India's supply chain vulnerability with Chinese APIs: Industrial policy vs. sophisticated policy design

by Gautam Bambawale, Vijay Kelkar, Raghunath Mashelkar, Ganesh Natarajan, Ajit Ranade, Ajay Shah.

India has a remarkable drugs industry. This involves a high dependence upon Chinese manufacturers of `active pharmaceutical ingredients' (APIs). Given the willingness of the Chinese state to behave in unusual ways in economic engagement (e.g. rare earths), there is a certain supply chain risk that is faced by Indian firms.

Should state power be used in addressing this problem? And if so, how should this be done? How do we avoid the long decades of failure in industrial policy, i.e. the experiments with policy pathways where a government picks winners, with a government that claims to know the correct ways in which production should be organised? Today we saw a fascinating article: Drugmakers cry ‘monopoly’ as Modi govt picks 1 firm each to make over 20 key raw materials by Himani Chandna in The Print. This narrates the story of a 1960s style Indian industrial policy intervention played out poorly.

Our book Checkmate China: Winning through strategic patience and accelerated economic growth is forthcoming from Rupa Publications later this year. A paper based on this book has been released in the public domain and summarises our strategic thinking for India about the China question. In the book, we have a treatment of the API question. This text is excerpted ahead. It represents our attempt at learning from 75 years of failure with industrial policy. This approach would have likely avoided the difficulties described in Himani Chandna's article.

Book excerpt: Designing a government intervention to address the supply chain risk faced by Indian firms that import APIs from China

The Indian drugs industry is a heavy user of Active Pharmaceutical Ingredients (APIs) sourced from China. In an environment where we see China as a bad actor in the global economy, where Chinese nationalism can harm counterparties abroad, this presents a risk to the supply chain. It is easy to design Indian economic nationalism which can combat this. However, as with all aspects of industrial policy, such use of state power raises many concerns. It is difficult for a government agency to know whether a certain industry merits subsidies and whether certain firms merit subsidies. There is a long history, in India, of “infant industry” arguments being used for decades, in which some well-connected Indian firms stay infants and continuously collect fiscal subsidies. Similarly, trade barriers in the form of quantity restrictions are prohibited under the WTO and tariffs are harmful and should best be avoided.

Thus, we face a puzzle: How can state intervention be designed, which can make a difference to India’s China problem with the supply of APIs? Given the failures of industrial policy as it was practiced in previous decades, how can this one sharp problem (supply chain risk faced by Indian pharma companies who rely on Chinese producers of APIs) be addressed by state action? How can this state action be done at the minimum fiscal cost, and while imposing the minimum distortions upon the economy? How can the risk of central planning – of officials determining the outcomes of the market-based competitive process – be avoided?

When faced with supply chain risk with a certain API from China, we should not jump to the conclusion that the answer lies in making the API in India. Perhaps the efficient solution is to import the API from a country other than China. Perhaps the efficient solution is to make it in India. Policy makers cannot assume that India has competitive advantage in making the API, when private persons have thus far chosen to not build such factories in India.

The first step in every policy analysis must be a thorough understanding of the behaviour of the private sector assuming there is zero state intervention. When faced with this new supply chain risk, what are Indian drug companies likely to do out of self interest:

1. Customers of these bulk drugs would be conscious about the business risk that they carry. They would watch the rise of nationalism in China with concern.
2. They would increasingly seek to diversify their sourcing. As an example, we are seeing Fortune 500 companies increasingly reduce the share of China in their global production.
3. One important response by the firms will be to buy APIs from countries other than China, e.g. Taiwan or Japan or Brazil. This is perfectly adequate solution, from the viewpoint of an Indian firm, to the threat of Chinese nationalism. Our problems with Chinese nationalism only imply that we should diversify away from China; this does not justify self-reliance.
4. One element of the process of looking for non-China sourcing is higher demand for firms in India that make APIs, which would kick off a supply response. Ordinarily, this market process will work itself out. But it is a difficult and slow journey. A government program can be designed that addresses this problem, which has a few key features: (a) We do not assume that in the long run India will be a successful producer of APIs, but we consider this possible; (b) The intervention is pre-announced and in a few years, liquidates itself; (c) The intervention imposes zero trade barriers upon imports or exports of APIs or drugs with respect to any country.

This proposed intervention would involve the following steps:

• A government agency would identify the top 50 APIs and the quantities $q = (q1, q2, .. q50)$ which are being imported from China.
• We establish the objective of domestic production that comes up to half of the imports from China over a five year period. This suggests escalation of quantities as: $0.1q, 0.2q, 0.3q, 0.4q, 0.5q$ over a period of five years.
• We put out a binding commitment on the part of the state that the government will run procurement restricted to domestic producers only, where there will be purchases over the next five years of these quantities. The government will commit to placing orders with 3 lowest-cost firms that produce in India, in each year’s bidding. The requirement from a bidder should be that production is done in India. Foreign or Indian firms should be permissible, subject to a restriction against firms controlled by the Chinese state e.g. bar a firm where any one member of the board of directors is an employee of the Chinese state or the CCP.
• These commitments about a rising scale of GOI procurement will create incentives for Indian/foreign firms, located in India, to build knowledge and physical capacity to produce APIs at a large scale.
• The government agency has only one objective: to trigger off economies of scale and competition by producers in India. Once the goods are purchased by the Indian government agency, what is it to do with them? Indian firms might not like to buy these APIs at the purchase price, as the purchase price may well be higher than the world price of these APIs. Once the goods are purchased, this agency would run a global auction to sell the same goods off, at the highest possible price. Indian drug companies could potentially choose to buy these goods, but these purchases would be at an import-parity-pricing price. As a consequence, through this program, the Indian government would be drop shipping the goods, purchased in the make-in-India auction to buyers who came into the sell-from-India auction.

This scheme constitutes a promise to buy from Indian firms, at rising quantities over five years, at the lowest prices that Indian firms are able to muster (3 firms for each product in each year). At first, the price in India will be high. Under this proposal, GOI will instantly turn around and sell off the goods at the highest possible price through a global tender. The gap between the two prices will be the fiscal subsidy that is being put down, to spark off API production in India.

At the end of five years, the domestic firms would be on their own. If the theory of change is correct – that there is a fixed cost of building knowledge and facilities to make APIs – then this is the minimum intervention that gets the job done. If the theory of change is incorrect – that India is not actually a good platform for making APIs – then in five years, this fiscal outgo would end, and India would not be a producer of APIs.

There are many strengths of this design:

1. Private persons face no new coercion, other than the coercion implicit in mobilising tax resources which are the source of government spending on this program.
2. There is no tariff; there is no interference in international trade. This program is layered on top of a free trade system.
3. It is a simple and transparent intervention. What it requires is the bureaucratic capability in the Indian state to do procurement: to run these auctions, to buy APIs in India, and to sell the same goods globally, doing high volumes of non-complex commodities. Indian officials are not asked to form a judgement about what APIs are important, about whether an API can efficiently be made in India, about the technology through which an API can be made, about whether public money should be used to build factories to make APIs.
4. There is a lack of fudge factors where there can be lobbying and negotiations.
5. No central planner should ever assume s/he knows the way forward. This design respects the possibility that India might actually have no place in API production. In this case, at the end of this program, there will be no API manufacturing in India. The program would have wasted taxpayer resources, but it would not distort the economy.

However, there are four main difficulties of this design:

1. For the desired impact upon incentives of private firms who should commit themselves to investing in building large scale API production, the private sector would have to believe that the deeds of the government will match the words of the government over the coming five years. If private persons feel that the Indian state cannot be trusted to stay the course for five years, then the incentive impact of the government program would not materialise.
2. The private sector has to feel safe engaging with government procurement; it has to believe that the procurement will be done correctly, that payments will be made on time, that there will be no investigations by agencies.
3. If this works, at the end of five years, Indian API vendors will lobby to not shut this down. Every policy designed to support an infant industry ends up with entrenched infants who like to wield state power in their favour.
4. While the objective of the program should be to foster Indian or foreign firms who choose to produce in India, there is the possibility that this could be skewed to favour Indian firms.