Big drop in industrial production

The information on the Quantum Index of Manufacturing (QIM) for the month of August 2019 has just been released by the Pakistan Bureau of Statistics. This has raised alarm bells. There has been a sizeable drop in production by the large-scale manufacturing sector of 7 percent in August. Cumulatively, over the first two months of the current year the fall is 6 percent.

The represents a process of continuing and increasing decline since June 2018. During the first quarter of 2018-19, the overall level of production remained, more or less, constant. The next quarter saw a fall of 3 percent followed by the drop of 4.5 percent in the next two quarters. Now, already in the first two months of the first quarter of 2019-20 we have seen an even bigger decline of 6 percent. Clearly, the industrial sector is losing more and more of its momentum with the passage of time. A stage has now been reached when we have the makings of a serious industrial crisis in the country.

The fall in industrial production is not only deep but also very widespread. Out of the 15 industry groups, 11 have experienced negative growth in August, leading to an overall decline in output by the sector of 7 percent. These eleven industrial groups have a combined weight of 93 percent in the QIM.

The industry which has been hit most severely is automobiles. It has a weight of almost 5 percent in the index. Sales had been buoyant in previous years and there was the prospect of entry of new firms. Also, the return on equity had been exceptionally high. The downturn has been caused by a crash in sales due to the big jump in prices and a consequential drop in production. The output of cars is down by 32 percent, of trucks by 59 percent and of motor cycles by over 20 percent. Apparently, the number of shifts operated has been reduced drastically.

The other big industries which have shown large declines of above 10 percent in output are food, beverages and tobacco, coke and petroleum products, pharmaceuticals and iron and steel products. Somewhat smaller falls in production have been experienced by industries like chemicals, cement, leather products and paper and board.

The output of the largest sector, textiles, with a weight of 21 percent has remained, more or less, unchanged. Only three industries, viz., fertilizer, electronics and engineering products have shown big increases in output ranging from 16 percent in fertilizer to 38 percent in electronics.

Two fundamental questions need to be asked. Why has such a precipitate decline occurred in the sector when one of the major constraints to higher production in the form of power loadshedding has largely been removed? If this slump in manufacturing persists what is the likely impact on the economy as a whole in terms of GDP growth, employment and tax revenues?

There are two common factors which have hit most industries and some special factors that have affected particular industries. The first major factor which has hit all industries is the quantum jump in electricity and gas tariffs. These have gone up significantly by 16 percent and 30 percent respectively. Second, there has been a big hike in interest rates which has raised the cost of working capital and hit the liquidity position of firms. It has also reduced the demand for consumer credit. Third, there has been an escalation in tax rates in the Federal Budget of 2019-20 which has hit a number of industries like textiles, vegetable ghee, sugar, automobiles, etc.

The large rupee devaluation ought to have had an ambiguous impact. On the negative side it has led to a big increase in the cost of imported inputs and put pressure on prices. However, on the positive side it should have provided a boost to both export-oriented and import substituting industries.

Unfortunately, the two major exporting industries of textiles and leather products have shown no increase in production. In the former industry, exports during July and August rose by 2 percent in quantitative terms in the case of cotton yarn but fell by 9 percent in the case of cotton cloth. Exports of leather products showed big increases, with the export of leather garments rising by 32 percent; leather gloves by 18 percent and footwear by almost 40 percent. However, this has been largely neutralized by a big drop in domestic sales.

Import-substituting industries ought to have benefited from the devaluation. Instead, production of iron and steel is down by 17 percent, of petroleum products by 18 percent, of pharmaceuticals by 14 percent, of chemicals by 8 percent and of paper and board by 4 percent. Clearly, cost push factors have deprived these industries of the competitive edge.

However, three import substituting industries have shown visible progress with quantum increases in output. These include fertilizers with increased output of 16 percent, electronics with a rise of 38 percent and engineering products of 23 percent. The fertilizer industry has been facilitated by increased access and lower cost of LNG.

We turn next to the broader consequences of the slump in industrial output. The large-scale manufacturing sector has strong backward and forward linkages with the respect of the economy. The small-scale manufacturing sector provides inputs to its large-scale counterpart. This is evident, for example, in the production of auto parts for the automobile industry. There are also strong forward linkages with large sectors like wholesale and retail trade and transport and communications.

Based on an input-output analysis, if the fall in large-scale manufacturing were to persist at 6 percent, then the overall indirect impact on the GDP growth rate is estimated at 0.8 percent. This is on top of the direct impact of approximately 0.5 percent. Consequently, the growth rate of the economy could be reduced by almost 1.3 percent. This will make the realization of even the modest GDP growth rate target in 2019-20 of 2.4 percent more difficult.

Turning to the impact on employment, this could also be sizeable. The large-scale manufacturing sector currently employs almost 4 million workers. A proportionate impact with respect to the fall in output could reduce employment in the sector by almost 240,000. The impact on other sectors could be over 220,000. Consequently, a persistent fall of 6 percent in industrial output could be accompanied by a fall in employment of almost half a million. The retrenchment of workers would reduce demand for consumer goods and thereby affect industrial production. In effect, the economy could be in a vicious cycle.

Then there is the negative impact on tax revenues. A first estimate is that the large-scale manufacturing sector contributes almost 70 percent to Federal tax revenues. If the tax base falls in real terms by 6 percent and the inflation in ex-factory prices is 12 percent, as is the case currently, then the increase in the nominal tax base will be only 6 percent. It may be smaller because two industries, namely, petroleum refining and automobiles, which contribute disproportionately to tax revenues have been very badly hit.

Altogether, there is the early warning of an industrial crisis and of adverse trends in the economy as a whole. There is no other option but to soften the impact of adverse measures as soon as some policy space becomes available. This will include a return to lower interest rates; rationalization of the tax system and more favored treatment of the export-oriented industries in the country. Otherwise, there is the prospect of a further plummeting of the GDP growth rate, rise in unemployment and a big shortfall in tax revenues.

(The writer is Professor Emeritus at BNU and former Federal Minister)