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The Price Of Growth

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Nine years in the US made Thomas John a successful entrepreneur in Infotech. But a dream and an idea brought him back to Chennai. Four months ago, his company, OOHA Services, rolled out the first of the 50-100 free internet kiosks it plans in the city. “Our revenues would come from selling advertising against the eyeballs,” says John. “I thought India is a developing country and it requires internet.”
But within two months of launch, the economics of his business went haywire. While he paid Rs 5,000 a month as rent for the first kiosk, he now has to shell out Rs 15,000 for the same space. He hired a software engineer for Rs 40,000 per month; today he can’t find one for Rs 80,000 per month. “Sometimes, I feel I can’t do business in India,” says a shocked John. “It’s too expensive. Right now we’re only burning cash. It’s very difficult, nearly impossible, for a start-up to take off. If costs escalate any further, I’ll have to recalculate everything.”
Start-ups as small as John’s and even established businesses as large as Reliance Industries are realising that even though India has for long been positioned as a low-cost destination, it is actually a high-cost economy. Several components of the cost of doing business here — such as spiralling wages, poor economies of scale, lack of infrastructure, high tax regimes and administrative corruption — have become too exorbitant to keep India competitive.

High-Cost Economy
In the worst case scenario, high-cost economies cause industrial migration, even services migration. Businesses today are so global — Dell, for instance, sources components from 35 countries and Boeing aircraft are put together with assemblies from 72 countries — and complex that uncompetitive economies force en masse emigration of businesses, human resources and capital, leaving trails of despair, unemployment and run-down factories in ghost towns.
For instance, semiconductors were invented in the US in the late 1950s, but Taiwan took over nearly the entire global market by the end of the 1980s. Now, China has outscaled, outpriced and outsmarted Taiwan, causing another migration of the semiconductor business.
In the past, the centre of gravity of the global textile business has shifted from the US and Europe to Asia, particularly China, Sri Lanka and India. And right now, China is overtaking South Africa as the world’s largest gold producer. Though the US is still the centre of the global automotive industry, Detroit, the Mecca, is losing out as large-scale manufacturing has shifted to Japan and Korea. Now, China and India are set to overtake them. Detroit’s population has halved to under 1 million since 1950 when it was the fourth largest city in the US. Today, it is not even among the 10 largest cities.
India has lessons to learn from such instances. “It is easier to do business abroad,” Tata Group Chairman Ratan Tata told BW in an interview in December. “Companies going abroad for business will hurt India’s development.”

EMIGRATION BLUES: Detroit, once the Mecca
of the automotive industry, had lost out when
manufacturing shifted to Japan and Korea

That may sound preposterous in these nascent years of India’s economic renaissance, but there is evidence to suggest that Tata’s fears aren’t unfounded. The unprecedented growth in the economy has led to a spectacular rise in the costs. Corporate India’s interest expenses have risen 28.74 per cent in the Jan-March 2008 quarter — the fastest in the past 10 quarters, according to the Centre for Monitoring Indian Economy (CMIE) (see graph ‘Rising Costs’ on page 31). The West’s average is 2-7 per cent. Profit after tax as a percentage of income was among the lowest in the past 10 quarters, indicating a squeeze on margins. Salaries and wages have risen 22.44 per cent, the second highest in the past 10 quarters, while power and fuel costs are growing at a fast clip of 14 per cent. “India’s cost-competitiveness has eroded,” says Sanjay Verma, managing director of real estate consulting firm Cushman & Wakefield India. “India will lose out if it doesn’t offer anything other than a cost advantage.”
Citi’s India Equity Strategy report of May 2008 says an analysis of the rising costs of setting up business over the past three years — asset, capital and services based — suggests ‘business inflation’ could be as high as 10-35 per cent a year, well ahead of 7-8 per cent headline inflation. “It has become expensive to live in India but probably even more expensive to do business in India,” says the report.

In particular, India must watch out for the current trend of foreign exchange outflows exceeding inflows while foreign direct investment (FDI) into China accelerates. China attracted $309 billion in FDI in 2007 and has already received $200 billion this year. The World Bank’s recent report on the “ease of doing business” has ranked India 120th out of 178 countries. High costs are affecting Indian companies’ ability to compete against companies in China and other emerging economies such as Brazil, Mexico or even Malaysia and Indonesia. When the Anil Dhirubhai Ambani Group (ADAG) company Reliance Communications wanted to expand its network by 20,000 towers quickly, it turned to China for import and installation of the towers at a much lower price. Another ADAG company, Reliance Power — which has projects of 28,200 MW in the pipeline — is buying a majority of its capital equipment from China.
The government, though, doesn’t think India must remain a low-cost destination. “We don’t want to be a low-cost destination for everything and everyone forever,” says Jayant Dasgupta, joint secretary at the Ministry of Commerce & Industry. “Cost and wages are increasing. It’s the law of economics. So be it.”

Protect Services
India’s reputation of being a low-cost nation was built around low-wage costs. That explains why human-intensive services sectors led by IT (where wage costs range from 35 per cent to 65 per cent) took off in India while manufacturing (wage costs: 7-10 per cent) floundered. But that advantage is nearly over in businesses such as financial services and R&D, and is rapidly disappearing in other areas such as IT.
Services, which accounts for 54 per cent of India’s GDP, is one frontier the country has to guard dearly. The sector has been hit by facilities and manpower expenses, which account for 65-70 per cent of costs. Several MNCs — including Nokia and Dell — have shut their captive business process outsourcing (BPO) units in India. “HR costs are growing at 15-20 per cent every year; globally, they grow at 2-5 per cent,” says Tanmay Kapoor, partner of business advisory at Ernst & Young (E&Y). In most areas of the services sector, CEOs in India are actually earning more than their counterparts in the US. The Rs 34-crore Cairn India’s CEO Rahul Dhir’s remuneration in 2007 was nearly Rs 7 crore. The median for a CEO’s salary in the US is $1.1 million (Rs 4.4 crore).
Sectors that run the maximum risk of migration are those where wage costs are disproportionately high. In the animation industry, wage costs are as high as 65 per cent, compared to 40-45 per cent in IT/ITeS. Minimum salaries for animators have gone up from Rs 5,000 per month a few years ago to Rs 16,000-20,000 per month. “We accounted for 17.5 per cent annual growth in wages; we have to re-evaluate our project costs,” says Suresh Kumar, chairman of Compact Discs India, south Asia’s largest animation company by revenues and order book.
A bigger challenge for companies is that demand-supply imbalance is raising employees’ salaries without adding to their skill sets. When London-based Axiom Estates was hiring its India staff, it analysed the wages versus skill sets of candidates in India, the UK and the US. It eventually hired the top level from the UK and the US and placed them in India. “We found that for that price, the skill level wasn’t that good in India,” explains Rajesh Goenka, chairman & CEO of Axiom Estates, which sells Indian real estate properties to buyers around the world.
Then there is the workforce inefficiency. “Labour in India is far more inefficient than labour in any developed country,” says Gaurav Taneja, partner at E&Y. A survey by Kelly Services, the world’s fourth largest recruitment company, last year said people efficiency in India (measured by financial performance against targets and deliveries) was barely 50-60 per cent against the global average of 80-90 per cent. “If you account for the cost of hiring, attrition, training and inefficiency, India will rank very high,” says Dhirendra Shantilal, Asia-pacific head of Kelly Services.

Mumbai’s Bandra-Kurla complex are one
of the highest in the world

Realty’s Reality
If wages would spare a business, exorbitant realty certainly won’t. Retail rentals in central business districts in India’s major metros are higher than those in downtown Shanghai (Rs 173 per sq. ft per month) and Manhattan, New York (Rs 160 per sq. ft per month). In Delhi’s prime business district, monthly rentals have gone up 340 per cent since March 2003 to Rs 334 per sq. ft in March 2008. A fully-furnished office space in Malaysia’s Petronas Towers is available at Rs 40 per sq. ft, while in Mumbai’s Nariman Point, the monthly rental is Rs 500 per sq ft.
Sale prices have also shot up from Rs 8,297 per sq ft to Rs 47,647 per sq. ft, according to Cushman & Wakefield. “Real estate costs are so much out of sync with global rates that it’s impossible to do business in India,” says Subbu Narayanswamy, partner at McKinsey India. This has applied the brakes on India’s ambitious retail rollout. “In purchasing power parity measure, revenues are one-third those in Manhattan,” says the executive director of a company who is seeing the rollout of a retail chain.


If the services sector is hit by high rentals, the manufacturing sector is a victim of Centre-state politics over land acquisition. Land, being a state subject, is beyond the control of the Central government. That often causes delays in setting up mega manufacturing projects such as Posco India, which has proposed a 12-million tonne steel plant in Orissa with an investment of $13 billion — the largest FDI India has ever seen. But three years since, it is yet to acquire the land. “States should try to clear the land acquisition hurdles,” says Soung-Sik Cho, managing director of Posco India. “These are hurdles in the development of the country.” Similarly, local politics over land at Singur in West Bengal threatens to derail the rollout of the world’s cheapest small car ‘Nano’ by Tata Motors.
Paul Hugentobler, the head of India operations for Holcim, the world’s second largest cement producer, has discovered that manufacturing cement in India is becoming increasingly expensive. It was possible to build a plant in India at $60 per tonne three years ago. Today, it costs $120-130 per tonne because of rising cost of land, equipment and project delays. In China, it costs $80 per tonne.
Subterranean Damage
Eventually, a host of subterranean costs such as regulatory delays, power costs and poor infrastructure contribute to a high-cost economy. India ranked 48 among 131 countries in the World Economic Forum’s Global Competitiveness Index in 2007-08, a fall from 43rd in 2006-07, behind China (34), Lithuania (38) and Latvia (45).
Take logistics and transportation infrastructure, which are estimated to raise product costs up to 25 per cent. Globally, trucks travel 1,000-1,200 km every 24 hours; in India they do barely 300-500 km. The 2,130-km Mumbai-Kolkata route takes up to eight days with 22 stopovers, each taking 30 minutes-3 hours due to lack of automation at checkpoints. “Each state in India is like another country, requiring separate declarations,” says K. Prabhakar, president & CEO of XPS, a subsidiary of Transport Corporation of India. “In Europe, a truck can go through electronically across different countries, without a barrier.”
Road infrastructure isn’t the only culprit, ports are equally inefficient and expensive. Mooring a vessel at Indian ports is nearly 50 per cent more expensive than Singapore, Dubai or Colombo. Besides, handling costs are also prohibitive. According to one of India’s largest retailers, loading a 40 ft container in the US costs $6, in India loading a 20 ft container costs $48 (Rs 2,000).
Also inadequate is power, hurting power-intensive industries such as cement, petroleum and petrochemicals. While the state supplies commercial power at Rs 6-8 per unit (power in the US costs Rs 1.50-3.50 per unit), the supply is mostly erratic, forcing companies to invest in large expensive gensets. The cost of running these gensets adds up to Rs 18 per unit.
Then there is the mother of all subterranean costs — regulatory delays. “Every delay has a value,” says Patu Keswani, managing director & CEO of Lemon Tree Hotels, which is setting up a chain of mid-range hotels in India. “The opportunity cost of delay has a financial impact.” Keswani says building a hotel in India is 45 per cent costlier than in the US. Due to procedural delays — of land acquisition, its approvals, getting the nod from the fire department, civil authorities, police, airport and pollution control — it takes him around three years to build a hotel that can be ideally built in a year. “If I take a 1:1 debt equity ratio in a Rs 200-crore project, Rs 100 crore isn’t giving returns for at least two years,” says Keswani. “That’s at least Rs 30 crore added to the project cost.”

“If companies find hotel rooms, salaries and real estate so expensive, where is the competitiveness left?” asks Emaar MGF’s Managing Director Shravan Gupta. You may argue that hospitality is a local industry and runs no risk of migration. But if a room in Colombo, Kathmandu, Dhaka or Islamabad is half the price of that in India, it may be more economical to stay there and take a flight to a major Indian city.
Lastly, high tax regulations and structures and the cost of their compliance also raise the overall cost of business. Corporate tax rate in India, for instance, is among the highest in the world (see table ‘Taxing Hurdles’). One of the biggest criticisms of the Sarbanes Oxley Act in the US is that it has raised the cost of compliance manifold. HSBC has declared that its compliance costs in India are 10 per cent of its overall cost. Companies are required to maintain wage registers and leave registers, with revenue stamp, even though ERP systems these days cater to all this electronically. “Global companies don’t understand this in an era of electronic funds transfer,” says IT services firm Quattro’s Vice-President S. Varadarajan.

Stringent regulations impact companies in a myriad other ways. Take shipping. More than half the new cargo ships being bought by Indian firms are being flagged (registered) outside India. This is to sidestep two things — cumbersome tax laws and a mandatory clause that Indian flag vessels must have an Indian crew.
Paul Hugentobler, Holcim’s member of executive committee and head of Indian and south Asian operations, says, “the government of India is building an expensive country. The effort should be to build it cheaper.” India must realise that a high-cost economy is unsustainable.

Many elements such as wage costs are purely due to demand-supply imbalances and, as Dasgupta says, driven by the laws of economics, but companies can still take remedial measures like either controlling their wage costs or moving to higher value-added businesses. But the government can certainly take measures that are within its control — like removing regulatory hurdles in land acquisition and setting up of power projects — and streamlining the tax rates. At least, then, India could avoid creating ghost towns in the near future.
With inputs from Noemie Bisserbe
(Businessworld Issue 15-21 July 2008)

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