Nitin Pai: Indian firms shy away from R&D spend, risks. That needs to change

He echoes what Naushad Forbes has argued for a long time: that India’s top companies underinvest in R&D. At a mere 0.3% of GDP, private spending on R&D is a fifth of the world average. India’s ten most profitable firms invest a mere 2% of their profit in research, compared to 29-55% invested by their counterparts in the US, China, Japan and Germany. Alphabet, BMW and Huawei individually invest more in R&D than India’s entire private sector does.

Two questions follow: Why is this the case and what can be done about it? Of the many causes, I want to focus on two that I think are most important.

The easier one first: Indian firms are sheltered from competition and have few incentives to innovate. Why invest in R&D when you can sell the same stuff to millions of new customers emerging across the vast country every year? Why venture into something risky—be it R&D or a foreign market—when there are returns to be had by serving the growing domestic market? Substantial parts of the domestic economy remain walled off with FDI restrictions and import tariffs.

By 2010, we had empirical evidence that trade liberalization after the 1991 reforms had boosted firm productivity and R&D expenditure in India. The effect was not limited to competition. Cheaper imports allowed Indian firms to access inputs, technologies and processes that enabled innovation.

Pinelopi Goldberg, Amit Khandelwal and colleagues found that “lower input tariffs account on average for 31 percent of the new products introduced by domestic firms" and that input tariff liberalization “relax(ed) technological constraints through firms’ access to new imported inputs." In another study, Khandelwal and Petia Topaleva found that when trade and FDI rules were liberalized together, firm productivity went up four times compared to just lowering import tariffs.

If Chinese firms have become R&D powerhouses in the past two decades, it is because they face stiff competition in both domestic and foreign markets. Indian firms are relatively protected. We have always given ourselves good reasons for this: from central planning, socialism and economic nationalism to geopolitics and economic statecraft. Well, if we believe that these are higher priorities, we should stop accusing Indian capital of under-investing in R&D. If necessity is the mother of invention, protectionism is its contraceptive.

It follows then that relaxation of trade and investment barriers are leverage points to galvanize Indian capital into greater competitiveness and innovation. That is why the Narendra Modi government should take advantage of the US tariff rampage to stir competition and shake up fat cats.

Promoting competition will certainly move the needle, but I suspect that even so, India will underinvest in R&D due to a deeper problem: inadequate social capital. India is hyper-diverse, a large population of small caste-communities that have strong in-group bonds but weak inter-group ones.

Capital often stays within communities, but talent, opportunities and risk appetite do not. A dispassionate analysis of why India did not industrialize in the 19th century leads us to conclude that, unlike in Meiji-era Japan, we had few financial institutions that could aggregate surpluses from communities to channel into entrepreneurship in sufficient quantities.

Global evidence shows that for entrepreneurs and R&D labs to be adequately funded, you need generalized social trust. Yijun Meng and her co-authors studied over 14,000 firms in 72 countries from 1992 to 2016 and found that “higher level of societal trust creates a higher R&D expenditure." Indeed, R&D might be the sharpest test of social trust, for it requires large sums of money to be invested in ventures with long gestation periods, high failure rates and uncertain returns.

I have written about how democratic politics in India sharpens social differences, damages civic community and reduces social trust. Whatever the utility of a caste census, it will strengthen bonds within caste groups and rivalry among them. Votaries of this path to social justice have perhaps not contended with its economic and strategic costs. Indian firms can be blamed for being unwilling to train their workforce (and thus cover failures of the education system), but we should ask ourselves how much of this can happen if public policy and attitudes continue to accentuate caste and linguistic identities.

It is true that economic policy can change behaviour to some extent. Competition under a fair and neutral umpire will create greater incentives for innovation. Nonetheless, Indian capital is cut from the same cloth as the rest of Indian society. Expecting it to vibe to a different tune is unreasonable. Mehta concludes that Indian capital perhaps gets the government it deserves. We might as well say that Indian society gets the capital it deserves.

The author is co-founder and director of The Takshashila Institution, an independent centre for research and education in public policy.