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Portfolio Commentary

Apr 20, 2023

The manufacturing promise
The Indian financial year concluded last month, and the headline indices saw a flat close in a highly volatile year. The broader market saw some divergence as the midcap 100 index closed with a return of 1.5%, while the smallcap 100 index closed in deep red with a negative 14% return.

As we navigated a year filled with twists and turns, India’s growth story stood out. It became the fastest- growing major economy with GDP growth projected at more than 7% in FY23. It’s another matter that this will be slower than the 8.7% saw in FY22.

A closer look at the long-term breakup of GDP numbers tells an atypical story. While India posted a robust 9% CAGR growth in nominal GDP from FY93 to FY23 (projected), the services sector outgrew the manufacturing sector by nearly a percentage point each year.

Source: Ministry of Statistics and Programme Implementation

This is atypical because the paths to prosperity for most nations have involved a move from agriculture to manufacturing and then to services. In India’s case, services have played a pivotal role in bringing economic prosperity, and at more than 53%, services now form a major chunk of the nation’s GDP. On the other hand, manufacturing share in the GDP declined by a percent to 14.5% in the same period.

Source: Ministry of Statistics and Programme Implementation

For a developing and populous economy like India, the decline in the share of manufacturing in GDP isn’t very healthy, as each dollar of manufacturing output brings in more employment as compared to services output. So, while robust services sector growth is good for GDP, it isn’t commensurately suitable for employment and hence may not be the best model for sustainable growth.

The below table shows the sectoral contribution of GDP and employment in the sectors for FY22.

Source: NITI Aayog Documents

As the table above shows, agriculture still employs a large chunk of India’s workforce while contributing less than a fifth to the GDP, while the services sector, which contributes more than half to the GDP, employs a much lesser 33% of the country’s population.

In an ideal economic scenario, the workforce should shift from low-productivity agriculture to high-paying manufacturing jobs. However, due to policy friction, manufacturing growth in India has been slow while the services sector has flourished. While some argue that the growth in services has created high-paying jobs and indirect employment, the reality is that it has not led to a commensurate growth in employment. As a result, most of the workforce remains in low-paying jobs, hindering overall economic progress.

This is concerning because, without adequate growth in manufacturing, the country’s service sector will eventually stall. Furthermore, failing to develop the manufacturing sector means that a large chunk of the workforce will be underutilized, turning the demographic dividend into a liability. Therefore, it is crucial to focus on developing the manufacturing sector to efficiently utilize the country’s workforce and ensure long- term economic progress.

Policymakers in action
Manufacturing has been a key focus for policymakers for some time now, as they recognize the need to balance out the economy. In 2005, the UPA government established the National Manufacturing Competitiveness Council (NMCC), which proposed the National Manufacturing Policy in 2011. However, this policy failed to gain much traction due to government policy paralysis.

The current government launched a similar policy in 2014, called “Make in India,” which aimed to make India the world’s manufacturing hub. The timing was perfect; with the US imposing tariffs on imports from China, India could have benefitted as a low-cost manufacturing destination. The goal was to increase manufacturing’s contribution to GDP to 25% by 2022, a target later shifted to 2025. The initiative identified 25 key sectors to boost local manufacturing through sector-specific policies, incentives, and subsidies.

However, unlike the services sector, which grew with minimal government intervention, manufacturing required significant support from the government. Successful post-war manufacturing stories in Japan, South Korea, and Taiwan were the result of close collaboration between manufacturers and policymakers.

India had its own set of inefficiencies, dating back to the pre-liberalization era, that clogged the growth in manufacturing sectors. Here are some of the major inefficiencies that kept major investments away from manufacturing.

• Outdated labor laws
• Cumbersome land acquisition laws
• Complex indirect tax structure
• Lack of adequate infrastructure
• High logistics cost

Clearly, the initiative’s launch wasn’t enough to attract manufacturers to set up shop in India. Therefore, the government kept bringing slow but incremental reforms:

• Relaxation of labor laws
• Implementation of GST
• Building infrastructure at a breakneck speed
• Developing industrial corridors
• Introducing a national single window clearance system and
• Launching the National Logistics Policy

The government also set itself on a path to improve the ease of doing business in India. The latest push came after COVID brought the economy to a standstill. The government announced the “Atmanirbhar Bharat” scheme, which provided an indirect stimulus for manufacturers and followed it up with production- linked incentives (PLIs) in several sectors.

Success so far
Now it seems the idea seeded in 2011 and reseeded in 2014 was a little ambitious and ill-planned. However, the reform process continued, and now, policymaking is progressing at a decent pace to improve further the ease of doing business. The need to de-risk supply chains from China has also generated significant interest in Indian manufacturing.

The “Make in India” initiative is still in its initial stages and is a work in progress. The data post its launch is scant, but there have been a few successes.

The best has been electronics and, more precisely, smartphones, an industry largely dependent on imports in 2014. India made only a fifth of smartphones sold in the country in 2014. Since 2022 almost all the smartphones sold in India have been locally manufactured, and India has become a net exporter of smartphones. Interestingly, it’s not mere assembly but also component manufacturing that has picked up in India and there is decent traction in semiconductor manufacturing as well.

By far, electronics has been Make in India’s poster boy.

Other smaller successes have been in railways, defence, aviation, chemicals, auto ancillary, food processing, renewable energy, textiles, and capital goods.

As per a report by ICRA, about 60% of the capex already approved under PLI is set to happen in 2023- 2026, and the potential investments due to PLIs stand at 3.5 lakh crore over the next 3-4 years. The plan, when fully implemented, will help integrate supply chains, reduce import dependencies, and potentially generate 18-19 million jobs.

The table below shows the incentives proposed, capex proposed, and actual investments done under different PLI schemes.

Source: PLI Documents, ICRA

With major bottlenecks being tackled, the manufacturing story might be on the cusp of taking off significantly. Policymakers are leaving no stone unturned to facilitate businesses to set up manufacturing facilities in the country. However, the change, as with all big changes, will be gradual and then sudden, as it was with smartphone manufacturing.

Sanctum’s take
At Sanctum, we were positive on industrials and manufacturing as a sector at the beginning of 2022 as we believed the grand PLI campaign, incremental reforms, and the push away from China held promise for local manufacturing. Our view has been vindicated so far as the manufacturers we chose did well on the execution and earnings front, and hence, the stock prices also followed suit.

The progress has been slow, but there is traction that can’t be ignored. Going forward, we believe that industrials and manufacturing is a long-term structural theme, and many winners will emerge as time progresses and business conditions become more accommodative. Indian per capita income has also doubled in the last nine years, providing a great local market for manufacturers, a case well proven by eliminating dependence on imported smartphones.

More success stories like electronics will alter the country’s manufacturing course. We remain optimistic about the same and continue to hunt for more names in the theme that fit our investment criteria and hold long-term outperformance potential.

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