Dec 24, 2012

Service sector incentives - Policy challenges

Services has emerged as an important part of our exports. More about facts and figures on service sector here  ;-)

Anyway, this blog is about the challenges when  it comes to grooming (?) services sector through incentives. There is a line of thinking which says that services sector grew as the Govt. was caught napping and didn't know how to deal with it. So all that the Govt has to do now, for services to keep growing, is to just let it be and don't spoil the party by interfering. However, from a trade policy-making point of view, services has emerged as a strong sector with a comparative advantage that is here to stay for some time to come. The policy-makers could not ignore this sector, and in good faith, decided to introduce incentives for this sector too, alongside other sectors. The current foreign trade policy incentivises services exports through schemes such as Served From India Scheme (SFIS). To know more about the scheme refer chapter 3 under this FTP link

SFIS provides incentives to service exports in the form of duty credit scrips, to the tune of 10% of total exports done in the financial year, which can be used to import capital goods. One can use the scrips to pay the customs duty on capital goods imported and used by the service provider. 

Under the scheme, the definition of service sector is very broad. See here. It covers everything from private real estate consulting to hospital and hotel services, except exports from SEZs, STPIs and such special zones. So anyone doing anything that can be put under services exports, is eligible to be incentivized. I won't get into hair-splitting over specifics, as the focus is broader here. 

What's wrong with such schemes. 

Firstly, there is no fool-proof way of establishing the 'value' of services provided. Whatever the exporter declares on the invoice, cannot be disputed easily. The organization which implements the FTP scheme (DGFT) is hardly competent to check if the declared value is correct or not. It goes by whatever foreign remittance was realized through banking channels. The realized money can be anything, including round routing of black money, as long as it says that it came as a payment for 'some' services provided. I must add here, that goods/merchandise trade cannot be easily mis-invoiced, especially if they are being incentivised. There is a specific group in customs which looks after incentivised exports, and checks the value of such exports strictly, using national level standardized database. There is no such known database for valuation guidelines in services.

Secondly, there is no link between services sector performance and incentive that is being provided. It is 'hoped' that it helps, but there is absolutely no data to back up the 'hope'. I am unaware of any study being conducted to check the efficacy of this incentive scheme. 

Thirdly, the Govt might be incentivising something that falls in grey area, viz capital control avoidance through trade mis-invoicing. An eloquent blog on the topic of capital control avoidance through mis-invoicing is here. The  blog accepts that services trade offers substantial opportunity for misinvoicing as valuation guidelines are not easy to come by. So services trade can easily be used to avoid capital controls. And this scheme (SFIS) seems to incentivise such efforts! 

If someone thinks that it is not easy to get benefits under this scheme, one just needs to see the procedures and details. It's cakewalk. And if it still feels difficult, you have consultants advertising on Google, promising to do exactly that for you. One can even float a company, get some money under the services head, take this incentive, and send the money back, all in the name of some service being exported and imported. You keep the capital good for free, without paying any duty. 

This blog is a strong advocate of measured incentivising. Incentives must come with a calculated goal in mind. They should be implemented on field with proper care, and the feedback must be continuous to ensure that the effect is as desired. The logic is simple. Given scarce funds, we need to look at the margins. Services sector, is not yet ready for such incentives. It is still a grey area for the Government, given that we do not have reliable way of capturing the data for this sector. 

Dec 14, 2012

Service sector of India and the Rybczynski effect on manufacturing

The theory I am going to propose below is not based upon any serious study. So the possibility of holes are not excluded. Thus it goes.

If there are two tradeable sectors in an economy, and if one of them is a leading sector and the other one lagging, Rybczynski (pronounced Rib-Chin-Skee) theorem predicts that, over a period of time, there would be more than proportionate expansion in the leading sector, at the cost of the lagging one. This would happen when one reads Rybczynski's theorem in the light of Heckscher-Ohlin model. Alongwith, you might be interested in understanding the mechanics, by reading about what's popularly known as Dutch disease.

Cut to India. We have a leading sector in services, and a lagging (albeit important) sector in manufacturing. When I say leading, I am not referring to the sheer size, I am referring to the productivity and comparative advantage the sector enjoys in international trade. In this respect, services sector is a leading sector today. Now, if I read the theory right, what should happen over a period of time is this: 

The service sector booms, at the cost of manufacturing sector and ultimately, the manufacturing sector loses its comparative advantage in the international markets. Service sector will do very well and will be the mainstay of our trade. 

How would this happen?

Three things would work in tandem. 

First. Exchange rate mechanism would work in favor of services. India will increasingly adopt floating exchange rate in future (it is almost floating as of now). This means that the real exchange rate would ultimately settle at a value which will be determined by the net exports, which in turn will be a function of all tradeable sectors' performance combined (plus capital flows). The value, whatever it is, will be an aggregate of all sectors competitiveness. For any given exchange rate, services sector will be at a discount, as by our definition, it is more competitive in international market. This would lead to strengthening of this sector. Manufacturing sector, being relatively a laggard, will face an adverse exchange rate when compared to its level of competitiveness. This would lead to gradual erosion of comparative advantage. 

Second. Service sector will pay relatively higher wages to the labour due to the above advantage. This would lead to a tendency in the labour market to lean towards services. As the sector expands, it would start absorbing labour from other sectors, mainly manufacturing and agriculture. This would make availability of labour in manufacturing sector scarce, leading to wage increase and further erosion of competitiveness.

Third. Investments would move into sectors where returns are maximized. The relative margins in service sector is better than manufacturing in the present, and will continue to be so for some time to come. This would mean, that given limited investment funds, a more than proportionate portion would invest into services sector.

Is this a cause for concern? My answer is yes. Services sector is not employment intensive, unlike manufacturing. A disproportionate growth in services doesn't bode well for a job-scarce economy. Absorption of new labour, and the labour released from agri sector is an important issue. Absorption could be higher in manufacturing sector, when compared to services, and the growth of manufacturing is important from this point of view. 

The Rybczynski effect is my speculation. It might not happen. There are good reasons for our manufacturing to do well in future. Let me deliberate on that part too.

Increasingly, our manufacturing, especially sub sectors such as auto and ancillary components, engineering etc are integrating into global value chains, or what I prefer to call, International production networks. Once our sector plugs in into the global manufacturing chains, the relative comparison with services will matter less. This alone might offset the Dutch syndrome.  

Secondly, productivity of manufacturing sector will rise with time, and if things go well, our manufacturing might keep up with the comparative advantage over a longer period of time.

Thirdly, the demographic dividend of having a younger labour force in India, and gradual drying up of chinese labour force, might keep us going (China is ageing faster). The supply of labour will keep the wages low. The challenge is to train and get the labour that's industry-ready, by boosting vocational training capability of the country. Vocational training currently is a disaster in India, I will elaborate on it some other day. 

Finally, the Govt is waking up to the uncomfortable fact that manufacturing sector cannot be ignored anymore. The initiatives on National manufacturing zones is a step in that direction  If right incentives are provided, the future of this sector might become bright.

A combination of above will play out in coming years. The results will determine not only India's trade, but also decide the developmental pace and stability of the society.