Marshallian theories in their new research and claim that market effects, such as proximity to input suppliers and labour market pooling, play a big role in explaining spatial differences in entrepreneurship and economic development, while there is less support for factors like entrepreneurial culture and industrial diversity. They find that co-agglomeration arising through shared natural advantages is more important than any single Marshallian factor, but not as important as the cumulative effect of the three Marshallian factors.

Why growth clusters may be oversold?

I had posted earlier here and here about the disproportionate focus of our industrial policy on growth clusters. While it is undoubtedly true that agglomeration economics - working through density of market linkages, labour market concentration and matching, and network effects from technology and knowledge spillovers - generates positive externalities, the available evidence on the extent of benefits from them do not merit the sort of indiscriminate subsidization that is being advocated and followed.

The latest evidence comes from a study by Philippe Martin, Thierry Mayer, and Florian Mayneris on the French government's policy of "employment areas". They find only marginal improvements arising from any policy of aggressive promotion of agglomeration economies, and feel that many of the gains are already internalized in the firm decisions.

They conclude that "spending public money to foster clusters is only wise if there is evidence that public policy might tap into significant unrealised gains from agglomeration". They write that this involves addressing two questions,

1. How large are the gains from agglomeration? In particular, how much does the productivity of a firm increase when other firms from the same sector decide to locate nearby?
2. Do firms internalise these gains when making their location decisions? In particular, are “natural” clusters too small?

Policy makers in many countries fail to acknowledge the distinction between policies that encourage the setting up of new industries and those that expedites the development of newly established industries. In fact, many of the SEZs in India appear to have been sanctioned to encourage the setting up of new industries. However, SEZs and industrial clusters, and the subsidies that go along with it, by themselves will not trigger the setting up of new industries. It will only help those setting up new industries, optimize their locations and take advantage of agglomeration economies. And in this too, it has been found (from the French evidence and other studies) that firms do internalize a substantial share of the gains from agglomeration economies when making their original locational choice.

The study also cautions about the less discussed issue of the dangers of congestion costs such as the saturation of transport infrastructure, inadequacy of other physical infrastructure, rising land rents, pollution etc. Given the indiscriminate manner in which some of the SEZs have been proposed to be located, and the legacy of governments failing to keep their infrastructure development commitments, there could be serious problems ahead. Already, a number of SEZs are facing problems with absence of adequate power supply and transport infrastructure.

Role of mega-regions in the global economy

Richard Florida claims that the real drivers of global growth are mega regions.

He writes,"While there are 191 nations in the world, just 40 significant mega-regions power the global economy. Home to more than one-fifth of the world's population, these 40 megas account for two-thirds of global economic output and more than 85% of all global innovation.

The world's largest mega is Greater Tokyo, with 55 million people and $2.5 trillion in economic activity. Next is the 500-mile Boston-Washington corridor, with some 54 million people and $2.2 trillion in output. Also in the top 10 are mega-regions that run from Chicago to Pittsburgh, Atlanta to Charlotte, Miami to Tampa, and L.A. to San Diego. Outside of the U.S., you can find megas around Amsterdam, London, Osaka and Nagoya, Milan, Rome and Turin, and Frankfurt and Stuttgart.

Mega-regions are the true force driving the rise of emerging economies. Some 40% of Brazil's total economy is made up of a corridor stretching from Rio to São Paolo. Russia is propelled by the Moscow mega. India's economy is shaped by the mega-regions of Bangalore and Mumbai."

He argues in favor of urban policies that favor densification, improving fast-rail transit between mega-region nodes, modernizing airports, and achieving greater cross-border flows of goods and people.

Paul Krugman however feels that mega-regions may not contain the density necessary to reinforce the positive spillovers from a large concentration of talent. He favors considering a smaller geogrpahical area as the basic economic unit because they are amenable to greater labor mobility and noer positive externalities arising from information spill-overs and network effects.

The Free Exchange differs and favors larger geogrpahical areas as the basic unit of economic growth. It highlights the importance of "forward and backward linkages--that is, the importance of being near to suppliers and customers in a world where transportation costs are non-negligible".

Quoting a paper by Anthony Venables and Stephen Redding, it argues that market potential--the nearness of a place to other economically vibrant places - can explain quite a bit of the differences in global wealth.

Florida's hypothesis is the policy logic behind the fast risisng support among policy makers in India for the Mumbai-Delhi and Chennai-Bangalore growth corridors. The Government of India have been actively pursuing this idea. The Japanese Government has evinced considerable interest in the Mumbai-Delhi mega region growth corridor, and a Detailed Project Report (DPR) is currently under preparation with Japanese government assistance.

However, I am more inclined to believe that while such mega regions may promote and hasten growth in those regions with an already established critical mass of entreprenuerial or industrial activity, it may achieve little in under and un-developed areas. In these areas, it may be necessary to concentrate on more important specific policies that can stimulate the local economy. Further, a mega region approach, while very efficient for promoting manufacturing and industrial gorwth, may not be relevant in case of knowledge-based industries like software and biotechnology R&D, which do not involve the same extent of linkages.

A mega region approach may be more appropriate to the Mumbai-Delhi corridor, as it would string together the numerous, already established industrial growth centers there, and promote backward and forward linkages among them. This would take care of the many inefficiencies inherent in the economic growth in these regions. In contrast, it may achieve little in the barren and undeveloped space between Chenna and Bangalore. In many ways, mega regions are something similar to the concept of integrated regional economic planning.