#282 It Ain't This Way

Stagnating Wage Growth, China's New Export Controls, and an America with Chinese Characteristics

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Programming update: We are taking a year-end break. Regular programming will resume on 4th Jan 2025. Happy holidays!

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India Policy Watch: Why Blame India Inc.?

Insights on current policy issues in India
— RSJ

We wrote about the surprising Q2 GDP growth figures in the last edition. I expected some soul-searching scapegoating to follow. And it arrived pretty quickly last week.

Here’s the Indian Express reporting:

“The sharp slump in economic growth rate to 5.4 per cent in July-September this year has sparked concerns among policymakers that low single-digit income growth in the corporate sector despite 4x (four times) growth in profits over the last four years, is one of the reasons behind the slowing of demand.

What has triggered conversations within corporate boardrooms, key economic ministries, and between the two, is a report prepared for the government by industry chamber FICCI and Quess Corp Ltd, a tech-enabled staffing firm with 3,000-plus clients, which showed that the compounded annual wage growth rate across six sectors between 2019 and 2023 ranged between 0.8 per cent for the engineering, manufacturing, process and infrastructure (EMPI) companies and 5.4 per cent for fast-moving consumer goods (FMCG) firms.

Sources in the government said weak income levels were one of the reasons for subdued consumption, especially in urban areas. “Post-Covid, consumption rose with pent-up demand, but the slower wage growth has brought to the fore concerns about a full economic recovery to the pre-Covid phase,” a source in the government told The Indian Express.

Chief Economic Advisor V Anantha Nageswaran has flagged this as “self-destructive” and urged India Inc to look within.”

Now that the problem has been identified expect some direct and indirect policy actions apart from the familiar Indian political rhetoric of blaming industrialists, corporates and the Sethjis for everything that’s wrong with the country.

It's all quite nostalgic. And imaginative.

But how far is it true?

Well, at a macro level, the economy can indeed go into a doom spiral with weak demand leading to weaker income growth for workers, which in turn feeds into further weak demand. The Keynesian formulation for this is to go out and stimulate income growth by putting more money into consumers’ pockets. This is a short-term fix, but it is the only way to reverse the spiral. Forget the long-term consequences of budget deficits, etc., because, as Keynes apparently put it, we are all dead anyway. So, if India Inc starts paying its workers more, maybe they will go out and spend more, and we will regain economic consumption growth.

There is a minor but fundamental problem with this assumption. The Keynesian solution of printing money and putting it into consumers’ pockets was meant for the governments. Not private corporations. Because the government (rather the State) is a permanent monopoly and can afford to ignore the long-term. No such luxury for the corporations. Private sector worker wages are driven by the usual demand and supply dynamics that affect any other product. India Inc. buys labour at a price determined by the market. It is not a single monolithic entity acting in unison to keep wage rates depressed. If it goes out and pays more than the market-determined price of labour, it will lead to worse economic consequences than just a quarter of slow growth. Trying to manage the market when there is no market failure is the road to perdition.

So, what explains the anaemic wage growth rates across sectors in India Inc.?

Broadly, I see three factors at play here.

First, there’s an oversupply of workers; worse is that it is of poor quality and low in productivity. Companies invest significant time and effort in inducting and training the brand new labour that joins the workforce. See all the global training campuses developed by software companies and the skilling start-ups around you, and then hear the constant lament among Indian HR leaders about how unemployable graduates in India are when they step out of college. There’s limited economic justification for inflating the entry-level compensation given these factors. As we have often written, India has a labour productivity problem whose roots go back to the State’s mismanagement of education and skilling sectors.

Second, the data points to the problem of the quality of jobs created in Indian Inc. If every marginal job created is of a lower quality, it is difficult to pay a higher marginal wage for it. At an aggregate level, the economy is producing marginal jobs of lower quality over the years. So, no surprise that unit wage rates have remained stagnant. This is the problem of underemployment that’s been around for a while in the economy. Again, underemployment is better than unemployment and up to a point given our demographics and our inability to create jobs fast enough for our economy, we shouldn’t mind the unit wage cost stagnating so long as overall employment continues to hold or go up. If we really have to trade-off between the quantity of jobs and their quality, it makes sense for us to focus on the quantity and overlook metrics that measure quality. What we need to do to improve the quality of jobs created is a different topic for another post. Given the present state of our demographics, infrastructure and capital availability, we will not be able to improve this in the short term.

Third, the CEA is factually correct in identifying what India Inc. has prioritised in the past few years - deleveraging its balance sheets. This was facilitated by a few factors coming together. The economy struggled through much of the last decade with the twin balance sheet problem where India Inc. was over-leveraged, and the banks were saddled with non-performing assets. As new loan sources dried up, India Inc. cut down on capacity expansion, reduced costs and began deleveraging. The pandemic gave India Inc. an opportunity to relook at its costs more fundamentally as the revenues dried up for almost a year. This led to further cost optimisation and headcount rationalisation before the growth came back. Almost simultaneously, the availability of private equity capital and the strong performance of the equity markets meant India Inc. found more options for funding itself and sunsetting its debt. So, yes, when it came to capital allocation decisions in the past few years, India Inc. chose to deleverage, invest in technology and automation, and earn treasury incomes from their surplus capital rather than invest in labour. But again to emphasise, this is individual actions of multiple companies acting in their self-interest based on how they see their business environment rather than a coordinated action to keep labour wages low.

Anyway, as I said before, I expect some policy nudge from the government through sectoral regulators or otherwise to private companies to increase their wage bill in the coming year. This is an easy target to blame who will willingly kowtow to such a nudge. But will a wage increase across the board in the private sector revive consumption and release the animal spirits in the economy?

Hardly.

The estimated working population in India is about 60 crore. Of which about 12-13 crore are employed in the formal sector. The remaining 47 crore work in the unorganised sector, whose wages are driven indirectly by government spending and not managed by a formal salary mechanism. About 1.2 crores of the formal sector employee base are in state and union government jobs whose salary growth is managed by the government itself. The top 1000 companies in the private sector who have a meaningful staff strength together employ around 1.4 crore employees. The remaining 10 crore workers in the formal private sector are employed by small and medium enterprises that may not necessarily be in the government’s target for the nudge to increase employee wages. And might not even respond to such a nudge if given. So, out of the 60 crore employed in India, only about 1.3 crore employed among the biggest 1000 companies might get a wage increase if one were to heed the government’s advice. And maybe if they go out and spend this windfall, they will begin a virtuous consumption cycle that will then lead to better demand and more income for the other people in the workforce. True. But what’s the guarantee they will go out and spend this? The choice between saving or spending any surplus for a consumer is driven by many factors, not least how they see their future. If they are optimistic about their prospects and of the economy doing well, they might spend. Otherwise, they will save or they will invest for the future in the hope of spending it later. And this optimism about their future or that of the economy isn’t driven by their employers in the private sector. It comes back to their view of their government and its policies.

This brings me back to the two key reasons that we have written about in the previous edition on what drove the surprisingly low GDP growth in Q2. The single biggest reason was the slowdown in government capital expenditure. The capex utilisation of the union government for H1 FY 25 was at 37 per cent (Rs. 4.4 lakh crore) which was down from 49 per cent (Rs. 4.9 lakh crore) in H1 FY 24 as published by the CGA. The union government capex for H1 FY25 was, therefore, down 15 per cent, while the consolidated state capex was down 11 per cent. These were significantly bigger contributors to the slowdown than private consumption, which grew at 6 per cent in Q2 and whose contribution to GDP remained in the 60+ per cent range. It will be useful to understand what has kept the government from meeting its capex targets so far in the year. Even if it were to make up in H2 and meet its annual capex targets, it would aid a significant recovery in H2 apart from the multiplier,r which will play out in future quarters.

The other reason was the tightening of the liquidity and policy actions by the central bank on lending institutions that brought down credit growth from 16 per cent to 11 per cent. Focusing on these might help bring growth back faster than barking up the wrong tree of dictating the wage bills of private companies. But like I wrote last time, the economic performance of this government doesn’t affect its electoral outcomes. This divergence allows it to build its own narrative, point fingers at others and arrive at solutions that might have limited relevance to the problem at hand. It's such a cosy blanket of comfort to be in.

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Matsyanyaaya #1: Anti-Money

Big fish eating small fish = Foreign Policy in action

— Pranay Kotasthane

On December 3, China responded to the latest round of American export controls on its semiconductor industry by strengthening export controls on gallium, germanium, antimony and superhard materials with immediate effect. Starting last year, the export of these materials required an export license. With the new update, the export of these materials to the US will not be permitted.

Interestingly, the exports of Gallium and Germanium to the US had already become a trickle after the export license requirement came into effect last year, which shows that American companies had already stockpiled earlier or were able to access these materials through other countries. Notably, the US does not have a national stockpile for Gallium but does maintain a Germanium stockpile.

Many observers called China’s response last year as a ‘tit-for-tat’ move. This year, there was hardly any coverage about the updated export controls. I have been following these developments eagerly.

Last year, I had written in edition #218 that:

I’ll go out on a limb and say that these controls will not significantly impact the critical sectors in other countries. Moreover, these controls expose China's weaknesses rather than strengths.

The US export controls on AI chips differ qualitatively from Chinese export controls over Gallium and Germanium. Cutting off the supply of the former is a much bigger deal…

the dominance of China in the production of Gallium and Germanium is impressive but not difficult to substitute if China opts for stricter export restrictions. China dominates the production of these upstream materials because it is able to absorb the costs - labor, environmental, etc.—while other countries were willing to let their production decline.

With China imposing export controls on these items, prices of these commodities will rise. Consumers will be adversely affected globally. But from a strategic angle, countries will prioritise the production of these materials. The increase in prices will automatically incentivise diversification.

China does not control any specific secretly-guarded know-how that can prevent other countries from extracting these elements elsewhere. I expect other countries to develop alternative production sites and techniques soon. But the fact that China chose to impose controls on upstream elements rather than knowledge products shows that it has a weak hand.

A year and a half later, does this claim hold true? Let’s have a look.

As expected, prices for both metals have increased—gallium price has risen by 80 per cent, while germanium is selling at 2x the pre-restrictions price. I was unable to mine data that could tell us if rival suppliers had already stepped up as a result of this price increase. Bloomberg identifies 5N Plus Inc. and Indium Corp. in the US, Umicore SA in Belgium, Russia, Ukraine, South Korea, and Japan as alternate providers, but it’s difficult to ascertain how quickly they were able to ramp up their production capacity. Given that the US survived a full year of near-zero imports of these materials from China, we can infer that alternate sites did rise to the challenge.

Thankfully, there’s a US Geological Survey study released a couple of months back modelling the impact of a supply shock from China. It develops three scenarios: a baseline case assumes that currently producing countries, along with countries that are not currently producing, have the ability to bring additional capacity online, but only after 6 months. The low-impact case assumes that all of the rest of the world's full production capacity is available immediately. The high-impact case assumes only the current low-purity gallium producers in the rest of the world have excess production capacity. These are the results:

A complete and simultaneous restriction of China’s net exports of gallium and germanium was estimated to cause U.S. GDP to decrease by $3.4 billion ($1.7 billion to $9.0 billion for the low- and high-impact cases, respectively).

Thus, in the worst case, the US GDP will reduce by 0.04 per cent as a result of this export ban. That’s because the market size for these materials is quite small. For instance, the total US imports of gallium metal and gallium arsenide wafers in 2022 were about $225 million. The entire US yearly consumption is just 18 tonnes and can be fitted in a single truckload.

Moreover, this impact is likely to be short-lived. This model doesn’t consider the emergence of new Gallium suppliers outside of China and only considers the existing excess production capacity outside of China. In reality, a supernormal increase in prices will lead to an increase in recycling, production, extraction, and mining. 

Thus, I still maintain my stance. These export controls will have no deterrent effect on the US. If anything, China is itsself taking out the overcapacity it created through these restrictions. While there will be a short-term effect of these restrictions, they do not pose a technological challenge to other countries in the way that US export controls on semiconductor equipment and advanced chips do. The fact that China chose to double down on these controls shows that it has a weak hand.

P.S.: This development should have been a great opportunity for India. All the world’s Gallium is extracted as a byproduct of alumina and zinc production. Two aluminium plants in India have recovered gallium in the past. The Indian Minerals Yearbook claims every year that “NALCO has plans to set up 10 tonners per year gallium extraction plant at its Alumina Refinery in Damanjodi (Odisha). NALCO has targets to produce gallium metal with a purity of 99.99%”. But we know better. The closed Indian market means that these firms can survive at a low-level equilibrium without having to invest in doing something new like extracting Gallium. So they will continue to let this opportunity pass by them.

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Matsyanyaaya #2: Don’t Copy China

Big fish eating small fish = Foreign Policy in action

— Pranay Kotasthane

"Choose your enemies carefully, 'cause they will define you.." Thus went a U2 song. In the strategic realm, China has become the primary adversary that is defining the US. That was the underlying theme of a recent Wall Street Journal article titled “We are all Mercantilists Now”. Its author, Greg Jensen, explains that liberalism and globalisation are being displaced not by socialism but by a fallback to mercantilism. In the author’s words:

The term “mercantilism,” popularized in the 18th century, was used to describe economic policies of colonial powers that focused on managing the economy to build up state power.

Modern mercantilism today is built on four tenets: First, the state has a large role in orchestrating the economy to increase national wealth and strength. Second, trade balances are an important determinant of national wealth and strength, and trade deficits should be avoided. Third, industrial policy is used to promote self-reliance and defense. Fourth, national corporate champions are protected.

Since China’s success is believed to have come from pursuing mercantilism, that idea has now infected the West. The US—under both administrations—has deployed the same policy instruments that one would associate with China. Tariffs, national champions, export controls, subsidies, public procurement, and a disregard for the WTO rules are no longer the sole preserve of China.

But there's a critical point that needs to be internalised: there's a difference between being defined by your adversary and becoming like your adversary. While there are many things to be learned from China’s impressive growth, it’s important to realise that liberal democracies cannot beat China at its own game.

The West (and India) will have to find alternative pathways. They will have to draw from their own comparative strengths and resolve three trade-offs to craft their own version of mercantilism.

First is the employment-output trade-off. Even as it pursues industrial policy aggressively, the West will have to contend with the fact that it can’t replicate China’s erstwhile labour-intensive manufacturing. Given the massive difference in the costs of labour, there is no way that a revival of manufacturing in the US would be accompanied by a revival of shopfloor jobs. Instead, the only way for the US to restart onshore manufacturing would be to rapidly automate, doubling down on its strength in software and hardware innovation.

Second is the indigenisation-diversification trade-off. The US has a large number of potential partners. Instead of replicating China’s zeal for indigenisation, it must create multilateral tech ecosystems and construct a diversified multinational high-tech manufacturing base. Instead of duplicating efforts, it needs to cooperate on developing new standards and remove the barriers to cross-border R&D cooperation. Besides being cost-efficient, this geographic diversification will make supply chains more resilient. Competing with China in manufacturing requires the US to arrest its own protectionist urges.

Third is the environment-economy trade-off. China’s growth could happen without much regard to the environment while the West will need to rebuild and decarbonise simultaneously.

Resolving these trade-offs is essential for the West to take on the China challenge. As the famous Marcus Aurelius quote goes - "the best revenge is not to be like your enemy".

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HomeWork

Reading and listening recommendations on public policy matters

1. [Podcast] In the year-end Puliyabaazi, we share three big ideas that made a mark on us this year.

   2024 में हमने क्या सीखा?

2. [Article] Noah Smith has a typically provocative article titled ‘Manufacturing is a war now’. Worth a read, especially if you disagree. As I do.

3. [Article] Ashok K Lahiri has an excellent article on the political economy of welfarism in India.

4. [Fun Fact] Total number of active LPG connections in India: 31.3 crore (as of March 2023). Total number of customers who have given up the LPG subsidy: 1.13 crore (as of April 2023). 96 per cent of households are still getting subsidised LPG.

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