By Dr. Mukul Asher, Visiting Faculty at Rashtram for Economic Reasoning in Public Policy
This article was published in MyInd.net.
The COVID-19 pandemic is shaking the very foundation and the edifice on which the global economy has been built since the Industrial Revolution.
Relatively unrestricted globalization, with much fewer restraints on capital and technology than on labor, and much less restrictions on goods flow than on services flow, has been the guiding factor in policy dialogues and in policymaking in most parts of the world, primarily led by the industrial countries, since the 1990s.
MNCs (Multinational Corporations), large and small, have moved their manufacturing and some service operations out of their home country and established these operations in distant locations, adjusting to different social, cultural, and political norms. In many cases, the main motivation for this shift has been to leverage low labor costs, less restrictive regulatory and tax environment. The favorite locations in Indo-Pacific region have been China, South East Asia, and Australia.
The learnings from relocation of many MNCs from the United States, Europe, Japan, and other countries to Indo-Pacific countries may be summarized as follows.
- Firms wishing to relocate search for a specific arbitrage that helps them either generate higher and sustainable revenue and or a decisive cost advantage, improving their returns.
- The need to access large growing markets to offset saturating home markets with marginal growth; growth not enough to offset cost escalations in home countries.
- Restrictions on repatriating profits while acting as a negative factor, are accepted without murmur, if the sought-after arbitrage works for them. For example, in China investing firms have to bring in their own working capital and cannot seek funds from banks. Yet China has been among the largest recipients of FDI.
- Transfer pricing was seldom an issue as China insisted on everything being produced locally. The MNCs fell in line and ensured their contractors moved there with them.
- MNCs were enticed by China’s large potential market, despite the repeated and sustained violation of IPR (Intellectual Property Right) and that too without reasonable compensation. China has exhibited a cavalier attitude in respecting trademarks and brands. These have been difficult to resolve in Chinese courts and expensive to wage a battle in the WTO. (World Trade organization)
- While the Chinese government ensured labor peace, often through draconian measures, the MNCs had to gradually increase labor compensation due to productivity-related and other factors. There were no references to honoring labor and human rights.
- A local partner as an intermediary was accepted by MNCs despite their intrusive behaviour.
- Land was made available in plenty in very quick time as were clearances. This has been among advantages of locating in China (and in Vietnam) as compared to other Indo-Pacific countries.
- The MNCs had to fund their entire capital requirements in full. Access to the domestic financial and capital markets was banned by law.
- Corporate tax rate in China is 25% only marginally lower than the tax rates in the US. Most European countries have a tax rate in excess of 30%
“…. Repatriating profits from China has long been a complicated and challenging issue for foreign businesses with subsidiaries in the country. China has a notoriously strict system of foreign exchange controls, which tightly restrict the flow of capital into and out of the Middle Kingdom – creating a headache for foreign investors looking to remit profits overseas…” 1
- The conditions for repatriation of profits out of China are complex and challenging
“…. Businesses can repatriate profits after a number of requirements have been met. First, companies must pay the 25% corporate income tax on profits. 10% of the remaining amount must be paid to the reserve fund (essentially to be reinvested in their Chinese operation). When the remaining amount is taken overseas, companies are charged a withholding tax. The withholding tax rate and terms vary depending on the relevant tax treaty in place between China and the country of the overseas account”. 2
- Closing businesses in China has also been complex and with high costs. “…Companies in China may want to end their operations for various reasons… investors cannot simply walk away without following specified closure procedures. Not properly closing the company will not only attract stringent penalties from the government’s tax and regulatory bodies, but also do lasting damage to the reputation of the company”.
- China made arbitrary and insolent demands for forced localization and technology transfer as the precondition for entering the market.
- China also insisted on the senior technical and management positions being peopled at key levels with patriotic nationals. Many, if not, most walked away with the know why and know how to set up competitive enterprises.
Not only did MNCs accept this capricious behaviour without a murmur, many praised the work ethic, the productivity and the industriousness of the people. They rushed in headlong despite these constraints. Many later regretted the decision but have been unable to withdraw for a variety of reasons, including inertia, the lure of large market and the hope all this will change.
To summarize, even if opening a business in China is relatively easy, the arduous conditions required to operate, run, earn and close a business, should have been a deterrent. But so far these deterrents have been overlooked by the MNCs.
The Covid-19 pandemic, originating in China, and its enormous economic, social, and political costs to the world, combined with China’s aggressive and predatory behavior has led to a situation where the global dynamics is moving towards reducing the dependence on China.
The conditions of doing business in China and access to China firms, most of them closely connected with the Chinese state, are coming under increasing scrutiny. The geo-political environment under the leadership of President Trump, is also not as favorable to China as before.
It is in the above context that India’s efforts to pursue relocation of some of the value addition and supply chain management currently undertaken in China to India needs to be viewed. Relocation of an activity or a firm to India is only the first, though critical, step. In investments, whether domestic or from abroad, even more critical is to create a longer-term business environment in which firms not just continue to stay but also find it profitable to flourish and expand to move up the value chain.
Besides the Central Government, some of the states in India, such as Tamil Nadu, Uttar Pradesh, Karnataka, have set up task forces to attract MNCs currently operating from China and elsewhere. So, the suggested approach of this column could also be useful to them.
STEPS SUGGESTED TO ENSURE LASTING MUTUAL BENEFIT TO INDIA AND THE INCOMING MNCs
The GOI (Government of India) has identified 450,000 plus hectares, twice the size of Luxembourg, to develop facilities to attract investment. This addresses a major constraint of attracting investments in India.
Ten mega clusters being proposed for locating incoming investments: Noida – Greater Noida (for electronics), Ahmedabad, Vadodara (Bharuch-Ankleshwar Cluster), Mumbai-Aurangabad, Pune, Bengaluru, Hyderabad (Pharma & Vaccine), Chennai, Tirupati – Nellore.
The intent is to provide a single window facilitation to start and set up a business. This must be implemented with competence, urgency, and result-orientation focused on outcomes and not investments and activities. The benefits must be tangible.
From an MNC perspective, they would weigh whether and to what extent, positive gains will accrue over the medium term. They would evaluate whether the positives of starting business operations in India against the other favorable aspects that China offers, and the extent to which their operations in India will not be burdened by the negatives of China. The Centre and State government would need to structure their investment packages accordingly.
Some of the challenging requirements India would need to fulfil to attract relocation of business from China (and elsewhere) are:
- stable laws and regulations permitting long term decisions
- high degree of systemic integrity, with economic freedom to structure unified national market, and facilitate international operations
- controlling any rent-seeking by misuse of public position and trust for private gain by the political operatives and their associates.
- facilitating incorporation of a business in as much time as is the best practice globally, across all states and locations.
- fair and equitable labour laws applicable nationally,
- strict norms for funding by Indian banks,
- a transparent tax system (India’s corporate tax rate of 15% for new manufacturing firms is already globally very competitive)
- speedy decisions by appellate authorities.
It is not that all of the above requirements must be met immediately, but enough reforms must be instituted, providing necessary confidence to the investors. Some investors will value some requirements more highly (e.g. stable laws and regulations) than others.
Therefore, structuring investment specific packages, within overall guidelines, and with integrity to minimize political economy distortions, would be essential.
The GOI has to carefully select industries, sectors and categories that will flourish long after dislocations created by COVID-19 pandemic are left behind. In a sense GOI needs to target sectors, industries and enterprises that will add long term value to the Indian economy.
The purpose is to add value to India and to improve livelihood opportunities of the Indians.
INITIAL STEPS TO ENSURE A SMOOTH START FOR VALUE ADDITION BY INCOMING INVESTMENTS
It is suggested that the GOI examine following steps that can be initiated on an urgent basis to realize the benefits of the incoming investments:
1. Make available leased, fully provisioned space and facilities, with electricity, water, transport, logistics etc being available when the enterprise walks in. This task could be facilitated by converting large, decrypt warehouses lying unused and requiring repair in many ports. This would require emptying these spaces, restoring the basic structures and securing and cordoning off these facilities from the routine bonded areas. The alternative is to take over the facilities of many industries that are bound to shut shop in the aftermath of the extended lockdown. While unfortunate, it is inevitable.
- End to End Logistics support -from the time a ship docks with capital equipment or raw materials it should reach the work site in as soon as possible, with the ideal time being less than two days. India can go a step further and appoint officers to clear these goods while on the high seas or in mid- air. Ideally the port and customs management system should be in line with all clearances provided before ships dock or planes land.
For example, Air India can deploy its freight fleet to ferry goods from overseas with a customs official both at the loading point and on board to clear the cargo instantaneously on landing. The resulting increase in inventory turns, lower warehousing and insurance costs, will be a major attraction.
- Labor supply and requisite skills are going to be a challenge. With the bulk of the migrant workers returning to their home states (though indications are that some are returning to some cities such as Bengaluru), local labor could become expensive.
The migrant labour has limited skills and GOI could consider asking these same countries for support for training the trainers and to skill the labour on their home turf in the relevant skills required by the enterprises transferring to India. This will require opening skill development centers, which will only stand India in good stead in the years ahead. These steps will assure that labour with appropriate skills is available.
4. Reform of labor laws must be expedited in the Parliament, and passed in 2020. As per the recommendations of the 2nd National Commission on Labor, the ministry is codifying existing 44 central labor laws into four codes by simplifying, amalgamating and rationalizing the relevant provisions of the legislations; the four codes relate to wages, industrial relations, social security and occupational safety, and health and working conditions.
Uttar Pradesh, Madhya Pradesh, and Gujarat have recognized this and announced ordinances to suspend all the cumbersome rules while retaining the rules to ensure fair play, dimensions like minimum wage and such. Gujarat has also relaxed rules relating to hiring and firing. But political economy needs to be managed before these become more firmly instituted in these states.
5. For electronic industries in particular, large amount of requisite quality water supply along with treatment plants will have to be provided.
6. Ensure clean uninterrupted power is provided without undue constraints. The National grid must be stabilized and local electricity boards tempted with loan waivers proportionate to the demand supplied as well as quality and availability of power
- With work from home trending and likely to become more of a norm, high speed broadband connectivity is critical. GOI has to go all out to network the country with optic fiber cabling; this could represent a huge opportunity for BSNL (Bharat Sanchar Nigam Limited) to revive itself by taking the lead and not leave it to private players.
- MNCs will depend on their proven staff and managers to set up shop. Clear rules for work permit, bulk visas for experts to travel have to enunciated and on line processing of visas expedited. Clearance and exit at major airports have to be streamlined by linking all requirements on line.
- Consider credible arrangements to respect trademarks and brand identities. Knowledgeable courts fast tracking the challenges should be set up.
MEDIUM TERM STEPS FOR FIRMS TO TAKE ROOT AND FEEL SECURE
- Construction clearances and related approvals to help build the new factories in record time with essential infrastructure should be expedited. Ideally GOI should encourage and incentivize environment and user-friendly factories. These should be accompanied by logistics centers to park trucks and clear cargo. Housing and schools for expatiate professionals, schools for Indian staff, training centers, entertainment facilities like clubs, playgrounds and other amenities should be facilitated using different methods, including public-private partnerships (PPPs.)
India has demonstrated during Kumbh mela, and other mega-events how to successfully create massive integrated infrastructure and logistics management. It should leverage this unique competence to the hilt. Stable power, clean water, sewage treatment centers etc should form an integral part of such clusters.
- When authorizing construction, it has to be borne in mind that many MNC’s have their unique set of requirements and codes for their factories. A quick clearance facility for such differences should be ensured. Outdated requirements must be done away with and a set of relevant standards codified quickly.
- The GOI and the state authorities have to provide long term stability in governing law, tax laws and civil codes. The number of licenses, and such, has to be minimal and must be fully on line. Verification should be through established neutral inspectors and as far as possible not through government agencies.
- The tax and legal authorities should be well briefed, avoid needless claims and escalations. The disposal should be time bound and by default if not resolved should be absolved. Retrospective demands going beyond, say three financial years, must be done away with.
- Banks must have clear guidelines for evaluating needs, bearing in mind that most current loan evaluation practices are obsolete, provide long term and working capital loans and facilitate banking. However, banks have to be strictly accountable and if these turn sour, encouraged to act in time to avoid NPAs. (non-performing assets).
- A mechanism to ensure that subsidies promised by the states are fully honored. There have been cases when the states have not honored them; and their payment has involved corruption. The GOI could consider set off against taxes payable.
- GOI is strongly urged to use its leverage to ensure new entrants contribute to knowledge KNOW- HOW and skill transfer. Bear in mind they are also desperate for skilled labour. They can be incentivized based on value- added per worker as well as annual increases in productivity and not just on cost of living.
- The state has to create a cluster around the main site for supplier’s storage logistics and other needs, and where required help in establishing MSMEs (Micro-Small and Medium Enterprises) to service large plants being set up.
- Where feasible, vehicular access to toll roads and rail heads should be made available.
LONG TERM STEPS TO ENSURE SUSTAINABLE AND PROFITABLE GROWTH
- GOI has to ensure a framework whereby growth is facilitated by increasingly high value-added work. This will require facilitation of KNOW WHY transfer. China is strong because it forced MNCs to do this. They will not volunteer to this more so after the bitter experiences for many in China.
- Tax breaks should be on value- added not on investment size, employment potential etc. If set benchmarks on revenue, growth, profitability is not reached the incentives should be scaled down. A post-investment monitoring unit capable of using analytics derived from the financials regulatory and statutory filings is essential.
- Dividend, after meeting the company law/SEBI norms, all conditions set and agreed for making the investment, should be repatriable freely after paying the dividend tax. Concessions as China has taught the world are really not essential. The laws can be tweaked to encourage reinvestment in preference to repatriation of dividends. Compete in the real world.
- The firms will have to sell locally and export based on their acceptability to the market and their competitiveness; there should be minimum export subsidies as they lower the fiscal base, and give room for rent-seeking. In this connection water tight, non-negotiable transfer pricing norms have to be set out and accepted without reservations very early in the proposal.
- The GOI and state can provide incentives for building a high quality internationally competitive supplier base again based on solid performance metrics of the vendors. It is worthwhile studying and understanding the German and Japanese models for building MSMEs. The recent changes to the MSME definition, lending and borrowing norms hardly address the core challenges that beset MSME’s.
- Stringent but fair rules for closure of a business, laying off employees, repatriating assets, ensuring settlement of liabilities, fair market systems for ensuring spare parts etc should be framed and agreed to without exception. Experience suggests that the itchy feet of MNCs are best controlled by strict but not draconian laws in this regard. GOI must be ready to facilitate closure and not wish it away. Unavoidable closure in many cases allows better utilization of existing physical and human assets and ensures improved factor productivity.
WHAT CAN AND SHOULD BE AVOIDED
To leverage a massive opportunity, it would behoove well for the GOI and the states to take a measured and calibrated approach to construct investment agreements with firms. Each investment agreement will be unique, but must be within broad principles enunciated in a transparent manner.
- Rather than define every minute do and every single do not a broad policy framework of principles and purpose is essential and will serve as a reference document for dispute management.
- While the government can facilitate it should subsidize only in a strategic manner. India does not have fiscal space to provide redundant ineffective investment subsidies.
- Capital subsidies should be linked to evidence on the ground for producing and selling products and or services profitably. It should not be upfront.
- The norms for long term and working capital should be refined to ensure capital flows into India. The norms applicable to Indian firms cannot be applied blindly. For working capital contribution, free cash flows, margins, and such benchmarks can be set, bearing in mind that these have to be relevant to the industry. A blanket approach may not be tenable.
- Bank loans have to be strict and must ensure it cannot be siphoned out of the country
- Ensure a sound solid dynamic framework for transfer pricing to ensure it cannot be ripped off. Benchmarked prices can be based on using the Ex factory prices they supplied out of China after making the necessary adjustments for differing resource costs. MNCs are good at giving very creative reasons. GOI has to be professional and have knowledge of global business practices.
- All firms must provide a risk profile by a neutral third party specialized in the area, using globally acceptable risk frameworks. Current risk dashboards used in India are anemic. The risk assessment should be in line with SEBI norms and not covered up by saying these do not apply in the home country. Australia and Canada have pioneered sound risk frameworks that are worth evaluating.
- Audits have to be strict. While MNCs will have an auditor of their choice, a second auditor verifying audits, an independent auditor verifying transfer pricing will be essential.
- Rules have to be uniform and enforced/ followed by all states to avoid working at cross purposes. Verification of compliance to regulatory, legal and statutory requirements should be covered by a separate, specialized audit to avoid needless nexus.
- Guidelines for dissolving the business and repatriating investments must be explicit and agreed upon when providing the initial clearance for the project.
Above lessons are distilled from analytical literature, and from the experiences with investment attraction policies around the world. These, however, globally run into constraints of the political economy, and into mismatch in expertise and knowledge between MNCs on the one hand and government organizations on the other. Under Prime Minister Modi, India has trustworthy government to manage the political economy reasonably well. But it must ensure it has either the requisite expertise at Centre and state levels, or has access to the requisite expertise.
The global economic and strategic environment currently has provided India to help attract investments from valued addition currently generated in China. But India is competing with several very well-placed competitors, such as Indonesia, Mexico, and Vietnam, to obtain its share of such value addition from firms considering relocation, particularly from China.
Finally, what should the GOI and the States combined aim for?
China’s manufacturing sector is around USD 4 trillion; the US is at USD 2.3 trillion, Japan at USD 1 trillion, South Korea at 459billion, and India at USD 412 billion. Many businesses are being incentivized to move back home. In these circumstances, India should aim to facilitate and attract transfer of roughly 10% of manufacturing from China. At USD 400 billion, this would double Make In India plans, moving the manufacturing sector closer to the target of contributing 25% of GDP by 2025.