Is India's formal manufacturing sector ‘hollowing out’- importance of intermediate input

Abstract

Changes in India's economic policies during the last three decades were expected to spur competition in the domestic market. Greater competition, particularly in capital goods, was expected to improve production efficiency. An important dynamic to analyze manufacturing sector's efficiency is to understand the relationship between industry's value addition and value of output. In the case of India's formal manufacturing sector, the share of value addition in output has declined sharply since 1998–99. This raises a question as to whether the Indian manufacturing sector is going through a phase of ‘hollowing out’. This paper examines the potential reasons behind such decline. One such reason relates to the intensity at which inter- mediate goods are used in the production process. The value of intermediate goods relative to the gross value of output is as high as two-third in India's formal manufacturing sector. Despite the recognition of the importance of intermediate goods as an input, it has received relatively little attention in the literature on development accounting. The paper considers a model on the assumption that a firm's production function is measured in terms of capital, labour, and intermediate goods. The paper estimates the output elasticity of intermediate inputs for the formal manufacturing sector and assesses how it has changed during the 1990s and 2000s. The production function is estimated using both fixed effects and Levinsohn and Petrin model to control for the endogenous productivity problem. The paper quantifies the relationship between the intensity at which a concerned industry utilises intermediate goods in the production process and productivity (TFP) of the sector. The empirical analysis points toward a biasness in productivity that may arise if one ignores the importance of intermediate goods as a production factor. The analysis highlights that the intensity of intermediate-goods impact the productivity observed in India's formal manufacturing sector from 1988–90 to 2015–16.