Synthesis of Sector Findings

Since growth in labour and capital productivity is the key engine of economic
growth, our main objective in this study was to assess labour and capital
productivity in India and identify the measures required to improve them. India
has already witnessed the impact of labour productivity on GDP growth. Since
1993, increases in GDP per capita have come mainly from the higher productivity
of the employed workforce. The fundamental link between productivity and output
has been confirmed by the experience of other countries (see Chapter 3: Current
Perspectives on Indias Economic Performance).
In this chapter, we present our assessment of Indias labour and capital
productivity performance, based on our 13 case studies, and draw out the
implications of these findings for Indias growth. To summarise:
Labour and capital productivity in India is well below its potential.
Indias agriculture and transition sectors, which account for around 85
per cent of employment, have limited potential for improving
productivity.
Indias modern sectors have the potential to increase productivity from
the existing 15 per cent to 63 per cent of US levels. The productivity
level will reach 43 per cent of US levels by 2010 and can drive Indias
GDP growth. Therefore, unleashing this potential will become the main
driver of Indias GDP growth. Historically, key operational factors such
as surplus labour, poor organisation of functions and tasks and lack of
viable investments have kept Indias labour and capital productivity well
below potential in these sectors.
The lack of competitive pressure is the main factor inhibiting
productivity. It reduces pressure on Indian companies from trying to
improve performance and allows less productive players to sur vive.
External factors such as distortions in the product and land markets,
together with government ownership, play a major role in limiting
competition and thwarting productivity growth.

PRODUCTIVITY IS WELL BELOW POTENTIAL

In most of the sectors studied, we have found labour productivity to be low with
most sectors achieving productivity levels, which are under 10 per cent of US
levels (Exhibit 4.1). Extrapolating our findings to the rest of the economy shows
that average productivity stands at around 5.8 per cent of US levels, compared to
an average of 7 per cent estimated from official statistics.1 Productivity is well
below potential even in new and growing sectors such as software where
productivity is 44 per cent of US levels. Moreover, in all t he sectors studied,
labour productivity can rise significantly even under current low labour costs.
Similarly, capital productivity is well below potential in all sectors (Exhibit 4.2).
As mentioned in the case studies, we distinguish between three types of sectors:
agriculture, transition and modern. These sectors differ substantially in their
current productivity levels as well as in their potential labour productivity growth,
given current factor costs (Exhibit 4.3).
Agriculture: This sector has the lowest labour productivity, at 1.2 per
cent of US levels on average, of all the sectors studied. Moreover, its
productivity potential is only double its current level. Most of this
growth will come from higher yield rather than investment in more
mechanised equipment. For example in dairy farming, the largest
employer in the agriculture sector, yield can improve six fold, but almost
no mechanisation is viable.
Transition sector: This sector, comprising entry-level jobs for people
migrating from agriculture has a somewhat higher productivity at 6.9 per
cent of US levels on average, but has very limited potential for
productivity growth. Transition sectors are usually one-/two-person
operations with very limited capital requirements, e.g., street vendors,
rural counter stores, tailors. They usually provide goods of lower quality
and have an inherently lower productivity than their modern
counterparts. Their goods typically act as cheaper substitutes for products
provided by the modern sector (e.g., mud houses instead of modern brick
houses and loose flour at flour mills or chakkis instead of packaged
flour).
Modern sector: Comprising the bulk of the output and employment in
developed countries but only 15 per cent of employment in India, the
modern sector has the highest labour productivity of the three around
15 per cent of US levels on average. But more importantly, productivity
can be almost three times higher reaching 43 per cent of US levels by
2010, even at Indias low labour costs. Similarly, capital productivity in

1 See Volume I, Chapter 5: Indias Growth Potential for details on the methodology used for this extrapolation.

the capital-intensive sectors can almost triple from 32 per cent to 88 per
cent of US levels.
AGRICULTURE AND TRANSITION SECTORS HAVE LIMITED
PRODUCTIVITY POTENTIAL
Current productivity in agriculture is very low at 1.2 per cent of the US levels and
potential productivity at current factor costs is only slightly higher at 2 per cent of
the US. Indian farming is characterised by three features. First, it follows a
fragmented, joint dairy and field-farming model, with low levels of mechanisation
and productivity. The average farm size is 4 acres and 78 per cent of farmers own
farms of less than 10 acres in size (Exhibit 4.4). Second, 60 per cent of farming
households are involved in dairy and, of these, 98 per cent engage in it on a part
time basis. Third, the potential for further mechanisation is low. For example, in
wheat farming almost 70 per cent of the land is already tilled using tractors and,
further mechanisation, by way of combine harvesters and larger irrigation pumps,
is not economically viable at the current low labour costs.
In short, most productivity gains will not come from mechanisation. At current
factor costs, the use of tractors in wheat can increase to 90 per cent, while the
scope for combine harvesters is limited to some regions in Punjab, constituting
less than 3 per cent of total land in the state. The gains will come instead from the
dispersal of extension and irrigation services, which will allow farmers to improve
their yields and achieve their productivity potential (Exhibit 4.5). In the near
future, most of the productivity improvements in dairy farming will come from the
spread of better farming practices through higher coverage from Direct Collection
Services (DCS) and private milk processors, which will facilitate the diffusion of
optimal breeding and feeding practices (Exhibit 4.6). These practices will increase
yield at least six fold and allow India to achieve its productivity potential of 3.1
per cent at current factor costs (Exhibit 4.7).
Unless other sectors of the economy absorb current idle hours, we expect wages in
the agriculture sector to remain stagnant and rise only once yields increase. In a
trend that is consistent with the agricultural evolution observed in other countries,
Indian agriculture will continue to be largely non-mechanised with the jointfarming model likely to stay well beyond 2010 for the following reasons:
Currently, part time dairy farmers have a significant cost advantage over
full time farmers due to the negligible opportunity cost of labour and
lower dry fodder cost.
The opportunity cost of labour will continue to be negligible as long as
rural under-employment continues to be significant.

 Once full-time dairy farming becomes viable, field and dairy farms will
grow independently as there will be limited synergies in their operations.
However, this will only happen when rural wages increase and allow
dairy farming to be independently sustainable. This is not expected to
happen in the next 10 years.
The experience of other countries suggests that dairy continues to be a
secondary occupation to farming for a fairly long period. In Thailand, a
shift away from agriculture was driven by job creation in other sectors.
Today, the low-productivity transition sector is absorbing labour migrating from
agriculture. The transition sector includes entry-level jobs requiring very little
capital and skills (for instance, street vending, building of mud houses, wheat
milling and tailoring) and can, therefore, be undertaken by rural workers.
Moreover, since these transition jobs mostly involve self-employment, they allow
migrant labour to return to agricultural activities during the harvesting season
when manpower is in short supply.2
As mentioned earlier, the transition sector usually provides lower quality goods
than those provided by the modern sector (for instance, mud houses instead of
modern brick houses) and are, therefore, purchased by lower income consumers.
The labour productivity of this sector is also very low. Although currently higher
than in agriculture (averaging 6.9 per cent of US levels), productivity is inherently
low due to the materials (such as mud housing), technology (such as primitive
flour mills or chakkis) or business formats (such as street vending and rural
counter stores) used. To illustrate, mud and stones used for construction are less
amenable to standardisation and scale economies than modern materials such as
bricks (Exhibit 4.8). Most of our case studies show that the transition sector has
already achieved its productivity potential in India.
INEFFICIENT OPERATIONS PREVENT MODERN SECTORS FROM
ACHIEVING THEIR HIGH POTENTIAL
Excess labour, poor organisation of functions and tasks (OFT), lack of scale and
lack of viable assets are the key operational reasons why Indian companies are not
achieving high productivity despite their potential to do so (Exhibits 4.9 & 4.10).
Poor OFT, and low capacity utilisation also explain why capital productivity is
well below potential in modern sectors (Exhibits 4.11 & 4.12). Less important
operational factors include inefficient format and product mix, poor suppliers.
Contrary to conventional wisdom, we did not find poor labour skills and work
disruptions arising from poor infrastructure to be significant factors.
2 See Volume I, Chapter 5: Indias Growth Potential for details on the wage dynamics for transition jobs and how they
relate to agricultural wages.

Surplus labour i s prevalent across sectors

Indian companies, especially government-owned ones, are plagued by redundancy
in employment. Redundant workers are those whose labour is not required even
before improvements are made in the way functions and tasks are performed.
These workers are typically idle or under-utilised all day long. This problem exists
in many of the sectors we studied:
In the steel industry, excess workers account for around 30 per cent of
the workforce in large integrated steel players.
Over 50 per cent of employment in pre-liberalisation automotive plants is
excess labour.
In cooperative and government-owned dairy plants, over 50 per cent of
employment is excess labour (Exhibit 4.13).
Most managers in government-owned telecom companies readily
acknowledge the presence of excess labour, with estimates ranging from
25 per cent to 50 per cent of the total workforce.
In the power sector, overstaffing occurs in all areas. In support functions
such as finance, administration, accounts and HR, there is one support
staff per MW compared to 0.1 per MW in the US. In areas such as
security, there are often over 100 people per plant compared to fewer
than five in the US. Finally, each worker/operator in shift operations has
a helper, a redundant function absent in US generation plants. In
transmission and distribution, unnecessary helpers and artisans,
comprising as much as 50-75 per cent of line staff, are employed.
In public retail banks, redundant staff in front desk and back office
clearing operations account for at least 10 per cent of total employment.
Poor organisation of functions and tasks is a major constraint
Poor OFT is the main operational reason why Indian companies do not achieve
their potential labour and capital productivity levels. Improvements in OFT can
almost double Indian labour productivity levels in modern sectors. We have
observed four types of OFT problems:
Lack of multi -tasking: Many Indian players have been following a
Taylor model with a functional orientation and high task specialisation
leading to significant downtime. To illustrate:
In steel shops, workers are typically assigned one role and conduct
only those tasks defined as part of that role. For example, in the steel
shop of an IBFP plant, there were 27 separately defined roles. Each
person did only those tasks that were defined as part of their role.
5

 In the power sector, maintenance workers are organised rigidly by

function (electrical, mechanical, control, instrumentation and so on)
instead of being organised into multi-skilled crews by area.
In the retail sector, limited use of multi-tasking and a negligible use of
part time help during peak hours lower the productivity of retail
stores.
Lack of centralisation of common tasks: Common and repetitive tasks
are often performed at different locations, each working below capacity,
as the examples that follow show.
Control rooms in State Electricity Board plants are placed in each area
of the main plant (e.g., boiler, turbine and boiler feed pump) instead
of between different units with shared staff.
Bill collection in telecom is typically done through staffed booths
where subscribers line up, make their payment and receive a receipt,
instead of through drop-in boxes that save resources and increase
customer convenience. Moreover, government-owned carriers usually
assign maintenance personnel on a geographic basis instead of
centralising them in one location to share fixed costs.
Low workforce motivation: Poor management and lack of incentive
payments reduce workers motivation and hence productivity.
Low motivation of workers in domestic apparel plants results in high
absenteeism, high rejection levels, and a high percentage of delayed
shipments (Exhibit 4.14). High absenteeism often results in slower,
unskilled operators filling in for skilled labour.
In the power sector, low motivation and high job security reduces the
managers incentive to limit outages and maintenance time.
Poor managerial practices: A range of poor managerial practices such
as inefficient planning, poor design and lack of delegation combine to
hamper productivity.
Lack of centralised planning and maintenance at steel plants often
result in massive load imbalances. Moreover, poor handling of
existing automation diminishes the quality of the steel produced.
Poorly trained personnel typically fail to optimise plant settings,
resulting in substantial differences in the chemical composition and
physical properties of the steel produced.
In the automotive sector, the late implementation of lean production
techniques significantly hampers the productivity of pre-liberalisation
plants. In these plants, a large proportion of cars leave the assembly
6

line with defects, which must then be remedied. The older Indian
post-liberalisation plants also suffer from lower skill levels with over
20 per cent of their workforce consisting of trainees with little
experience.
In dairy processing, poor scheduling of cleaning time and idle time at
process bottlenecks (such as unloading of milk) disrupt workflow and
increase labour requirements (Exhibit 4.15).
In housing construction, poor planning by contractors results in time
and cost overruns. Material and equipment deliveries are not planned
in advance and workers sometimes remain idle until the required
resources are procured. Moreover, workers are not specialised: It is
common to find masons in India doing both bricklaying and
plastering. Moreover, in small cities and rural areas, houses are
typically built one room at a time. Finally, owners choose to act as
both developer and contractor despite having low skills and capability
in planning and managing the construction process.
Poor store layout in Indian supermarkets increases labour
requirements by around 10 per cent.
Managers of public sector banks do not delegate authority to branch
employees, resulting in multiple approvals being needed to complete
transactions. Cash withdrawals in cashier-based public banks can take
three times longer than in teller-based private banks (Exhibit 4.16).
Similar inefficiencies are found i n operations such as clearing
cheques, issuing demand drafts, making telegraphic and electronic
funds transfers, opening accounts and approving retail credit.
Lack of investment in viable assets also inhibits productivity
A lack of investment in economically viable assets is another key factor limiting
labour productivity in modern sectors. These investments can increase value added
and optimise labour usage.
Automation in steel melting shops and continuous casting machines will
reduce the amount of labour required and improve the quality and
consistency of steel produced (Exhibit 4.17). Moreover, investments in
cold rolling facilities will increase the value of the steel produced to
more than justify the investment required.
Many domestic apparel manufacturers lack simple assets such as
suitable ironing equipment and adequate washing and drying facilities.
The common use of hand-washing and line-drying often results in fading
or shrinking. Moreover, exporters lack specialised equipment such as
7

spreading machines. Instead, cloth for cutting is laid out manually, often
stretching the fabric and distorting the size of the final garment.
Automation in network and fault management systems can increase
labour productivity in telecom by almost 50 per cent. The cost of
interactive voice response hotlines, automated test procedures to localise
faults and verify fault repair, and automated scheduling systems, is more
than compensated for by the reduction in labour costs and improvements
in the quality of service provided to customers (Exhibit 4.18).
In the power sector, customers are not charged for over 30 per cent of
the electricity produced, owing to a lack of metering or faulty meters
(Exhibit 4.19). Investment in electronic meters will cost only 20 per cent
of the annual savings it will yield. Furthermore, technical power losses
are also greater due to under-investment in high-tension lines and lack of
power capacitors. Besides electronic metering, viable investment in
computerisation of inventory, billing and accounting as well as call
centres will improve service levels and reduce labour requirements by
over a third.
In retail banking, a lack of automation and rationalisation of processes
makes banking operations very inefficient. In an average public sector
bank branch, a customer has to go to different windows where most of
the tasks are carried out manually (Exhibit 4.20). Cheques are collected
and dispatched to individual branches for signature recognition instead of
using collection boxes and centralised signature databases. Automating
and centralising key repetitive processes will more than double the
productivity of public retail banks.
In housing construction, workers lack even basic tools and small
equipment. They carry material as head loads as opposed to the
wheelbarrows used in other countries. Manual tools are used to prepare
wood for shutters, instead of more efficient circular saws and electric
surface planers. Large surfaces are painted with standard brushes instead
of the more efficient roller brushes or spray-painting equipment.
Other operational factors also play a significant role
Apart from the major causes of low productivity listed earlier, inefficiencies across
the value chain also constrain productivity. These include:
Poor marketing and inefficient product/service mix: Poor marketing
practices increase costs and reduce value added in service sectors. A lack
of attention to product and service mix has the same effect. The examples
that follow prove the point.

 In telecom, the lack of marketing efforts for call completion services

(such as call waiting, voicemail) by government-owned telecom
operators reduces usage and limits labour and capital productivity.
Modern retail channels account for only 2 per cent of Indian sales
compared to 30 per cent in Indonesia and around 85 per cent in the
US (Exhibit 4.21). Modern formats like supermarkets and specialty
chains are two to three times more productive than the traditional ones
even in India. Moreover, the larger volumes they can support raise
productivity potential by lowering procurement, distribution and
marketing costs. In addition, the higher skills of best practice
supermarkets and specialty stores allow them to optimise
merchandising and marketing as well as supply chain and inventory
management.
A large share of the revenues of Indian software companies comes
from low value added services. On average, Indian companies earn
about 30 per cent of their revenues from the lower value added
domestic services market. In global markets as well, Indian companies
focus on inherently lower value added services. Moreover, lack of
brand recognition and poor marketing is forcing average service
companies to offer significant price discounts (25-30 per cent lower
than prices of best practice companies) in order to induce clients to
outsource business to them.
Low capacity utilisation: Low capacity utilisation leads to considerable
productivity loss. To illustrate:
In the automotive sector, average plant utilisation is only 59 per cent
compared to 80 per cent in the US (Exhibit 4.22). Lower capacity
utilisation for plants producing mid-sized cars causes a productivity
loss mainly in indirect and production support functions.
At dairy processing plants, capacity utilisation during the flush season
is around 69 per cent compared to an average utilisation of 77 per cent
in the US. Raising utilisation to US levels will require only a small
increase in staffing of managerial and unloading functions.
Inefficient supply: Inefficiencies in supply affect utilisation of labour,
increase complexity and hence costs, and reduce quality of output. To
illustrate:
In dairy processing, due to seasonal variations in milk supply, plant
utilisation during the lean season often falls below 60 per cent
(Exhibit 4.23). To make up for the shortfall, dairy plants typically
undertake liquid milk reconstitution from milk powder and fat during
the summer months, thereby duplicating processing efforts. Moreover,
9

additional labour needs to be employed in the lean season to reprocess

inputs previously processed in the flush season. Using crossbred cows
can reduce these seasonal fluctuations in milk supply.
In housing construction, the lack of standardised and pre-fabricated
materials increases complexity and hampers task specialisation on
construction sites. Brick sizes in India typically vary significantly
even within the same lot, requiring additional levelling work when
building and plastering walls. Furthermore, using pre-cut and prethreaded plumbing (such as PVC plumbing) instead of the plain tubes
currently used will reduce installation time and increase task
repetition at the work site.
In retail banking, the lack of credit bureaus forces branch employees
to spend a lot of time making credit decisions. As a result, mortgage
approvals can take up to 4 weeks compared to 2 days in the US.
Similarly, the lack of a reliable postal system limits centralisation and
automation of cheque clearing functions. As a result, clearing is done
in small, decentralised centres for which investment in Magnetic Ink
Character Recognition (MICR) reader-sorter machines is not
economical.
Lack of scale: Low scale operations in many manufacturing sectors add
up to considerable productivity losses.
In the steel industry, around a third of the output is produced in very
small mini-mills with an average capacity of only 50,000 tons
compared to the more than 1 million tons of average US mini-mills.
In apparel, the average domestic manufacturer and exporter employs
fewer than 50 machines, whereas producers in China and Sri Lanka
often have 1,000 machines under one roof. Technically, a 500machine factory is the minimum size needed for efficient functioning
and larger factories are still more efficient.
In housing construction, individual houses are typically built one at a
time. In contrast, in best practice countries such as the US and the
Netherlands, over 70 per cent of total single family construction is
built in projects of over 20 houses each. Building on a larger scale
provides savings through bulk material purchasing, less idle time,
better equipment utilisation and more efficient use of prefabricated
materials (Exhibit 4.24).
Poor design for manufacturing (DFM): Design for manufacturing
involves incorporating the optimisation of the production process into the
product design without compromising on quality. As the two examples
we elucidate show, DFM is not fulfilling its promise in India.
10

 In the automotive sector, post-liberalisation plants still produce old

and outdated models. For example, we estimate that the largest selling
small car in India could be assembled in roughly 15 per cent less time
if it were totally redesigned today. Even new models in India do not
reflect best practice DFM: Indian models require almost twice as
many body panels and spot welds compared to global best practice
models (Exhibit 4.25).
In housing construction, non-optimal design and lack of modularity
increases the amount of rework in construction projects (Exhibit
4.26). Bricks and tiles need to be broken to fit corners while windows
and doors need to be custom built to fit the unique design of each
building. Moreover, poor planning often results in disruption of tasks
or rework. For example, to install electrical wiring, a builder often
needs to cut and re-plaster walls, causing disruption in the masonry
work.
Lack of skills and poor infrastructure have less impact on
operations than estimated
Contrary to conventional wisdom, low labour skills and poor infrastructure do not
have a significant effect on productivity. We found that with appropriate training
and adequate managerial practices, even illiterate workers in sectors such as
housing construction and retail could achieve best practice productivity levels.
In terms of infrastructure, although energy shortages and poor transportation
conditions can potentially affect operations, their impact on Indian productivity is
actually quite limited (less than 5 per cent) since companies have learnt to
overcome infrastructure constraints. To overcome power shortages, for example,
companies often build their own generation facilities with few efficiency losses.
Similarly, automotive parts suppliers and apparel exporters overcome poor road
conditions by locating their production facilities close to assembly plants and
ports. Bottlenecks at ports, however, do constrain the competitiveness of Indian
exporters.
Main causes of low labour productivity also lead to low
capital productivity
The key factors behind the labour productivity gap, namely poor OFT, low
capacity utilisation and lack of viable assets, are also responsible for low capital
productivity.
Poor OFT: Improvements in OFT alone can increase capital
productivity by around 60 per cent. In the sectors we have studied, cost
overruns, poor planning and over-invoicing considerabl y curtail capital
productivity. To illustrate:
11

 Constructing a steel plant in India typically takes almost twice as long

as it would to build the same plant in the US. Moreover, overinvoicing of imported equipment is reportedly common practice,
mainly due to inadequate supervision by shareholders and bankers.
In telecom, managers typically lay lower than optimal capacity copper
cable in order to meet their line growth targets for that year (Exhibit
4.27). This practice results in higher costs per subscriber as it does not
take advantage of scale economies in cable capacity (lower cost per
line of higher capacity cable) and in major work such as digging
trenches (digging the trench only once for a higher capacity cable).
State Electricity Boards (SEBs) take o ver 5 years, on average, to
construct large coal plants compared to 3-4 years by best practice
Indian plants. Construction overruns arise due to lack of funds, delays
in tendering and antiquated engineering, procurement and
construction practices. Moreover, plant redundancies and the absence
of standardised plant designs often result in over-engineering and
increase capital costs.
Low capacity utilisation: Small steel mini-mills run at round 31 per
cent of their capacity. In contrast, mini-mills in the US r un at 90 per cent.
Similarly, a lack of focus on marketing efforts by telecom operators
results in 18 per cent fewer minutes per installed line compared to US
operators (excluding Public Call Offices). Improvements in capacity
utilisation will increase capital productivity by over 30 per cent.
Lack of viable assets: A lack of investment in viable assets also
hampers capital productivity by reducing the value added per physical
unit of production. As discussed earlier, investments in cold rolling
facilities in steel and in electronic metering in transmission and
distribution will increase the value added to more than justify the
investment required.
LACK OF COMPETITION GIVES COMPANIES LITTLE REASON
TO IMPROVE PRODUCTIVITY
The lack of competition in Indian industry is the main reason for the poor
operational performance of Indian companies and hence for the low labour and
capital productivity described earlier (Exhibit 4.28). In the absence of strong
competition, managers can afford to ignore significant operational issues under
their control (such as excess workers, poor OFT and inadequate equipment) and
are able to earn high profits despite these inefficiencies. The lack of competition
also shields companies from exposure to global best practices. Moreover,
competition in some markets is distorted by unequally applied rules and
12

enforcement, allowing less productive players to thrive at the expense of the more
productive ones.
The importance of competition in improving productivity and output growth is
clearly seen in the Indian automotive industry. After the entry of Maruti Udyog
Ltd and other foreign players, competitive intensity has increased dramatically,
resulting in substantial market share loss for pre-liberalisation plants (Exhibit
4.29). The resulting lower prices and improved quality have boosted demand,
thereby increasing employment despite the very high productivity growth
(Exhibit 4.30).
Lack of competition leads to inefficiency and low consumer
choice
The absence of competition creates monopoly power for incumbent players. This
in turn results in low choice and higher prices for customers. The ill effects of low
competition are evident in the examples cited.
In dairy processing, the licensing regime ensures that new plants are not
established close to existing plants (i.e., in the milk shed area of the
existing plant). This practically ensures that the incumbent plants have a
procurement monopoly, as it is not feasible for farmers to supply to
plants located geographically far away from them. As a result, incumbent
processors have little incentive to rationalise labour and improve OFT.
Competitive pressure on small domestic apparel manufacturers is low
because large players cannot benefit from economies of scale without
modern retail formats. Furthermore, the reservation of this area for smallscale industry protects small manufacturers and limits the expansion of
large modern producers.
In telecom, government-owned incumbents still account for over 93 per
cent of the market while private entrants in the local market have limited
their operations to the more profitable business segment. Moreover, the
prices of the long distance and international segments (currently a
government monopoly) remain very high, when compared to countries
such as the US. As a result, government-owned incumbents enjoy higher
profits than their counterparts in the US who face greater competitive
pressures (Exhibit 4.31).
In power generation, there is very little wholesale competition (i.e., interutility buying and selling of electricity). Although private players were
allowed to enter the market in 1991, very few have actually entered
owing to contractual disputes and payment delays by SEBs. Furthermore,
retail competition in generation (i.e., where customers can buy electricity
from competing producers) is non-existent in India. The experience of
13

other countries shows that competition in the wholesale and retail

segments results in lower prices and better supply.
Developers in Indias real estate sector are shielded from competition by
the scarcity of land, which is available only to a few insiders. As a result,
these well-connected players are able to keep their profits high by
focusing their efforts on land procurement and clearing red tape and
more or less neglecting productivity in construction (Exhibit 4.32).
In food retailing, counter stores typically enjoy a captive clientele based
on personal relationships and services like home delivery and credit. The
choice available to customers is further limited by the low penetration of
modern supermarkets.
Finally, in banking, despite delicensing in 1993, competition is still not
strong enough for the larger public banks. Private banks are still small
and active only in select urban and metropolitan areas.
Exposure to global best practices is also limited in many sectors
Exposure to best practices increases pressure on managers to improve
productivity. Furthermore, as recent experience in the automotive sector has
shown, the presence of best practice companies also facilitates the dissemination
of more efficient managerial practices.
One sector in which global best practice is almost totally absent is the apparel
industry. Foreign firms often prefer to establish operations in countries such as
China or Thailand where they can find sufficient good quality textiles as well as
cheap labour. In retail, existing restrictions on foreign best practice players limit
the diffusion of sophisticated sourcing and organisational practices, a key success
factor in this complex business.
Unfair competition allows less productive players to survive
In a market economy, strong competition ensures that the more productive
companies grow at the expense of the less productive ones. In India, however, the
presence of a non-level playing field and uneven enforcement of regulation allow
less productive players to thrive even when domestic competition is high.
In the steel industry, for example, uneven enforcement of taxes and energy
payments allows sub-scale, inefficient plants to compete despite their lower
quality and higher inefficiencies. In retail, lax enforcement of taxes and duties
among small players helps unproductive retail counter stores and limits
penetration of supermarkets.
In dairy processing, the subsidisation of cooperatives and government-owned
plants allows overstaffed and inefficient government-owned cooperatives to stay
14

in business. In telecom, higher licence fees and interconnection agreements

increase entry costs and limit the entry of telecom operators using wireless
technology.
EXTERNAL FACTORS LIMIT COMPETITION AND THWART
PRODUCTIVITY GROWTH
Widespread market distortions in India raise many barriers to high capital and
labour productivity (Exhibit 4.33 & Exhibit 4.34). It has its most negative effect
through product market barriers, that is regulation governing specific sectors. Land
market barriers, government ownership and problems in related industries (mostly
due to product market barriers in these sectors) are other important barriers to
labour and capital. However, our case studies show that other widely discussed
obstacles such as stringent labour laws, poor infrastructure and low literacy rates
have a lower effect on productivity than assumed. Restrictions on labour laws
were found to be overcome through use of voluntary retirement schemes (VRS).
Product market distortions are the most important barrier to
productivity growth
On average, in our case studies, we have found that removing product market
barriers will increase labour productivity by around 80 per cent. In contrast,
government ownership lowers productivity in almost 40 per cent of labour in
modern sectors. Moreover, removing product market distortions is a key
prerequisite for reaping the productivity benefits from privatisation. As we showed
in our report on the Russian economy, distortions to competition introduced by
distortions in the product market will limit managers incentives to improve
productivity despite privatisation.3
Product market barriers also play a key role in limiting capital productivity in the
sectors we have studied. For example, regulation on the rate of returns limits
managers incentives to cut capital costs and encourages over-engineering in
power generation, transmission and distribution. Similarly, unequal tax
enforcement and investment subsidies allow under-utilised small mini-mills to
compete despite their higher capital costs per ton of steel produced.
Outright barriers to entry, differential rules and uneven enforcement play a major
role in hampering productivity.
Outright entry barriers: A number of regulations such as restrictions
on foreign direct investment (FDI), high import tariffs and licensing and

3Unlocking Economic Growth in Russia, McKinsey Global Institute, October 1999.

15

small-scale reservations decrease competition and thus productivity in

India.
Restrictions on FDI: Three examples show the adverse effect of FDI
restrictions on productivity. In the retail sector, current regulation
restricts global retailers to wholesale trade and operating retail outlets
through local franchisees. In apparel, FDI in domestic-oriented
manufacturers is limited to 24 per cent of equity. This restricts the
transfer of technology, skills and managerial knowledge from foreign
best practice firms to local ones. In housing construction, restrictions
on foreign ownership of land limit the entry of foreign builders and
developers into the construction market. Foreign players face higher
risks when operating in India, as they are unable to take land ownership
as collateral for the capital they have invested.
High tariffs on imports: In three of the sectors we have studied, high
tariffs considerably depress competition and thus productivity. Import
duties in the steel industry still protect Indian companies from pricebased competition with global best practice players, reducing their
incentive to increase the efficiency of their plant operations and make
economically viable investments.
In the automotive sector, high import duties on mid-sized cars allow
subscale and under-utilised automotive assembly plants to compete
with productive foreign players. In apparel, quantitative restrictions
prevent imports from more productive lower cost countries. As a
result, Indias domestic apparel industry faces less pressure to
improve productivity. If quotas are removed, Indias apparel sector
will be forced to restructure in order to compete with China, which,
unlike India, has already gained ground in markets not currently
protected by the quota system (Exhibit 4.35).
Processing licences through Milk and Milk Products Order
(MMPO): This prevents new entry in dairy processing. Although the
MMPO was set up primarily to ensure high levels of quality and
hygiene, its ability to grant processing licences has become a way to
limit the entry of new cooperatives and, in particular, private plants
into particular milk shed areas. As a result, government-owned and
cooperative dairy plants remain profitable and have little incentive to
rationalise excess labour and improve OFT.
Reservation for small-scale industry (SSI): In the apparel industry,
reservation of specific areas for small-scale players limits entry and
competition. Although removed for the woven segment since
November 2000, reservations remain in place in the knitted and
hosiery segments. With increasing trade in apparel products, SSI
16

restrictions are protecting subscale plants from competing with largescale Chinese manufacturers.
Non-level rules and uneven enforcement: Rules that sometimes
irrationally differentiate between different kinds of players or the uneven
enforcement of rules (e.g., on taxes and inputs payments) give some
industry players an unfair advantage. Protected players have little
motivation to improve productivity and are able to compete despite their
inefficiencies. To illustrate:
In the steel industry, small mini-mills frequently evade energy
payments and t axes by under-reporting their sales. This gives them an
unfair cost advantage of 15 per cent that allows them to survive and
compete against larger, more visible players. Moreover, subsidies
for new companies in underdeveloped areas have contributed to the
proliferation of these small-scale players. The tax subsidy regime
gives incentives to invest in several small plants rather than a single
larger one. Similarly, large integrated players benefit from subsidised
coal and iron ore prices obtained through preferential long-term
mining leases. As a result, overstaffed and inefficient integrated
players have a cost advantage over more efficient large mini-mills
(Exhibit 4.36).
Cooperative dairy plants have received large subsidies from state
governments in the form of loss write-offs and soft loans. These
subsidies have allowed them to survive despite their excess labour and
poor OFT.
For some products in the apparel industry, firms with investments of
less than US$ 200,000 are exempt from paying excise duty, thereby
improving their cost position vis--vis larger manufacturers.
Pro-incumbent regulation in telecom often inhibits the entry of new
players, limiting competition. Moreover, even when entry occurs,
differential regulation increases the costs for new private players. This
allows government-owned incumbents to maintain market share
despite their lower productivity. Besides paying a high licensing fee
(17 per cent of revenues), new local telecom providers also face
limitations on geographical coverage, delays in interconnecting and
unequal access to long distance telephony. In the wireless market,
recent legislation permits incumbent wireline operators to provide
limited mobility mobile services without paying the additional
licence fees that regular mobile providers are required to pay.
Power wholesale tariffs protect SEBs and central government-owned
generators from competition through capacity additions by private
17

players. Furthermore, the lack of independent regulators allowed

SEBs to pass the costs arising from operating inefficiencies and
energy losses/thefts on to consumers.
In retail, unequal tax and labour laws give traditional counter stores a
15-20 per cent benefit in gross margins vis--vis supermarkets. Most
traditional retailers evade most of their income tax as well as some of
their sales tax. Moreover, traditional stores also pay lower rates for
land and energy compared to modern formats. Frozen rents and lower
residential power rates typically halve the land and power costs for
some traditional counter stores.
Other product market barriers: Productivity also suffers through
restrictions on or practices in specific industries.
In retail banking, interest rate restrictions hamper bank operations.
Indias central bank, the Reserve Bank of India, prevents banks from
offering any interest on checking accounts (current accounts) for
small businesses and limits interest on checking accounts for retail
customers to 4.5 per cent. Similarly, the interest rates on small loans
are limited to 12-13.5 per cent. Although these restrictions have not
stopped new private banks from rapidly attracting wealthier customers
on the strength of better service and higher rates for fixed term retail
deposits, they could restrict their growth into the mass market which
has a higher demand for liquidity.
Cross subsidies in telecom limit operators incentives to boost usage,
lowering both labour and capital productivity. Moreover, under
current conditions, cross subsidisation allows local incumbents to take
advant age of artificially high long distance prices to finance their
local operations, lowering their costs vis--vis new local providers not
present in the long distance market.

Inadequate standards for building and materials hamper DFM in

housing construction and limit competition. Better building standards
will facilitate the diffusion of best practice DFM (with competition
among developers as a prerequisite), increase the information
available to consumers, and facilitate housing financing. Moreover,
enforcement of standards will compel contractors to focus on
lowering labour costs rather than on sourcing cheap, lower quality
materials.

In software, weak enforcement of intellectual property rights increases

software piracy rates to around 61 per cent compared to only 25 per
cent in the US. As a result, product companies lose revenues that can
increase their productivity by 88 per cent (Exhibit 4.37). While the
18

direct impact of this will be a virtual doubling of current productivity

in products, the indirect impact is far higher. With the right protection,
products companies will derive higher returns on their investments in
research and development, gain scale and dramatically improve
productivity.
Land market distortions also restrict productivity growth
Land market barriers, usually ignored in the public debate over economic reforms,
critically affect large domestic sectors such as housing construction and retail. The
important issues here are unclear titles, low property taxes, subsidised user
charges, rent control and stringent tenancy laws and zoning laws.
Unclear titles: It is believed that most, over 90 per cent by one estimate,
of the land titles in India are unclear, leading to numerous legal
disputes over property. The lack of clear titles affects price-based
competition in housing construction and retail in several ways. First and
foremost, it limits access to land to a few privileged developers who
thrive in this environment, making their profits on the basis of offering
clear titles as opposed to lower prices. Second, it makes collateral-based
financing very difficult, restricting the number of transactions in both the
primary and secondary housing markets. The lower number of
transactions, in turn, limits price information for consumers and further
reduces competitive intensity among developers. Finally, unclear land
titles also limit the expansion of large modern retailers by limiting access
to a few well-connected players.
Low property taxes: Low property tax and its collection reduces the
local governments incentives to build new infrastructure. Again, this
restricts the land available to housing developers and retailers. Property
tax collection, a key source of revenue for infrastructure financing in
other countries, is low in India for two reasons. First, in city centres,
property valuations for tax purposes are usually outdated and often
linked to the controlled rents paid by existing tenants. Second, in city
suburbs, where rents are not controlled, property tax collection is low
since there is a larger amount of unauthorised construction (i.e., slums)
and higher tax evasion due to corrupt officials.
The lack of infrastructure development restricts new construction to the
city centres where only well-connected developers and retailers are able
to acquire land. In particular, it severely limits the large-scale
development of single-family homes, which require large land lots at the
city edges. Moreover, the lack of suburban developments reduces the
amount of price information available to consumers by reducing the size
of the built for sale housing market.
19

 Subsidised user charges: As with low property taxes, heavily subsidised

user charges limit the incentives for local governments to invest in new
infrastructure and limit the land available for housing and retail
developments. Water and sewerage services are typically governmentowned and pricing decisions are often taken on political rather than
economic grounds. Similar issues affect the electricity sector where,
despite private participation, energy thefts and subsidised tariffs for
certain segments of consumers greatly reduce collection.
Rent control and stringent tenancy laws: Stringent rent control and
tenancy laws reduce competition among housing developers and
retailers. First, they freeze land in city centres, thereby contributing to
the lack of clear land for construction and retail. Second, rent control
directly hampers the size of the rental market. More and cheaper rental
accommodation will increase competitive pressure on developers.
Zoning laws: Zoning laws contribute to the lack of clear land and
limit competition among housing developers and retailers. Local
governments are often slow to convert rural land to residential land and
this limits the supply of land in city subur bs. In other countries, the
incentives offered to local government to convert rural land are linked to
the future tax collection from new developments on this land. These
incentives are severely restricted in India as a result of the low property
tax and user charge collection in suburban areas.
Government ownership is a major restraint on productivity
Government ownership inhibits productivity in modern industries such as steel,
power, telecom and banking. Government-owned bodies, which account for
around 40 per cent of employment in modern sectors, exhibit substantially lower
productivity than their private counterparts who, incidentally, also perform well
below their productivity potential because of product market barriers (Exhibit
4.38).
Government ownership lowers productivity in three main ways. First, political
interference and the compulsion to create jobs have led to massive overemployment, resulting in poor labour productivity at government-owned plants.
Second, the constant bailing out of companies in financial trouble and the
subsidising of operational inefficiencies allows these players to survive without
restructuring. Finally, government ownership often induces regulation that protects
inefficient incumbents at the expense of more efficient private entrants.
At the operational level, government ownership affects productivity in two ways.
For one, it hampers labour productivity by reducing the managers incentives to
rationalise the labour force, improve organisational practices and invest in viable
assets, as is described in the instances that follow.
20

 Despite being vastly overstaffed and inefficient, subsidies and bail-out

packages allow large government-owned steel producers to compete with
more efficient private players.
In the power sector, state-owned SEBs employ, on average, four persons
per MW as against one person per MW at even the old private sector
plants.
In telecommunications, the government monopoly leads to very high
long distance telecom tariffs and thus high revenues, reducing pressure
on the management to improve operations. As a result, heavily
overstaffed operators are able to compete with more efficient new private
entrants. Moreover, the governments investment targets limit
economically viable investment by favouring investment in new lines as
the only performance target. Viable investments are further limited by
the multiple layers of approvals required to obtain funds for items outside
the annual budget.
In banking, subsidised public sector banks have little financial
incentive/pressure to automate branches and rationalise labour. Managers
are also typically unwilling to confront powerful labour unions, which
have imposed many internal barriers to increasing productivity.
At the external level, government ownership also hampers capital productivity.
Public enterprise managers, with little reason to maximise profits, are complacent
and often tolerate under-billing, construction time and cost overruns and overinvoicing of imported equipment. Similarly, the lack of shareholder vigilance from
government-owned banks and insurance companies also leads to over invoicing.
Corruption and lack of profit incentives often result in over invoicing of
equipment and time overruns in building government-owned steel plants.
Moreover, private steel plants, under the lenient eye of government
banks and large state-owned institutional shareholders (e.g., insurance
companies), incur similar time and cost over-runs.
Government targets and bureaucratic delays hamper the capital
productivity of government-owned telecom operators. First, viable
investments are limited by the multiple approvals required to obtain
funds for items outside the annual budget. Second, network planning
becomes short sighted as the capacity in place only reflects current
targets instead of anticipating future demand. Finally, corrupt practices
sometimes result in over invoicing of capital equipment.
Poor corporate governance in the power sector, primarily at SEBs, is the
main external factor leading to low capital productivity in generation and
transmission and distribution. In generation, SEBs have the longest
construction overruns and the lowest capacity utilisation. In transmission
21

and distribution, they lose about 20-25 per cent of power (mainly due to
theft) compared to the 2-3 per cent mainly technical losses of best
practice private players
Distortions in related sectors have negative spillover effects
Distortions in related industries harm productivity in many of the sectors we have
studied. Typically, these distortions are the result of product market barriers in
these sectors, as the examples we have elucidated show.
The food value chain: The underdeveloped supply chain of this sector is
a critical barrier for global food retailers who will not invest in India
unless they can source a large proportion of their requirements locally
and at the right quality. This prevents the spread of best practice, for
example, through contract farming or in streamlining the distribution
chain and reducing downstream costs for processors.
Large players account for only 25 per cent of the food processing output
in India. The small-scale industry (SSI) accounts for a third of the output
and non-registered traditional manufacturers for another 42 per cent.
While the SSI reservation is being progressively relaxed, some products
remain restricted (bread, some confectionery, etc.) and the legacy effect
is strong. As a result, food processors in India remain small and
fragmented, and are unable to reap the benefits of scale or invest in
brand building. The absence of large processors also limits the diffusion
of contract farming, an efficient way to provide extension services to
farmers. Extension services such as bulk buying of feed and fodder,
provision of management information, and education about animal
health and hygienic practices are very important if dairy farmers are to
increase their productivity.
The absence of large retailers also increases distribution inefficiencies
and reduces competition in wholesaling. In India, distribution of most
food items involves multiple intermediaries, high cycle times and losses
during transportation and storage (Exhibit 4.39). These distribution
inefficiencies are the largest in the fruit and vegetable chain where the
absence of a cold chain and convenient marketing channels leads to huge
wastage.
The apparel value chain: The apparel industry suffers from fragmented
textile suppliers and retailers. Retailers are also constrained by the lack
of large producers of branded apparel. Large mills that can produce
significant quantities of quality fabric are scarce and export much of their
production. One of the reasons is that small-scale reservation, the uneven
enforcement of labour laws and non-level taxes allow powerlooms and
handlooms to thrive despite their lower productivity (Exhibit 4.40).
22

Furthermore, zoning codes and labour laws make it difficult for the mills
to move to cheaper land/labour cost areas.
The poor quality of local textile fabrics hampers the productivity of
apparel exporters as well as domestic manufacturers. For exporters, poor
quality deters FDI. All things being equal, investors prefer a country
with a readily accessible supply of textiles to cut down on the turnaround
time and minimise problems with customs clearance. Poor quality
textiles affect domestic producers even more dramatically since they do
not have the option of importing fabric at low duties. Small lots of faulty
fabric push up complexity costs and prevent the adoption of new
technology.
Finally, the fragmentation of domestic apparel producers increases the
sourcing costs for retailers since it makes it difficult for large formats
such as department stores to find sufficient brands and quality
merchandise.
The steel value chain: Here, government control on ore deposits acts
against the market. Government long-term leases on iron ore and coal
mines enable integrated players to source iron ore and coal at highly
subsidised prices and thus compete with more productive large minimills and foreign imports. At the same time, a lack of concern for quality
steel on the part of real estate developers and contractors helps many of
the small mini-mills and rolling mills, which typically serve only their
local construction market. Larger players would not produce substandard steel because it would damage their brand.
Power generation and transmission and distribution: As mentioned
earlier, the bankruptcy of the SEBs is one of the key reasons why entry
into the wholesale generation market has been very slow. Private
investors, fearing default on payments, attach a high risk premium to
generation projects. In turn, SEBs are bankrupt mainly because of
government ownership, which limits the incentives to improve operations
and reduce rampant theft.
Credit rating systems and retail banking: The lack of reliable credit
information in India directly reduces productivity in retail banking. In the
US, the Fair Credit Reporting Act of 1971 allows credit bureaus to
release customer histories to entities with a legitimate need to determine
customers creditworthiness. In contrast, regulation on credit bureaus is
not clear in India. Moreover, government-owned banks have little
interest in improving their credit approval process. Consequently, most
banks do not have access to credit data and hence have to spend a vast
amount of time on the underwriting process (Exhibit 4.41).
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Factors with less influence on labour and capital productivity

Despite a widely-held view that rigid labour laws, worker illiteracy, red tape and
corruption and poor infrastructure are important causes of the productivity gap
between India and the US, we found these barriers to be not as important as
commonly believed.
Labour market distortions: Stringent labour laws are not significant
barriers to high productivity. This is because rigid labour laws are only
applicable to the manufacturing and government sectors. Even in these
sectors, it is possible to gradually prune the workforce. Thus labour
market rigidities may slow down productivity growth in some cases, but
they do not generally prevent an industry from achieving its potential
labour productivity over time. Although it is difficult to dismiss workers
except on disciplinary grounds, the workforce can still be rationalised
using VRS. For example, large private steel plants have already reduced
their labour force by 10 per cent in one year using VRS. Similarly,
overstaffed government-owned companies now facing competition from
best practice private entrants have recently offered VRS and over 10 per
cent of the employees have applied for it. Labour laws do, however,
affect Indias attractiveness as a manufacturing destination for exports to
global markets. This has been the experience in the apparel sector, where
global players have chosen to locate their sourcing bases in other Asian
countries.
Poor transportation infrastructure: We have not found poor
transportation infrastructure (i.e., roads and ports) to be as significant a
constraint on productivity and output growth in our case studies as the
top three factors, belying the common belief that poor infrastructure
represents a serious bottleneck. Indian road and railway coverage appears
to be well in line with that of other developing countries (Exhibit 4.42).
Road shipping delays are due in part to the poor quality of roads and also
to poor traffic management. Similarly, delays in ports are mainly a
consequence of red tape and inadequate and poorly managed material
handling facilities rather than the shortage of berthing capacity.
Best practice companies usually find ways of overcoming the operational
effects of infrastructure inefficiencies. For instance, automotive suppliers
tend to locate themselves close to the assembly plants and best practice
supermarkets typically use small generating facilities to cope with the
energy shortages during peak demand.
Low labour skills or literacy rates: We did not find Indias current low
literacy rates to be a constraint on productivity growth. In all the sectors
we studied, we found that Indian blue collar workers could improve their
performance if on-the-job training were provided and managerial best
24

practices put in place. We found similar examples in the US as well.4 A

Houston-based housing builder achieved best practice productivity with
illiterate Mexican ex-agricultural workers who were not fluent in
English. Similarly, a Richmond food processor trained his employees,
many of whom had difficulties in reading and writing, to fulfil complex
work within a highly automated plant.
Where labour skills are more important is in the software sector whose
future growth may be hampered by the expected shortage of experienced
software professionals. Although the availability of English-speaking
software professionals has not been an issue in the past, increased
sourcing of software professionals by companies in developed markets
might limit the Indian industrys ability to continue growing at its current
rate. Public and private training institutions that have increased their
output of specialised engineers over the past few years, however, are
already addressing this issue.
Red tape and corruption: These are factors that do have a negative
effect on productivity, albeit not as great as assumed. Red tape and
corruption directly affect productivity by disrupting workflow and
making planning difficult. Moreover, red tape and corruption can also
discourage entry, especially by foreign players, thereby limiting
competition for domestic as well as foreign best practice players. Two
examples prove the point:
In housing construction, frequent site inspections and harassment by
government inspectors often cause work stoppage, making it difficult
to plan work.
In apparel, red tape and corruption in Indian ports is a strong deterrent
to FDI. Delays in ports critically affect exporters by increasing
transportation costs and making time to market difficult. As a result,
foreign investors prefer to establish their operations in China, where
higher labour costs are more than compensated for by lower
transportation costs.

4 Productivity The Key to an Accelerated Development Path for Brazil, McKinsey Global Institute, March 1998.

25