By Sarah Watson —

India’s Department of Heavy Industry (DHI) on October 23 released a draft National Capital Goods Policy (NCGP), the first step in India’s attempt to revitalize its moribund capital goods manufacturing industry. The policy has a worthy goal: to arrest the decline in this critical sector. But many of the policy’s recommendations are backward-looking, and its overall approach to stimulating the capital goods industry shows the continued grip of protectionism on Indian economic thinking. Similar policies by the previous, Congress-led government triggered a strong anti-India backlash among U.S. and European companies. Those same companies hoped that Modi’s administration would offer a new approach.

The policy seems designed to remove high-quality foreign-made capital goods from the market, yet does not take any steps to ensure that adequate domestic alternatives are available. If the report’s suggestions are adopted, it will have wide-ranging repercussions for national priorities like India’s defense modernization drive and the ‘Make in India’ initiative.

The report contained some arresting statistics about the state of the industry: overall production in this sector grew at an average rate of .3 percent over the past three years, while market size has actually shrunk by 4.1 percent. These figures mask even more dire news: production of heavy electrical equipment—with a market size of $23 billion, by far the largest area of the sector—shrunk by over 7 percent over the last three years.

The NCGP identifies a number of factors driving this downward trend. Perhaps the most important is the inability of Indian manufacturers to compete on quality and cost with imports. The report paints an unsparing portrait of an industry that lacks critical technology, struggles with a shortage of skilled workers, and is unable to produce to the standard that customers demand (whether in India or abroad). The problem is exacerbated by the persistence of inverse tariff structures, in which the finished good bears no tariff but its components do—making it cheaper to import the finished product than to buy the basic components and make it in India. The result is a vicious cycle in which Indian manufacturers of capital goods, unable to find a steady market for their product, are unable or unwilling to invest in improving the quality of their product or in technology that would make it cheaper to produce.

The NCGP offers many sensible suggestions for actions the Indian government can take long-term to help improve the quality and competitiveness of its manufacturers: investing in education to produce skilled engineers; increasing the share of gross domestic product spent on research and development; and rationalizing India’s taxation structure to ensure that internal taxes on capital goods are less than or equal to import tariffs.

The bulk of the policy draft, however, is aimed at dissuading (or preventing) Indian private- and public-sector customers from purchasing imported rather than domestic capital goods. The policy leans heavily on procurement regulations, tariff increases, and deliberately stifling regulations (used capital goods can only enter India through one of two ports). Government procurement will be subject to a host of new regulations: foreign contractors will be required to obtain “local certification” and meet “specifically Indian standards”; in the case of a tie between hopefuls, the intensity of a bidder’s ties to India will be the deciding factor.

Furthermore, the policy almost ensures that the quality and variety of domestic goods will remain low by nearly ignoring the high factor costs and other obstacles that make it difficult to carry out high-tech manufacturing in India. While its suggestions for blocking imports are immediate, its suggestions for improving the quality of domestic manufactures could take years to carry out.

The policy could have wide-reaching implications for India’s future course on trade. It suggests that India should revise free trade agreements (FTAs) with nations that manufacture competitive capital goods in order to prevent the export of such goods to India. The draft recommends that India focus its future FTA negotiations on countries that would be interested in Indian-made capital goods—particularly in Africa and Latin America—rather than countries whose exports could add to the stress on Indian manufacturers. If followed, this guidance would counsel India to walk away from ongoing negotiations for FTAs with the EU, Canada, and Australia.

If the draft policy is accepted (the comment period closed on October 31 and the cabinet has not made any statements as to its future), it will place serious obstacles in the way of some of Prime Minister Modi’s highest profile initiatives, including the Make in India program itself. Unless India’s capital goods manufacturers can quickly improve quality while lowering prices, foreign companies considering starting a factory in India will have to factor the increased cost and difficulty of obtaining high quality machinery into their calculations.

The policy could also have a particularly negative impact on defense production, where cutting-edge technology is key and there is little margin for error. A capital goods policy that makes it difficult for the world’s best defense contractors to bring production to India will make it even more difficult for India to indigenize defense production while concurrently modernizing its armed forces. At the same time that India is removing barriers to entry in the defense sector by lifting foreign direct investment caps, its emphasis on import substitution could create new obstacles.

Ms. Sarah Watson is an associate fellow with the Wadhwani Chair in U.S.-India Policy Studies at CSIS.