Productivity boost key to a robust manufacturing sector

Companies and policymakers need to expand their focus beyond job creation

Few large countries have achieved the kind of sustained high growth that India will need if it is to transition to being a middle-income country. The traditional prescription by economists as well as industry leaders has been to accelerate the industrialisation process to meet the need for 30 to 50 million new jobs required over the next decade.

Last year we highlighted the sense of urgency on this. The long-established industrialisation pathway is losing its ability to generate masses of new jobs, as manufacturing firms face competitive pressures and the cost of automation falls. Recent political changes and protectionist rhetoric in Europe and the United States reinforce this trend, adding uncertainty to any growth strategy contingent on exports or investment by foreign multinationals.

Looking solely at job creation risks missing an important piece of the pathway to prosperity for a nation — and that is productivity growth. Simply put, rising productivity helps an economy generate more wealth with its labour, capital, and resource inputs. It enables companies to create better products, reduce prices, and innovate faster.

The true value of a robust manufacturing sector is its disproportionate contribution to productivity growth. In the US and the European Union, for instance, manufacturing accounts for about eight to 10 per cent of GDP and employment, but it makes up 35 to 40 per cent of annual productivity growth. It also drives 60 to 70 per cent of exports and over 80 per cent of private sector R&D spending, both of which reinforce the productivity cycle.

In this context, among the most worrying trends for Indian manufacturing is the decline in productivity growth in the past decade.

India’s worrying trends

Total factor productivity growth, a technical measure of an economy’s technological dynamism, surged in Indian manufacturing during the mid- to late-2000s, when many manufacturing industries experienced rapid productivity growth. This is consistent with growth of capital investment in the 1990s after liberalisation. Research shows that firms take eight to 10 years to realise the efficiency gains of technology and capital investments.

Overall, India productivity has trended downwards since then, with productivity of labour and capital resources both showing similar trends of stagnation and decline. These trends are especially worrying because of India’s significant gap to global productivity, and the massive catch-up opportunities that exist. The productivity level of India’s workers is only about half that of workers in other large developing economies, and less than one-fifth that of workers in advanced economies. India’s productivity of capital is also low. While other developing economies such as China have managed to catch up with advanced economies in terms of capital productivity, India’s capital is only about one-third as efficient.

Opportunities beyond job creation

Government initiatives to bring down barriers on land and labour arbitrage and to improve infrastructure could be the key to bridging India’s productivity gaps. But our estimates suggest that a lion’s share of the improvements could be achieved through action on factory premises. Four key factors could help companies raise the game. 

Higher investment in R&D and innovation: Indian companies should focus on high-value additions. Innovation can raise productivity growth through better quality (and higher prices), lower operational costs, and more efficient asset utilisation. China, for example, has made significant investments on innovation capital in robotics, semiconductors and heavy engineering.

Scaling up: While start-ups are an important indicator of innovation, equally vital is the need for them to scale up. There is a strong correlation between company size and productivity levels in most countries. Economies where resources do not flow to the most productive companies end up with small, inefficient firms that continue to survive, but drag down overall productivity growth. Large, fast-growing companies are net job creators. 

Growth through exports: Companies that export have significantly higher productivity levels than those that don’t. Many of our finalists for the TIME India Awards for manufacturing embody this sense of urgency and focus, as they push forward on exports.

Building digital capabilities: Despite the productivity slowdown in advanced economies, the most digitised sectors in the US and Europe have shown the largest productivity gains. Our research shows a high correlation between digital capability and corporate income gains that could also be a reflection of higher productivity. “Industry 4.0” may arrive faster in India than expected, and the big differentiator between the most successful companies and the rest will be the deployment of digital capabilities in operations. 

As we invite investment in India’s manufacturing sector, the archetypes of Make in India are changing. Increasing productivity will be imperative. Both companies and policymakers need to build a long-term view on expanding the focus beyond job creation.

Rajat Dhawan is a senior partner, McKinsey & Company; Ashok Kumar is a senior expert; and Sree Ramaswamy is a partner at the McKinsey Global Institute