India's key to earnings growth

Let me try, in this piece, to revive the debate on the impact of industrial growth on employment. A couple of years back, when the manufacturing sector started looking up, many of us had argued that this would be a phase of "jobless recovery".

This was quite evident from company balance sheets- although their top line was improving, their wage costs continued to drop. Domestic companies were rising to the challenge of globalisation by becoming leaner.

Indian firms, across the board, were using voluntary retirement schemes to lighten their payrolls. In short, the up-tick in the manufacturing cycle was not manifesting in improved labour market conditions.

This observation was confined to the organised sector. The unorganised sector is notoriously difficult to gauge since data are sparse and sporadic. Some analysts chose to interpret this disconnect between labour demand and organised sector growth as the failure of reform-unbridled private sector activity meant that the "social commitment" of industry had been jettisoned. The less doctrinaire saw this malaise as a symptom of the failure to reform.

Draconian labour laws incentivised capital-intensive, labour-shedding investments. Indian manufacturing was reviving but in defiance of the economy's comparative advantage, its abundance of labour.

However, evidence on the ground suggests that this somewhat perverse inverse relationship between employment and industrial growth is breaking down. My data are a sample of 650 companies that is used to construct a Purchase Manager's Index (the ABN-AMRO purchase manager's index) that my bank sponsors.

Of the various questions that are put to the sample of companies that are surveyed, there is one on whether their employment levels have risen over the previous month. For the last fourteen months or so, the index has been posting values of over around 52. The index is constructed in such a manner that a value over 50 suggests an overall increase in the variable, in this case employment.

The greater the deviation from the level of 50, the greater is the improvement or deterioration in the variable. A persistent reading of 52 suggests that there is slow but steady increase in labour demand. The phase of large-scale labour-shedding seems to be over.

Let me quickly address possible concerns about the nature of the quality of data. The objective of computing the index is to gauge key trends in the manufacturing sector, ranging from their output, prices, to inventory positions. The agency that computes this for us, NTC Economics of London, assures us that they have taken great pains to ensure that it is broad-based and representative.

They have also ensured that it is robust in the sense that it closely tracks more "established" variables like GDP and the index of industrial production. The sample of companies is incidentally surveyed every month.

Thus, if there are no serious reservations about the credibility of the index, the employment information that comes with it is indeed encouraging. It appears that Indian companies have sweated their assets to a maximum and if they are to grow they have to put more capacity in place and more workers to utilise the capacity.

Indian companies seem confident of their business environment in the future and are willing to ramp up operations. The success of schemes like the VRS has also given them the confidence that if it comes to a crunch, they can streamline the work-force yet again.

There are some interesting nuances that the PMI reveals, which could have implications. Recent readings suggest that the backlog of work for a significant proportion of firms has increased, which could induce a more rapid hiring of workers.

What does this mean for the larger economy? If I were an economist sitting in the US or Europe, I would have been concerned about wage inflation and its pass-through to overall inflation. I wouldn't worry that much about wage spirals in India simply because there is a lot of slack in the labour market for manufacturing workers. That's likely to keep a lid on wages.

If indeed manufacturing employment continues to trend up, there could be a virtuous cycle with more incomes in the worker's hands, greater demand for products and a further fillip to the manufacturing sector. In fact, if the manufacturing sector is indeed hiring more, it is likely to create a broader demand base and actually help sustain the momentum of growth.

A company analyst could have some cause for concern. Capital investments tend to depress the return on capital, and from that perspective, corporate profitability could take a bit of a hit. If additionally, companies are taking on more workers, it would bloat their wage bills and erode operating margins. On both counts, there could be a dip in profitability.

Profit growth would depend on whether the growth in sales (volumes) offsets this dip. If I were to make a simplistic generalisation, I would say that the phase of profit growth for companies driven by pure productivity gains (and windfall like a decline in interest rates) is coming to an end. The key to earnings growth going forward for corporate India now lies in its ability to ramp up sales and improve pricing power.

I am, by no means, making a claim that the overhaul of labour regulations does not deserve top priority on our policy agenda. Even if I were to go by my limited sample, the rate of employment creation is, at best, sedate.

If this is to accelerate, companies (particularly those setting up new projects) need a strong incentive to actually exploit India's labour advantage. I sincerely hope that the move to relax labour laws in the new special economic zones or the tentative plans of allowing contract work in select industries are not jettisoned due to political imperatives.

The author is chief economist, ABN AMRO. The views here are personal.