Strangling MSMEs with an Inverted Duty Structure

Legacy of protectionism

Among the many things which throttled and continue to throttle the growth of the manufacturing Industry in India, particularly the MSMEs, it is the Licence-Permit Raj and its step-sister “protectionism”.

This protectionism manifested itself in the form of high tariffs to permit our hideously inefficient Public Sector Units to survive, prosper and even flourish at the expense of the smaller downstream units, most of them MSMEs which utilised the expensive industrial raw materials from these so-called giants for manufacturing other products.

Protectionism and corruption went hand-in-hand with manipulations in a high tariff regime till the whole unholy mess brought us near-bankruptcy in 1991 when economic reforms had to be willy-nilly instituted under the auspices of the World Bank.

Inverted Duty Structure

Manufacturing currently hovers around 15% of the Gross Domestic Product (GDP) and the Government dreams of jacking it up to 25%.

Given the current circumstances of slowdown this seems a pipe-dream. Apart from all other identifiable problems in our “protected economy” which gave us cold feet in signing the RCEP, the single biggest impediment is the inverted duty structure.

In very simple terms, inverted duty structure is when the tariff on raw materials is higher than on finished goods, whereas in any sensible economy it ought to be the other way around. In any sensible nation indigenous manufacturers generally get their main raw materials from the cheapest sources wherever it is available in the world, except when there are serious security implications.

Anomaly leads to inability to export & vulnerability to imports

However, in India we have long lived behind high tariff walls protecting the producers of main raw materials like steel or coal or chemicals etc. What this does, is to prevent indigenous manufacturers from sourcing material from the cheapest producers world-wide.  Instead they are forced to source materials from virtually monopoly producers within the country.

A number of extra costs due to poor efficiency, lack of quality power, high interest rates, poor and high cost of logistics, corruption etc.,along with the compulsion to buy local high cost raw materials, drives up our prices and often lowers our quality. Weare, therefore, notcompetitive in the international market which lessens oreven totally dries up our ability to export.

Wait there is a double whammy here. Not only are we not in a position to export but because the tariff is pretty low on the finished goods, the local manufacturer is also likely to be thrown out from the indigenous market.

Examples -Can’t compete abroad & not even at home

In April 2019, Engineering export body EEPC India was petitioning the Government to rectify the anomaly of inverted duty structure in copper to help the Indian export industry becoming globally competitive.

“The duty on copper concentrate is presently 2.5 per cent while the finished goods are coming at zero duty. There is a situation of inverted duty structure. Government should consider removal of this duty to help the industry become globally competitive,” EEPC India chairman Ravi Sehgal said.

Then there is the classic example of steel. Equipment manufacturers across India, many of them MSMEs are under severe strain due to the high duty on steel raw materials.To add insult to injurymost factories in India would prefer to source their equipment from abroad, as the duty on the finished equipment is lower.

Again, the duty on HR coils is higher than the duty on large diameter Line Pipes with the result that the domestic market gets flooded with imported pipes and the capacity usage of Indian firms is down to 40% for no fault of their own. The Inverted Duty Structure is again the villain of the piece.

These protective tariffs induce a vicious spiral of monopoly, lower quality, inefficiency and higher costs which affect all areas of our manufacturing and infrastructural development from highways, roads, bridges, ports, railways, vehicle etc.  It is no magic by which China is zipping ahead and we are in decline. Why even our national projects such as Make in India and Smart Cities are infected by the same disease.

Who is the villain?

The problems we refer to above are definitely due to the Inverted duty structure which is not sensible but the funny thing is that it is not irrational. 

In fact, from the politician, policy-maker’s point of view it is counter-intuitive to lower tariffs on raw materials which may swamp the large (most often) Public Sector Units with terrible consequences of job losses and labour unions to contend with.

They, along with large private sector producers, are a very vocal and influential minority. 

It is easier to jack up tariffs to protect large producer A, then B, then C of major raw materials and emerge as a hero to the electorate, who are basically concerned with preservation of their jobs.

That it seriously affects a humongous number of mainly MSME downstream users of raw materials doesn’t really matter because those who are affected are fragmented and have neither influence nor voice to alter such policies.

That is how a number of large firms end up make primary products but downstream producers, even exporters are largely MSMEs. The broad scenario is that raw material producers are protected from global competition through high import duties. But MSMEs have to compete with global manufacturers for exports and in the domestic market. And they have to do this using high cost local raw materials.It is no wonder that MSMEs who cut costs to the bone are successful, not because of, but in spite so many adverse factors, including inverted duty structure.

Why no to RCEP?

While there is no one reason for not entering into the Free Trade Agreement with RCEP grouping of 10 ASEAN and 5 other nations including China, let no one be under any illusion – the main reason is our inability to compete in manufacturing.  Even Bangladesh is doing better than us in garment exports and giving China a run for its money. Actually, the word “Even” should be deleted in the last sentence.

And the main reason for our inability to compete comes from the accumulated historical weaknesses of our manufacturing industries, which have been, by and large, protected from competition over decades, through a number of policy measures, chief among them the inverted tariff structure.

Free Trade Agreements increase the duty gap between a large producer of raw material and the MSMEs who are mainly the downstream users because customs duty on most finished goods becomes zero. The gap may, in fact, widen even further in some cases, such as synthetics, where  GST is higher on the raw material than on the finished product.

We never grew up in manufacturing

If we cut import duties on input raw material a lot of our large industries, many of them Public sector units with crores of investment and huge number of employees may simply collapse overnight. Seventy years of inefficiently creating self-sufficiency in manufacture of major raw material inputs will be eroded.  

But this is the bitter medicine India has been putting off for the past 70 years. If we don’t do it now, our downstream value-adding industries are likely to continue to be MSMEs, with no hopes of ever climbing out of the pit and competing on even terms with the best manufacturers of the world.

What to do?

In a fine article “A Manufacturing Game Changer” in TOI, Ajay Srivastava, an Indian Trade Service Officer provides some possible solutions.

“A possible way out is to recognise that not all Key Raw Materials may need protection from imports. When should we protect a KRM? I suggest three criteria:

One: If local production of a KRM meets 80% of domestic demand, do not protect. Limited imports will put healthy pressure on local firms to improve productivity.

Two: High protection comes at high cost to the economy. It should not expand the profits of KRM producers. For example, usually firms export at lower prices than it sells in the domestic market. The price difference must equal or be less than the tax rebates/ incentives provided by the government on exports. Any substantial difference merely increases personal profits. Lower the protection in such cases.

Three: Create a national vision for important products. Bring import duties, GST rates, FTA openings, exports and domestic incentives in sync with this vision.

Finally, continue land, labour, power, infra and capital reforms. They will make most distortions lose justification for their existence.”

What is clear is that, for India the game has to change!

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